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National Media Trifecta

We hit the trifecta last week in getting reform ideas reported in the national media:

See here, here, and here

Keeping up the pressure for real reform.

How a Financial Balances Approach Can Keep Wall Street Honest

By Marshall Auerback

Even on Wall Street and the City of London, not everybody has bought into the “green shoots” recovery story. Société Generale Cross Asset Research has just come out with a report entitled, “Worst case debt scenario – Protecting yourself against economic collapse; hope for the best, be prepared for the worst”

A lot of interesting asset allocation recommendations come out of the report including many of the usual favourites amongst the “we’re all going to hell and a hand-basket crowd”, such as gold, and basic agricultural commodities. Given the underlying deflationist theme in the report, bonds are also a big favourite, notably US government 10 year bonds (“10 YR bonds should perform well as long-term rates decline”), investment grade bonds, and a smaller portion in high yield bonds. Equities take a much lower percentage. So much for “stocks always go up over the longer term”.

All in all, some good ideas here, although the writers demonstrate an affliction common to many on Wall Street, who suffer from the “loanable funds theory” delusion, thereby lending the work some intellectual incoherence (much the same as our US policy makers). For example, they speak of a potential US dollar decline as the cost of “funding” its debt becomes “prohibitive” and posit a Japan-like analogy.

Here is where the problems start: Japan does not suffer from a “national solvency” problem and there has never been a default. The subsequent comparison of the US with emerging markets, which have high levels of foreign debt, or currency boards or exchange rate regimes is intellectually dishonest.

Although I have much sympathy with the bonds conclusion, I wouldn’t be happy investing in US dollar denominated asset if I truly believed the “loanable funds” theory. After all won’t the US have problems “funding” its debts if the dollar weakens and foreign investors demand a higher rate of return for their bonds?

You can see the incoherence here. That’s the beauty of a financial balances approach. It keeps you honest.

As for the other currencies, I have no problem with gold and think it could well explode if the market’s begin to refocus on the EU’s national solvency issues.

But the euro and yen? Let’s get serious here. As Randy Wray says in his book, “Understanding Modern Money”:

“Government spending is financed through the issue of currency, taxes generate demand for that currency that results in sales to government, bond sales merely substitute bonds for cash, and central bank operations determine interest rates and defensively add or subtract reserves. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; in this circumstance, taxes really do ‘finance’ state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries.”

Wray highlights that the euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. Deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained. That’s why Iceland and Latvia are in a mess and suffer from solvency issues. It’s also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan.

In many respects, the EMU policy makers desired this, particularly the Teutonic bloc. They hated (and still despise) the notion of “crass Keynesianism” (in the words of Axel Weber, the President of the German Bundesbank). But the absence of a “United States of Europe” entity that could conduct fiscal policy on a supranational scale means that regional disparities (which have been present since the inception of the euro) remain in force and have been exacerbated by the recent credit crisis. It’s Wilhem Buiter’s blind spot. He always used to argue that operating under a common monetary regime would lead increasingly to economic convergence, but this is crap in the absence of a supra-national fiscal policy. This is why credit spreads between the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) have expanded so dramatically vis a vis Germany, even though all are part of the euro zone. Yes, they’ve come down from the peak, but still well above pre-crisis levels.

By the same token, for the euro to act as a viable reserve currency alternative to the dollar, the euro zone countries would have to tolerate running sustained current account deficits, thereby facilitating the ability of foreigners to hold euro denominated financial claims. Unfortunately, given the fiscal constraint and resultant national solvency issues, the euro zone nations feel compelled to run current account surpluses (this is a particularly prevalent view in Germany), so that questions of national solvency never arise. There is certainly a compelling economic logic for Germany’s desire to run significant trade surpluses (even if left unsaid), but it does undermine the objective of the euro ever emerging as a serious reserve currency alternative to the dollar, assuming the maintenance of this odd bifurcated fiscal/monetary structure within the EU.

What about the yen? The yen might be the biggest basket-case currency of all. The credit expansion in China over the past year has been so great that there may well be strong growth (at least in a statistical sense) from China for several quarters to come. But this is not good for Japan. Look at the real trade weighted yen. It has appreciated because Japan has had deflation and everyone else inflation. Yet it has a zero trade surplus for the first time in decades. What happened? Japan was at the technological frontier. It dominated many export markets. The rest of mercantilist Asia was way behind, but progressively they have caught up. They have eaten Japan’s lunch, first in shipbuilding and steel and the like, now in consumer electronics and the like. To compete, Japan has had to move its production platform abroad. Now the worst will come from China. Chinas credit expansion means a giant investment boom in all the export sectors that mercantilist Asia is in. Chinas provinces do not conduct business with a profits’ agenda in mind. They continue to invest on an uneconomic basis. They will finance loss making enterprises. They will dump, steal market share, in effect do anything to keep the blind stupid duplicative factories running and exports from falling further. At whose expense? Above all at Japan’s. This troubling long term implications for the yen, especially if the analysis of Michael Pettis on China is correct. You ain’t seen nothing yet in terms of the competitive pressures they will unleash against Japan.

On balance, since I tend to share many of the gloomier predictions of the SocGen crowd (albeit for different reasons), I would be inclined to construct an investment portfolio geared toward deflation and Japanese style stagnation, as opposed to inflation and surprisingly high GDP growth. Obviously, I don’t tend to share the belief expressed by certain members of the Federal Reserve that a 10% official unemployment rate might be the “natural rate” in the US. The upshot is that a portfolio that has lots of 5 year treasuries, gold, some Norwegian Krona (although I’m not sure what happens to the Krona if the euro comes under a lot of strain) and stuff like natural gas stocks, and probably countries which own a lot of natural gas like Canada seem eminently rational to me. Natural gas is the perfect transitional green tech fuel. Not as sexy as solar or wind, but way more economic and a realistic alternative (Al Gore doesn’t seem to understand the laws of basic thermodynamics). My friend, Robert Bryce ), (author of “Gusher of Lies: The Dangerous Delusions of ‘Energy Independence’) is writing a new follow-up book on this theme and and basically comes out with a “natural gas to nuclear” proposal, which is probably right if we’re serious about clean energy and less dependence on Middle Eastern oil (although I have my doubts about whether the latter is feasible, given oil’s fungibility). At the very least, it’s a more intelligent proposal than the Obama Administration’s horrible “cap and trade” policy, another boondoggle to Wall Street to ensure that our environmental policies are financialised as well.
Keeping on this theme, one other conspicuous omission by SocGen (surprising, given that it’s a French bank): nuclear energy related and uranium stocks. When the next market downdraft comes I’d load up on these types of companies as well, although tactically it’s probably advisable to start buying 5 year Treasuries now on the basis that I think the dollar is very oversold and, equally significant, oversold for the wrong reasons (i.e. the US is “going broke” and we’ll have to raise rates “to attract funding from the foreigners”). Of course if the stock market tanks (as I suspect it might soon given that the thrust of US policy has been great for banks and disastrous for everybody else) bonds could start doing well much sooner. In any event, given the extent to which we have hitherto misallocated our fiscal resources (virtually ensuring no growth surprise to the upside in my opinion), I’d much rather own bonds than stocks over the next 12 months. As I said earlier, US national solvency is not an issue.One final point. For those of you who think that a gold standard system of some form would create “honest money” I would recommend that you read a paper from Marc Lavoie from the University of Ottawa (“Credit, Interest Rates and the Open Economy”, Essays on Horizontalism, Ch. 10, “The Reflux Mechanism and the Open Economy”, Marc Lavoie, Edward Elgar Publishing, 2001) The paper highlights that when looking at year to year changes in the period before the First World War – the heyday of the gold standard – the foreign assets and domestic assets of central banks moved in opposite directions 60 per cent of the time. Foreign assets and domestic assets moved in the same direction only 34 per cent of the time for the 11 central banks under consideration. The prevalence of a negative correlation therefore demonstrates that the so-called Rules of the Game were violated more often than not, even during the heyday of the gold standard. Indeed, according to A.I. Bloomfield (“Monetary History under the International Gold Standard: 1880-1914″, Federal Reserve Bank of New York, 1959),”In the case of every central bank, the year-to-year changes in international and domestic assets were more often in the opposite than in the same direction.” To state the obvious, the “honest money” types believe that inflation is theft from savers, and by implication, anyone who is not for “sound” money is a pinko favoring redistribution. It’s a class warfare posture in disguise. But among the many disingenuous (or just plain wrong) aspects of their argument is that they contend that sound money = no inflation, meaning price stability. This essay by Marc explodes that myth. As anyone who has looked at the record knows, inflation was highly variable during the gold standard years, swinging from deflation to inflation, and in not trivial amounts to boot.

Showdown in Chicago

Countdown to the Showdown [via New Deal 2.0].

The same financial institutions that caused the economic crisis and took billions in taxpayer bailouts are back to earning incredible profits. Meanwhile, Americans face shrinking pensions, rising foreclosures and unemployment, state budget cuts, predatory lending, outrageous overdraft fees, and sky-high credit card interest rates.

The American people want oversight, accountability and common-sense financial reform NOW. This is the classic David vs. Goliath fight, with Wall Street spending millions and millions on lobbying to defeat reforms that would protect the American people and our economy.

Systemically Dangerous Institutions

The Obama administration is continuing the Bush administration policy of refusing to comply with the Prompt Corrective Action (PCA) law (see here and here). Both administrations twisted a deeply flawed doctrine – “too big to fail” – into a policy enshrining crony capitalism.

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing. That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.” “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy). In this crisis, however, regulators have twisted the term into immunity. Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital. This policy is indefensible. It is also unlawful. It violates the Prompt Corrective Action law. If it is continued it will cause future crises and recurrent scandals.


On October 16, 2006, Chairman Bernanke delivered a speech explaining why regulators must not allow banks with inadequate capital to remain open.

Capital regulation is the cornerstone of bank regulators’ efforts to maintain asafe and sound banking system, a critical element of overall financial stability. For example, supervisory policies regarding prompt corrective action are linked to a bank’s leverage and risk-based capital ratios. Moreover, a strong capital base significantly reduces the moral hazard risks associated with the extension of the federal safety net.

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

We need to comply with the Prompt Corrective Action law. Any institution that the administration deems “too big to fail” should be placed on a public list of “systemically dangerous institutions” (SDIs). SDIs should be subject to regulatory and tax incentives to shrink to a size where they are no longer too big to fail, manage, and regulate. No single financial entity should be permitted to become, or remain, so large that it poses a systemic risk.

SDIs should:

1. Not be permitted to acquire other firms

2. Not be permitted to grow

3. Be subject to a premium federal corporate income tax rate that increases with asset size

4. Be subject to comprehensive federal and state regulation, including:

a. Annual, full-scope examinations by their primary federal regulator
b. Annual examination by the systemic risk regulator
c. Annual tax audits by the IRS
d. An annual forensic (anti-fraud) audit by a firm chosen by their primary federal regulator
e. An annual audit by a firm chosen by their primary federal regulator
f. SEC review of every securities filing

5. A prohibition on any stock buy-backs

6. Limits on dividends

7. A requirement to follow “best practices” on executive compensation as specified by their primary federal regulator

8. A prohibition against growth and a requirement for phased shrinkage

9. A ban (which becomes effective in 18 months) on having an equity interest in any affiliate that is headquartered in or doing business in any tax haven (designated by the IRS) or engaging in any transaction with an entity located in any tax haven

10. A ban on lobbying any governmental entity

11. Consolidation of all affiliates, including SIVs, so that the SDI could not evade leverage or capital requirements

12. Leverage limits

13. Increased capital requirements

14. A ban on the purchase, sale, or guarantee of any new OTC financial derivative

15. A ban on all new speculative investments

16. A ban on so-called “dynamic hedging”

17. A requirement to file criminal referrals meeting the standards set by the FBI

18. A requirement to establish “hot lines” encouraging whistleblowing

19. The appointment of public interest directors on the BPSR’s board of directors

20. The appointment by the primary federal regulator of an ombudsman as a senior officer of the SDI with the mission to function like an Inspector General

Healthcare Diversions Part 3: The Financialization of Health and Everything Else in the Universe

By L. Randall Wray

In the previous two blogs I have argued that extending healthcare insurance is neither desirable nor will it reduce healthcare costs. Indeed, healthcare insurance is a particularly bad way to provide funding of the provision of healthcare services. In this blog I argue that 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. It is no coincidence that Senator Baucus, the Chair of the Senate Finance Committee, has been chosen to head the push on healthcare—not, say, someone who actually knows something about healthcare. The choice was obvious, similar to the choice of Goldman Sach’s flunky, Timmy Geithner to head the Treasury. (In truth, many of President Obama’s appointees have no more expertise in their assigned missions than did President Bush’s “heckuvajob” Brown chosen to oversee the response to Hurricane Katrina. The difference here is not really incompetence but rather inappropriate competence—as in foxes and henhouses.) When it comes to Washington, “Wall Street R Us”.

I have previously written about the financialization of houses and commodities (go to www.levy.org) and the plan to financialize death (earlier on this blog). In all of these cases, Wall Street packages assets (home mortgages, commodities futures, and life insurance policies) so that gamblers can speculate on outcomes. If you lose your home through a mortgage delinquency, if food prices rise high enough to cause starvation, or if you die an untimely death, Wall Streeters make out like bandits. Health insurance works out a bit differently: they sell you insurance and then the insurer denies your claim due to pre-existing conditions or simply because denial is more profitable and you probably don’t have sufficient funding to fight your way through the courts. You then go bankrupt (according to Steffie Woolhandler, two-thirds of US bankruptcies are due to healthcare bills) and Wall Street takes your assets and garnishes your wages.

Here’s the opportunity, Wall Street’s newest and bestest gamble: there is a huge untapped market of some 50 million people who are not paying insurance premiums—and the number grows every year because employers drop coverage and people can’t afford premiums. Solution? Health insurance “reform” that requires everyone to turn over their pay to Wall Street. Can’t afford the premiums? That is OK—Uncle Sam will kick in a few hundred billion to help out the insurers. Of course, do not expect more health care or better health outcomes because that has nothing to do with “reform”. “Heckuvajob” Baucus is more concerned about Wall Street’s insurers, who see a missed opportunity. They’ll collect the extra premiums and deny the claims. This is just another bailout of the financial system, because the tens of trillions of dollars already committed are not nearly enough.

You might wonder about the connection between insurance and Wall Street finance. They are two peas in a pod. Indeed, we threw out the Glass-Steagall Act that separated commercial banking from investment banking and insurance with the Gramm-Leach-Bliley Act of 1999 (note how easily that rolls off the tongue—sort of like a mixture of wool and superglue) that let Wall Street form Bank Holding Companies that integrate the full range of “financial services” such as loans and deposits, 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.

Student loans, credit card debt, and auto leases? Financialized—packaged and sold to gamblers making bets on default. Even the weather can be financialized. You think I jest? The World Food Programme proposed to issue “catastrophe bonds” linked to low rainfall. The WFP would pay principal and interest when rainfall was sufficient; if there was no rainfall, the WFP would cease making payments on the bonds and would instead fund relief efforts. (Satyajit Das, Traders, Guns & Money, p. 32). As are earthquakes—Tokyo Disneyland issued bonds that did not have to be repaid in the event of an earthquake. (ibid) It is rumored that Wall Street will even take bets on assassination of world leaders (perhaps explaining the presence of armed protestors at President Obama’s speeches). Why not? Someone even set up a charitable trust called the “Sisters of Perpetual Ecstasy” as a special purpose vehicle to move risky assets off the books of its mother superior bank, to escape what passed for regulation in recent years. (Das, again) I once facetiously recommended the creation of a market in Martian ocean front condo futures to satisfy the cravings of Wall Street for new frontiers in risk. Obviously, I set my sights too low. The next bubble will probably be in carbon trading—financialization of pollution!—this time truly toxic waste will be packaged and sold off to global savers. According to Das (p. 320), traders talk about new frontiers “trading in rights to clean air, water and access to fishing grounds; basics of human life that I had always taken for granted”.

Is there an alternative? Frankly, I do not know. Leaving aside the political problems—once Wall Street has got its greedy hands on some aspect of our lives it is very difficult to wrest control from its grasp—health care is a very complex issue. It is clear (to me) that provision of routine care should not be left to insurance companies. Marshall Auerback believes that unforeseen and major expenses due to accidents might be insurable costs. I am sympathetic. Perhaps “single payer” (that is, the federal government) should provide basic coverage for all of life’s normal healthcare needs, with individuals purchasing additional coverage for accidents. Basic coverage can be de-insured—births, routine exams and screening, inoculations, hospice and elder care. On the other hand, a significant portion of healthcare expenses is due to chronic problems, some of which can be traced to birth. I have already argued that these are not really insurable—they are the existing conditions that insurers must exclude. Others can be traced to lifestyle “choices”. Some employers are already charging higher premiums to employees whose body mass index exceeds a chosen limit—with rebates provided to those who manage to lose weight. While I am skeptical that a monetary incentive will be effective in changing behavior that is certainly quite complex, this approach is probably better than excluding individuals from insurance simply because of their BMI.

Some have called for extending a Medicare-like program to all. Although sometimes called insurance, Medicare is not really an insurance program. Rather it pays for qualifying health care of qualified individuals. It is essentially a universal payer, paygo system. Its revenues come from taxes and “premiums” paid by covered individuals for a portion of the program. I will not go into the details, but “paygo” means it is not really advance funded. While many believe that its Trust Fund could be strengthened through higher taxes now so that more benefits could be paid later as America ages, actually, Medicare spending today is covered by today’s government spending—and tomorrow’s Medicare spending will be covered by tomorrow’s government spending. At the national level, it is not possible to transport today’s tax revenue to tomorrow to “pay for” future Medicare spending.

I realize this is a difficult concept. In real terms, however, it is simpler to understand: Medicare is paygo because the health care services are provided today, to today’s seniors; there is no way to stockpile medical services for future use (ok, yes, some medical machinery and hospitals can be built now to be used later). And the true purpose of taxes and premiums paid today is to reduce net personal income so that resources can be diverted to the health care sector. Many believe we already have too many resources directed to that sector. Hence, the solution cannot be to raise taxes or premiums today in order to build a bigger trust fund to reduce burdens tomorrow. If we find that 25 years from now we need more resources in the health care sector, the best way to do that will be to spend more on health care at that time, and to tax incomes at that time to reduce consumption in other areas so that resources can be shifted to health care at that time.

Our problem today is that we need to allocate more health care services to the currently underserved, which is comprised of two different sets of people: folks with no health insurance, and those with health insurance that is too limited in coverage to provide the care they need. A general proposed solution is to provide a subsidy to get private insurers to expand coverage. (According to Taibi, the current House Bill subsidies are projected to reach $773 billion by 2019.) If we take my example pursued in an earlier blog of a person with diabetes who is excluded because of the existing condition, the marginal subsidy required would have to equal the expected cost of care, plus a risk premium in case that estimate turns out to be too low, plus the costs of running the insurance business, plus normal profits. If on the other hand diabetes care were directly covered by a federal government payment to health care providers, the risk premium, insurance business costs, and profits on the insurance business would not be necessary. In other words, using the insurance system to pay for added costs of providing care to people with diabetes adds several layers of costs. That just makes no sense.

It will be clear by now that I really do not have any magic bullet. We face three serious and complex issues that can be separately analyzed. First, we need a system that provides health care services. Our current healthcare system does a tolerably good job for most people, although a large portion of the population does not receive adequate preventative and routine care, thus, is forced to rely on expensive emergency treatment. The solution to that is fairly obvious and easy to implement—if we leave payment to the side. As discussed in my first blog we must also recognize that a big part of America’s health expenses are due to chronic and avoidable conditions that result from the corporatization of food—a more difficult problem to resolve.

Second, our system might, on the other hand, provide in the aggregate too many resources toward the provision of healthcare (leaving other needs of our population unmet). Rational discussion and then rational allocation can deal with that. We don’t need “death panels” (which we already have—run by the insurance companies), but we do need rational allocation. I expect that healthcare professionals can do a far better job than Wall Street will ever do in deciding how much care and what type of care should be provided. Individuals who would like more care than professionals decide to be in the public interest can always pay out of pocket, or can purchase private insurance. Maybe the cost of botox treatments is an insurable expense? Obviously, what is deemed to be necessary healthcare will evolve over time—it, like human rights is “aspirational”—and some day might include nose jobs and tummy tucks for everyone.

Third, we need a way to pay for healthcare services. For routine healthcare and for pre-existing conditions it seems to me that the only logical conclusion is that the best risk pool is the population as a whole. It is in the public interest to see that the entire population receives routine care. It is also in the public interest to see that our little bundles of pre-existing conditions (otherwise known as infants) get the care they need. I cannot see any obvious advantage to involving private insurance in the payment system for this kind of care. If we decided to have more than one insurer, we would have to be sure that each had the same risks, hence, the same sort of insured pool. It is conceivable that competition among private insurers could drive down premiums, but it is more likely that competition would instead take the form of excluding as many claims as possible. We’d thus get high premiums and lots of exclusions—exactly what we’ve got now.

We could instead have a single national private insurer pursuing the normal monopoly pricing and poor service strategy (remember those good old days when you could choose from among one single telephone service provider?), but in that case we would have to regulate the premiums as well as the rejection of claims. Regulation of premiums cannot be undertaken without regulating the health care costs that the insurer(s) would have to cover. If we are going to go to all the trouble of regulating premiums, claim rejections, and healthcare prices we might as well go whole-hog and have the federal government pay the costs. Difficult and contentious, yes. Impossible? No—we can look to our fellow developed nations for examples, and to our own Medicare system.

Finally, there may still be a role for private insurers, albeit a substantially downsized one. Private insurance can be reserved for accidents, with individuals grouped according to similar risks: hang-gliders, smokers, and texting drivers can all be sorted into risk classes for insurance purposes. If it is any consolation to the downsized insurers, we also need to downsize the role played by the whole financial sector. Finance won’t like that because it has become accustomed to its outsized role. In recent years it has been taking 40% of corporate profits. It takes most of its share off the top—fees and premiums that it receives before anyone else gets paid. Rather than playing an auxiliary role, helping to ensure that goods and services get produced and distributed to those who need them, Wall Street has come to see its role as primary, with all aspects of our economy run by the Masters of the Universe. As John Kenneth Galbraith’s The Great Crash shows, that was exactly the situation our country faced in the late 1920s. It took the Great Depression to put Wall Street back into its proper place. The question is whether we can get it into the backseat without another great depression.

Health Insurance Diversions, Part 2: We Need Less Health Insurance, Not More

by L. Randall Wray

In my last blog, I argued that the benefits of extending health insurance coverage are probably overstated and are not likely to reduce health care costs or improve health outcomes. In this blog I will argue that we do not need more health insurance, rather, we need less.

Here is the point. Healthcare is not a service that should be funded by insurance companies. An individual should ensure against expensive and undesirable calamities: tornadoes, fires, auto accidents. These need to be insurable risks, or insurance will not be made available. This means the events need to be reasonably random and relatively rare, with calculable probabilities that do not change much over time. As discussed in a previous blog, we need to make sure that the existence of insurance does not increase the probability of insured losses: (http://neweconomicperspectives.blogspot.com/2009/09/selling-death-wall-streets-newest.html) This is why we do not let you insure your neighbor’s house. Insurance works by using the premiums paid in by all of the insured to cover the losses that infrequently visit a small subset of them. Of course, insurance always turns out to be a bad deal for almost all of the insured—the return is hugely negative because most of the insured never collect benefits, and the insurance company has to cover all costs and earn profits on its business. Its operating costs and profits are more or less equal to the net losses suffered by its policy holders.


Ideally, insurance premiums ought to be linked to individual risks; if this actually changes behavior so that risk falls, so much the better. That reduces the costs to the other policy holders who do not experience insured events, and it also increases profitability of the insurance companies. Competition among insurers will then reduce the premiums for those whose behavior modifications have reduced risks.

In practice, people are put into classes—say, over age 55 with no accidents or moving violations in the case of auto insurance. Some people are uninsurable—risks are too high. For example, one who repeatedly wrecks cars while driving drunk will not be able to purchase insurance. The government might help out by taking away the driver’s license, in which case the insurer could not sell insurance even if it were willing to take on the risks. Further, one cannot insure a burning house against fire because it is, well, already afire. And even if insurance had already been purchased, the insurer can deny a claim if it determines that the policyholder was at fault.
The insured try to get into the low risk, low premium classes; the insurers try to sort people by risk and try to narrow risk classes. To be sure, insurers do not want to avoid all risks—given a risk/return trade-off, higher risk individuals will be charged higher premiums. Problems for the insurer arise if high risk individuals are placed in low risk classes, thus, enjoy inappropriately low premiums. The problem for many individuals is that appropriately priced premiums will be unaffordable. At the extreme, if the probability of an insurable event approaches certainty, the premium that must be charged equals the expected loss plus insurance company operating costs and profits. However, it is likely that high risk individuals would refuse insurance long before premiums reached that level.

Of course insured risks change over time—which means premiums charged might not cover the new risks. Cars become safer. More people wear seat belts. Fire resistant materials become standard and fire fighting technologies improve. Global warming produces more frequent and perhaps more severe hurricanes and tornadoes. But these changes are generally sufficiently slow that premiums and underwriting standards can be adjusted. Obviously, big and abrupt changes to risks would make it difficult to properly price premiums.

In any event, once insurance is written, the insurer does its best to deny claims. It will look at the fine print, try to find exclusions, and uncover pre-existing conditions (say, faulty wiring) that invalidate the claim. All of that is good business practice. Regulators are needed to protect the insured from overly aggressive denials of claims, a responsibility mostly of state government.
Let us examine the goal of universal health insurance from this perspective. It should now be obvious that using health “insurance” as the primary payment mechanism for health care is terribly inappropriate.

From the day of our births, each of us is a little bundle of pre-existing conditions—congenital abnormalities and genetic predispositions to disease or perhaps to risky behavior. Many of these conditions will only be discovered much later, probably in a doctor’s office. The health insurer will likely remain in the dark until a bill is submitted for payment. It then must seek a way to deny the claim. The insurer will check the fine print and patient records for exclusions and pre-existing conditions. Often, insurers automatically issue a denial, forcing patients to file an appeal. This burdens the insured and their care-givers with mountains of paperwork. Again, that is just good business practice—exactly what one would expect from an insurer.

And, again, it would be best to match individual premiums to risk, but usually people are placed into groups, often (for historical reasons) into employee groups. Insurers prefer youngish, urban, well educated, professionals—those jogging yuppies with good habits and enough income to join expensive gyms with personal trainers. Naturally, the insurer wants to charge premiums higher than what the risks would justify, and to exclude from coverage the most expensive procedures.
Many individuals are not really insurable, due to pre-existing conditions or risky behavior. However, many of these will be covered by negotiated group insurance due to their employment status. The idea is that the risks are spread and the healthier members of the group will subsidize the least healthy. This allows the insurer to escape the abnormally high risks of insuring high risk individuals. It is, of course, a bum deal for the healthy employees and their employers.

This is not the place for a detailed examination of the wisdom of tying health insurance to one’s employer. It is very difficult to believe that any justification can be made for it, so no one tries to justify it as far as I can tell. It is simply accepted as a horrible historical accident. It adds to the marginal cost of producing output since employers usually pick up a share of the premiums. It depresses the number of employees while forcing more overtime work (since health care costs are fixed per employee, not based on hours worked) as well as more part-time work (since insurance coverage usually requires a minimum number of hours worked). And it burdens “legacy firms” that offer life-time work as well as healthcare for retirees. Finally, and fairly obviously, it leaves huge segments of the population uncovered because they are not employed, because they are self-employed, or because they work in small firms. In short, one probably could not design a worse way of grouping individuals for the purposes of insurance provision. Would anyone reasonably propose that the primary means of delivering drivers to auto insurers would be through their employers? Or that auto insurance premiums ought to be set by the insurable loss experience of one’s co-workers? That is too ridiculous to contemplate—and so we do not–but it is what we do with health insurance.

Extending coverage to a diabetic against the risk of coming down with diabetes is like insuring a burning house. An individual with diabetes does not need insurance—he needs quality health care and good advice that is followed in order to increase the quality of life while reducing health care costs. Accompanying this health care with an insurance premium is not likely to have much effect on the health care outcome because it won’t change behavior beyond what could be accomplished through effective counseling. Indeed, charging higher premiums to those with diabetes is only likely to postpone diagnosis among those whose condition has not yet been identified. Getting people with diabetes into an insured pool increases costs for the other members of the pool. Both the insurer as well as the other insured members have an interest in keeping high risk individuals out of the pool. Experience shows that health care costs follow an 80/20 pattern: 80% of health care costs are incurred due to treatment of 20% of patients. (Steffie Woolhandler http://www.prospect.org/cs/articles?article=more_than_a_prayer_for_single_payer) If only a fraction of those high costs individuals can be excluded, costs to the insurer can be cut dramatically.

We have nearly 50 million individuals without health insurance, and the number grows every day. Most health “reform” proposals would somehow insure many or most of these people—mostly by forcing them to buy insurance. All of them have pre-existing conditions, many of which are precisely the type that if known would make them uninsurable if insurance companies could exclude them. While it is likely that only a fraction of the currently uninsured have been explicitly excluded from insurance because of existing conditions (many more are excluded because they cannot afford premiums)—but every one of them has numerous existing conditions and one of the main goals of “reform” is to make it more difficult for insurers to exclude people with existing conditions. In other words, “reform” will require people who do not want to buy insurance to buy it, and will require insurers who do not want to extend insurance to them to provide it. That is not a happy situation even in the best of circumstances.

So here is what the outcome will look like. Individuals will be forced to buy insurance against their will, often with premiums set unaffordably high. Government will provide a subsidy so that insurance can be provided. Insurance companies will impose high co-payments as well as deductibles that the insured cannot possibly afford. In this way, they will minimize claims and routine use of health care services by the nominally insured. When disaster strikes—putting a poorly covered individual into that 20/80 high cost class of patients–the insurer will find a way to dismiss claims. The “insured” individual will then be faced with bankrupting uncovered costs.
That is not far fetched. Currently, two-thirds of household bankruptcies are due to health care costs. Surprisingly, most of those who are forced into bankruptcy had health insurance—but lost it after treatment began, or simply could not afford the out-of-pocket expenses that the insurer refused to cover. As Woolhandler says, in 2007 an individual in her 50s would pay an insurance premium of $4200 per year, with a $2000 deductible. Many of those currently without insurance would not be able to pay the deductible, meaning that the health insurance would not provide any coverage for routine care. Only an emergency or development of a chronic condition would drive such a patient into the health care system; with exclusions and limitations on coverage, the patient could find that even after meetinging the $2000 deductible plus extra spending on co-payments, bankruptcy would be the only way to deal with all of the uncovered expenses. Of course, that leaves care providers with the bill—which is more-or-less what happens now without the universal insurance mandate.

In truth, insurance is a particularly bad way to provide payments for health care. Insurance is best suited to covering unexpected losses that result from acts of god, accidents, and other unavoidable calamities. But except in the case of teenagers and young adult males, accidents are not a major source of health care costs. In other words the costs to the insurer are not the equivalent of a tornado that randomly sets its sights on a trailer park. Rather, chronic illnesses, sometimes severe, and often those that lead to death, are more important. Selling insurance to a patient with a chronic and ultimately fatal illness would be like selling home insurance on a house that is slowly but certainly sliding down a cliff into the sea. Neither of these is really an insurable risk—rather each represents a certain cost with an actuarially sound premium that must exceed the loss (to cover operating costs and profits for the insurer). So if the policy were properly priced, no one would have an economic incentive to purchase it.

Another significant health care cost results from provision of what could be seen as public health services—vaccinations, mother and infant care, and so on. And a large part of that has nothing to do with calamity but rather with normal life processes: pregnancy, birth, well child care, school physicals, and certification of death at the other end of life. Treating a pregnancy as an insurable loss seems silly—even if it is unplanned. It does not make much sense to finance the health care costs associated with pregnancy and birth in the same way that we finance the costs of repairing an auto after a wreck—that is, through an insurance claim. Many of these expenditures have public goods aspects; while there are private benefits, if the health care cannot be covered through private insurance or out-of-pocket the consequences can lead to huge public sector costs. For this reason, it does not make sense to try to fund all private benefits of such care by charges to the individuals who may—or may not—be able and willing to pay for them. Nor does it make sense to raise premiums on one’s co-workers to cover expected pregnancies as young women join a firm.

Health care is not similar to protecting a homeowner against losses due to natural disasters. The risks to the health insurer are greatly affected by the behavior of the covered individuals, as well as by social policy. Discovering cures and new treatments can greatly increase, or reduce, costs. To a large extent that is outside the control of the insurer or the insured—if a new treatment becomes standard care, there will be pressures on insurers to cover it. Death might be the most cost effective way to deal with heart attacks, but standard practice does not present that as a standard treatment—nor would public policy want it to do so. In other words, social policy dictates to a large degree the losses that insurers must cover; acts of congress are not equivalent in their origins to acts of god—although their impacts on insurers are similar.

We currently pay most health care expenses through health insurance. But people need health care services on a routine basis—and not simply for unexpected calamities. We have become so accustomed to health insurance that we cannot understand how absurd it is to finance health care services in this manner. Our automobiles need routine maintenance, including oil changes. Imagine if we expected our auto insurer to cover such expected costs. We are, of course, all familiar with various “extended warranty” plans sold on practically all consumer items—from toasters to flat screen TVs. But we recognize that these are little more than scams—a way to increase the purchase price so that the retailer gets more revenue. We tolerate the scams because we can “just say no”—caveat emptor and all that. But health care “reform” proposes to force us to turn over a larger portion of our income to insurance companies—who will then do their best to ensure that any health care services we need will not be covered by the plan we are forced to buy. Unlike a broken toaster that can just be thrown out when the warranty fails to cover repairs, we do not, and do not want to, throw out people whose insurance coverage proves to be inadequate.

It is worthwhile to step back to look at the costs of providing health care payments through insurers. According to Woolhandler, 20 cents of every health care dollar goes to insurance companies. Another 11 cents goes to administrative overhead and profit of the health care providers. Much of that is due to all the paperwork required to try to get the insurance companies to pay claims (there are 1300 private insurers, with nearly as many different forms that health care providers must fill out to file claims); it is estimated that $350 billion a year could be saved on paperwork if the US adopted a single payer system. (Matt Taibi, “Sick and Wrong”, Rolling Stone, September 3, 2009). Hence, it is plausible that a full quarter of all health care spending in the US results from the peculiar way that we finance our health care system—relying on insurance companies for a fundamentally uninsurable service. Getting insurance companies out of the loop would almost certainly “pay for” provision of health care services to all of those who currently have inadequate access—including the under-insured.

In sum, using insurers to provide funding is a complex, costly, and distorting method of financing health care. Imagine sending your weekly grocery bill to an insurance clerk for review, and having the grocer reimbursed by the insurer to whom you have been paying “food insurance” premiums—with some of your purchases excluded from coverage at the whim of the insurer. Is there any plausible reason for putting an insurance agent between you and your grocer? Why do we put an insurer between you and your health care provider?
Next time: How to build a better mousetrap.

Healthcare Diversions, Part 1: The Elephant in the Room

By L. Randall Wray

I have tried to stay clear of the current healthcare debate because all sides appear to be so far from any sensible policy that I remain indifferent to the outcome. However a recent three-hour layover in a major airport in the “new South” brought into sharp focus—at least for me—the elephant in the room that no one wants to discuss.

I won’t belabor the obvious point that Americans are, to put it delicately, a bit on the hefty side. But what really struck me is that many have evolved to the point that they are barely bipedal. As passengers attempted to perambulate their way from one gate to the next, it appeared that most had forgotten how to walk. I saw the most ungainly gaits—peregrination with great effort but little forward progress, the zigzag, the toe-heel-toe, the Quasimodo, the sideways roll, the zombie, the stop-start-stop again, all whilst occasionally careening off walls and other passengers. Of course, in some cases the attire dictated the method. A few of the boys had their pants waist bands down around their knees, forcing a duck-like waddle, made even more difficult by the need to use one hand to hold onto the belt lest gravity complete its work and bring the pants down to the ankles. A lot of the girls wore PJs and flip-flops, making it impossible to do much more than shuffle along. Some forty-somethings had eight inch stilettos in which only flamingos could parade about with grace. Still, the vast majority of passengers wore shoes marketed as sporting equipment, designed presumably for activities involving two legs and an upright posture rather than for those of the aquatic or slithering or knuckle-dragging variety.

And here is an interesting factoid: the average American walks just the length of three football fields daily. (Sierra Magazine, Jan/Feb 2007, p. 25) It shows. Since that is the average, it is no doubt boosted by the still considerable number of aging yuppies who manage 3k runs before breakfast, as well as by children the soccer moms idolized by Sarah Palin drive to practice. I presume that most of the airport patrons typically manage little more than a few schlepps from couch to fridge each day, taking a momentary break from their average 1600 hours in front of the TV each year. (Uncle John’s Bathroom Reader, 2006 p. 115)

Like many other airlines, ours had provided a welcoming speech as the plane pulled up to the gate, helpfully reminding passengers that the most dangerous part of their journey would soon begin. I had always thought that they were alluding to the fact that we would shortly be behind the wheel of our autos, taking our lives into our own unprofessional hands as we attempted to pilot 2 tons of steel on a 65 mph freeway through an obstacle course of text-messaging drivers (which studies show are twice as impaired as a drunk driver). Actually, they were referring to our more immediate mission—to walk without major mishap to the baggage claim area before returning to the relative safety of a seated or prone position in a vehicle, like the humans in the Wall-E movie. A few centuries ago, our ancestors here in America were able to run down buffalo, or even mastodons, and kill them with spears. Today, most Americans can, with some effort, spear a French fry—providing it is not moving too quickly and that they are seated to steady the aim.

Don’t get me wrong. I am not one of the contrarians who reject the argument that lack of access to healthcare by the uninsured contributes to the US’s relatively poor ranking in terms of health outcome. Surely that explains some of our problem. But too little exercise, too much smoking, too much food, and especially too much bad food have got to be a huge factor. As Michael Pollan argues (In Defense of Food, 2008), unless we address the problem with American Food, Inc., we will not significantly improve our health no matter what we do with health care. According to Pollan, the cost to society of the American addiction to “fast food” (which is neither all that fast nor is it food) is already $250 billion per year in diet-related health care costs. One-third of Americans born in 2000 will develop diabetes in her lifetime; on average, diabetes subtracts 12 years from life expectancy, and raises annual medical costs from $2500 for a person without diabetes to $13,000. While it is true that life expectancy today is higher than it was in 1900, almost all of this is due to reduction of death rates of infants and young children—mostly not due to the high tech healthcare that we celebrate as the contribution of our innovative, profit seeking system, but rather to lower tech inoculations, sewage treatment, mosquito abatement, and cleaner water. The life expectancy of a 65 year old in 1900 was only about 6 years less than it is for a 65 year old today—and rates of chronic diseases like cancer and type 2 diabetes are much higher. (Pollan, p. 93)

Smoking causes 400,000 deaths yearly. Simply banning smoking from public places throughout our country could reduce deaths by 156,000 annually. (NPR 22 Sept) We incarcerate a far higher percentage of our population than any developed society on earth—and health care costs in prisons are exploding for the obvious reason that prisons are not healthy environments. Our relatively high poverty rates, and high percentage of the population left outside the labor market (especially young adult males without a high school degree) all contribute to very poor health outcomes. In a very important sense that I will explore thoroughly in the next blog, more health insurance coverage would no more resolve our health care problems than would provision of car insurance to chronic drunk drivers solve our DUI problem.

So, before ramping up health care insurance, how about an education program to teach people the mechanics of walking. It is not as simple as it sounds. I speak from experience because some years ago I tore a calf muscle and after a long and painful healing process, I developed a gait that was all kinds of ugly. A physical therapist helped me to redevelop a human stride. While we are at it, we can reintroduce Americans to food. I don’t mean the corporate offal that Pollan calls “food-like substances”—products derived from plants and animals, but generated by breaking the original foods into their most basic molecules and then reconstituting them in a manner that can be more profitably marketed. What I mean is real food, produced by farmers and consumed after as little processing as possible. Preferably it will be local, cooked at home, eaten at a table, and will consist mostly of vegetables, grains, and fruits. And let us provide decent jobs to anyone ready to work, as an alternative to locking them up in prison. Ban smoking from all public places and regulate tobacco like the highly addictive and dangerous drug that it is. Together these policies will do far more to improve American health and to reduce health care costs than anything that “reformers” are proposing.

To conclude this part of the analysis: the benefits of extending health insurance coverage are almost certainly overstated and are not likely to make a major dent in our two comparative gaps: we spend far more than any other nation but do not obtain better outcomes and in important areas actually get worse results. Nations that adopt diets closer to ours begin to suffer similar afflictions: obesity, diabetes, heart disease, hypertension, diverticulitis, malformed dental arches and tooth decay, varicose veins, ulcers, hemorrhoids, and cancer. (Pollan p. 91) Even universal health insurance is not going to lower the costs of such chronic afflictions that are largely due to the fact that we eat too much of the wrong kinds of food and get too little exercise. It makes more sense to attack the problem directly by increasing exercise, reducing caloric intake, and minimizing consumption of corporate food-like substances that make us sick, than to provide insurance so that those who suffer the consequences of our lifestyle can afford costly care.

Let me be as clear as possible: it is neither rational nor humane to deny health care to any US resident. Further, I accept the arguments contending that early treatment through primary care is far more cost effective than waiting for emergency care—and it is obviously more humane. However in the next blog I will explain why I believe that extending health insurance is the wrong way to go if the goal is to extend health care coverage.

What the Fed has to Say About This?

An interesting article by Ryan Grym on Fed control of research. “Priceless: How The Federal Reserve Bought The Economics Profession

According to the article,

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed’s thrall, the economists missed it, too.

“The Fed has a lock on the economics world,” says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. “There is no room for other views, which I guess is why economists got it so wrong.”

One critical way the Fed exerts control on academic economists is through its relationships with the field’s gatekeepers. For instance, at the Journal of Monetary Economics, a must-publish venue for rising economists, more than half of the editorial board members are currently on the Fed payroll — and the rest have been in the past.

Even the late Milton Friedman, whose monetary economic theories heavily influenced Greenspan, was concerned about the stifled nature of the debate.
Friedman, in a 1993 letter to Auerbach that the author quotes in his book, argued that the Fed practice was harming objectivity: “I cannot disagree with you that having something like 500 economists is extremely unhealthy. As you say, it is not conducive to independent, objective research. You and I know there has been censorship of the material published. Equally important, the location of the economists in the Federal Reserve has had a significant influence on the kind of research they do, biasing that research toward noncontroversial technical papers on method as opposed to substantive papers on policy and results,” Friedman wrote.

It is time for a new start.

Selling Death: Wall Street’s Newest Bubble

When Wall Street’s commodities bubble crashed last year, I asked whether the next bubble might be in securitized body parts. Wall Street would search the world for transplantable organs, holding them in cold storage as collateral against securities sold to managed money such as pension funds. Of course, it was meant to be an apocryphal story about unregulated banksters gone wild. But as the NYT reports, Wall Street really is moving forward to market bets on death. The banksters would purchase life insurance policies, pool and tranch them, and sell securities that allow money managers to bet that the underlying “collateral” (human beings) will die an untimely death. You can’t make this stuff up.

This is just the latest Wall Street scheme to profit on death, of course. It has been marketing credit default swaps that allow one to bet on the death of firms, cities, and even nations. And the commodities futures speculation pushed by Goldman caused starvation and death around the globe when the prices of agricultural products exploded (along with the price of gasoline) between 2004 and 2008. But now Goldman will directly cash-in on death.

Here is how it works. Goldman will package a bunch of life insurance policies of individuals with an alphabet soup of diseases: AIDS, leukemia, lung cancer, heart disease, breast cancer, diabetes, and Alzheimer’s. The idea is to diversify across diseases to protect “investors” from the horror that a cure might be found for one or more afflictions–prolonging life and reducing profits. These policies are the collateral behind securities graded by those same ratings agencies that thought subprime mortgages should be as safe as US Treasuries. Investors purchase the securities, paying fees to Wall Street originators. The underlying collateralized humans receive a single pay-out. Securities holders pay the life insurance premiums until the “collateral” dies, at which point they receive the death benefits. Naturally, managed money hopes death comes sooner rather than later.

Moral hazards abound. There is a fundamental reason why you are not permitted to take out fire insurance on your neighbor’s house: you would have a strong interest in seeing that house burn. If you held a life insurance policy on him, you probably would not warn him about the loose lug nuts on his Volvo. Heck, if you lost your job and you were sufficiently ethically challenged, you might even loosen them yourself.

Imagine the hit to portfolios of securitized death if universal health care were to make it through Congress. Or the efforts by Wall Street to keep new miracle drugs off the market if they were capable of extending life of human collateral. Who knows, perhaps the bankster’s next investment product will be gansters in the business of guaranteeing lifespans do not exceed actuarially-based estimates.

If you think all of this is far-fetched, you have not been paying attention. From Charles Keating’s admonition to his sales staff that the weak, meek and ignorant elderly widows always make good targets, to recent internal emails boasting about giving high risk ratings to toxic securities, we know that Wall Street’s contempt for the rest of us knows no bounds. Those hedge funds holding CDS “insurance” fought to force the US auto industry into bankruptcy for the simple reason that they would make more from its death than from its resurrection. And the reason that most troubled mortgages cannot obtain relief is because the firms that service the mortgages gain more from foreclosure. It is not a big step for Wall Street and global money managers with big gambling stakes at risk to slow efforts to improve health. Indeed, it is easy to see some very nice and profitable synergies developing between Wall Street sellers of death and health insurers opposed to universal, single-payer health care. As AFL-CIO Secretary Treasurer Trumka recently remarked on NPR, we already have committees deciding when to cut-off care—the private health insurers decide when to deny coverage. It would not be in the interest of securities holders or health insurers to provide expensive care that would prolong the life of human collateral—a natural synergy that someone will notice.

It should be amply evident that Wall Street intends to recreate the conditions that existed in 2005. Virtually every element that created the real estate, commodities, and CDS bubbles will be replicated in the securitization of life insurance policies. If Wall Street succeeds in this scheme, it will probably bankrupt the life insurance companies (premiums are set on the assumption that many policyholders will cancel long before death—but once securitized, the premiums will be paid so that benefits can be collected). But it is likely that the bubble will be popped long before that happens, at which point Wall Street will look for the next opportunity. Securitized pharmaceuticals? Body parts?

Here’s the problem. There is still—even after massive losses in this crisis—far too much managed money chasing far too few returns. And there are far too many “rocket scientists” looking for the next newest and bestest financial product. Each new product brings a rush of funds that narrows returns; this then spurs rising leverage ratios using borrowed funds to make up for low spreads by increasing volume; this causes risk to rise far too high to be covered by the returns. Eventually, lenders and managed money try to get out, but de-levering creates a liquidity crisis as asset prices plunge. Resulting losses are socialized as government bails-out the banksters. Repeat as often as necessary.

Reform of the US financial sector is neither possible nor would it ever be sufficient. As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street’s vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

Fed Profits From The Bailout? Don’t Count Those Chickens Before They Hatch

A flurry of reports appears to indicate simultaneously that the government’s bailout of Wall Street is working to bring banks back to life, and that the Fed is making profits on the deal: See for instance here, here and here. According to these reports, the Fed received $19 billion in interest on its emergency loans to troubled institutions, which was about $14 billion more than it would have received if it had instead bought Treasuries. In addition, it was reported that the Fed made $4 billion of profits from the eight largest banks that have repaid TARP funds. This is seen as good news in Congress: “The taxpayers want their money back and they want the government out of our banking system,” said Representative Jeb Hensarling.

There are three fundamental problems with these stories. The first is that it raises a question about the function of the Fed: should a branch of government seek profits at the expense of the private sector? As we all know, the Fed is normally profitable and returns earnings above 6% on equity back to the Treasury. When the Fed profits on its holdings of government debt, that is essentially the government paying itself and thus of no consequence. Profiting at the expense of private institutions—even if they are the hated “banksters” of Wall Street—doesn’t seem to be something to celebrate. Especially when we are in a deep recession or depression, with a long way to go before the financial system recovers. All else equal, I’d rather see the private sector accumulate some profits so that it can recover.

Don’t get me wrong. I want retribution, too. We need a “bank holiday”, to begin next Friday: close suspect banks including all of the biggest that were subjected to the wimpy “stress test”. Spend the weekend going through the books and then on Monday begin to resolve the insolvent, to prosecute the banksters for fraud, and to retrieve from them their outsized bonuses financed by the public purse. It is payback time. My only objection is to the notion that we should be celebrating because the Fed appears to have made a profit on (a small part of) the bailout.

Second, there is every reason to suspect that the banks that have repaid TARP money and those making payments on loans from the Fed are still massively insolvent at any true valuation of the toxic waste still on their balance sheets. Recent reported profit in the financial sector is window-dressing, designed to fuel the irrationally exuberant stock market bubble. This will allow traders and other employees to cash in their stock options to recover some of the losses they incurred last year, even as bonuses are boosted for this year. Indeed, the main reason for returning the borrowed funds is to escape controls on executive salaries and bonuses. And, finally, it provides some important PR to counteract the growing anger over the financial bailouts. Only the foolish or those with some dog in the hunt will believe that the banksters have really managed to restore health to the financial sector as they continue to do what they did to cause the crisis.

Last but not least, the Fed’s “profits” are based on an infinitesimally small fraction of its ramped-up operations—its liquidity facilities (that also include discount window loans and currency swaps with other central banks, purchases of commercial paper and financing for investors in asset-backed securities). It has also spent $1.75 trillion buying bad assets, with any losses on those excluded from the profits numbers. The government’s profits also exclude current and expected spending on the rest of its reported $23.7 trillion dollar commitment to the financial bailout and fiscal stimulus package. The failure of just one medium-sized bank could easily wipe out the entire $14 billion of profits that has attracted so much notice. (See also Dean Baker on the government’s “profits”)

It is ironic that Euroland’s regulators are calling for much more radical steps than Washington is willing to take. German Chancellor Angela Merkel and French President Nicolas Sarkozy are calling for more regulation and for limits on executive compensation even as the Obama administration continues to argue that such limits would constrain the financial sector’s ability to retain the “best and the brightest”. If the bozos that created this crisis are the best that Wall Street can find, it would be better to shut down the US financial system than to keep them in charge. It is doubly ironic that Nigeria (a country that normally would not come immediately to mind as a role model) has actually charged the leadership of five of its major banks with crimes. Each of these banks had received government money in a bailout, and the CEOs stand accused of “fraud, giving loans to fake companies, lending to businesses they had a personal interest in and conspiring with stockbrokers to drive up share prices.”

Isn’t that normal business practice for Wall Street banks favored by Ben Bernanke and Timothy Geithner? It is time to get the NY Fed out of Goldman’s back pocket, and to permanently downsize the role played by Wall Street and the Fed in our economic system.