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Geithner and Greenspan do Standup

Posted on March 22, 2010 | 1 comment

My friends have to put up with my complaints that Brits think Americans are incapable of irony when, in reality, we are world class. Further proof of our preeminence in the irony department comes in the last five days from Geithner and Greenspan. The G2 are locked in a competition for droll humor. Today, in prepared remarks – he didn’t make some impromptu slip – he told Americans that when it comes to financial regulatory reform:

Listen less to those whose judgments brought us this crisis. Listen less to those who told us all they were the masters of noble financial innovation and sophisticated risk management.

Because I took his advice to heart I stopped reading his prepared remarks at that point and cannot report to you on the remainder of the regulatory advice given by an exemplar of “those whose judgments brought us this crisis.” The gentle reader will recall that Geithner testified to Congress that he had never been a regulator. True, but you’re not supposed to admit it. Your job statement required you to be a regulator and protect the public. Geithner’s advice means that we should all stop listening to Rubin, Summers, Greenspan, Bernanke, Gramm, Dodd, Patrick Parkinson (the Fed’s anti-supervisor), Dugan (OCC), Bowman (OTS), and Mary Shapiro (SEC). Thank you Mr. Geithner! Your advice is incredibly liberating.

Moreover, the Geithner corollary is that we should listen more to those that warned that war on regulation was producing an epidemic of fraud, a massive bubble, and an economic crisis. I trust that similar calls will be coming any minute to Ed Gray, Mike Patriarca, and our colleagues that led the successful reregulation of the S&L industry and prevented the S&L debacle from causing a recession (much less a Great Recession). Geithner’s novel idea that we should take our regulatory advice from regulators with a track record of success, courage, and integrity hasn’t been tried in over a decade.

Greenspan’s entry into the irony sweepstakes was a paper entitled “The Crisis” in which he purported to give advice about financial regulation. Seriously! The man that Charles Keating, the most infamous S&L fraud, used as a lobbyist to troll the Senate office buildings to recruit the infamous “Keating Five,” who wrote that Keating’s Lincoln Savings posed “no foreseeable risk of loss” (it turned to be the most expensive failure), and who praised the types of investments that Lincoln Savings’ (unlawfully) made that caused its catastrophic failure – all this before he became Fed Chairman – went on to become the leading anti-regulator that ignored copious warnings of the bubble and the “epidemic” of mortgage fraud to produce the environment that caused the Great Recession. Greenspan giving advice on regulation is standup at its finest.

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Neoliberal Deficit Hysteria Strikes Again

Posted on March 22, 2010 | 8 comments

ADVICE TO PRESIDENT OBAMA AND PRIME MINISTER BROWN: Tell the IMF, the European Commission, and the Ratings Agencies to Take a Hike

By L. Randall Wray and Yeva Nersisyan

In recent days, articles in Der Speigel, the NYTimes, and the AP have all highlighted Neoliberal commentary warning of the dangers of growing budget deficits in the wealthiest nations—specifically in the US and the UK.

Marco Evers, writing in Der Speigel helpfully argues that the UK’s deficit to GDP ratio (at 12.9%) is actually larger than the ratio of Greece (12.2%), which is already in crisis. According to the AP report, the European Commission has somberly warned London to tighten its budget–to bring its deficit down to 3% of GDP by 2014-15 as promised–through higher fees and taxes, as well as cuts that “will be more drastic than those under (former Prime Minister) Margaret Thatcher”, according to economist Carl Emmerson. It should be remembered that Thatcher oversaw the downsizing of the UK economy, moving it to second-rate status so far as economies go. (In 1980 the UK’s per capita income was 79% of that of the US; by 1985 it had fallen below half. It is now the third largest economy in Europe, and sixth in the world—but it ranks 21st on the Human Development Index.) Apparently the EC would like to see the UK reduced to a third-rate economy—perhaps as punishment for dealing with the global financial crisis in more reasonable manner than the EC has. According to PricewaterhouseCoopers’s calculations, to cut the budget deficit in half by 2014, spending in most areas will have to be cut by 10% per year beginning next year. The EU warns that these cuts will have to be made even in an economic climate that could be “distinctly less favorable” than the UK is now assuming. In other words, fiscal tightening should be undertaken even without economic recovery. That ought to bring the profligate Brits to their knees!

Not to be outdone, the IMF’s John Lipsky (deputy managing director) “offered a grim prognosis for the world’s wealthiest nations, which are at a level of indebtedness not seen since the aftermath of World War II.” Even if fiscal stimulus is ended, he warned, debt ratios on average will rise to 110% by 2014. “Maintaining public debt at postcrisis levels could reduce potential growth in advanced economies by as much as half a percentage point annually.” And to reduce debt ratios appreciably will require an 8 percentage point swing, from structural deficits of 4% of GDP to surpluses of 4% annually by 2010. Note that in the case of the US, this would be equivalent to a reduction of national income by more than a trillion dollars. In other words, the Neoliberal doctors at the IMF recommend lots of pain.

Finally, Moody’s warned that the US and UK have moved closer to credit downgrades, negatively impacting their ability to borrow at favorable interest rates. Presumably, they can look to Greece and Portugal for lessons on the folly of ignoring the warnings of Neoliberal credit raters. Moody’s also warned that these nations cannot rely on growth alone to work their way out of debt. They will “require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.” Moody’s repeated the assertion that the UK is relying on overly rosy economic forecasts—tax receipts will be lower than anticipated, hence the pain that Brown must inflict on his economy is higher—presumably high enough to provoke the kind of civil unrest we now see in Greece.

It is very hard to avoid the conclusion that the Neoliberals at the EU (which seems to act on these matters as a front for the Bundesbank), the IMF, and the ratings agencies are trying to do to the UK and US what they already did to Greece. A real conspiracy theorist might even wonder whether they are trying to succeed where the Third Reich could not—destruction of the US and UK economies in a bid to annihilate the nations themselves. Obviously, that is not a view we suggest. But if one were to adopt it, it could be noted that Neoliberals in Germany have been picking off its neighbors one-by-one, first Greece, then Portugal and Spain, then on to Italy and finally France. (here) These Neoliberals use a combination of mercantilism—trade surpluses that suck demand and jobs out of its fellow EU nations—and then “market discipline” that punishes any nation that tries to fill resulting demand gaps with government spending. (here) However, a more charitable interpretation is that it is the Teutonic Calvinism that guides EU prognostication on government deficits: today’s “excesses” must surely impose a tradeoff in the form of tomorrow’s costs. But when the EC begins to criticize UK and US policy, that is certainly a step that goes too far—even if it is simply due to muddled thought rather than to a nefarious agenda.

The ratings agencies are another matter altogether. These blessed every kind of Wall Street excess with triple A ratings. They never saw a NINJA loan they did not love. Yet, they are engaged in an ugly form of deficit terrorism, attacking one country after another, downgrading debt, raising interest rates and causing budget deficits to rise, which then pushes up credit default swap prices and triggers further downgrades. Ratings agencies serve no public purpose. They are thoroughly incompetent, and probably irredeemably fraudulent. They should be shut down, investigated, and prosecuted.

President Obama and PM Brown should “just say no” to the attempted intervention by these fundamentally misguided deficit hawks into their economic and political affairs. Not only would fiscal tightening now or even within the next several years be a monumental mistake, the notion that continued deficits threaten our economies is unsound. In the remainder of this piece we will briefly explain why. What these Neoliberals do not understand is that the UK and US operate with sovereign currencies—that is both of these nations issue their own non-convertible (floating exchange rate) currencies. For this reason the comparison with any nation that uses the Euro (such as Greece), or with a nation that pegs to precious metals or foreign currencies is invalid. In other words, there is no question of solvency or sustainability of deficits for the US and UK. Sovereign debt of these nations never carries default risk and hence cannot be rated below triple A.

Further, budget deficits are largely endogenously determined by economic performance, so that even if the US and UK adopted the Neoliberal recommendations, the budgetary outcome is not discretionary—indeed, tight fiscal policy would probably increase budget deficits by killing nascent economic recovery. Again, this would not raise any questions about solvency, but it certainly would impose unnecessary pain and sacrifice on the populations of the countries. Since we find it very difficult to believe that the ratings agencies, the IMF and the EU do not understand this, it is equally hard to avoid the conclusion that their policy recommendations are designed to subvert the economies of the US and UK. To what end we can only wonder.

Mr. Lipsky is certainly not alone in arguing that high debt levels will be detrimental for economic growth. A new and influential study by Kenneth Rogoff and Carmen Reinhart, heavily publicized by the media, purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically—by at least one percentage point. But the findings reported in Rogoff and Reinhart cannot be applied to the situation of the US or to the case of many other nations today—those that are not pegging their currency to gold or any other currency. Indeed, the Rogoff and Reinhart study is fatally flawed precisely because it does not recognize the difference between sovereign debt—debt of a national government that issues its own nonconvertible currency—and private debt or the debt issued by nonsovereign government that pegs its currency to precious metal or foreign currency (or Euro nations that adopt the euro).

Governments across the world have inflicted so many self-imposed constraints on public spending that the relatively simple operational realities behind public spending have been obscured. Most people tend to think that a balanced budget, be it for a household or a government, is a good thing, failing to make a distinction between a currency issuer and a currency user. Indeed, one of the most common analogies used by politicians and the media is the claim that a government is like a household: the household cannot continue to spend more than its income, so neither can the government. See here for more on the differences between a household and a government. Yet that comparison is completely fallacious. Most importantly, households do not have the power to levy taxes, and to give a name to—and issue–the currency that those taxes are paid in. Rather, households are users of the currency issued by the sovereign government. Here the same distinction applies to firms, which are also users of the currency.

Operationally the sovereign government spends by crediting bank deposits (and simultaneously crediting the reserves of those banks) at its own central bank, in the case of the US, the Federal Reserve Bank. No household (or firm) is able to spend by crediting bank deposits and reserves, or by issuing currency. Households and firms can spend by going into debt if some entity will lend to them, which is something the national, sovereign government in no case requires when using its own currency. Unlike private debtors it can always make payments, including debt service payments, simply by changing numbers on its own spread sheet at its own central bank. This is a key to understanding why perpetual budget deficits are “sustainable” in the conventional sense of that term because government can always make any payments it desires on a timely basis.

A government that issues its currency that is not backed by any metal or pegged to another currency is not constrained in its ability to spend by the possibility that holders of dollars might ‘cash them in’ for gold, for example, as is the case with a gold standard. With a non-convertible sovereign currency, a government doesn’t need tax and bond revenues to protect its gold reserves—because it does not use gold reserves! While all governments today spend by crediting bank accounts and tax by debiting bank accounts, with convertible currencies budget deficits risk the loss of reserves, while with non-convertible sovereign currencies there is no such risk.

If we take the US as an example, its budget deficits add to the total of the outstanding stock of outstanding US Treasury securities, bank balances in their reserve accounts at the Federal Reserve Bank, and/or cash in circulation, together on a dollar for dollar basis. Treasury Securities are functionally nothing more than ‘time deposits’ at the Fed, held in what are called ‘securities accounts’ at the Fed. They are often measured relative to the size of GDP, as are the annual federal deficits, to help scale the nominal numbers to provide perspective. (Note this is often NOT done by those who try to scare the population with talk of “tens of trillions of dollars of unfunded entitlements” due to retirements of the babyboomers, rather than show those numbers as a % of future GDP.)

Figure 1 shows federal government debt since 1943.

Note that during WWII the government’s deficit (which reached 25% of GDP) raised the publicly held debt ratio above 100%– much higher than the ratio expected to be achieved by 2015 (just under 73%). Further, in spite of the warnings issued in the Reinhart and Rogoff study, US growth in the postwar period was robust— in fact it was the golden age of US economic growth. Ironically, this is even acknowledged in the report by the IMF’s Lipsky—who noted that the average ratio of government debt to GDP in the advanced countries will reach the postwar 1950 peak of somewhat more than 75%. Again, misfortune did not befall those big government spenders after WWII. Actually, debt ratios came down over the postwar period as relatively robust growth grew the denominator (GDP) relative to the numerator (government debt).

Indeed, robust growth reduces budget deficits by raising tax revenue and reducing certain kinds of government spending such as unemployment compensation. That was exactly the US experience in the postwar period. The budget deficit is highly counter-cyclical, and will come down automatically when the economy recovers.

The claim made by Moody’s that growth will not reduce debt ratios does not square with the facts of historical experience and must rely on the twin assumptions that growth in the future will be sluggish and that government spending will grow relative to GDP. However, such an outcome is inconsistent: if government spending grows fast it raises GDP growth and hence tax revenues, reducing the budget deficit. This is precisely what has happened in the US over the entire postwar period. It is only when government spending lags behind GDP growth by a considerable amount that it slows growth of GDP and tax revenues, causing the budget deficit to grow. What Rogoff and Reinhart do not sufficiently account for is the “reverse causation”: slow growth generates budget deficits. This goes a long way toward explaining the correlation they find between slow growth and deficits: as economists teach, correlation does not prove causation!

Actually, there are always two ways to achieve the same budget deficit ratio: the ugly (Japanese) way and the virtuous way. If fiscal policy remains chronically too tight even in recession, economic growth is destroyed, tax revenues plummet, and a deficit opens up. So far, that is—unfortunately—the US path in this recession, a path already well-worn by two decades of Japanese experiments with belt-tightening. The alternative (let us call it the Chinese example) is that a downturn is met with an aggressive and appropriately-sized discretionary response. In that case, growth is quickly restored, tax revenue begins to grow, and the budget deficit is reduced.

We emphasize that the deficit outcome is of no consequence for a sovereign nation. What is important is that the “ugly” Neoliberal path means chronically insufficient demand, high unemployment, and lots of suffering. The virtuous path—which is always available to a sovereign government—means less loss of output and employment, and relatively rapid resumption of economic growth. So it is not the deficit outcome that matters, rather it is the real suffering imposed by slow growth that results when fiscal policy is too tight.

In conclusion, the Neoliberal agenda would impose the ugly path on the US and UK. President Obama and Prime Minister Brown should tell the Neoliberals to take a hike.

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“The Hyperinflation Hyperventalists”

Posted on March 22, 2010 | 1 comment

By Rob Parenteau**

After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer. And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition.

Think this is yet another rant against the “deficit errorists?” Think again. Paul Krugman treated this question in his March 18th New York Times column:

Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage – revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.

Krugman locates the source of hyperinflation in what is termed the “monetization” of fiscal deficit spending. He then attributes its perpetuation to shifts in the liquidity preferences of people — that is, the share of their portfolio that households and firms wish to hold in cash or cash like investment instruments (think Treasury bills, or money market mutual funds, for example). Krugman’s logic means that even the liberal wing, or the saltwater contingent, of the economics world has a touch of deficit errorism. We would invite Paul to take a closer look at the UBS research on public debt to GDP ratios and inflation first released last summer, reprinted in a FT Alphaville note, and discussed on Naked Capitalism. The story of inflation and fiscal deficits is more ambiguous, or at least more complex than the deficit errorists would have you believe.

Coincidentally, an investment manager friend forwarded me a letter that Ebullio Capital Management* allegedly sent to its clients after February’s investment results, which took them down nearly 96% for the year – virtually wiping out their stellar gains of the prior two years. The letter reveals that Ebullio was so ebullient about the possibility (inevitability?) of hyperinflation emerging from recent policy excesses that they bet the ranch on hyperinflation plays in the commodity corner of the investing world (metals), and lost big time. While we still have questions as to whether this is a spoof or not, there are undoubtedly people sitting around in gold wondering whether the old yellow dog is going to get up and bark again anytime soon. Although hyperinflation hyperventilation has been catching on in recent months, especially amongst the deficit errorists, gold has been dead money since late November 2009.

What gives? As a piece I wrote in the July issue of The Richebacher Letter explains, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well. A month after the Richebacher piece, Bill Mitchell published a similar conclusion. To summarize our findings: on the demand side, in order for household spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in synch with price hikes. Otherwise, the price hikes will not stick. Households will have to pull back less-essential spending areas to afford the same quantity of goods in essential items. So your gas, home heating oil, health care, or food bill goes up, and you cut back on your restaurant and entertainment spending, unless your paycheck also increases, or you can tap more credit. That is why hyperinflation episodes need more than just deficit spending. It is true, as Marshall Auerback and I explained in a recent New Deal 2.0 post, that fiscal deficits increase the net cash flow for the household sector as a whole. But we also usually observe some sort of escalator clauses or cost of living adjustment mechanisms built into wage contracts that allow this ratcheting up of household income pari passu with the inflation hikes. Take that element away — and it is a recurring theme in historical episodes of hyperinflation — and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.

Beyond this demand side component, which is scarcely to be found in the US wage contracts these days (although we must mention it is built into some government benefit programs like social security), there is the supply side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip. There is a built-in dynamic that encourages this. As the hyperinflation gets recognized, entrepreneurs eventually figure out that they would be much better off speculating in commodities (like Ebullio), buying farmland, chasing gold and other precious metals, or more generally, repositioning their portfolios and reinvesting their profits in tangible assets with relatively fixed supplies. That is, goods that are fairly nonreproducible become stores of value, as it is their prices that tend to rise most swiftly, since higher prices cannot, by definition, elicit any new supplies. Hence, those of you who lived through the ‘70s (and still remember what you were doing) will recall high net worth households were busy hoarding ancient Chinese ceramics while the middle class was chasing residential real estate, and the stock market basically went sideways.

In the case of the Weimar Republic following WWI, and Zimbabwe most recently, remember that war (civil or international), has an impeccable way of destroying productive capacity in a nation, or rerouting it to the production of war material. In the Weimar episode, the final back-breaking run up in hyperinflation accompanied the occupation by the French of the Ruhr Valley, which held a fair concentration of German production facilities. In solidarity with the workers who struck those plants in response, the Weimar Republic continued to pay the workers through fiscal measures. Cut production, but continue income flows, and you have the recipe for the kind of unresolved distributional conflict that often lies at the heart of the inflation process. Mainstream economics and popular lore refuse to see this.

Suffice it to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you and I use to pay taxes or buy Treasury bonds (because even though we “make” money, we cannot create it, without risking a spell in jail for counterfeiting). Know your history. Try not to pass out with the hyperventilating hyperinflationistas: they are a particularly virulent wing of the deficit errorists, and they may simply leave you in a state similar to the one alleged to have been experienced by Ebullio Capital Management’s clients.

P.S. I have a piece called “On Fiscal Correctness and Animal Sacrifices” appearing on several blogs that formed the basis for the March 2010 Richebacher Letter. It is crucial that this piece get into the hands of Paul Krugman. If anyone knows how to get to him, I would be much obliged. His July 15th, 2009 NY Times diagram, which I call the Krugman Curve, has planted a seed that he would benefit greatly from watering. I believe it would help him escape the trap of continually returning to the manipulation of real interests rates (now requiring that he advocate central banks push a credible plan to deliver higher inflation in perpetuity, since policy rates are near the zero nominal bound in many places) as the holy grail for all countries operating below potential output. Time for him to exit from the IS/LM straight jacket, which even Sir John Hicks, one of its fathers, had his sincere doubts about, as well as the intertemporal utility maximization straight jacket of his more orthodox contemporaries. He knows how to do it…he just does not know it yet, which is why this paper needs to get in his hands, and soon, before the deficit errorists claim him as one of their own.

* You can go to Ebullio’s website, but unfortunately, authorization is required to see their performance, their track record, and their client letters.

**This article originally appeared on new deal 2.0

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“Britain Not Part of Any Greek Tragedy”

Posted on March 19, 2010 | 2 comments

By Marshall Auerback*

They certainly know what “schadenfreude” means in Germany. But the attempt by the German paper, Der Spiegel, to link the UK to the travails of Greece, takes the concept to a malicious and irrational extreme:

The British pound is tottering. The economy finds itself in its worst crisis since 1931, and the country came within a hair’s breadth of a deep recession. Speculators are betting against an upturn. Instability in the banking sector has had a more severe impact on government finances in Great Britain than in other industrialized countries. London’s budget deficit will amount to £186 billion (€205 billion, or $280 billion) this year — fully 12.9 percent of gross domestic product.

Sounds pretty, grim, especially given that Britain’s budget deficit is even higher than that of the “corrupt” Greeks, whom the Germans also seem so intent on abusing in print and punishing for their alleged fiscal profligacy.

But the article itself is rife with intellectual dishonesty. You cannot mindlessly conflate EMU states — Germany included — which operate with no real fiscal authority as sovereign states in the full sense — with countries, such as the United Kingdom, which fortunately has a government with currency issuing monopolies operating under flexible exchange rates (even though the British haven’t quite figured it out). And, as strange as it may sound, public sector profligacy at this time is preferable to Germanic style prudence, because as the private sector’s spending and borrowing go into hibernation, government borrowing must expand significantly to compensate. Even the French Finance Minister, Christine Lagarde, seems to understand that fact (and is taking heat from her German “allies” as a result). Her sin? She had the temerity to suggest that Berlin should consider boosting domestic demand to help deficit countries regain competitiveness and sort out their public finances. Noting that “it takes two to tango”, Lagarde suggested that an expansionary fiscal policy had a role to play here, not simply “enforcing deficit principles”.

Of course, that’s harder to do in the euro zone, given the insane constraints put forward as a condition of euro entry. As a consequence of these rules, the EMU nations cannot even run their own region properly. They have established a system which has consistently drained aggregate demand and brought increasingly high levels of unemployment to bear on their respective populations. In the words of Bill Mitchell:

The rules that the EU made up and then imposed on the EMU via the Maastricht Treaty’s Stability and Growth Pact were not based on any coherent models of fiscal sustainability or variations that might be encountered in these aggregates during a swing in the business cycle. The rules are biased towards high unemployment and stagnant growth of the sort that has bedeviled Europe for years.

Having conspicuously failed to deliver prosperity to their own countrymen, the Germans now see fit to lecture the UK (after taking out the Greeks, of course) on the grounds of Britain’s “crass Keynesianism” (in the words of Axel Weber, the President of the German Bundesbank).

There is no question that the UK has some unique features which make it more than just another casualty of the global credit crunch. It foolishly leveraged its growth strategy to the growth in financial services and is now paying the price for that misconceived policy, as the industry inevitably contracts and restructures as a percentage of GDP. This structural headwind will no doubt force the UK authorities to adopt an even more aggressive fiscal posture than would normally be the case. This is politically problematic, given that the vast majority of the UK’s policy makers (and the chattering classes in the media) still cling to the prevailing deficit hysteria now taking hold all over the world. But the reality is that the UK has considerably greater fiscal latitude of action than any of the euro zone countries, including Germany.

Let’s go back to first principles: In a country with a currency that is not convertible upon demand into anything other than itself (no gold “backing”, no fixed exchange rate), the government can never run out of money to spend, nor does it need to acquire money from the private sector in order to spend. This does not mean the government doesn’t face the risk of inflation, currency depreciation, or capital flight as a result of shifting private sector portfolio preferences. But the budget constraint on the government, the monopoly supplier of currency, is different than what most have been taught from classical economics, which is largely predicated on the notion of a now non-existent gold standard. The UK Treasury cuts you a benefits check, your check account gets credited, and then some reserves get moved around on the Bank of England’s balance sheet and on bank balance sheets to enable the central bank (in this case, the Bank of England) to hit its interest rate target. If anything, some inflation would probably be a good thing right now, given the prevailing high levels of private sector debt and the deflationary risk that PRIVATE debt represents because of the natural constraints against income and assets which operate in the absence of the ability to tax and create currency.

Unlike Germany, or any other EMU nation, there is no notion of “national solvency” that applies here, so the idea that the UK should follow Greece down the road to national suicide reflects nothing more than the traditional German predisposition to sado-monetarism and deficit reduction fetishism. A commitment to close the deficit is also what doomed Japan throughout most of the 1990s and 2000s, when foolish premature attempts at “fiscal consolidation” actually increased budget deficits by deflating incipient economic activity. Why would you tighten fiscal policy when there is anemic private demand and unemployment is still high?

Remember Accounting 101. It is the reversal of trade deficits and the increase in fiscal deficits, which gets a country to an increase in net private saving, ASSUMING NO STUPID SELF IMPOSED CONSTRAINTS along the lines proposed by Germany under the Stability and Growth Pact (which should be re-christened the “Instability and Non-Growth Pact”). Ideally, we want the deficits to be achieved in a good way: not with automatic stabilizers driving the budget into deficit because unemployment is rising and tax revenue is falling as private demand falters, but one in which a government uses discretionary fiscal policy to ensure that demand is sufficient to support high levels of employment and private saving. That in turn will stabilize growth and improve the deficit picture. Once this is achieved, any notions of national insolvency (or more “Greek tragedies”) should go out the window.

The UK can do this, even if its policy makers fail to recognize this. But not in the eyes of Der Spiegel, which warns that “tough times are ahead for the United Kingdom, so tough, in fact, that none of the parties has dared to say out loud what many in their ranks already know. At a minimum, Britons can look forward to higher taxes and fees.” And much lower growth if that prescription is followed.

We suspect that many in Germany and the rest of Europe understand this. So what other motivations are at work here? Clearly, calling attention to the state of Britain’s public finances and drawing specious comparisons to Greece in effect invites speculative capital to take its collective eye off the euro zone and focus it on the UK. Given that the alleged “Greek solution” proposed recently by the European Commission does nothing to resolve the country’s underlying problems, it behooves the euro zone countries to draw attention elsewhere before their collective resolve to defend their currency union comes under attack again.

And heaven forbid that the UK was actually successful (admittedly unlikely today, given the paucity of British political leaders who truly understand how modern money actually works). If Her Majesty’s Government spending actually managed to conduct fiscal policy in a manner which supported higher levels of employment and a more equitable transfers of national income (via, for example, a government Job Guarantee program) then what would be the response in the euro zone? Wouldn’t this cause its citizens to query what sort of bogus economic “expertise” that has been fed to them from their technocratic elites over the past two decades? The same sort of neo-liberal pap fed to the US courtesy of groups such as the Concord Coalition.

No question that public spending should be carefully mobilized to ensure that it is consonant with national purpose (not corporate cronyism). But the idea perpetuated by Der Spiegel that the government is somehow constrained by some self imposed rules with no reference to the underlying economy is comedy worthy of a Brechtian farce. Unfortunately, this particular German joke is no laughing matter.

*This post originally appeared on new deal 2.0

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Greece Cannot Reduce Its Budget Deficit So Long As Its Neighbors Pursue Mercantilist Policy

Posted on March 19, 2010 | 2 comments

By Yeva Nersisyan

When the 12 European Nations raced to embrace the single currency, euro, it was supposed to be a forward step in the process of European Integration, towards the United States of Europe. In retrospect, the euro has not only not contributed to deeper integration but is certainly close to undermining its foundations. The economic and debt crises have forced countries to resort back to their bitter past relations up to the point where Greeks are demanding that Germany pay WWII reparations.

Much has been said about Greece’s debt crisis with a few proposals on how it should deal with it. All of these eventually turn into proposals of how the Greeks should manage their own country. A recent article in the New York Times critically examines Greece’s pension system which has 580 occupations that qualify for early retirement at the age 50. Greece has promised early retirement to about 700,000 workers and its average retirement age is one of the lowest in Europe, 61. While the effectiveness or the reasonableness of the Greek pension system is beyond the scope of this blog, what is incomprehensible is how does a developed and politically sovereign nation such as Greece completely give up its domestic policy space, up to the point where it is told what to do about its pensioners, how to behave with the unions, what to do about public sector wages, etc? Politicians, rating agencies and media commentators somehow feel that they all have the right to give some advice on how the Greek government should manage their country. As long as we know, Greece is a representative democracy where the people elect their government and can demand that it do whatever it has promised to its population. It is up to the people of Greece, through the Greek government to decide what to do with their country, not to us, to you and especially not to the fraudulent and corrupt rating agencies and media commentators looking to make a career. Moreover, it sounds like Greece is simply trying to solve its unemployment problems by making people retire earlier. Prolonging the retirement age won’t do much to solve the problem, as the government will still need to spend to boost aggregate spending to create jobs for all those people.

Most commentators of course overlook the main issue which is that by entering the monetary union and divorcing fiscal and monetary authorities individual nations have given up their currency issuing capacity. So unlike the Untied States government that spends by simply crediting bank accounts, i.e. changing numbers on spreadsheets (see here), the Greek and even German governments need to have tax and bond revenues prior to spending. But euronations differ vastly in their ability to collect taxes and raise revenue through bond sales. The convergence in debt levels, interest rates and number of other economic variables among individual countries that was being predicted by mainstream economists never really materialized. Germany and to some degree France have remained the important players in the euro landscape reserving the right to dictate policy prescriptions to their less powerful southern neighbors. At this point, Greece largely depends on Germany to determine its fate. It is now similar to a developing country being told what policy to implement by the IMF, only in this case it’s Germany that has assumed the role of the IMF.

It is useful to recall the financial balance identity for analyzing what policy options Greece has (see here). The balance of the private sector (surplus/deficit) equals the balance of the government (deficit/surplus) plus the current account balance (surplus/deficit). In plain English this means that private sector savings (surplus) is financed by government deficit (an injection into private incomes and hence saving) and by the current account surplus (net exports are an injection into nominal income and hence saving). By entering the monetary union the euronations have voluntarily agreed to the debt and deficit constraints imposed by the Maastricht treaty. So what are the policy options for these countries under these self-imposed constraints? We know that the private sector cannot be perpetually in deficit; in fact the normal situation is for the private sector to try to save some of its income. The current account balance of Greece was -9.98% in 2009. If Greece only had a budget deficit of 3% (the Maastricht limit) then its private sector would need to run a deficit of 6.98%. If we want the Greeks to have a positive saving (>0) what needs to be true about the government deficit? Simple math will show that it has to be greater than 9.98% of GDP. So to balance its budget, either the private sector needs to go in debt (making bankers richer) or Greece needs to balance its current account and even try to achieve a small surplus which is neither desirable nor achievable.

But what happens when all euronations try to export their way out of their economic problems? Basically, they will have to revert to mercantilist-type beggar-thy-neighbor policies where each country tries to solve its growth and unemployment problems by exporting them to their trading partners. Germany has already taken this route which has allowed it to be a “role model” for “fiscal responsibility” and given it the “right” to criticize other countries which don’t follow it. But all the countries cannot be net exporters; some have to be net importers. Germany can only be a net exporter to Euroland if some other euro nations are willing to be on the other end of the transaction. France, Italy, Belgium and Spain are among the 11 largest export partners of Germany with each of these countries having a net deficit with it. It is the government or private deficit in these countries that’s financing Germany’s exports.

So what options do net importer countries such as Greece or Spain have to maintain their aggregate demand at a reasonable level? If sovereign indebtedness is not acceptable, the only thing left is private sector indebtedness which will eventually lead to a financial collapse as we have witnessed in the US, UK and elsewhere. And some countries such as Spain don’t even have that option as their private sector is already highly indebted.

To summarize, the problem is not Greece’s profligate spending, but rather the design of the European monetary system. It has been specifically created to divorce the monetary and fiscal authorities to make the monetary authority super independent from “political pressures”. It has tied the hands of governments restricting them in using their fiscal capacity to employ their labor resources and has forced the countries into sluggish growth, high unemployment rates, stagnating wages, cuts in social services, etc. They have been able to achieve low inflation rates though. What a fair trade-off! Moreover, as countries on the periphery approach the Maastricht debt limits, the markets start betting against the country’s debt forcing it to pay higher interest rates. And of course no mess is complete without the rating agencies which are “diligently” monitoring the debt and deficit situations threatening to cut countries’ ratings further exacerbating the problem.

If Germany wants to increase its retirement age and cut social benefits it should be up to the German public to accept it or protest against it. But foreigners shouldn’t be allowed to dictate this to Greece and other nations. If they are doing that, and successfully so, it means that something is wrong with the way the system is set up. It is time for Greece and other nations in the outskirts of Europe to push for a change in the institutional structure which is obviously dysfunctional.

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Tagged International Finance

This Is Not The Way To Do Healthcare Reform: Democrats Propose Windfall For Insurance Industry

Posted on March 18, 2010 | 10 comments

By L. Randall Wray

It is beginning to look like Congress is going to vote to pass health care legislation on Sunday. According to the NYTimes, Democrats are practically celebrating already. (here)It is interesting, however, that no one is talking about providing benefits to the currently underserved.
Rather, the “good news” is that the bill is supposed to be “the largest deficit reduction of any bill we have adopted in Congress since 1993,” according to House Democratic leader, Rep.Steny H. Hoyer of Maryland. “We are absolutely giddy over the great news,” said the House’s number three Democrat, Rep. James Clyburn of South Carolina. (Of course, deficit hysteria is nothing new. See here)

Who would have thought that health care “reform” would morph into deficit cutting?

As Marshall Auerback and I argue in a new policy brief (here), the proposed legislation is not “reform” and it will not reduce US health care costs. I will not repeat the arguments there. But very briefly, the most significant outcome of this legislation is the windfall gain for insurance companies—who will be able to tap the wages of the huge pool of nearly 50 million Americans who currently do not purchase health insurance. Since many of these are too poor to afford the premiums, the government will kick in hundreds of billions of dollars to line the pockets of health insurers. This legislation has nothing to do with improving health services for the currently underserved—it is all about increasing the insurance sector’s share of the economy.

You might wonder how Democrats can call this a deficit reduction deal? Elementary, dear Watson. They will slash Medicare spending. No wonder—it stands as an alternative to the US’s massively inefficient private insurance system, hence, needs to be downsized in favor of an upsized private system.

There is nothing in the deal that will significantly reduce health care costs. At best, it will simply shift more costs to employers and employees—higher premiums, higher deductibles, higher co-pays, and more exclusions forcing higher out-of-pocket expenses and personal bankruptcies. As we show in our paper, the US’s high health care costs (at 17% of GDP, double or triple the per capita costs in other similarly wealthy nations) are due to three factors. As many commentators have argued (especially those who advocate single-payer) part of the difference is due to the costs of operating a complex payment system that relies on private insurers—resulting in paperwork and overhead costs, plus high profits and executive compensation for insurance executives. This adds about 25% to our health care system costs. Obviously, the proposed legislation is “business as usual”, actually adding more insurance costs to our system.

In addition, Americans spend more for medical supplies and drugs. Since the Democrats ruled out any attempt to constrain Big Pharma through, for example, negotiating lower prices for drugs, there will not be any savings there.

Finally, and most importantly, the biggest contributor to higher US health care costs is our American “lifestyle”: too little exercise, too much bad food, and too much risky behavior (such as smoking). (here) This is why we spend far more on outpatient costs for chronic diseases such as diabetes—40% of healthcare spending and rising rapidly. Ending the subsidies to Big Agriculture that produces the products that make us sick would not only do more to improve US health outcomes than will the proposed legislation, but it would also reduce health care spending—while reducing government spending at the same time. That would be real healthcare reform! But, of course, no one talks about this.

Interestingly, according to the NYTimes article, President Obama likened the legislation to fixing the financial system or passing the economic recovery act. “I knew these things might not be popular, but I was absolutely positive that it was the right thing to do,” he said. That is an apt and scary comparison. This legislation will do as much to “fix” the US healthcare system as the Obama administration has done to “fix” the financial sector and to put the economy on the road to recovery?

Of course, we have not done anything to “fix” the financial sector, or to put Mainstreet on the road to recovery.

I think the President’s comparison is uncannily accurate. So far the main thing his administration has done is to funnel trillions of dollars to the FIRE sector in an attempt to restore money manager capitalism. The current legislation will simply continue that policy—the trillions spent so far to bail-out Wall Street have not been nearly enough. Hence, the effort to funnel billions more to the insurance industry.

But what is the connection between Wall Street and health insurers? As Marshall and I argue in our brief, they are “two peas in a pod” since the deregulation of financial institutions. We threw out the Glass-Steagall Act that separated commercial banking from investment banking and insurance with the Gramm-Leach-Bliley Act of 1999 that let Wall Street form Bank Holding Companies that integrate the full range of “financial services”, that sell toxic waste mortgage securities to your pension funds, that create commodity futures indexes for university endowments to drive up the price of your petrol, and that take bets on the deaths of firms, countries, and your loved ones. (See also here)

Hence, extension of healthcare insurance represents yet another unwelcome intrusion of finance into every part of our economy and our lives. In other words, the “reforms” envisioned would simply complete the financialization of healthcare that is already sucking money and resources into the same black hole that swallowed residential real estate. (here)

Just as the bail-out of Wall Street was sold on the argument that we need to save the big banks so that they will increase lending to Main Street, health care “reform” was initially promoted as a way to improve provision of healthcare to the underserved. What we got instead is a bail-out for insurers and cuts to Medicare. Funny how that happens.

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Echoes of The ‘80s and The Collateral Damage of Fraud

Posted on March 17, 2010 | 3 comments

By Sigrún Davíðsdóttir

Recently, I talked to the CEO of a very successful Icelandic company that has grown steadily over the decade it’s been operating. Every year, the CEO would go through the annual report, lean back and think with great satisfaction that his company was indeed showing a healthily steady growth. Then the banks and their satellite companies would come out with their annual accounts – and the CEO’s heart would sink, questioning what on earth was he was doing: compared to these companies his company’s growth was pitiful. Now, anno 2010, his company is still doing well and even hiring people. The three main Icelandic banks collapsed in October 2008 and most of the companies owned by those favoured by the banks are now bankrupt.*

This conversation came to mind as I read ‘Den of Thieves’ by WSJ journalist James B. Stewart, on the insider trading involving the arbitrageur king of the 1980s, Ivan Boesky and junk bond emperor Michael Milken. Their apparent success became a gold standard everyone else tried to achieve. But as it was based on questionable business practices and outright fraud this measure proved an unhealthy standard. Their success was also a measurement in remuneration, again not a healthy measure. The same happened in Iceland: the banks rapidly raised salaries after they had become entirely privatised in 2003. With hindsight, their success can now be doubted and their rising remuneration levels affected the whole business community.

In his book Stewart points out that the ‘arrival of the big-money ‘star’ system in the eighties had made national celebrities’ out of people like Milken, Boesky and others who were condemned for fraud and doomed old-fashioned investment bankers that earlier had dominated the financial world. There is no need to be unduly nostalgic about the old way of banking but one of the great but too little noticed harm of fraudsters like Milken ed al. is the unhealthy standards they created in terms of growth rates and remuneration.

We still do not know the extent of fraud within the Icelandic banking bubble. The Icelandic FME, comparable to the UK Financial Services Authorities, has already sent several extensive cases of alleged market manipulation to the Office of Special Prosecutor, set up to deal with possible cases of criminal activity connected to the collapse of the banks. The Special Prosecutor is both conducting his own investigations and working on specific cases that have been sent to him from i.a. the FME and the resolution committees of the collapsed banks.

Apart from the general damage of fraud by creating harmful standards it feels as if some of those who led the Icelandic banking bubble had reopened the tool kit of the prolific fraudsters that Stewart writes about. The difference is of course that Milken was working for his own benefit, often at the cost of the bank where he worked, whereas the Icelandic banks, in cahoots with major shareholders seemed to favour certain clients more than others and possibly worked against the interest of other shareholders.

In the Icelandic context, two of the counts to which Milken pleaded guilty are of particular interest. Milken pleaded guilty to selling stock without disclosing that included in the deal was the understanding that the purchaser would not lose money. The other count involves selling securities to a client and then buying those securities back at a real loss to the customer, but with an understanding that Milken would try to find a future profitable transaction to make up for any losses.

One of the peculiarities of Icelandic banking up until the collapse is that certain clients were sold stock with a kind of ‘no loss guarantee.’ This was particularly common among key staff at the banks: the staff would get a loan from the bank where they worked to buy shares in that same bank. In most cases these were bullet loans, the staff wasn’t expected to pay anything off the loans but had the shares at their disposal to reap the dividend. The benefit for the bank was that the shares would not be used for short-selling. This practice escalated in 2007 and 2008 as foreign banks made margin calls on some of their big Icelandic clients who had pledged Icelandic bank shares against foreign loans. In order to avoid dumping these shares into the market, causing further decline in the share price, the banks would ‘park’ them with their staff, lend against them, with the understanding that these arrangement wouldn’t harm the borrower.

A bank manager from one of the collapsed banks informed me recently that among the big favored clients there was an understanding that in deals where the client lost money the bank would then try to find a profitable transaction to make up the loss. There would be many ways of making this happen, i.a. buying assets at a price above market price. It’s difficult to ascertain if and when this happened but certain sales guarantees could be scrutinised.

The interesting thing is that Milken and others convicted at the end of the ‘80s were rogues in the financial markets who defrauded clients and the banks they worked for. The Icelandic example suggests that the banks’ management, together with their main shareholders, were operating like the rogue bankers of the ‘80s bubble. It is still early day, no big cases of fraud have so far been brought to court and when that happens it will take a while until the first cases are brought to closure. So far, the possibility of a certain echo of the ’80s’ financial fraudsters remains only an intriguing thought based on striking but so far unproven parallels.

* For more on various aspects of the collapse of the Icelandic banks and connections with international banking see Icelog, my blog at http://uti.is/

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Tagged Control Fraud, Financial crisis

What Do Our Nation’s Biggest Banks Owe Us Now?

Posted on March 16, 2010 | 6 comments

By William K. Black

This week, ABC News World News with Diane Sawyer is airing a series about the struggling middle class. The show’s producers posed the following question to a few of the nation’s leading economic and financial analysts, including UMKC’s own William K. Black.

QUESTION: As the nation’s largest banks have regained their footing, what, if anything, can or should they do to help Americans still struggling as a result of the financial crisis and recession? Are there specific solutions or actions the banks should take or HAVE they already done enough? Do the banks have an “ethical obligation” to help those average American families still struggling?

ANSWER: First, banks have not recovered. It is essential to remember that the banks used their political clout last year to induce Congress to extort the Financial Accounting Standards Board (FASB) to change the accounting rules such that banks no longer have to recognize losses on their bad assets unless and until they sell them. Absent this massive accounting abuse, hiding over a trillion dollars in losses, banks would (overall) not be reporting these fictional “profits” and would not be permitted to award the exceptional executive bonuses that they have paid out.

Second, banks have, in reality (as opposed to their fictional accounting ala Lehman) been suffering large losses for at least five years. They only appeared to be profitable in 2005-2007 because they provided only trivial loss reserves (slightly over 1%) while making nonprime loans that, on average, suffer roughly 50% losses. Loss reserves fell for five straight years as bank risks exploded during those same five years. Had they reserved properly for their losses the industry would have reported large losses no later than 2005.

Third, banks have performed dismally when they were supposedly profitable. They funded the nonprime and the commercial real estate (CRE) bubbles that not only cause trillions of dollars of losses and the Great Recession, but also misallocated assets (physical and human) during those bubbles. Far too few societal resources went to productive investments that would increase productivity and employment. Our nation has critical shortages of workers with expertise in physics, engineering, and mathematics — precisely the categories that we misallocated to finance instead of science and production. In finance, they (net) destroyed wealth by creating “mark to myth” financial models that maximized executive bonuses by inflating asset values and understating risk.

Fourth, when finance seems to be working well in the modern era it is working badly. Finance is a “middleman.” Its sole function is to allocate capital to the most useful and productive purposes in the real economy. As with any middleman, the goal is to have the middleman be as small and take as little profit as possible. Finance has not functioned that way. It has gone from roughly 5% of total profits to roughly 40% of total profits. That means that finance has, increasingly, become wildly inefficient. It is a morbidly obese parasite (in economics terms) that drains capital from the productive sectors of the economy.

Fifth, the things that finance is good at are harmful to our nation. Finance is very good at exporting U.S. jobs to other nations. Finance is very good at fostering immense speculation. When banks “win” their speculative bets Americans suffer, e.g., when their speculation increases gas and food prices. When they lose their bets the American people bail them out. (The least they could do would be to support the proposed Volcker rules. In reality, of course, they will gut them.) For the overwhelmingly majority of Americans, increased speculation simply causes economic injury. In very poor countries, however, “successful” speculation by hedge funds that runs up the price of basic food kills people. Speculation has also become intensely political. The right wing Greek parties engaged in accounting fraud to allow Greece to issue the Euro. When a left wing Greek party defeated the right at the polls the banks and hedge funds decided to engage in a speculative frenzy designed to cripple the nation’s recovery from recession. Finance is also superb at increasing inequality.

Sixth, the rise of “systemically dangerous institutions” (SDIs) that the government will not allow to fail optimizes moral hazard (fraud and speculation) and means that future crises will be common and unusually severe.

Seventh, while lending by smaller banks is flat, funding by SDIs fell by over $1/2 trillion.

Eighth, banking theory is horribly flawed. Financial markets are normally not “efficient”, markets do not inevitably “clear,” and banks fund “accounting control frauds” rather than providing effective “private market discipline.”

To sum it up, whether I’m wearing my economics, law, regulatory, or white-collar criminologist hat the situation in banking demands prompt, fundamental reform so that banking will stop being so harmful. Then we have to keep working to make it helpful.

Banks cannot do many of the things that need to be done to fix our economy. In the interest of limiting space, I’ll talk about only five economic priorities. I think banks can be helpful in only a few of these priorities. The most important thing we can do with financial institutions is reduce the damage they cause.

1) It is nuts that we think it is OK for 8 million Americans to lose their jobs (and far more lose their ability to work full time) and that we think that it makes sense to pay people not to work but is “socialism” to pay them to work during a Great Recession. We need a government-funded jobs program.

2) It is a disgrace that well over 20% of American children grow up in poverty. It is a greater moral failing that ending this is not a national priority. The banks have done a terrible job in this sphere. They caused the greatest loss of working class wealth since the Great Depression and have made tens of thousands homeless. This is overwhelmingly the product of what the FBI began warning of in 2004 — and “epidemic” of mortgage fraud. The FBI states that 80% of the fraud is driven by finance industry insiders.

3) It is insanity to the nth to run our state and local governments into massive cutbacks during a Great Recession when that undercuts the need for stimulus. The obvious answer is a public policy with impeccable Republican origins — revenue sharing. It passes all understanding that the Republicans and blue dog Democrats targeted revenue sharing for attack and reduced it to a pittance (relative to the scale of the crisis). The best things the banks could do in this regard are to stop (a) all participation in “pay to play” corruption involving state & local bond issuances, and (b) stop all sales of unsuitable financial products to governments (and the public). The opposite is happening: Goldman fleeces its public sector clients, the SDIs sell toxic derivatives to small Scandinavian cities, the investment bankers are all over public pension funds desperate for higher yields (on their underfunded pension funds) selling them grotesquely unsuitable financial products (typically, the “dogs” they can’t unload on more sophisticated investors), and the inimitable Goldman Sachs helping Greek governments deceive the EU.

4) Related to points two and three above, the most productive investment we can make is educating superbly the coming generations. The best thing the banks can do is get out of student lending. The governmental lending program for college students was administered in a much cheaper fashion. The privatized lending program is an inefficient scandal that keeps on giving.

5) Banks could put the payday lenders out of business by outcompeting them. That would be a real public service.

And, on a level of fantasy, banks as a group could tell FASB to restore honesty in accounting. Individual banks could report their real losses and change their executive compensation systems to accord with the premises that purportedly underlie performance pay. They could start making criminal referrals against the mortgage frauds (a mere 25 banks and S&Ls make over 80% of the total criminal referrals for mortgage fraud) — most banks refuse to file and help us jail the crooks. They could stop adding to the glut in commercial real estate. They could support the Kaptur bill to authorize the FBI to hire an additional 1000 agents so that we can investigate and jail elite financial felons. They could support a prompt end to the existence of systemically dangerous institutions (SDIs) by supporting rules and regulatory policies to require them to shrink to the point that they no longer endanger the global economic system. Pinch me if any of these dreams come true. I’d like to be awake to experience and celebrate the miracle.

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Posted in Regulation, Uncategorized, William K. Black

Tagged Control Fraud, Financial crisis, regulation, William K. Black

Timmy-Gate: Did Geithner Help Hide Lehman’s Fraud?

Posted on March 15, 2010 | 7 comments

Timmy-Gate Takes a Turn For The Worse: Did Geithner Help Lehman Hide Accounting Tricks?

By L. Randall Wray

Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting gimmick to hide debt. The report, which runs to 2200 pages, was released by Anton Valukas, the court-appointed examiner. It actually makes the AIG bailout look tame by comparison. It is now crystal clear why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any light to shine on the massive cover-up underway.

Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties—benefiting Goldman Sachs and a handful of other favored Wall Street firms. (see here) The purported reason is that Geithner so feared any negative repercussions resulting from debt write-downs that he wanted Uncle Sam to make sure that Wall Street banks could not lose on bad bets. Now we find that Geithner’s NYFed supported Lehman’s efforts to conceal the extent of its problems. (see here) Not only did the NYFed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better. Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent. (see here)

Geithner told Congress that he has never been a regulator. (see here) That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of the NYFed. Apparently, Geithner has never met an accounting gimmick that he does not like, if it appears to improve the reported finances of a Wall Street firm. We will leave to the side his own checkered past as a taxpayer, although one might question the wisdom of appointing someone who is apparently insufficiently skilled to file accurate tax returns to a position as our nation’s chief tax collector. What is far more troubling is that he now heads the Treaury—which means that he is not only responsible for managing two regulatory units (the FDIC and OCC), but also that he has got hold of the government’s purse strings. How many more billions or trillions will he commit to a futile effort to help Wall Street avoid its losses?

Geithner has denied that he played any direct role in the AIG bail-out—a somewhat implausible claim given that he was the President of the NYFed and given that this was a monumental and unprecedented action to funnel government funds to AIG’s counterparties. He may try to deny involvement in the Lehman deals. (Again, this is implausible. Lehman executives claimed they “gave full and complete financial information to government agencies”, and that the government never raised significant objections or directed that Lehman take any corrective action. In fairness, the SEC also overlooked any problems at Lehman. (see here) But here is what is so astounding about the gimmicks: Lehman used “Repo 105” to temporarily move liabilities off its balance sheet—essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a “material misrepresentation” of Lehman’s financial statements. (see here) The court-appointed examiner hired to look into the failure of Lehman found “materially misleading” accounting and “actionable balance sheet manipulation.” (here) But just as Arthur Andersen had signed off on Enron’s scams, Ernst & Young found no problem with Lehman. (here)

In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman’s had been using this trick since 2001. (here) It looked fine to Timmy’s Fed, which extended loans allowing Lehman to flip bad assets onto the Fed’s balance sheet to keep the fraud going.

More generally, this revelation drives home three related points. First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable. He must determine what did Geithner know, and when did he know it. All internal documents and emails related to the AIG bailout and the attempt to keep Lehman afloat need to be released. Further, Obama must ask what has Geithner done to favor his clients on Wall Street? It now looks like even the Fed BOG, not just the NYFed, is involved in the cover-up. It is in the interest of the Obama administration to come clean. It is hard to believe that it does not already have sufficient cause to fire Geithner. In terms of dollar costs to the government, this is surely the biggest scandal in US history. It terms of sheer sleaze does it rank with Watergate? I suppose that depends on whether you believe that political hit lists and spying that had no real impact on the outcome of an election is as bad as a wholesale handing-over of government and the economy to Wall Street.

What did Timmy know, and when did he know it?

Point number two. Lehman used an innovation, “Repo 105” to hide debt. The whole Greek debt fiasco was caused by Goldman, et. al., who helped hide government debt. (here and here) Whether legal or illegal, Wall Street has for many years been producing financial instruments designed to mislead shareholders, creditors, and regulators about the true financial position of its clients. Note that Lehman’s counterparties in this fraud included JP Morgan and Citigroup (who actually precipitated Lehman’s final failure when they finally called in their loans). It always takes at least three to tango: the firm that wants to hide debt, the counterparty that temporarily takes it off their books, and the accounting firm that provides the kiss of approval.

Worse, after aiding and abetting such deception, Goldman and other Wall Street institutions then place bets (using another nefarious innovation, credit default swaps) against their clients, wagering that they will not be able to service the debts—which are greater than the market believes them to be. Does that sound something like insider trading? How can regulators permit such actions?

What did Timmy know, and when did he know it?

Third point. To the extent that debt is hidden, financial institution balance sheets present an overly rosy picture—of course, that is the purpose of the financial “innovations”. Enron did it; AIG did it; Lehman did it. What about Bank of America, Citi, JP Morgan, Wells Fargo and Goldman? We now know that the New York Fed subjected Lehman to three wimpy “stress tests”, all of which it failed. Timmy’s Fed then allowed Lehman to construct its own sure-to-pass “stress” test. (We know, of course, that the test was absolutely meaningless because, well, Lehman passed the test and then immediately failed spectacularly. Timmy then let the biggest banks run their own stress tests, which they (surprise, surprise) managed to pass.

What did Timmy know, and when did he know it?

As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason to believe that this time will be different. Mike Konczal reports that there is every reason to believe the biggest banks are hiding huge losses on second liens. (here) These are second mortgages or home equity loans that amount to about $1 trillion of which almost half are held by the top four banks. Since the first principal of a mortgage is paid first, it is likely that much of the second liens are worthless. Yet banks are carrying these on their books at 86 to 87 percent of face value—which was necessary to allow them to pass the stress tests. Konczal shows that at a more reasonable loss rate of 40% to 60%, the four largest banks would have “an extra $150 billion hole in the balance sheet”. I won’t go into the policy conundrum implied for President Obama’s plan for principal reduction to help homeowners (the banks will not allow renegotiation of underwater mortgages because that would force them to recognize losses on the second liens).

Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months—probably before summer. The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking. In the bigger scheme of things, this is only 1931. We have a long way to go before bank assets (and nonbank debts) are written down sufficiently to allow a real recovery. In other words, a Minsky-Fisher debt deflation is still in the cards.

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Interview with Randall Wray about Greece’s Debt Crisis

Posted on March 13, 2010 | 5 comments

See below Prof. L Randall Wray’s interview for the Greek newspaper (Eleftherotypia) about Greece’s debt crisis.

By Chronis Polychroniou
*This is an english translation of the greek publication.

1.Goldman Sachs created financial instruments to hide European government debt and Greece is one of its first victims in the eurozone. In a recent article of yours, co-written with Marshall Auerback, you argue that Wall Street firms should not only be held accountable for such practices, but war should be declared on them. How can a small nation like Greece declare war on Wall Street’s financial institutions?

Wray: Of course the best strategy would be a coordinated investigation by all Euro member nations to get to the bottom of the financial manipulation perpetrated by these institutions on European soil. As we said, investigators should invade the offices and secure all files, internal memos, and emails. This is the only way to find out which laws have been broken and to prosecute guilty parties. In our article we focused on recent revelations about Goldman, but it is likely that other behemoth financial institutions, including some European banks, have engaged in similar practices.

Beyond that, it is important to send a message to these institutions that “business as usual” will not be permitted any longer. It is no stretch to say that the fate of European Union is in question. These institutions are testing whether they can bring down Greece. If they are permitted to do so, there is absolutely no doubt that they will set their sights on the next victim—Portugal, Italy, or Spain. It is not just that they helped to hide debt. They are placing bets on default, driving up credit default swap (CDS) prices, inducing credit down-grades, and hence raising finance costs. None of the Euro nations would be able to survive this onslaught—not even Germany.

This is why we have used the term “war” to describe the nature of this conflict. No country should sit idly by and allow financial institutions to bring it down. If Greece cannot secure the support of other Euro nations, it will have to unilaterally declare war on those institutions operating on its soil—those actively engaged in undermining its economy.

1.Why isn’t the Obama administration doing something about Wall street’s manipulation and destruction of the world’s economies?

Wray: That is of course a difficult question to answer because it is not possible to get inside the heads of administration officials. We can only look at this from the outside, and from the outside it stinks of scandal. I am beginning to think that this will go down in history as one of the worst scandals the US has ever seen. The triggering event will be seen as the AIG bailout—in which the NYFed led by Timothy Geithner gave billions of dollars to AIG that it funneled to counterparties like Goldman to pay off CDSs at one hundred cents on the dollar. There was and is absolutely no justification for that action. But far worse is the cover-up, in which the Fed and Treasury are still engaged. It is always the cover-up that brings down administrations. This one looks like it ranks with a Watergate cover-up. I repeat that we do not have the facts, so the appearances might be incorrect. But that is all the more reason for the Obama administration to come clean. It must release all internal documents, and all emails, and account for every dollar spent. It must name names and it must then prosecute all fraud—even if that goes right to the top of the Treasury and Fed.

2.How do you explain the hysteria against Greece by major European financial newspapers?

Wray: There is of course always some sensationalism in the press. And Greece looks on the surface like an easy victim. And there is some residual belief that “Mediterranean nations” need more discipline (I have lived in Italy and am aware that even some Italians welcomed the Euro on the belief that it would discipline their own government). But leaving all that to the side, this story of Greece has elements that are sure to grab the attention of the press. A “profligate” government that spends well beyond its means. Shady backroom deals with huge Wall Street firms who help to hide debt and deceive the public as well as the rest of Euroland. And then a turn-coat Goldman that bets against its client (a normal practice at Goldman). The government now proposes austerity, and the population predictably reacts against cuts to pay and services. Civil unrest always makes headlines.

I think there is probably also a fear that they may be next. When bullies beat up a hapless child on the schoolyard, a crowd circles and cheers them on—in the fear that one of them might be next. I repeat, no Euro country is safe. So there is no doubt some perversity in the financial press’s attack on Greece, a sort of marveling at how easy it is to bring down a nation and an uneasy recognition that a similar fate awaits their own.

Greece’s real problem is the set up of the Euro, it is not due to failings of national character. In a sense, the arbitrary unfairness of this is what makes the story so much more exciting for the press.

3.What’s your assessment of the Greek government’s fiscal austerity program?

Wray: It will fail. Austerity eliminates any possibility of growth, imposes deflationary pressures, reduces tax revenues, and results in a growing budget deficit. An estimated 40% of Greece’s GDP is already unrecorded, and more activity will go underground to escape taxes. Add to the mix the fact that with the major exception of China, the entire globe is in deep recession that is likely to last many years. That means there is no hope for Greece to export its way out of this predicament. Wages are falling all across Euroland (13 out of 24 nations had falling wages last year, and more will this year), so no matter how much pressure the government can put on wages, it will not be able to significantly lower wages relative to European wages. Some have remarked that Greece is the next Latvia—which is trying to use austerity to become the lowest cost country. It will not work—it is a competitive race to the bottom. No one wins such a race.

4.Aside from Greece seceding from the EE and defaulting on its euro debt, what other options may have been available to the government other than the austere fiscal measures it introduced last week?

Wray: Seceding is, I think, a last resort. It would be quite costly. If Greece does secede then of course it should default on its debt and reinstate its own sovereign currency. In the short run it will be painful; in the long run it would be the correct strategy only if there is no hope for changing fiscal arrangements in Euroland.
Some have argued that stronger Euro nations might bail out Greece. I do not think that will happen, for reasons discussed above. Greece is only the first victim. The stronger nations might take over Greece’s debt, but then they would need to take over Portugal’s, then Italy’s, then Spain’s. That is not possible as markets would then attack Germany and France.

So here is the best course of action. The ECB will purchase government debt of all Euro member nations with a view to settling markets, bringing down risk spreads, and reducing interest payments by governments. It will also provide an emergency package of fiscal stimulus equal to one trillion euros distributed among all Euro nations on a per capita basis. Individual governments will decide how to spend the euros. Finally, the configuration of Euroland will be changed to increase the fiscal authority of the European Parliament, to provide funding equal to ten or fifteen percent of Euroland GDP (up from less than 1% today). Some of this funding would be managed from the center, but most would be distributed among member nations.

This would help to resolve the main problem faced by Euronations—and the real cause of Greece’s current crisis. The set-up was flawed from the very beginning. The individual nations gave up sovereign fiscal power when they joined the Euro. All of the focus has been on setting up the ECB, and surrender of monetary policy to the center. This was a neoliberal policy—to put economic power in the hands of an independent authority whose one mission was to fight inflation. But there was never a countervailing fiscal authority, responsible for maintaining full employment and robust economic growth. Individual nations could not really fill the gap, because markets would punish deficits—just as they are now doing to Greece. It is time to throw out the neoliberal agenda and to reformulate the union along more sensible lines.