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Bye, Bye Pensions, Goodbye

Posted on January 19, 2010 | 7 comments

I recently attended a financial markets conference at which some pension funds managers as well as a former head of the Pension Benefit Guarantee Corporation (PBGC, the FDIC of the pension world) spoke. Private pensions are just over 80% funded, meaning that the value of accumulated assets falls short of meeting promised pay-outs of defined benefit pension plans by about a fifth, amounting to a $400 billion shortfall. Not surprisingly, they are down considerably due to losses incurred during the financial crisis. Public pensions provided by state and local governments have a shortfall estimated to run as high as $2 trillion. On any reasonable accounting standard, the PBGC is bankrupt because its reserves will be wiped out by the failure of just a couple of large firms on “legacy” pensions. Most pensions have already been converted to defined contribution plans—which means that workers and retirees take all the risks. That will be the outcome of “legacy” plans that require bail-outs. In spite of some attempts to improve management and transparency of pension funds, it is almost certain that the PBGC , itself, will need a government bail-out, and that retirees face a more difficult future.

It is important to understand how we got into this predicament. During WWII government wanted to hold down wages to prevent inflation given that much of the nation’s productive activity was oriented toward the war. Unions and employers negotiated postponed payment in the form of pensions—which pleased all three parties: big firms, big government, and big unions. Government promoted this with tax advantages for contributions to pensions. Firms loved pushing costs to an indefinite future—rather than paying wages, they would promise to pay pensions 30 or 40 years down the road. Much of the promise was unfunded, or met by stock in the firm. This meant that pensions could be paid only if the firm was successful for a very long time into the future.

(As an aside, it is worth noting the similarities between the US healthcare system and its pension system. Firms also offered healthcare as a tax-advantaged benefit in lieu of wage increases. Over time, this became our current “managed care” highly financialized system. Like pension funds that are controlled by money managers, our healthcare is managed by highly oligopolized financial firms run by well-compensated executives. Workers have little control over their healthcare or their pensions. They are not “sovereign consumers” because they have neither the knowledge nor the ability to shop around for healthcare or pensions—in both cases, employers negotiate with providers and pass fees along to workers. With others in control, there is little to hold down costs—even as wages were sacrificed on the argument that workers were receiving valuable nonwage compensation. Now both healthcare and pensions are endangered by the same Washington forces promoting even greater financialization. (Go here.)

As time went on and it became apparent that “legacy” firms might not survive for the necessary half century (or more), unions and government felt that a mere promise to pay pensions would not suffice. Either firms would have to kick in a huge amount of cash to fully fund the pensions, or government would have to guarantee the pensions. Corporations did not like the costs attached to full funding. The grand compromise was that firms would increase funding a bit, and government would provide insurance through the PBGC. Funding did increase, although the more frequent and more severe crises in the post 1970 period always wiped out enough assets in each crisis to cause pension funding to dip below prudent levels. Only a financial bubble could get them back to full funding. To make matters worse, firms were allowed to reduce contributions during speculative bubbles (since asset values would be rising)—ensuring that the funds would face a crisis whenever the economy was not bubbling.

Just before the current global crisis hit, pension funding was, on average, doing well—thanks to the speculative bubble as well as to some deregulation that took place at the end of the Clinton administration that allowed pensions to gamble in more exotic instruments, and in riskier markets such as commodities. Previous to 2000, pensions could not buy commodities because these are purely speculative bets. There is no return to holding commodities unless their prices rise—indeed, holding them is costly. However, Goldman Sachs promoted investment in commodities as a hedge, on the basis that commodities prices are uncorrelated with equities. In the aftermath of the dot com collapse, that was appealing. (In truth, when managed money flows into an asset class that had previously been uncorrelated with other assets, that asset will become correlated. Hence, by marketing commodities Wall Street ensured a commodities bubble that would collapse along with everything else.)

You know the rest of that story: pension funds poured into commodities and commodity futures, driving up prices of energy, metals, and food. As energy prices rose, Congress mandated biofuels—which added to pressures on food prices that contributed to starvation around the globe. The bubble popped in what is known as the great Mike Masters inventory liquidation, as pension funds pulled out of commodities on the fear that Congress was coming after them. They didn’t want all the bad publicity that would be caused if workers knew that it was their own pension funds that were driving up gas prices at the pump.
However, pensions have quietly moved back into commodities—and oil prices have doubled. (go here) Indeed, pensions are also looking into placing bets on death through the so-called life settlements market (securitized life insurance policies that pay-off when people die early). (Go here) Ironically, this would be a sort of doubling down on death of retirees—since early death reduces the amount of time that pensions have to be paid, even as it increases pension fund assets. To conclude, pension funds are so large that they will bubble-up any financial market they are allowed to enter—and what goes up must come down.

But that is not what I want to write about here. I always had my suspicions about the strategy followed by pension fund managers, so the conference gave me the opportunity to talk to experts.
Here’s the deal. Each pension fund manager must come from the land of Lake Wobegone, because she/he must beat the average return or get fired. There are two fundamental principles widely believed to operate in financial markets that make such an outcome unlikely: the risk-return relation and the efficient markets hypothesis. Higher risk is rewarded with higher returns, hence, fund managers must take on more risk to get the reward of above-average returns. But since the higher return only rewards higher risk, with efficient markets the average fund manager will only receive the risk-free return. The higher returns of the brighter or luckier managers will be offset by the lower returns of the dumber and luckless money runners.

In other words, if your fund manager does not come from Lake Wobegone, you’d be better off investing in riskless Treasury bonds. Indeed, it is even worse than that because hiring an above average fund manager will require above average compensation—so even those funds with B-rated managers would probably provide lower net returns than Treasuries. To be sure, there is some shuffling of the deck so that one manager with a run of good luck can beat the average for a while, but she will probably fail catastrophically and wipe out several years of winnings in one swoop as some other lucky fool takes her place in the Wall Street lottery. Only the fortunate few can permanently live in Lake Wobegone and thereby beat Treasuries over the long run.

To be clear, these two principles may not be entirely correct—or, there could be other forces at play to allow for a positive return to risk even after subtracting losses. If so, that would go against the conventional wisdom that drives Wall Street. I think it is likely that over long periods of time, markets do tend to push risk-adjusted net returns toward zero so that on average safe Treasuries will beat net returns on risky assets. There is, however, a positive return to taking illiquid positions. And all things equal, it is probable that longer term maturities (long duration) receive a premium. Still, when all is said and done, pension managers that follow similar strategies, including taking positions in traded, liquid assets, will push risk spreads toward to the point that they just compensate for losses due to risk.

Each time there is a financial crisis, the funds tank and managers look for strategies to reduce risk. Enter Wall Street marketeers with an array of instruments to hedge and diversify risks. That was one of the big topics of the conference I attended. There is one sure bet when it comes to gambling: the house always wins. In financial markets, the big boys on Wall Street are the house, and they always win. Even if we leave to the side their ability to dupe and defraud country bumpkin pension fund managers, they charge fees for all the stuff they are selling. This ensures that on average pension funds will net less than a risk-free return. But wherever Wall Street intrudes, sucker bets and fraud exist. So the average return should be way below that of Treasuries, and even the managers from Lake Wobegone will probably net less than the risk-free return.
To recap: pension fund managers take on risk on the assumption that with higher risk comes higher return. Wall Street manufactures risky assets such as securitized subprime mortgages. It then convinces pension funds that they ought to diversify to reduce risk, for example by gambling on commodities. By coincidence, Wall Street just happens to be marketing commodities futures indexes to satisfy the demand it has created. It also provides a wide array of complex hedging strategies to shift risk onto better fools, as well as credit default “insurance” and buy-back assurances in case anything goes wrong. If all of these “risk management” strategies were completely successful, the pension fund would achieve a risk-free portfolio. Of course, it could have achieved this if it had bypassed Wall Street entirely and gone straight to the Treasury. However, Wall Street’s masters of the universe then would have had no market for the junk they were pushing, and pension fund managers would not have received their generous compensation. So workers are left with fees that drain their pension funds, and with massive counter-party risk as the hedges, insurance, and assurance go bad.

As mentioned above, we reward pensions with tax advantages and government guarantees. Before this crisis, private pension fund assets reached about 50% of GDP and state and local government pension fund assets reached almost 25%. That is a huge industry that has created a lot of well-compensated jobs for managers as well as Wall Street snake oil sales staff. The entire industry can be justified only if through skill or luck pension fund management can beat the average risk-free return by enough to pay all of those industry compensations. Yet, the expectation should be that fund managers are significantly less skilled and less “lucky” than, say, Goldman Sachs and J.P. Morgan banksters. Hence, workers would be far better off if their employers were required to fully fund pensions with investments restricted to Treasury debt. At most, each pension plan would require one lowly paid employee who would log-in to www.treasurydirect.gov to transfer funds out of the firm’s bank deposit and into Treasuries, in an amount determined by actuarial tables plus nominal benefits promised. Goodbye fund managers and Wall Street sales staff.

Indeed, this raises the question: should the federal government promote and protect pensions at all? Surely individuals should be free to place savings with fund managers of their choice, and each saver can try to find that manager from Lake Wobegone. But it makes no sense to promote a scheme that cannot succeed at the aggregate level—the average fund manager cannot beat the average, and on average there is no reason to believe that managed funds will provide a net return that is above the return on Treasuries. It would be far better to remove the tax advantages and government guarantees provided to pension plans, and instead allow individuals to put their savings directly into US Treasuries that are automatically government-backed and provide a risk-free return.

The US retirement system is supposed to rest on a three-legged stool: pensions, individual savings, and Social Security. Pensions are mostly employer-related and are chronically and seriously underfunded. There are also huge and growing administrative problems posed by the transformation of the US workplace—with the typical worker switching jobs many times over the course of her career, and with the lifespan of the typical firm measured in years rather than decades. And, finally, as discussed here the most plausible long-term return on managed money would be somewhat below the risk-free return on Treasuries.
The problem with private savings is that Americans do not save enough for their retirement. They never have. And even if they tried to do so, they would be duped out of their savings by Wall Street.
Thus, the best solution would be to eliminate government support for pension plans and instead to boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. They can supplement this with private savings, according to ability and desires.

I ran these arguments by several of the pension experts at the conference. All of them agreed that this would be the best public policy. But they pleaded with me to keep it a secret because such a change would be devastating for fund managers and Wall Street. Can you keep a secret?

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Sheila Bair Exposes Wall Street’s Power Grab: Angelides Commission Hearings, days 1 and 2

Posted on January 18, 2010 | 2 comments

By Michael Hudson*

You almost could hear the bankers heave a sigh of relief when Haiti’s earthquake knocked the Financial Crisis Inquiry Commission hearings off the front pages and evening news broadcasts last week. At stake, after all, is Wall Street’s power grab seeking to centralize policy control firmly in its own hands by neutralizing the government’s regulatory agencies. The first day – Wednesday, January 15 – went innocuously enough. Four emperors of finance were called on to voice ceremonial platitudes and pro forma apologies without explaining what they might be apologizing for. Typical was the statement by Goldman Sachs chairman Lloyd C. Blankfein: “Whatever we did, it didn’t work out well. We regret the consequence that people have lost money.”

Their strategy certainly made money for themselves – and they made it off those for whom the financial crisis “didn’t work out well,” whose bad bets ended up paying Wall Street’s bonuses. So when Paul Krugman poked fun at the four leading “Bankers without a clue” in his New York Times column, he was giving credibility to their pretense at innocent gullibility.

Recipients of such enormous bonuses cannot be deemed all that clueless. They blamed the problem on natural cycles – what Mr. Blankfein called a “100-year storm.” Jamie Dimon of JPMorgan Chase trivialized the crisis as a normal and even unsurprising event that “happens every five to seven years,” as if the crash is just another business cycle downturn, not aggravated by any systemic financial flaws. If anything, Wall Street accuses liberal government planners of being too nice to poor people, by providing cheap mortgage credit to the uninitiated who could not quite handle the responsibility.

But the Wall Street executives were careful not to blame the government. This was not just an attempt to avoid antagonizing the Congressional panel. The last thing Wall Street wants is for the government to change its behavior.

I think the Wall Street boys are playing possum. Why should we expect them to explain their strategy to us? To understand their game plan, the Commissioners had to wait for the second day of the hearings, when Sheila Bair of the Federal Deposit Insurance Corp. (FDIC) spelled it out. Their first order of business is to make sure that the Federal Reserve Board is designated the sole financial regulator, knocking out any more activist regulators – above all the proposed Consumer Financial Products Agency that Harvard Professor Elizabeth Warren has helped design. Wall Street also is seeking to avert any thought of restoring the Glass-Steagall Act in an attempt to protect the economy from having merged retail commercial banking with wholesale investment banking, insurance, real estate brokerage and kindred arms of high finance.

Perception – and exposure – of this strategy is what made the second day’s hearing (on Thursday) so important. From Sheila Bair down to state officials, these administrators explained that the problem was structural. They blamed government and the financial sector’s short-run time frame.

The past few years have demonstrated just how thoroughly the commercial and investment-banking sector already has taken control of government. Having succeeded in disabling the Securities and Exchange Commission (SEC) to such an extent that it refused to act even when warned about Bernie Madoff, deregulators did not raise a protest against the junk accounting that was burying the financial system in junk mortgages and kindred accounting fraud.

The Comptroller of the Currency blocked local prosecutors from moving against financial fraud, citing a small-print rule from the Civil War era National Bank Act giving federal agencies the right to override state agencies. Passed in the era of wildcat banking, the rule aimed to prevent elites from using crooked local courts to protect them. But in the early 2000s it was Washington that was protecting national banking elites from state prosecutors such as New York attorney general Eliot Spitzer and his counterparts in Massachusetts and other states. This prompted Illinois Attorney General Lisa Madigan to remind the Angelides Commission that the Office of the Comptroller of the Currency and the Office of Thrift Supervision were “actively engaged in a campaign to thwart state efforts to avert the coming crisis.”*

By far the major enabler was the Federal Reserve Board (FRB). Acting as the banking system’s lobbying organization, its tandem of Alan Greenspan and Ben Bernanke fought as a free-market Taliban against attempts to introduce financial regulation. Working with the Goldman Sachs managers on loan to the Treasury, the Fed managed to block attempts to rein in debt pyramiding.

Mr. Bernanke ignored the very first lesson taught in business schools. This was the lesson taught by William Petty in the 17th century and used by economists ever since: The market price of land, a government bond or other security is calculated by dividing its expected income stream by the going rate of interest – that is, “capitalizing” its rent (or any other flow of income) into what a bank would lend. The lower the rate of interest, the higher a loan can be capitalized. At an interest rate of 10%, a $10,000 annual income is worth $100,000. At 5%, this income stream is worth $200,000; at 4%, $250,000. Mr. Bernanke thus rejected over three hundred years of economic orthodoxy in testifying recently that the Fed was blameless in fueling the real estate bubble by slashing interest rates after 2001. Financial fraud also was not to blame. Anointed with the reputation for being a “student of the Great Depression,” he showed himself to be clueless.

He is not really all that clueless, of course. His role is to play the “useful idiot” whom financial elites can blame to distract attention from how they have gamed the system. Wall Street’s first aim is to make sure that the Fed remains in control as the government’s central regulator – or in the present case, deregulator, able to disable any serious attempt to check Wall Street’s drive to load down the economy with yet more debt so as to “borrow its way out of the bubble.”

Public relations “think tanks” (spin centers adept in crafting blame-the-victim rhetoric) use simple Orwellian Doublethink 101 tactics to call this “free market” policy. Financial self-regulation is to be left to bankers, shifting economic planning out of the hands of elected representatives to those of planners drawn from the ranks of Wall Street. This centralization of authority in a public agency “independent” from control by elected representatives is dubbed “market efficiency,” with an “independent central bank” deemed to be the hallmark of democracy. The words “democracy,” “progress” and “reform,” are thus given meanings opposite from what they meant back in the Progressive Era a century ago. The pretense is that constraints on finance are anti-democratic, not public protection against today’s emerging financial oligarchy. And to distract attention from the road to debt peonage, financial lobbyists accuse governments strong enough to check the financial interest” of threatening to lead society down “the road to serfdom.”

Avoiding regulation by having the Fed “regulate,” with neoliberal deregulators in charge

All that is needed is to reduce the number of regulators to one – and to appoint a deregulator to that key position. The most dependable deregulator is the commercial banking system’s in-house lobbyist, the Federal Reserve. This requires knocking out potential rivals. But at the Federal Deposit Insurance Corporation (FDIC), Sheila Bair is not willing to relinquish this authority. Her testimony last Thursday was buried on the back pages of the press, and her most trenchant written arguments lost in the hubbub caused by the earthquake in Haiti. Not reported by the media-of-record, her testimony should have been welcomed as intellectual dynamite.

For Ms. Bair the task requires blocking three key battles that the financial sector is waging in its war to control and extract tribute from the “real” economy of production and consumption. Her first policy to get the economy back on track is to ward off any plans that politicians might harbor to keep Wall Street unregulated. “Over the past two decades, there was a world view that markets were, by their very nature, self-regulating and self-correcting – resulting in a period that was referred to as the ‘Great Moderation’ [Mr. Bernanke’s notorious euphemism]. However, we now know that this period was one of great excess.” **

Banks are using the ploy familiar to readers of the Uncle Remus stories about B’rer Rabbit. When the fox finally catches him, the rabbit begs, “Please don’t throw me in the briar batch.” The fox does just that, wanting to harm the rabbit – who gets up and laughs, “Born and bred in the briar patch!” and hops happily away, free. This is essentially what the financial scenario would be under Federal Reserve aegis. “Not only did market discipline fail to prevent the excesses of the last few years, but the regulatory system also failed in its responsibilities. There were critical shortcomings in our approach that permitted excessive risks to build in the system. Existing authorities were not always used, regulatory gaps within the financial system provided an environment in which regulatory arbitrage became rampant …”

No more damning reason could be given for Congress to reject Mr. Bernanke out of hand, if not indeed to set about restructuring the Fed to bring it back into the Treasury, from which it emerged in 1914 in one of the most unfortunate Caesarian births of the 20th century. In detail, she explained how the Fed had acted as an agent of the commercial banks perpetrating fraud, protecting their sale of toxic mortgage products against consumer interests and indeed, the solvency of the economy itself. Nobody can read her explanation without seeing what utter folly it would be to put Creditor Fox in charge of the Debtor Henhouse.

Blocking creation of a Consumer Protection Agency

Ms. Bair’s second aim was to counter Wall Street’s attempt to block enactment of the Consumer Protection Agency. Its lobbyists have had a year to disable any real reform, and Washington obviously believes that it can be safely jettisoned. But Ms. Bair spelled out just how willful and egregious the Fed’s refusal to use its regulatory powers – and indeed, its designated responsibilities – has been. “Federal consumer protections from predatory and abusive mortgage-lending practices are established principally under the Home Ownership and Equity Protection Act (HOEPA), which is part of the Truth in Lending Act (TILA). TILA and HOEPA regulations are the responsibility of the Board of Governors of the Federal Reserve System (FRB) and apply to both bank and non-bank lenders,” she explained. “Many of the toxic mortgage products that were originated to fund the housing boom … could have been regulated and restricted under another provision of HOEPA that requires the FRB to prohibit acts or practices in connection with any mortgage loan that it finds to be unfair or deceptive, or acts and practices associated with refinancing of mortgage loans that it finds abusive or not otherwise in the interest of the borrower.”

This was not done. It was actively thwarted by the Fed:

Problems in the subprime mortgage market were identified well before many of the abusive mortgage loans were made. A joint report issued in 2000 by HUD and the Department of the Treasury entitled Curbing Predatory Home Mortgage Lending … found that certain terms of subprime loans appear to be harmful or abusive in practically all cases. To address these issues, the report made a number of recommendations, including that the FRB use its HOEPA authority to prohibit certain unfair, deceptive and abusive practices by lenders and third parties. During hearings held in 2000, consumer groups urged the FRB to use its HOEPA rulemaking authority to address concerns about predatory lending. Both the House and Senate held hearings on predatory abuses in the subprime market in May 2000 and July 2001, respectively. In December 2001 the FRB issued a HOEPA rule that addressed a narrow range of predatory lending issues.

It was not until 2008 that the FRB issued a more extensive regulation using its broader HOEPA authority to restrict unfair, deceptive, or abusive practices in the mortgage market.

This was closing the barn door after the horses had fled, of course. “The rule imposes an ‘ability to repay’ standard in connection with higher-priced mortgage loans. For these loans, the rule underscores a fundamental rule of underwriting: that all lenders, banks and nonbanks, should only make loans where they have documented a reasonable ability on the part of the borrower to repay. The rule also restricts abusive prepayment penalties.”

Warning that “the consequences we have seen during this crisis will recur,” Ms. Bair reiterated a recommendation she had earlier made to the effect that “an ability to repay standard should be required for all mortgages, including interest-only and negative-amortization mortgages and home equity lines of credit (HELOCs). Interest-only and negative-amortization mortgages must be underwritten to qualify the borrower to pay a fully amortizing payment.” The Fed blocked this common-sense regulatory policy. And by doing so, it became an enabler of fraud.

As the private-label MBS [Mortgage-Backed Securities] market grew, issuances became increasingly driven by interest-only, hybrid adjustable-rate, second-lien, pay-option and Alt-A mortgage products. Many of these products had debt-service burdens that exceeded the homeowner’s payment capacity. For example, Alt-A mortgages typically included loans with high loan-to-value ratios or loans where borrowers provided little or no documentation regarding the magnitude or source of their income or assets. Unfortunately, this class of mortgage products was particularly susceptible to fraud, both from borrowers who intentionally overstated their financial resources and from the mortgage brokers who misrepresented borrower resources without the borrower’s knowledge.

As Paul Volcker recently suggested, financial “innovation” did not contribute much to production. Packaging junk mortgages and organizing CDO swaps made real estate more debt-leveraged, while adding higher debt balances to the economy’s homes and office properties. But “the regulatory capital requirements for holding these rated instruments were far lower than for directly holding these toxic loans,” Ms. Bair explained. “Many of the current problems affecting the safety and soundness of the financial system were caused by a lack of strong, comprehensive rules against abusive lending practices applying to both banks and non-banks.”

Improved consumer protections are in everyone’s best interest. It is important to understand that many of the current problems affecting the safety and soundness of the financial system were caused by a lack of strong, comprehensive rules against abusive practices in mortgage lending. If HOEPA regulations had been amended in 2001, instead of in 2008, a large number of the toxic mortgage loans could not have been originated and much of the crisis may have been prevented. The FDIC strongly supported the FRB’s promulgation of an “ability to repay” standard for high priced loans in 2008, and continues to urge the FRB to apply common sense, “ability to repay” requirements to all mortgages, including interest-only and option-ARM loans.

The absence of proper consumer protection was a major contributing factor to the present financial meltdown, for “it has now become clear that abrogating sound state laws, particularly regarding consumer protection, created opportunity for regulatory arbitrage that resulted in a regulatory ‘race-to-the-bottom.’” Mortgage fraud became rife as bank regulators failed to protect consumers or the economy at large. This is why an independent agency is needed rather than hoping that the Federal Reserve somehow can change its spots. “If the bank regulators are not performing this role properly, the consumer regulator should retain backup examination and enforcement authority to address any situation where it determines that a banking agency is providing insufficient supervision.”

Summarizing her 54-page written testimony orally, Ms. Bar commented that, “looking back, I think if we had had some good strong constraints at that time, just simple standards like … you’ve got to document income and make sure they can repay the loan . . . we could have avoided a lot of this.”*** But the same day on which her testimony was capsulized, the Wall Street Journal leaked the story that “Senate Banking Committee Chairman Christopher Dodd is considering scrapping the idea of creating a Consumer Financial Protection Agency … as a way to secure a bipartisan deal on the legislation,” that is, a deal with “Richard Shelby of Alabama, who has referred to the Consumer Financial Protection Agency as a ‘nanny state.’ … The banking industry has spent months lobbying aggressively to defeat the creation of the CFPA. ‘One of our principal objections all along is that you would have a terrible conflict on an ongoing basis between a separate consumer regulator and the safety and soundness regulator, with the bank constantly caught in the middle,’ said Ed Yingling, chief executive of the American Bankers Association trade group.”**** The idea is that a “conflict” between an institution seeking to protect consumers – and indeed, the economy – from an in-house banking lobbying institution (the Fed), backed by the Treasury safely in the hands of Goldman-Sachs caretakers on loan is “inefficient” rather than a necessary democratic safeguard! But the paper gave more space crowing over the likely defeat of the Consumer Financial Protection Agency than it did to Ms. Bair’s eloquent written testimony!

Avert any thought of re-enacting Glass-Steagall

On the institutional level, Wall Street’s managers want to ward off any threat that the Glass-Steagall legislation might be revived to separate consumer deposit banking and money management from today’s casino capitalism. This is what Paul Volcker has urged, but it is now obvious that Pres. Obama appointed him only for window dressing, much like that of Pres. Johnson said of J. Edgar Hoover: he would rather have him inside his tent pissing out than outside pissing in. Appointing Mr. Volcker as a nominal advisor effectively prevents the former Fed Chairman from making hostile criticisms. Pres. Obama simply ignores his advice to re-instate Glass-Steagall, having appointed as his senior advisor the major advocate of the repeal in the first place – Larry Summers, along with the rest of the old Rubinomics gang taken over from the Clinton administration.

Ms. Bair explained why Wall Street’s preferred “reforms” along the current line – maintaining the “too big to fail” financial oligopoly intact, along with the Bush-Obama deregulatory “free market” ideology – threatens to return the financial system to its bad old ways of crashing. To Wall Street, of course, this is the “good old way.” Wall Street is consolidating the finance, insurance and real estate (FIRE) sector across the board into oligopolistic conglomerates “too big to fail.”

But being realistic under the circumstances, Ms. Bair avoided taking on more of a battle than likely can be won at this time. “One way to address large interconnected institutions,” she proposed, “is to make it expensive to be one. Industry assessments could be risk-based. Firms engaging in higher risk activities, such as proprietary trading, complex structured finance, and other high-risk activities would pay more” for their deposit insurance, to reflect the higher systemic risks they are taking. This suggestion is along the lines of proposals (made for over half a century now) to set different reserve requirements or capital adequacy requirements for different categories of bank loans.

Alas, she acknowledged, the Basel agreements regarding capital adequacy standards are being loosened rather than tightened. “In 2004, the Basel Committee published a new international capital standard, the Basel II advanced internal ratings-based approach (as implemented in the United States, the Advanced Approaches), that allows banks to use their own internal risk assessments to compute their risk-based capital requirements. The overwhelming preponderance of evidence is that the Advanced Approaches will lower capital requirements significantly, to levels well below current requirements that are widely regarded as too low.” She criticized the new, euphemistically termed “Advanced Approach” as producing “capital requirements that are both too low and too subjective.” The result is to increase rather than mitigate financial risk.

The need for tax reform to accompany financial reform

Beyond the scope of the FDIC or other financial regulatory agencies is the symbiosis between financial and fiscal reform.

For example, federal tax policy has long favored investment in owner-occupied housing and the consumption of housing services. The government-sponsored housing enterprises have also used the implicit backing of the government to lower the cost of mortgage credit and stimulate demand for housing and housing-linked debt. In political terms, these policies have proven to be highly popular. Who will stand up to say they are against homeownership? Yet, we have failed to recognize that there are both opportunity costs and downside risks associated with these policies. Policies that channel capital towards housing necessarily divert capital from other investments, such as plant and equipment, technology, and education—investments that are also necessary for long-term economic growth and improved standards of living. *****

The problem is that U.S. financial and fiscal policy has institutionalized the financial sector’s short-term outlook,“distorting of decision-making away from long-term profitability and stability and toward short-term gains with insufficient regard for risk.” For example, money managers are graded every three months on their performance against the norm. Ms. Bair focused on how employee compensation in the form of stock options tended to promote short-termism. “Formula-driven compensation allows high short-term profits to be translated into generous bonus payments, without regard to any longer-term risks. Many derivative products are long-dated, while employees’ compensation was weighted toward near-term results. These short-term incentives magnified risk-taking.” In sum, “performance bonuses and equity-based compensation should have aligned the financial interests of shareholders and managers. Instead, we now see – especially in the financial sector – that they frequently had the effect of promoting short-term thinking and excessive risk-taking that bred instability in our financial system. Meaningful reform of these practices will be essential to promote better long-term decision-making in the U.S. corporate sector.”

Conclusion: Pushing the economy even deeper into debt beyond the ability to pay

The banking system’s marketing departments have set their eyes on the economy’s largest asset, real estate, as its prime customer. The major component of real estate is land. For years, banks lent against the cost of building, using land (tending to rise in value) as the borrower’s equity investment in case of downturn. This was the basic plan in lending 70%, then 80% and finally 100% or even more of the real estate price to mortgage borrowers. The effect is to make housing even more expensive.

Suppose that Wall Street succeeds in its strategy to re-inflate the Bubble Economy. Will this create even larger problems to come, by making the costs of living even higher as labor and industry become even more highly debt leveraged? That is the banking sector’s business plan, after all. The aim of bank marketing departments – backed by the Obama administration – is to steer credit to re-inflate the bubble and thus save financial balance sheets from their current negative equity position.

This policy cannot work. One constraint is the balance of payments. The competitive power of U.S. exports of the products of American labor is undercut by the fact that housing costs absorb some 40% of labor’s family budgets today, other debt 15%, FICA wage withholding 12%, and various taxes another 20%. U.S. labor is priced out of world markets by the economy’s FIRE sector overhead even before food and essential needs of life are bought. The “solution” to the financial sector’s negative equity squeeze thus threatens to create even larger problems for the “real” economy. Ms. Bair appropriately concluded her written testimony by commenting that the context for the present discussion of financial reform should be the fact that “our financial sector has grown disproportionately in relation to the rest of our economy,” from “less than 15 percent of total U.S. corporate profits in the 1950s and 1960s … to 25 percent in the 1990s and 34 percent in the most recent decade through 2008.” While financial services “are essential to our modern economy, the excesses of the last decade” represent “a costly diversion of resources from other sectors of the economy.”

This is the same criticism that John Maynard Keynes levied in his General Theory, citing all the money, effort and genius that went into making money from money in the stock market, without actually contributing to the production process or even to tangible capital formation. In effect, we are seeing finance capitalism autonomous from industrial capitalism. The problem is how to restore a more balanced economy and rescue society from the financial sector’s self-destructive short-term practices.

*Sewell Chan, “A Call for More Regulation at Fiscal Crisis Inquiry,” The New York Times, January 15, 2010. William Black provides the classic narrative in The Best Way to Rob a Bank is to Own One. He documents how the FBI’s anti-fraud teams and those of other agencies were reduced to merely skeleton levels, overseen by do-nothing deregulatory ideologues of the sort who served as enablers to Wall Street’s Bernie Madoffs.

**Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation on the Causes and Current State of the Financial Crisis before the Financial Crisis Inquiry Commission; Room 1100, Longworth House Office Building, January 14, 2010. http://www.fdic.gov/news/news/speeches/chairman/spjan1410.html.

***Tom Braithwaite, “Deposits regulator points finger of blame at Fed,” Financial Times, January 15, 2010.

****Damian Paletta, “Consumer Protection Agency in Doubt,” Wall Street Journal, January 15, 2010.

*****The Wall Street Journal cut this passage from the on-line version of Friday’s article by John D. McKinnon and Michael R. Crittenden, “Financial Inquiry Widens to Include Past Regulators,” January 15, 2010.

On-line transcripts of the hearings are available at
http://www.fcic.gov/hearings/pdfs/2010

Prof. Hudson has just republished a new and expanded edition of his Trade, Development and Foreign Debt, a history of theories of international trade and finance. It is available from Amazon.com.

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“Enough Wall Street Nonsense”

Posted on January 13, 2010 | Comments Off

http://cosmos.bcst.yahoo.com/up/fop/embedflv/swf/fop_wrapper.swf?id=17587579&autoStart=0&prepanelEnable=1&infopanelEnable=1&carouselEnable=0

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Geithner-AIG scandal

Posted on January 11, 2010 | Comments Off

“NY Fed, AIG Emails Spark New, Bipartisan Criticism Of Geithner“. See the discussion here, here and here.
The video is here.

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The Contributions of Paul Samuelson: An Institutionalist’s Perspective

Posted on January 10, 2010 | Comments Off

By Phil Klein

I know I’m a little behind, but I’m only just catching up with the debate (see here and here) over the importance of Paul Samuelson’s contribution to economics. I’ve found the discussion of the underconsumption controversy especially interesting because it took me back to a debate in the department of economics, not exactly yesterday, but germane to the discussion in AFEE in December. It also pertains to a reconsideration of the forecasting ability of Paul Samuelson.

I have always found it useful to acquire each edition of Samuelson’s book as it appears because it chronicles neatly each fad in economics, particularly economic theory, as it appears.

The underconsumption controversy and Paul Samuelson were both involved ultimately in the appraisal of Keynes’ General Theory and the work on which it was based.

In Samuelson’s first edition (1948), Keynes is mentioned exactly twice in the index (pages 253 and 303). (How long ago was 1948? For answer, my edition informs us that the book cost $3.25.) To be fair to Samuelson, he did recognize that Keynes might be different – he does call him, “a many-sided genius.” But he then refers to his non-economics interests – a large insurance company, the ballet, the drama, how to make money, etc. In the end, he tells us that the General Theory “created one of the greatest stirs in economic thinking of the century, and is likely to live longer than his other works as a classic.”

It is clear that Samuelson had reservations about Keynes from the beginning. For example, he says of Keynes’ work that “its broad fundamentals are increasingly accepted by economists of all schools of thought, including, it is important to notice, many writers that do not share Keynes’ particular policy viewpoints and who differ on technical details on analysis.”

At the University of Texas, there was considerable discussion concerning the General Theory when it came out in 1936. The Austin discussion of Keynes’ General Theory started from its publication. By the mid 40s, it had begun to focus on the relationship of Keynes’ work in contrast to the work of S. Gordon Hayes. In this early discussion of Keynes, it is interesting and important to note Ayres’ position. At this time, the “underconsumption controversy” was going hot and heavy. Keynes was discussed in connection with the book by H. Gordon Hayes, Spending, Saving, and Employment (1946):

“The principal difference between the position taken in this book and that taken by Keynes is, in part, a matter of emphasis. He stresses the importance of investing what is not consumed, and here the emphasis is on consuming what is not invested. The difference, however, is more than a matter of emphasis. Keynes holds that the real cause of unemployment is lack of investment, while I ascribe it to a lack of consumption. He sees a continuous increase in investment as the remedy for unemployment, while I regard that as impossible. I believe that the very condition that ‘makes investment necessary’ if we are to have employment – namely, lack of consumption – prevents additional investments from being profitable.” (Samuelson’s only comment is to include the underconsumption theory among what he refers to as “one of the five better known theories” of the business cycle.)

The dispute between the underconsumption theory and the overinvestment theory waxed hot and heavy in the department. Ayres sided with the underconsumptionists, and his colleague, Professor Everett Hale, led the overinvestment theorists. The dispute culminated with Ayres’ ultimately declaring, “I would gladly sell Gordon Hayes down the river if it would keep peace in the family.”

Upon reflection, I would think today the possible cause of unemployment, it could be argued, rather than being caused by underconsumption OR overinvestment, is caused by the disparity between the rate of consumption and the rate of investment.

The underconsumption controversy was by no means the last time that Samuelson’s position was murky at best and unhelpful in introducing the Americans to Keynes’ work. (That job was far better done by Dudley Dillard, whose book introduced the basic Keynesian theory in a simpler framework designed to make the introduction to Keynes easier to grasp.) As for the theory itself, Alvin Hansen applied the theory to the United States’ economy in a way that made the international relevance of the theory easier to understand.

Samuelson restricts his comments on Hansen mainly to his work on the “secular stagnation” view.

Work at the National Bureau of Economic Research did a good deal to study the implications of Keynesian theory for the study of business cycles. In this connection, the Bureau, particularly in the work of Ilse Mintz, focused the business cycle theory on growth cycles as well as level cycles. Not only did this work show that the level of economic activity fluctuated cyclically, but so did the rate of growth. The turning points in the rates of growth had the further advantage of leading the fluctuations in the level of activity.

Instead of recognizing the value of this insight for forecasting, Samuelson said that the National Bureau was in danger working itself out of a job. Therefore, it was clear in short order that Samuelson was dead wrong here. Much work has since been done showing that studies of growth rates was a valuable contribution to the efforts to make leading indicators lead cyclical activity as well as reflecting it.

In sum, Paul Samuelson’s reputation for making accurate contributions to our understanding of business cycles are at most very small indeed.

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Anti-Regulators: the Federal Reserve’s War against Effective Regulation

Posted on January 8, 2010 | 4 comments

By William K. Black

Introduction

The first decade of this century proved how essential effective regulators are to prevent economic catastrophe and epidemics of fraud. The most severe failure was at the Federal Reserve. The Fed’s failure was the most harmful because it had unique authority to prevent the fraud epidemic and the resulting economic crisis. The Fed refused to exercise that authority despite knowing of the fraud epidemic and potential for crisis.

The Fed’s failures were legion, but five are worthy of particular note.

Greenspan believed that the Fed should not regulate v. fraud
Bernanke believed that the Fed should rely on self-regulation by “the market”
(Former) Federal Reserve Bank of New York President Geithner testified that he had never been a regulator (a true statement, but not one he’s supposed to admit)
Bernanke gave the key support to the Chamber of Commerce’s effort to gimmick bank accounting rules to cover up their massive losses – allowing them to report fictional profits and “earn” tens of billions of dollars of bonuses
Bernanke recently appointed Dr. Parkinson as the Fed’s top supervisor. He is an economist that has never examined or supervised. He is known for claiming that credit default swaps (CDS) (the financial derivatives that destroyed AIG) should be unregulated because fraud was impossible among sophisticated parties.

Each error arises from the intersection of ideology and bad economics.

The Fed’s regulatory failures pose severe risks today. Three of the key failed anti-regulators occupy some of the most important regulatory positions in the World. Each was a serial failure as regulator. Each has failed to take accountability for their failures. Last week, Dr. Bernanke asserted that bad regulation caused the crisis – yet he was one of the most senior bad regulators that failed to respond to the fraud epidemic and prevent the crisis. As Dr. Bernanke’s appointment of Dr. Parkinson as the Fed’s top supervisor demonstrates, the Fed’s senior leadership has failed, despite the Great Recession, to learn from the crisis and abandon their faith in the theories and policies that caused the crisis. Worse, the Fed is an imperial anti-regulator, seeking vastly greater regulatory scope at the expense of (modestly) more effective sister regulatory agencies. The Fed’s failed leadership is setting us up for repeated, more severe financial crises.

Dr. Parkinson as Anti-Regulator

This essay focuses on Chairman Bernanke’s recent appointment of Dr. Parkinson to lead the Fed’s examination and supervision. My central point is that Dr. Bernanke appointed Dr. Parkinson because he shared Dr. Bernanke’s anti-regulatory ideology and has never changed those views even in the face of the Great Recession. The anti-regulator policies that Bernanke and Parkinson championed were the principal drivers of the fraud epidemic that have produced recurrent, intensifying crises.

Bernanke’s appointment as the Fed’s top supervisor of an individual that had no experience in regulation, in the midst of the greatest crisis of our lifetime, is irresponsible and dangerous on its face. No ideology has proven more disabling in this crisis than neoclassical economics. Dr. Parkinson is a neoclassical economist. The “skills” an economist would purportedly bring to supervision have proven to be disabilities in identifying and understanding fraud and risk.

We need not rely on generalities – Dr. Parkinson has a record relevant to supervision that we can evaluate. The most revealing aspects of that record fall into three categories. First, Dr. Parkinson was a leading proponent of the obscene (and successful) effort to prevent CFTC Chair Born from taking regulatory action to prevent destructive credit default swaps (CDS). Second, Dr. Parkinson, like Greenspan and Bernanke, subscribed to the naïve view that fraud was impossible in sophisticated financial markets and that credit rating agencies were reliable. Third, Dr. Parkinson endorsed the international “competition in regulatory laxity” that Dr. Bernanke (belatedly) warned has degraded regulation on a global basis. Here are the key passages from Dr. Parkinson’s congressional testimony:

Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from counterparty insolvencies and from fraud. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud.

***

If this opportunity is lost, the Board is concerned that market participants will abandon hope for regulatory reform in the United States and take critical steps to shift their activity to jurisdictions that provide more appropriate legal and regulatory frameworks.

The “opportunity” Dr. Parkinson feared would be “lost” was to remove the CFTC’s ability to regulate CDS. Anti-regulation would “win” the international competition in laxity. His policies made possible the catastrophe that is AIG. Dr. Bernanke is aware of Dr. Parkinson’s record of anti-regulatory failure. He chose Dr. Parkinson because of that record in order to ensure that the Fed would not take regulatory actions that would upset the biggest banks, particularly the systemically dangerous institutions (SDIs) that are the real governors of the Fed’s anti-regulatory policies.

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Timmy Geithner Must Go

Posted on January 7, 2010 | 6 comments

SECRET EMAILS SHOW GEITHNER’S NYFED FORCED AIG TO HIDE DATA
By L. Randall Wray

Breaking News: As reported on Bloomberg here and in NYT here, secret emails show that the NYFed under Geithner’s command prohibited AIG from reporting that it was passing government bail-out funds directly to counterparties, including Goldman Sachs. AIG had been negotiating with the banks, asking them to take as little as 40 cents on the dollar against bad CDOs they held. AIG was the biggest insurer in the country and had provided $62 billion of credit default “insurance” to these banks. The CDOs went bad and AIG could not cover claims. It was forced into insolvency and the government came to the rescue, with $182 billion of bailout funds through last June. By all rights, its counterparties should have lost big on their bad bets. Apparently, Geithner arranged the bailout of AIG with full knowledge that it would pass the bailout funds directly to the banks. Whether or not some protection should have been provided to the banks, it clearly was not good public policy to provide dollar-for-dollar protection to them. If you are a favored Wall Street bank, no bet can go bad!

Note that Geithner worked with then Treasury Secretary Paulson to broker this deal. Paulson, of course, had been the CEO of Goldman. Geithner is the protégé of Clinton’s Treasury Secretary Rubin, also from Goldman.

According to Representative Darrell Issa, Republican of California, “It appears that the New York Fed deliberately pressured AIG to restrict and delay the disclosure of important information to the S.E.C.”. Not only did Geithner want to keep this information from the public, but also from fellow regulators. (Whoops, Geithner admitted he was never a regulator.) This smells fishy because it is. Geithner not only oversaw the operation but his office prohibited AIG from telling the truth about it. Remember, this is the same guy who “forgot” to pay his taxes (see here). He is ethically challenged. Should he be running the Treasury?

As Republican Congressman Brady of Texas put it, “Conservatives agree that, as point person, you’ve failed. Liberals are growing in that consensus as well. Poll after poll shows the public has lost confidence in this president’s ability to handle the economy. For the sake of our jobs, will you step down from your post?” (see here).

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Let The Mea Culpas Begin, Part 2

Posted on January 6, 2010 | 10 comments

BERNANKE’S APOLOGY FALLS FLAT
By L. Randall Wray

As discussed in Part 1 (see here), some of the policymakers responsible for this calamity have started to apologize. On January 3 Chairman Bernanke admitted that rather than using rate hikes back in 2004 to deflate the housing bubble, the Fed should have used “[s]tronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management” (see here).

There appear to be at least three reasons for Bernanke’s admission that the Fed did not do its job. First, and most obviously, Bernanke is up for reappointment (his term expires January 31)—and he will not sail through. The public is mad as hell, and politicians will have to put him through the wringer or face voter’s wrath in the next election. So Bernanke will have to appear contrite, and will apologize for his misdeeds many more times while Congress makes him sweat it out.

Second, Congress is actually considering whether it should strip the Fed of all regulatory and supervisory authority, given its miserable performance over the past decade—during which the Fed has consistently demonstrated that it has neither the competence nor the will to restrain Wall Street’s bankers. Since Greenspan took over the helm, the Fed has never seen a financial instrument or practice that it did not like—no matter how predatory or dangerous it was. Adjustable rate mortgages with teaser rates that would reset to levels guaranteed to produce defaults? Greenspan praised them (see here). Liar loans? Bring them on! NINJA loans (no income, no job, no assets)? No problem! Credit default swaps that let one gamble on the death of assets, firms, and countries? Prohibit government from regulating them! So Bernanke has to grovel and beg Congress to let the Fed retain at least some of its authority.

Third, many commentators blame the Fed for the crisis, arguing that it kept interest rates too low for too long, fueling the real estate bubble. Bernanke argues “When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment”. If he can convince Congress that the problem was lack of oversight and regulation he can shift at least some of the blame to Treasury and Congress—since it was Treasury Secretary Rubin, and his protégé Summers, as well as Barney Frank, Christopher Dodd, and many others (significantly, Democrats who will now decide the Fed’s fate) who pushed through the deregulation bills in 1999 and 2000. He figures that if the Fed now supports re-regulation, he will be forgiven and the Democrats will be too embarrassed to admit their own misdeeds. (Significantly, Dodd has announced his retirement, in recognition of the role he played in creating the crisis. Another mea culpa on the way?)

While I do believe the Fed should be stripped of all such authority, I am sympathetic to his argument about monetary policy. Low interest rates do not cause bubbles. The Fed kept interest rates low after the NASDAQ crash because it feared deflation in the face of significant downward pressures on wages and prices globally (see here). The belief was that low interest rates would keep borrowing costs low for firms and households, helping to promote spending and recovery. In truth, spending is not very interest sensitive and the economy stumbled along in a “jobless recovery” in spite of the low rates. What was actually needed was a fiscal stimulus (if anything, low rates are counterproductive because they reduce government interest spending on its debt—as Japan’s experience taught us over the past couple of decades—but that is a point for another blog).

Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!) The worst excesses in real estate markets began only after the Fed had started raising rates, and lending standards continued their downward spiral the higher the Fed pushed its target interest rate. In other words, contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets.

Why not? Two main reasons. First, recall that Greenspan had promoted adjustable rate mortgages with teasers. No matter how high the Fed pushed rates, lenders could offer “option rate” deals in which borrowers would pay a rate of 1 or 2 percent for two to three years, after which there would be a huge reset. Lenders ensured the borrowers that there was no reason to worry about resets, since they would refinance into another option rate mortgage before the reset. That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate.

Second, and this was the key, house prices would only go up. At the time of refinance, the borrower would have far more equity in the home, thus obtain a better mortgage. Further, the borrower could flip the house and walk away with cash. While I will not go into this now, public policy actually encouraged homeowners to look at their houses as assets, rather than as homes (see here) (And now that many are walking away from underwater mortgages—treating houses as assets that became bad deals—policy makers and banksters are shocked, shocked!, that borrowers are treating their homes as nothing but bad assets.)

In truth, when speculation comes to dominate an asset class, there is no interest rate hike that can kill a bubble. If one expects asset prices to rise by 20%, 30%, or more per year, an interest rate of 10% will not dampen enthusiasm. To kill the housing boom, the Fed would have had to engage in a Volcker-like double-digit rate hike (in the early 1980s, he raised short-term interest rates above 20%). There was no political will in Washington (either at the Fed or the White House) for such drastic measures. Nor was there any reason to do this. Bernanke is quite correct: the Fed could have and should have killed the real estate boom with much less pain by directly clamping down on lenders, prohibiting the dangerous practices that were rampant.

Is there any reason to believe that Bernanke is the right Chairman, or that the Fed is the right institution, to lead the effort to re-regulate and re-supervise the financial sector? Quite simply, no.

The Bernanke-led Fed still does not understand monetary operations, as indicated by its recently announced plan to unwind its balance sheet. Over the course of the crisis, the Fed invented new procedures such as auctions through which it provided reserves. Throughout, it always was focused on quantities, rather than prices, using quantitative constraints on the size of the auctions. Further, Bernanke continually promoted “quantitative easing”, reflecting the view that quantities are what matter. Now, the Fed has begun to worry about the size of its balance sheet—and also the size of reserve holdings of the banking system (the other side of the balance sheet coin, because the Fed buys assets by issuing reserves). Still following the thoroughly discredited theory of Milton Friedman, too many bank reserves are supposed to promote too much lending which then causes too much spending and hence inflation. Thus, Bernanke and many outside the Fed fret about how the Fed can reduce outstanding reserves to prevent incipient inflation. The Fed proposes to create new bonds it will sell to reverse the “quantitative easing”.

Actually, the Fed’s tool is price, not quantity, of reserves. When the crisis hit, the Fed should have opened its discount window to lend reserves without limit, to all comers, and without collateral. That is how you stop a run. The Fed’s dallying and dillying about worsened the liquidity crisis, but it eventually provided the reserves that the financial institutions wanted to hold and its balance sheet eventually grew to $2 trillion. Banks are still worried about counterparty risk and possible runs, so they remain willing to hold massive amounts of reserves. When they decide risks have declined, they will begin to reduce reserve holdings. This will not require any special practices by the Fed. Banks will repay their loans from the Fed, using reserves. This automatically reduces reserves and the size of the Fed’s balance sheet. They will offer undesired reserves in the overnight, fed funds market. Since many banks will be trying to unload reserves at the same time, this will put downward pressure on the fed funds rate. The Fed will then offer to sell assets it is holding to mop up the excess reserves (banks will use reserves to buy assets the Fed offers). This will also reduce reserves and the size of the Fed’s balance sheet. All of this will happen automatically, following the same procedures the Fed has always followed. All it needs to do is to watch the fed funds rate, and when it falls below target the Fed will drain reserves to relieve the downward pressure on overnight rates.

Quantitative easing was a misguided notion, and reversal of quantitative easing is similarly misguided. It simply indicates that Bernanke still does not understand how the Fed operates. In truth, formulating and implementing monetary policy is extremely simple and can be reduced to the following:

1. Offer to lend reserves at the discount window at 50 basis points to all qualifying institutions;

2. Pay 25 basis points on reserve holdings;

3. Perform par clearing of checks between banks, and for the Treasury.

Surely President Obama can find a chair who can do that.

The Fed’s relationship with banks is too cozy to make it a good regulator. It is, after all, owned by private banks. The Fed’s district banks are often run by bankers, and district Fed presidents take turns sitting on the policy-making FOMC. There is a particularly incestuous relationship between the NYFed and Wall Street banks—with Timmy Geithner as a prime example of the dangers posed (“I’ve never been a regulator” proclaimed the former head of the NYFed). It does not have the proper culture to closely supervise financial institutions. Its top body, the Board of Governors, are political appointees often with no experience in regulation (many are academic economists, typically mainstream and with a free market orientation). While the FDIC was also mostly asleep at the wheel over the past decade, it does have the proper culture and experience to take over responsibility for regulating and supervising the financial sector. With some management changes, and hiring of a team of criminologists tasked to pursue fraud, the FDIC is the right institution for this job.

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Let the Mea Culpas Begin, Part 1

Posted on January 5, 2010 | 3 comments

RUBIN AND BERNANKE APOLOGIZE (SORT OF) FOR PAST SINS

By L. Randall Wray

Alan Greenspan has already apologized for the damage he wrought, admitting the crisis reveals that his approach to economics is fundamentally flawed.

Apparently it is now time for mea culpas from the rest of the team most responsible for creating this mess: Rubin, Summers, and Bernanke. Rubin and Bernanke just provided theirs (here and here) —albeit somewhat half-heartedly, a bit more Tiger Woods than David Letterman.

Don’t hold your breath for an apology from Summers, who never owns up to his mistakes, ranging from his proposal to use developing nations as toxic waste dumps to his argument that females suffer from congenital handicaps that render them incapable of doing science (here and here).

Still, with three out of the four acknowledging errors, this could indicate a New Year’s trend. Next we can hope that the University of Chicago—the institution most responsible for producing the theories that guided our misguided policymakers—will apologize for its indiscretions. That could set an example for all mainstream economists who, as the Queen pointedly put it, failed to foresee the crisis.

The statements by Rubin and Bernanke are quite interesting—both for what they say and for what they leave out. Rubin claims to have learned that we “need to reform the financial system to better protect against systemic risk and devastating crises in the future.” Nice deduction, Sherlock! But he goes further, admitting he has long had misgivings about the shape of the financial system: “About four years ago, a well-known London investor said to me that the only undervalued asset in the world was risk. I had the same view, as did many others, and often said that markets, including credit, had gone to excess and that would probably be followed by a cyclical downturn—perhaps a sharp one—though the timing, as always, was unpredictable.” Really? Four years ago? Did he try to warn the Bush administration’s regulators? Or his protégé, Timmy Geithner at the NYFed who was busy (by his own admission) NOT regulating banks?

At that time did he feel any guilt, since he was among the most important deregulators who had created the conditions that would ensure undervaluation of risk? Did he push for re-regulation of the financial institution he was running into the ground?

To be fair, Rubin notes other problems with the “free market” approach he used to advocate, indeed, his complaints sound remarkably similar to the arguments long made by progressives (including heterodox economists). For example, the market should not be counted on to determine income distribution:

“Even before the recession hit, our current model had displayed major shortcomings that markets, by their nature, won’t address and that need to be met through public policy. For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries.”

He even engages in a bit of class warfare:

“For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries. In the United States, median real wages have lagged behind productivity growth for more than three decades (except for the second half of the 1990s), and income has become more heavily distributed toward the most affluent.”

Hold it a second. The redistribution of income toward the affluent occurred as Wall Street “fat cat bankers” grabbed an ever rising share of corporate profits—the source of the bonuses paid to Rubin and his cronies. In 2006 Rubin received $29.4 million from Citigroup. That was four years ago, when he was supposedly fretting that the whole financial bubble was heading toward collapse (see here).

How about some clawbacks? Compensation caps? Investigations for fraud and significant jail time for fat cat bankers? Ban Goldman Sachs alum from Washington? Unfortunately, Rubin is mum on these issues.

After acknowledging the real suffering generated by Wall Street’s excesses, Rubin concludes:

“…virtually no one involved in the financial system—whether institutions, investors, regulators, analysts, or commentators—recognized the breadth of forces at work or the possibility of a megacrisis, and this included the most experienced among us. More personally, I regret that I, too, didn’t see the potential for such extreme conditions despite my many years involved in financial matters and my concern for market excesses.”

The sentiment is touching, but the attempt to share the blame is factually incorrect. Many financial market participants and commentators saw this coming. Many warned of the consequences of allowing banksters to run wild—but they were mostly ignored or even ridiculed by Rubin and his buddies. There was a very strong will to believe that when the crash came, government would be able to quickly bail-out the financial institutions, as it had so many times before over the course of the postwar period. Of course, that will to believe was bolstered by a strong financial interest in engaging in those practices that would eventually lead to crisis. Perhaps Rubin’s claim that he had not foreseen such a deep crisis is correct, but many others did. He chose not to listen to them.

There are, however, two quite disturbing arguments raised by Rubin in his apology. First, he cites a fundamentally flawed study put out by the Commission on Growth and Development (a task force founded by the World Bank and a collection of “advisors” including Rubin) that purports to prove that market liberalization is a necessary condition for growth and development:

“In the six decades since the end of the Second World War, there has been a broad movement around the world toward a model of market-based economics, public investment, and global integration. With that move came enormous economic progress in industrial countries, including the recovery of war-torn Europe and Japan and, as time went on, in various developing countries.” Further, “The commission also found that no economy anywhere in the world had been successful with largely state-directed activities and high walls against global integration. The evidence, in other words, strongly suggests that a market-based model is still the best way forward.”

Surprisingly, the countries he cites as examples of the success of the Neoliberal market model are South Korea, Singapore, China, and India. While it is true that these nations have relaxed constraints on markets, none is a good candidate for demonstrating the wondrous advantages of market-based economics. Indeed, most analysts recognize that there is a highly successful alternative Asian model of development that opens markets only as development reaches a sufficient level to compete in international markets. Development then continues almost in spite of markets, guided by the very visible hand of government.

And China? Can Rubin actually believe that China’s success is due to reliance on free markets? True, the Chinese government uses international markets when it sees an advantage. And it squelches markets when that is advantageous. Its ability to avoid any of the damages of the “market fall-out” occasioned by the crisis is proof not that markets “work” but that a sovereign government does not have to allow markets to dictate economic outcomes. China grows at an 8% pace in spite of markets. Maybe to spite them—to show off the superiority of its government-led model. And unlike Obama, its premier has no fear of being called a socialist as its government ramps up spending and reigns-in errant entrepreneurs (occasionally sentencing particularly nefarious individuals to death—a practice Rubin might want to adopt here?). It avoids financial crises by avoiding financialization of the sort that Rubin pushed onto the US economy.

The other error is even more serious, as Rubin continues his role as cheerleader for deficit hawks. Clearly he learned nothing from his term as Clinton’s Treasury Secretary, when budget surpluses killed the economy and helped to bring on the NASDAQ-led equities crash. (Memo to Rubin: a decade later, stocks still have not recovered their values.) He still, mistakenly, believes that the Clinton boom was due to budget surpluses, failing to realize that the boom created the surpluses (as tax revenue exploded) and this fiscal drag sucked so much income and wealth out of the private sector that a crash was inevitable. He now wants to prevent recovery or at least kill one should it get underway:

“Putting another major stimulus on top of already huge deficits and rising debt-to-GDP ratios would have risks. And further expansion of the Federal Reserve Board’s balance sheet could create significant problems. Second, while the measures taken were absolutely necessary, unwinding the stimulus, restoring a sound fiscal regime, undoing the expansion of the Federal Reserve Board’s balance sheet, and reducing government’s involvement in the financial system will be very difficult, both substantively and politically.”

So what we have is a former head of the Treasury, and who still plays an outsized role in advising Obama administration policy-makers like Geithner, who does not understand how the Treasury works (or, for that matter, how the Fed works). It spends by crediting bank accounts; it taxes by debiting them; and any net spending by the Treasury (called deficit spending) adds to the nongovernment sector’s net income and wealth. There are no risks that would arise from additional stimulus; but there are huge risks of not doing enough. Rather than focusing on the budget deficit—which provides no information of importance to guide policy-makers—Rubin ought to be recommending policy that could create the 25 million or so jobs we will need to restore the nation’s health.

As to unwinding the Fed’s balance sheet, that will be done simply and following normal Fed operational procedures. That is the topic for the next blog, which will also examine Bernanke’s mea culpa.

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

Tagged Financial crisis, L. Randall Wray, Policy and Reform

Fixing the Small Banks

Posted on January 1, 2010 | 3 comments

By Warren Mosler*

Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.

*First published on Moslereconomics.com