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MMP Blog #31: FUNCTIONAL FINANCE: Monetary and Fiscal Policy for Sovereign Currencies

Posted on January 8, 2012 | Comments Off on MMP Blog #31: FUNCTIONAL FINANCE: Monetary and Fiscal Policy for Sovereign Currencies

By L. Randall Wray

This weekwe begin a new topic: functional finance. This will occupy us for the nextseveral blogs. Today we will lay out Abba Lerner’s approach to policy. In the1940s he came up with what he called the functional finance approach to policy.In one of those amazing historical coincidences, Lerner happened to teach atUMKC when he published one of his most famous papers, laying out the approach.Maybe there is something special in the air in Kansas City?

Lerner’s Functional Finance Approach. Lerner posed two principles:

First Principle: if domestic income is too low, governmentneeds to spend more. Unemployment is sufficient evidence of this condition, soif there is unemployment it means government spending is too low.

Second Principle: if the domestic interest rate is too high, itmeans government needs to provide more “money”, mostly in the form of bankreserves.

The idea ispretty simple. A government that issues its own currency has the fiscal andmonetary policy space to spend enough to get the economy to full employment andto set its interest rate target where it wants. (We will address exchange rateregimes later; a fixed exchange rate system requires a modification to thisclaim.) For a sovereign nation, “affordability” is not an issue—it spends bycrediting bank accounts with its own IOUs, something it can never run out of.If there is unemployed labor, government can always afford to hire it—and by definition,unemployed labor is willing to work for money.

Lernerrealized that this does not mean government should spend as if the “sky is thelimit”—runaway spending would be inflationary (and, as discussed many times inthe MMP, it does not presume that government spending won’t affect the exchangerate). When Lerner first formulated the functional finance approach (in theearly 1940s), inflation was not a major concern—the US had recently livedthrough deflation in the GreatDepression. However, over time, inflation became a serious concern, and Lernerproposed a form of wage and price controls to constrain inflation that hebelieved would result as the economy nears full employment. Whether or not thatwould be an effective and desired way of attenuating inflation pressures is notour concern here. The point is that Lerner was only arguing that governmentshould use its spending power with a view to moving the economy toward fullemployment—while recognizing that it might have to adopt measures to fight inflation.

Lernerrejected the notion of “sound finance”—that is the belief that government oughtto run its finances as if it were like a household or a firm. He could see noreason for the government to try to balance its budget annually, over thecourse of a business cycle, or ever. For Lerner, “sound” finance (budgetbalancing) was not “functional”—it did not help to achieve the public purpose(including, for example, full employment). If the budget were occasionallybalanced, so be it; but if it never balanced, that would be fine too. He alsorejected any attempt to keep a budget deficit below any specific ratio to GDP,as well as any arbitrary debt to GDP ratio. The “correct” deficit would be theone that achieves full employment.

Similarlythe “correct” debt ratio would be the one consistent with achieving the desiredinterest rate target. This follows from his second principle: if governmentissues too much debt, it has by the same token issued too few bank reserves andcash. The solution is for the treasury and central bank to stop selling bonds,and, indeed, for the central bank to engage in open market purchases (buyingtreasuries by crediting the selling banks with reserves). That will allow theovernight rate to fall as banks obtain more reserves and the public gets morecash.

Essentially,the second principle just says that government ought to let the banks,households, and firms achieve the portfolio balance between “money” (reservesand cash) and bonds desired. It follows that government bond sales are notreally a “borrowing” operation required to let the government deficit spend.Rather, bond sales are really part of monetary policy, designed to help thecentral bank to hit its interest rate target. All of that is consistent withthe modern money view advanced previously.

Functional Finance versus Superstition. The functional finance approach ofLerner was mostly forgotten by the 1970s. Indeed, it was replaced in academiawith something known as the “government budget constraint”. The idea is also simple:a government’s spending is constrained by its tax revenue, its ability toborrow (sell bonds) and “printing money”. In this view, government reallyspends its tax revenue and borrows money from markets in order to finance ashortfall of tax revenue. If all else fails, it can run the printing presses,but most economists abhor this activity because it is believed to be highlyinflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’s experience, or in moderntimes, Zimbabwe—as a cautionary tale against “financing” spending throughprinting money.

Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes using government’sown IOUs; banks use government’s own IOUs to buy bonds from government.

Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in theUS—is far more confused. For example, President Obama frequently assertedthroughout 2010 that the US government was “running out of money”—like ahousehold that had spent all the money it had saved in a cookie jar.

So how didwe get to this point? How could we have forgotten what Lerner clearlyunderstood and explained?

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:
                “I think there is anelement of truth in the view that the superstition that the budget must bebalanced at all times [is necessary]. Once it is debunked [that] takes away oneof the bulwarks that every society must have against expenditure                 out of control. There must bediscipline in the allocation of resources or you will have anarchistic chaosand inefficiency. And one of the functions of old fashioned religion was toscare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he    would say “uh, oh what you havedone” and James Buchanan argues in those terms. I have to say that I seemerit in that view.”

The beliefthat the government must balance its budget over some timeframe is likened to a“religion”, a “superstition” that is necessary to scare the population intobehaving in a desired manner. Otherwise, voters might demand that their electedofficials spend too much, causing inflation. Thus, the view that balancedbudgets are desirable has nothing to do with “affordability” and the analogiesbetween a household budget and a government budget are not correct. Rather, itis necessary to constrain government spending with the “myth” precisely becauseit does not really face a budget constraint.

The US (andmany other nations) really did face inflationary pressures from the late 1960suntil the 1990s (at least periodically). Those who believed the inflationresulted from too much government spending helped to fuel the creation of thebalanced budget “religion” to fight the inflation. The problem is that whatstarted as something recognized by economists and policymakers to be a “myth”came to be believed as the truth. An incorrect understanding was developed.

Originallythe myth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation and endangering the dollarpeg to gold. But like many useful myths, this one eventually became a harmfulmyth—an example of what John Kenneth Galbraith called an “innocent fraud”, anunwarranted belief that prevents proper behaviour. Sovereign governments beganto believe that the really could not “afford” to undertake desired policy, onthe belief they might become insolvent. Ironically, in the midst of the worsteconomic crisis since the Great Depression of the 1930s, President Obamarepeatedly claimed that the US government had “run out of money”—that it couldnot afford to undertake policy that most believed to be desired. Asunemployment rose to nearly 10%, the government was paralysed—it could notadopt the policy that Lerner advocated: spend enough to return the economy towardfull employment.

Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional$600 billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.

Thatindicates just how dysfunctional the myth has become.

Next week, we’ll show that some Kansas City airmight have drifted northeast to the bastion of free market economics: theUniversity of Chicago

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Geithner’s Ploy: Saving U.S. Banks at Taxpayer Expense, Once Again

Posted on January 8, 2012 | Comments Off on Geithner’s Ploy: Saving U.S. Banks at Taxpayer Expense, Once Again

By Michael Hudson


U.S. and foreign stockmarkets continue to zigzag wildly in response to expectations about whether theeuro can survive, in the face of populations suffering under neoliberalausterity policies being imposed on Ireland, Greece, Spain, Italy, etc. Here’sthe story that I’m being told by Europeans regarding the recent turmoil inGreece and other European debtor and budget-deficit economies. (The details arenot out, as the negotiations have been handled in utter secrecy. So whatfollows is a reconstruction.)

In autumn 2012, it became apparentthat Greece could not roll over its public debt. The EU concluded that debtshad to be written down by 50 percent. The alternative was outright default onall debt. So basically, the solution for Greece reflected what had happened toLatin American debt in the 1980s, when governments replaced existing debts andbank loans with Brady bonds, named for Reagan Treasury Secretary Nicolas F.Brady. These bonds had a lower principal, but at least their payment was deemedsecure. And indeed, their payments were made.
            
This write-down seemed radical, butEuropean banks already had hedged their bets and taken out default insurance.U.S. banks were the counterparties to much of this insurance.

In December (?) 2011, a quartercentury after Mr. Brady, Mr. Obama’s Secretary Geithner went to Europe met withEU leaders to demand that Greece make the write-downs voluntary on the part ofbanks and creditors. He explained that U.S. banks had bet that Greece would notdefault – and their net worth position was so shaky that if they had to pay ontheir bad gambles, they would go broke.
            
As German bankers have described thesituation to me, Mr. Geithner said he would kill the European banks andeconomies if they did not agree to take it on the chin and suffer the lossesthemselves – so that U.S. banks would not have to pay off on the collateralizeddefault swaps (CDOs) and other gambles for which they had collected billions ofdollars.

Europeans were enraged. But Mr.Geithner made a deal. OK, he finally agreed: The White House would indeedpermit Greece to default. But America needed time.
            
He agreed to open a credit line fromthe Federal Reserve Bank to the European Central Bank (ECB). The Fed wouldprovide the money to lend to banks during the interim when European governmentfinances faltered. The banks would be given time to unwind their defaultguarantees. In the end, the ECB would be the creditor. It – and presumably theFed – would bear the losses, “at taxpayer expense.” The U.S. banks (andprobably the European ones too) can avoid taking a loss that would wipe outtheir net worth.
            
What really are the details? What wedo know is that U.S. banks are pulling bank their credit lines to Europeanbanks and other borrowers as the old ones expire. The ECB is stepping in tofill the gap. This is called ‘providing liquidity,’ but it seems more to be acase of providing solvency for a basically insolvent situation. A debt thatcan’t be paid, won’t be, after all.
            
Geithner’s idea is that what workedbefore will work again. When the Federal Reserve or Treasury picks up a bankloss, they simply print government debt or open a Federal Reserve bank depositfor the banks. The public doesn’t view this as being as blatant as simplyhanding out money. The government says it is “saving the financial system,”without spelling out the cost at “taxpayer expense” (not that of the banks!).
            
It’s a giveaway.

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Responses to Blog #30: What is Modern Money?

Posted on January 4, 2012 | 1 comment

By L. Randall Wray

Q1: AA fewquick questions:
(1) Isn’t Charles Goodhart essentially a neoclassical who accepts thechartalist approach to money?
(2) Would it be accurate to say the sources of modern chartalism/MMT are:
    (a) Mitchell Innes’s work
    (b) G. Frederick Knapp’s work
    (c) Keynes and Abba Lerner’s functional finance model
    (d) Post Keynesianism
    (e) some contribution from Minsky? (i.e, FIH)
In this sense it is a new macrotheory sharing many ideas with older PostKeynesians (uncertianty, endogenous money, subjective expectations) but thathas done innovative work in shattering myths about how the central bank andtreasury really function, even though one might argue that Abba Lerner was thetrailblazer in this work:
Lerner, A. P. 1943. “Functional Finance and the Federal Debt,” Social Research10: 38–51
Lerner, A. P. 1944. The Economics of Control, New York, Macmillan.
I’ll just end by saying that when Keynes finally read Lerner’s he appeared toendorse it.

A: The first MMT conference I recall was organized by WarrenMosler at Bretton Woods in 1996. At that time, he called it “Soft CurrencyEconomics”, but most of the pieces of the MMT puzzle were there. The 3economists invited by Warren were: Charles Goodhart, Basil Moore, and YoursTruly. I would not accept “essentially neoclassical” as an accuratedescription of Charles. However, to say that he marches to his own drummerwould be accurate! We don’t agree on everything, but we agree on much. A bitmore on that conference: a) the one who actually did the work of organizingWarren’s conference was none other than Pavlina Tcherneva, who at the time wasan undergrad student of Mat Forstater;
b) my memory is notoriously bad and someone will probably correct me byreminding me that the BW conference was not the first meeting of MMT, butit was certainly the first time I met Warren and Pavlina! I think I hadmet Mat before, and had known Stephanie for quite some time; I think I had metBill before 1996–but memory is foggy. I knew all of these people on-line andwe had been working on MMT for several years, but I think the meetings andconferences began in 1996.

Q2:  Does Basil J.Moore subscribe to MMT? I know his work on endogenous money. Just to clarify:the founders of MMT are Warren Mosler, Charles Goodhart, Basil Moore, RandallWray, Bill Mitchell, Pavlina Tcherneva, Stephanie A. Kelton and Mat Forstater?Since Basil Moore was obviously a Post Keynesian, is it correct to say thatmany of the founders were influenced by Post Keynesianism ? Does not WarrenMosler have a connection with Paul Davidson? And good old Hyman Minskyinfluenced you, Profesor Wray? Finally here are my brief thoughts on thehistory of MMT: http://socialdemocracy21stcent…

A: Looks good. Look at the first MMP blog which has a list of contributors, andstudents etc that I thank. It is impossible to formulate a complete, definitivelist. Kelton is Bell. Except for my “students” (Tcherneva, Tymoigne,Kaboub, Nersisyan, Leclaire, Fullwiler, Bell, etc, too many to list here)most of us originally met on the old PKT internet discussion group. Others,like Moore and Davidson and Minsky and Kregel are “fathers” in somesense of the PK approach–so I knew them from early 1980s. They accept elementsof MMT, but except for Kregel it probably would not be good to list them asMMTers. We all learned from them. Note I have been negligent in forgetting tolist Ed Nell–and will do so–because he was a supporter from the earliestdays. And he helped to organize meetings at the New School. Minsky is withoutquestion the greatest economist of the second half of the 20thcentury. So, yes, we were influenced.


Q3: Would Henry C. Carey be considered as a kind ofprecursor to MMT?  Was he an influence in your intellectual formation?Could this be the source? http://www.amazon.com/Modern-M…

A: Professor Mat Forstater isour resident historian of thought. He might know Carey or this Burstein; thenames do not ring a bell with me. 0 Like
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Q4: John Carney’s piece referring to crony capitalismwas most interesting as was Mitchell’s response talking about the JG. I alsosaw your blog on the JG. These all have a great appeal and I hope you willcomment more. There is no doubt there is just plain corruption when thegovernment tries to stimulate the economy directly but even the JG will besubject to that. I suppose corruption or whatever name you give it exists inall endeavors.  The JG has some problems in this world, not least of whichis a base for effective political support.  So, again, I hope you willspend some time on those issues. At some point the economics has to come togrips with political power and society.

A: We will deal with most of these issues in coming blogs.But if we all agree on the theory then all we need to do is put our headstogether to make it work. What amazes me is that upward of 95% of theobjections now—20 years later—are about program implementation, politicalfeasibility, and corruption. OK I think some of you are smart. Put your darnedheads together. Stop criticizing. Start solving problems. I cannot see any useof economics or any other branch of human endeavor if it does not try to tackleproblems. Finding useful work for a JG employee seems to me to be on the orderof difficulty as finding a pot for your 2 year old to pee in. If you cannotresolve that problem, you are up the creek without a paddle, so to speak. Haveany of you ever put a diaper on your damned kid? You began as all thumbs andsharp pins. After a few months you could do it with eyes closed, one-handed, ina restaurant while serving your guests with your other hand. As Keynes said,this is like dentistry. Solve the damned problem. Stop complaining. All of you,every single one of you, should be able to resolve all these issues before Ieven start posting blogs about the JG. That’s a challenge. My upcoming posts onJG should be completely redundant. Get your buns in gear. You’ve been here formore than half a year; all the pieces are in place. Go for it. Prizes and fameawait.

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A Cri du cœur in Defense of English from Cerro Gordo, Iowa

Posted on January 2, 2012 | Comments Off on A Cri du cœur in Defense of English from Cerro Gordo, Iowa

By William K. Black

Rick Perry is now pledging to save conservative IowaRepublicans from a great peril – accidentally reading a phrase on a productlabel on one’s soup can before realizing that it is written in a language otherthan English.  Read and be amazed:

December 30, 2011

Perry Supports English as Official Language in US

“Perry, whosecampaign needs a boost before Tuesday’s lead-off Iowa caucuses, spoke at aCerro Gordo County GOP fundraiser and took questions from the audience at theMason County Country Club.

The voter who toldthe Texas governor he was tired of multilingual directions for products drewapplause when he said he’d like to see English become the official language ofthe U.S. government.

“I don’t knowhow the rest of the conservatives in the room feel, but personally, I’m fed upwith seeing the directions on every single product on every single shelf ofevery single store written in four languages,” said the man, who didn’tgive his name.

Perry replied,”That is a statement, that’s not a question, and I can agree with it.””


The Art of Generating a “Moral Panic”

Meredith Willson, author, composer, and songwriter of themusical The Music Man made Iowafamous.  The musical is famous amongcriminologists and sociologists because it simultaneously exemplifies andsatirizes the deliberate creation of “moral panics.”  The phrase is reasonablyself-explanatory.  The creator of thepanic simultaneously generates fear of and loathing for “the other.”  Famous examples in movies are “ReeferMadness” (smoking grass makes one depraved) and “Birth of a Nation” (blacks areout to rape white women and the KKK are the heroes).  Willson’s flawed protagonist, a not veryelite white-collar criminal, “Professor” Harold Hill, pretends to be a musicianand band leader.  He needs to convincenormally conservative Iowa parents to purchase expensive musical instrumentsand uniforms from him.  Hill’s solutionis to create a moral panic, which he does through the song “Ya’ Got Trouble!”  Hill’s song explains that the youth of RiverCity, Iowa are headed toward damnation because the town has a new pooltable.  Yes, a pool table.  Indeed, to accentuate the absurdity of themoral panic he is generating, Hill’s song differentiates between people playingbilliards (high-class, desirable) and those who play pool (low-class,delinquents).  Meredith Willson grew upin Mason City, Iowa, the county seat for Cerro Gordo, and based his play on hisexperiences there.  In the musical, Mrs.Paroo, “Marian the Librarian’s” mother, despairs that her daughter reads foreignauthors.  Mrs. Paroo shares the distressof modern Cerro Gordo residents with languages other than English.

Mrs. Paroo:
But, darlin’–when a woman has a husband
And you’ve got none,
Why should she take advice from you?
Even if you can quote Balzac and Shakespeare
And all them other highfalutin’ Greeks.


SavingCerro Gordo and the English Language

Putting aside the major imponderable – why is the “Cerro Gordo County GOP fundraiser [meeting]at the Mason County Country Club – one must delight in the exquisite irony thata conservative Republican who is driven to rant by the fact that some productshave labels describing the product in multiple languages chooses to live in“Cerro Gordo.”  Perhaps he is scarred byhaving to use these two Spanish words so frequently in America.  One must concede that it is un-American tofail to despise languages other than English. I have often been driven to paroxysms of rage when I see that my currencyhas been defiled by a foreign language.

Indeed, I havebeen scarred for decades by living in a city with an un-American name.  During my time in law school I lived in aYpsilanti, Michigan, which was named after a Greek hero of their war forindependence from the Ottoman Empire.  Ofcourse, Ypsilanti’s other claim to fame, the “brick dick” (a building voted themost phallic structure in a survey) may have been even more responsible for myfeelings of inadequacy.  In any event, Ifeel the pain of the Cerro Gordo resident beset by un-American languages on hiscan of soup.      

I urge thecitizens of Cerro Gordo to change the county’s name to “Fat Hill.”   


How an Iowa County was Given aSpanish Name

I can reassurereal Americans that the handful of citizens of Iowa that named their newlycreated county “Cerro Gordo” roughly 150 years ago did not do so out ofpolitical correctness or any love of the Spanish language.  They named their County to celebrate a greatvictory by the United States over Mexico. This was a very different era with no parallels to our own.  President Polk actively sought a pretext toinvade another nation, Mexico.  The U.S.had just annexed Texas, in violation of a treaty with Mexico.  The annexation followed the Texas war forindependence from Mexico, a struggles won largely by U.S. expats demanding thefreedom to own slaves.  Mexico, being abackward nation, had made slavery unlawful.   

Polk wasuncomfortable that his general, Zachary Taylor, won the initial battles in theU.S. invasion of Mexico (launched south form Texas) so decisively that hebecame a potential political rival.  (TheU.S. contemporaneously made multiple successful land grabs from Mexico in NewMexico and California.)  Polk, therefore,ordered General Windfield Scott to invade Mexico via the sea with the missionto capture the port of Veracruz (“True Cross”) and then march to Mexico Cityand capture it.  Scott’s siege ofVeracruz in 1847 was successful, but it gave time for substantial Mexicanforces outnumbering Scott’s forces to establish a strong defensive positionanchored on the heights of Cerro Gordo on the Federal Highway blocking Scott’sroute of march to Mexico City.  TheMexican defenders had the advantages of being on the defense of their ownnation, control of the high ground, prepared positions, limited frontage,greater numbers, greater artillery (in defilade)commanding the approaches to their main line of defense, and (what should havebeen) superior knowledge of the terrain. Scott’s forces should have been decisively defeated.  U.S. engineers, however, with Captain Robert E.Lee playing an important role, engaged in bold scouting that revealed a meansof flanking the Mexican forces commanded by Santa Anna.  The US flanking movement allowed Scott’sforces to attack the defenders in enfilade,which allowed them to rout the Mexicanforces.  The U.S. victory at Cerro Gordoopened the door for Scott’s capture of Mexico City, which led to Mexico’scapitulation in the Treaty of Guadalupe Hidalgo.  The war was as ignoble as any the U.S. hasever fought, but the U.S. army performed brilliantly at Cerro Gordo. 


The Rich White Sparkling Whine forthe New Year

Press reports call the Cerro Gordo resident’s statements toPerry a “rant,” but this is unfair.  Itwas a whine.  As a resident of CerroGordo the man has chosen to live in an area where he will rarely hear anylanguage other than English.  The CensusBureau informs us that while 95% of the residents of Cerro Gordo are white,they are being overrun by the 3.8% of the population that are Latinos – a fifthcolumn of roughly 1500 dedicated to the sole purpose of reversing thehumiliation of Mexico at Cerro Gordo over 150 years ago.  Mexican-Americans have long memories and aburning desire to bring about a Reconquista.  Mexican-Americans are not the onlyforeign threat to real Americans living in Cerro Gordo.  Roughly one-thousand county residents (2.4%)are “foreign born.”  Nearly one-in-twentyhouseholds (4.9%) in Cerro Gordo speaks a language other than English in thehome – the better to plot against America. Cerro Gordo is a veritable Tower of Babel. 

The Cerro Gordo resident who shared his pain with Perry wasnot suffering because he was forced to patronize the 1.8% of Cerro Gordo firmsowned by Latinos.  (Fewer than 100 firmsare owned by black or Asian residents of Cerro Gordo.)  It must be Cerro Gordo firms owned by real(mono-lingual, white) Americans that caused the valiant Cerro Gordo speaker’scry of distress by stocking products with labels that include languages otherthan English. 


TheIncident puts the Lie to the Canard that Conservatives Oppose SensibleRegulation

The U.S. does not require companies to label consumer goodsin multiple languages.  Many U.S. andforeign manufacturers print labels and product information in multiplelanguages so that they can increase sales and minimize costs.  It gives the producer more flexibility tosell its goods in whatever nation and region offers the producer the greatestprofit opportunity. 

Most so-called American consumers, unlike the real Americanhero of Cerro Gordo who brought this great moral crisis to Perry’s attention,do not have enough respect for the purity of the English language to be upsetthat the jar of mustard they purchase also says Senf on it.  It has come tothis in our once great nation – the language of the Third Reich is on ourmustard.  Why did we bother to fightWorld War II if we were going to capitulate to German demands for lebensraum on our product labels?  It gets worse – I saw bottles in the storeyesterday labeled Zinfandel and Champagne that did not even have anEnglish translation!  Wahnsinnig! 

The real American hero of Cerro Gordo who brought his cryfrom the heart about the assault on English on our soup cans to Perry’sattention, reminds me of that great patriot, General Jack D. Ripper in the movie“Dr. Strangelove.”  General Ripper, like theunknown patriot of Cerro Gordo that inspired Perry, was the first to understandthat the “loss of [English] essence” indicated that we were entering a fin de siècle.  “Purity of English” must be ourmantra.  As true conservatives we mustmake the preservation of the exclusivity of English in America our raison d’être.        
  
Only faux conservativeswould oppose regulation in these circumstances. Yes, consumers could just refuse to buy products defiled by the presenceof un-American languages on their labels. Entrepreneurs could enter the market and offer English-only labelspreserving the Purity of (English) Essence. But we should not rely on freedom of consumer choice when the assault onEnglish and America poses such an existential threat.  One cannot overstate the trauma caused to areal American when he tries to read a word or two in English before realizingthat he has been exposed to seeing a foreign language.  Our children are helpless absent a lawforbidding foreign words on products sold in America.  The danger of a pool table in Cerro Gordo,Iowa is de minimus compared to thescourge of seeing French on the label of cans of consommé.  RealAmericans believe in bullion, not bouillon.  

Why did Perry endorse the proposal to purify the labels ofour soup cans?  He is the chief executiveof a state with millions of citizens who prefer to have Spanish and English ontheir soup cans.  It is a testament tohis political courage that he would side with a single resident of Cerro Gordo,Iowa who is phobic about seeing languages other than English rather than sidewith those millions of citizens of Texas who would continue to betray ourEnglish language by purchasing soup with multilingual labels.  Only extensive government regulation of allproduct labels led by a Language Czar can rid us of these accursed languages.          


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MMP Blog #30: What is Modern Money Theory?

Posted on January 1, 2012 | Comments Off on MMP Blog #30: What is Modern Money Theory?

By L. Randall Wray

Happy New Year to All. We are (I think) a bit over half-waythrough the Modern Money Primer. We should be able to finish it by sometimenext summer.

OK, you might be wondering: Isn’t this a strange point atwhich to raise the question, “what is modern money theory?” Yes, in someimportant ways, it is. However in the past week there have been some reallypretty extraordinary pieces in the popular media trumpeting MMT.

The Economist magazine featured a major story, Heterodox economics, Marginalrevolutionaries: The crisis and the blogosphere have opened mainstreameconomics up to new attack.Of the three heterodox approaches it discussed, one was the “neo-chartalist” or“modern money theory”. Warren Mosler as well as UMKC appeared in the story;indeed, there are two cartoon caricatures featuring Warren adorning the story.

In addition, John Carney at CNBC has been running a seriesof pieces that discusses MMT. This one is particularly good: MMT, NGDP, AndAustrian Economics: Alphabet Noodling!.And here is a link to his previous one: 

Further, the debates about MMT continue in the blogosphere,including over at Cullen Roche’s blog: THE FUNDAMENTAL DIFFERENCE BETWEENAUSTRIANS AND MMT’ERS .And a truly excellent piece on Bill Mitchell’s Billyblog: . Bill’spost led to a bit of a scuffle over what is actually in MMT—with Cullen arguingthat the Job Guarantee cannot be acomponent, while Bill insisted that it mustbe. Warren has sided with Bill and written very persuasive comments arguingthat we need the price anchor.


In this Primer we will eventually get to the Job Guarantee,so I do not want to discuss that today. But the arguments made by Cullen haveled to two questions: what is within the realm of MMT? And just where did thename “Modern Money Theory” come from? Indeed, Stephanie Kelton was asked thesecond question and did a bit of investigation. To be sure, we are not sure
.
My 1998 book was entitled “Understanding Modern Money”. WhenI was writing the book, it had a much more boring working title, and I askedMat Forstater and Warren to help think of something catchier. We threw around alot of ideas and rejected all of them. I had in the manuscript the quote I lovefrom Keynes that argues that the State names the money of account and chooseswhat can answer to that name, and has done so “for some four thousand years atleast”. And so I chose to use the term “modern money” to apply only to monetarysystems that have existed for the past “four thousand years at least”. Whatevertype of money that might have existed before that, we cannot be sure. But forthe past 4000 years, at least, we have had State Money—that is, Modern Money. Fromwhence came the book title.

I tended to call our approach the State Money approach inthe early years; perhaps I also used the term Chartalist. That derived from thework of Knapp, who was followed by Keynes in his Treatise on Money (1930). This has usually been misinterpreted,following Schumpeter, as a “legal tender law” approach—a position clearlyrejected by Knapp and Keynes. Both Keynes and Schumpeter knew that it had to bemore than legal tender laws. But that is a matter for another time.

Later, our approach was given the name“neo-Chartalist”—which I think was supposed to be somehow derogatory. After severalof us moved to UMKC, it began to be called “the Kansas City approach”. That ofcourse was misleading because our sister center was in Newcastle under BillMitchell’s direction, and it also ignored the work of Charles Goodhart in theUK; by that time there were already many other people working on the approach,spread around the country and even around the world.

In any event, somehow it got the name Modern Money Theory. Wethink the first time those exact words were used might have been in a commentto Bill’s blog in 2007; if anyone can find that comment or a previous use,please send it along. It also looks like Bill used the term “modern monetarytheory” in an academic paper in 2008.

I decided to look back over my own powerpoints to see how mypresentations of the approach evolved. I’ll provide three. Please bekind—looking at those early ones is a bit painful. But remember that ppt was anew technology back in 2005! And I am still no match for Steve Keen.

The first one is titled THE CREDIT MONEY, STATEMONEY, AND ENDOGENOUS MONEY APPROACHES, from a series of lectures I gave for ashort course at UNAM in Mexico City in May 2005.


 

As noted on the first slide,the lecture’s primary purpose was “to draw out the links among the state,credit, and endogenous money approaches, after first discussing the nature ofmoney via historical and sociological analysis”.  “The credit approach locates the origin ofmoney in credit and debt relations…” On the other hand, the state moneyapproach “Highlights the role played by “authorities” in the origins andevolution of money. The state imposes a liability in the form of a generalized,social, unit of account–a money–used for measuring the obligation. Once theauthorities can levy such obligations, they can name what fulfills thisobligation by denominating those things that can be delivered, in other words,by pricing them.” And, finally, the endogenous money approach consists of fourmain components. “1. Money is “endogenous”: loans create deposits, which arecredit money. 2. Reserves are “horizontal”, nondiscretionary. 3. Overnightinter-bank lending rates are “exogenously” set by policy. 4. Banking Schoolreflux principle: deposits return to banks to retire loans, destroying money.Similar to the “fundamental law of credit” of Innes: the creditor/issuer mustaccept its own liabilities to retire debt of the debtor. “Excess Money” is notpossible.”



The slideshow concludes with the attempted integration(sorry, a bit long): “The state choosesthe unit of account in which the various money things will be denominated. Inall modern economies, it does this when it chooses the unit in which taxes willbe denominated and names what is accepted in tax payments. Imposition of thetax liability is what makes these money things desirable in the first place.And those things will then become the (HPM) money-thing at the top of the“money pyramid” used for ultimate clearing. The state then issues HPM in itsown payments—in the modern economy by crediting bank reserves, and banks, inturn, credit accounts of their depositors. Most transactions that do notinvolve the government take place on the basis of credits and debits, that is,privately-issued credit money. This can be thought of as a leveraging of HPMused for ultimate clearing. In all modern monetary systems the central banktargets an overnight interest rate, supplying HPM on demand (“horizontally”) tothe banking sector (or withdrawing it from the banking sector when excessreserves exist) to hit its target. There is an important hierarchical relationin the debt/credit system, with power—especially in the form of command oversociety’s resources—underlying and deriving from the hierarchy. The ability toimpose liabilities, name the unit of account, and issue the money used to paydown these liabilities gives power to the authority that can be used to furtherthe social good. “Sovereignty” However, misunderstanding or mystification ofthe nature of money constrains government by the principles of “sound finance”.While it is commonly believed that taxes “pay for” government activity,actually obligations denominated in a unit of account create a demand for moneythat, in turn, allows society to organize social production, through a monetarysystem of nominal prices. Much of the public production is undertaken byemitting state money through government purchase. Much private sector activity,in turn, takes the form of  “monetaryproduction”, or M-C-M’ as Marx put it, that is, to realize “more money”. Thisis mostly financed by credits and debits—that is, “private” money creation.Because money is fundamental to these production processes, it cannot beneutral. Indeed, it contributes to the creation and evolution of a “logic” tothe operation of a capitalist system, largely “disembedding” the economy. Atthe same time, many of the social relations can be, and are, hidden behind aveil of money. This becomes most problematic with respect to misunderstandingabout government budgets, where the monetary veil conceals the potential to usethe monetary system in the public interest.”

Well, I think readers of this Primer will recognize manythemes we have already covered, and we will be going through those that areunfamiliar in coming weeks. Not much of anything in this passage that I’dchange.

The second ppt to be examined is titled MODERN MONEYAND FUNCTIONAL FINANCE, from a lecture (again) at UNAM in May 2007.


  

It has somesnazzy pictures I downloaded from the internet, and repeats much of the themefrom above. What I want to point to is the introductory slide:“The state moneyapproach is associated with Knapp, Keynes, and Lerner, while credit money isassociated with Innes and Schumpeter, and more loosely with the Circuit andendogenous money approaches. The functional finance approach is associated withLerner.



Modern Money =endogenous money + state money + credit money + functional finance”

This was the first slide I could find in which I wrote outan “equation” listing what I took to be the fundamental components of my“modern money” approach. There is a later slide that lists the various“heterodox” schools of thought from which my approach derives:

•         Marx,Keynes, Veblen: M-C-M’; MTP; Theory of business enterprise
•         Institutionalists:M is all bound up with power: to do good and bad; perhaps the most importantinstitution in CapEcon
•         PostKeynesians: M and uncertainty; M and contracts; holding M
•         Chartalists:State M, bound up with sovereignty
•         FunctionalFinance: State M and Govt spending

Sorry for the abbreviations—I was learning to reduce theamount of writing put on each slide—but I think you can figure out what theystand for. (MTP refers to Keynes’s “monetary theory of production”, which isvery similar to Marx’s M-C-M’ formulation and to Veblen’s “theory of businessenterprise”. M, of course, stands for money. And CapEcon is a capitalisteconomy.)

The final presentation comes from a panel at the Associationfor Institutionalist Thought, April 2008, on “how to teach economics”. Mypresentation was: How to Teach Money

 

And what I want to point to is the addition I had made tothe slide just presented:
•         Marx,Keynes, Veblen: M-C-M’; MTP; Theory of business enterprise
•         Institutionalists:M is all bound up with power: to do good and bad; perhaps the most importantinstitution in CapEcon
•         PostKeynesians: M and uncertainty; M and contracts; holding M
•         Chartalists:State M, bound up with sovereignty
•         FunctionalFinance: State M and Govt spending
•         TOGETHER:MODERN MONEY

In other words, my argument then—and now—is that the modernmoney approach integrates all ofthese approaches into a coherent theory of the way money “works” in the moderneconomy.

Much of the new ground explored by MMT has been focused onproviding an accurate description of what we call “monetaryoperations”—including the coordination between the central bank and treasury,with special focus on describing how “government really spends”. We have spentso much of our time on this for two reasons: first, almost no one understoodthis as recently as 2 or 3 years ago. Second, it is important, criticallyimportant, to formulating sensible policy.

And as an accurate description, this part of MMT should beaccepted by anyone, no matter what their theoretical, political, or ideologicalpersuasion. Ironically, it is the description that has been viciously attacked,even though no one, and I mean no one, has found any holes in the argument.
But MMT is much more, at least in my view.






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Control Frauds Continue to Maim and Kill

Posted on December 31, 2011 | Comments Off on Control Frauds Continue to Maim and Kill

By William K Black

The financial scandal and the Great Recession that it causedhave understandably captured the bulk of our attention, but we must not losesight of the fact that “control frauds” continue to maim and kill enormousnumbers of people and damage the environment and society throughout theworld.  Several examples of these fraudshave led to recent press reports.  Iwrite to point out that control fraud is the common feature of thesescandals.  I address four recentmanifestations of control fraud:  theFrench manufacturer of defective silicone breast implants, the death of manyFillipinoes in floods made lethal by illegal deforestation, the deaths anddevastation caused by illegal seizure and exploitation of mines in the Congo,and the scrap metal dealers who put the profit in the theft of metals in theUK.  This first column explains theFrench breast implant fraud.

Varietiesof Control Fraud

Control frauds occur when the persons controlling aseemingly legitimate entity use it as a “weapon” to defraud.  Such frauds occur in the private, NGO, andpublic sector.  I write primarily aboutaccounting control frauds because accounting is the “weapon of choice” forfinancial control frauds.  (Liar’s loanswere the best ammunition, and subprime liar’s loans were the equivalent ofteflon-coated bullets designed to pierce protective armor.)  Shareholders and creditors are the primaryintended victims of accounting control fraud, which creates record, but fakeprofits.  Other forms of control fraudcreate real profits.  Anti-purchasercontrol frauds target the customer and involve deception as to the qualityand/or quantity of the product. Anti-public control frauds target the public.  Illegal logging, the illegal seizure andexploitation of mines, and purchasing goods one knows are likely to be stolenare examples of frauds designed to harm primarily the public. 

TheFrench Manufacturer of Defective Breast Implants

Poly Implant Prothese (PIP) was a French manufacturer ofsaline and silicone breast implants.  TheFDA found severe problems with PIP’s production of saline implants a decade agoand alerted PIP and its French regulatory counterpart to the problems in 2000.  The FDA described the saline implants as“adulterated” due to eleven flaws in its manufacturing processes.     

Learning about Jean-Claude Mas, PIP’s CEO, should serve as anecessary caution.  Far too many peoplecannot believe that people who run corporations can be “real” criminals.  CEOs can be despicable, and their approach totheir customers can be loathsome.  MasCEO knowingly put the health of hundreds of thousands of women at risk.

“Haddad[Mas’ lawyer] said that Mas freely admits using unapproved silicone gel, butremains adamant it is safe.

“PIP knew it wasn’t in compliance, but it wasn’t a toxic product,” the lawyersaid, adding it “had not been proven” the implants were any more likely toleak.

“The fact that it’s an irritant (when ruptured) is the same for all siliconegels….”

PIPused two types of silicone in its implants, Haddad said. One of them was anapproved gel made by American firm Nusil, but it also used an “identical”homemade gel that was five times cheaper.

According to PIP’s 2010 bankruptcy filing, it had exported 84 percent of itsannual production of 100,000 implants.”


But the substitute gel was not “identical” and whilemedical-grade silicone is an “irritant” when an implant ruptures thenon-medical gel posed a substantially greater risk.  PIP’s production quality problems continued,so PIP’s poor quality implants were also more likely to leak.  Indeed, PIP began putting the unlawfulsilicone in its products in 2001, shortly after it received the FDA warningabout its unsafe production methods (see here).

TheoclassicalEconomists Assume that Greater Consumer Choice is Unambiguously Good

Why would PIP continue to purchase some medical-gradesilicone at five times the price?  

“The tycoon at the heart of the breast implantsscandal that has affected hundreds of thousands of women has admitted hiscompany deliberately used inferior silicone gel.

The owner of bankrupt company Poly Implant Prothese(PIP) Jean-Claude Mas revealed that PIP sold protheses with industrial-gradesilicone that had not been approved by health authorities to be sold atdiscounted prices.

But wealthier clients were sold implants withhigh-quality gel, The Times newspaper reported.
Mr Mas, 72, explained through his lawyer, YvesHaddad, that the reason behind the product was that his company had an’economic objective’ and that his management aimed to get ‘the best cost’.

He also admitted that the industrial-grade siliconeimplants, which could cause health problems if they burst or leak, ‘did notformally receive approval’ and regulations were violated.
France’s medical safety regulators AFSSAPS werenever asked to inspect or approve the products.

Mr. Mas said there was a basic and a high-endversion of the implant, but that the cheaper version – which was ‘five timescheaper’ – was just as effective as the costlier version.”

PIP did not inform its poorer customers that it was illegally selling theminserts made with cheaper, unapproved industrial-grade silicone (see here).


PIP also did not inform its customers that “the casingaround the filling was also faulty and prone to rupture or leakage’” (see here).

Interpol’sImplicit View of the Seriousness of various Crimes

There were a flurry of press reports that Interpol had issued an arrestrequest for Mas, but it turned out that Interpol’s action was unrelated to Mas’placing the health of hundreds of thousands of women at risk through fraud. (see here)

“International police agency Interpol has beenissued a “red notice” for Mas, however it’s for an unrelated case — he wasarrested in June 2010 for drunk driving, but left the country and did not showup for a scheduled court date.”

That Interpol incident illustrates brilliantly thedifference in societal reactions to different varieties of crimes, but it alsooffers some hope.  Drunk driving is aserious crime that often maims and kills. An individual impaired driver of a car can put dozens of lives atrisk.  A fraudulent CEO running a medicalequipment company can put hundreds of thousands of lives at risk.  Only a few decades ago it was rare for lawenforcement to take drunk driving seriously, particularly if the driver waselite.  A social movement, MothersAgainst Drunk Driving (MADD), worked for many years to get society and lawenforcement to think of drunk driving as grave crime.  We need a similar social movement to getsociety and law enforcement to see control fraud as a grave crime worthy of anInterpol “red notice.”   

Audacity

What separates the most destructive fraudulent CEOs fromtheir lesser counterparts is audacity. The French (naturally) have a saying that captures the conceptperfectly.  “L’audace, encore l’audace,toujours l’audace” (audacity, more audacity, always audacity).  Mas is off the scale when it comes toaudacity.  Mas exemplifies the Spanishmeaning of his name (“more”).  No soonerhad he (for the second time) been found to have endangered his customers, thanhe was planning to go back into the business of producing and selling breastimplants. (see here)

“The French head of the company at the centre of theinternational breast implant scare was employed by a second firm making [breastimplants] set up by two of his children.
The plan described Mas, 72, as a “creativegenius” and says its collaborators have “30 years of experience inthe field of quality, research and development, production andcommercialisation of breast implants”.
It stated its aim was to produce 400 silicone gelimplants every day at the former PIP production site in the south-east ofFrance, to be sold to “the European, South American and Chinesemarket”.”

It takes a special kind of depravity to describe oneself asa “creative genius” after a life of defrauding one’s customers through meansthat put their health at undue risk.  Iwrote an earlier column discussing what ring of hell Dante would make thefrauds that drove the financial crisis reside in if he were able to write amodern Divine Comedy.  After a career of preying on women, Masshould pray fervently that there is no physical or spiritual hell.  

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President Obama Negotiates our Formal Surrender to Crony Capitalism – and the Nation Yawns

Posted on December 30, 2011 | 1 comment

By William K. Black

On December 13, 2011, the Wall Street Journal published an article entitled “Banks in Pushfor Pact.” It was an obscure article buried in the real estatesection.  The article contained thisclause:  “Under the proposal, banks wouldbe released from legal claims tied to servicing delinquent mortgages as well ascertain mortgage-origination practices….” Opponents of this proposed amnesty for mortgage-origination fraud havecharged repeatedly that the federal government and Tom Miller, the AttorneyGeneral of Iowa, who is leading the settlement negotiations, support theamnesty.  Previously, Miller’s keylieutenant, but not the Obama administration, angrily denounced thecharge. 

TheFour Levels of Control Fraud Involving Mortgages


Home lenders, particularly those making liar’s loans,typically committed endemic “accounting control fraud” on multiple levels.  Control fraud occurs when the personscontrolling a seemingly legitimate entity use it as a “weapon” to defraud.  Accounting is the “weapon of choice” forfinancial control frauds.  Mortgagefrauds can be grouped into four levels, each of them exceptionallywidespread:  loan origination fraud bythe lenders and their agents, the fraudulent sale of fraudulent mortgages, thefraudulent pooling and sale of collateralized debt obligations (CDOs) in whichthe underlying was largely fraudulent mortgages, and foreclosure fraud. 

LoanOrigination Fraud

The classic economics article describing such frauds isGeorge Akerlof and Paul Romer’s “Looting: the Economic Underworld of Bankruptcyfor Profit” (1993).  The recipe” foraccounting control fraud by a lender (or purchaser) has four ingredients.

  1. Extreme growth by making (or purchasing)
  2. Loans of extremely poor quality at a premium yield
  3. While employing extreme leverage, and
  4. Providing grossly inadequate allowances for loan and lease losses (ALLL)
Origination fraud involved a series of mutually supportivefrauds: inflating the borrower’s income, inflating the appraised value of thehome, providing grossly inadequate allowances for loan and lease losses (ALLL),and failing to recognize losses on fraudulent loans held in portfolio.  It was also common for federally insuredlenders to file false reports with and make false statements to theregulators.  Lenders that made liar’sloans were “accounting control frauds.” Their CEOs cause them to create perverse incentives to suborn thesupposedly independent experts to provide opinions that inflate values andunderstate risk in order to aid and abet the underlying accounting fraud.  These perverse incentives create a“Gresham’s” dynamic in which bad ethics drives good ethics out of themarketplace.  The result is “echo” fraudepidemics.  Each of these fraudsconstitutes a federal felony.  Most ofthe frauds I have described are also felonies under state law.  Collectively, there were millions oforigination frauds with a total dollar amount of fraudulent originations wellin excess of $1 trillion.

TheFraudulent Sale of Fraudulent Loans

The second level of fraud is the fraudulent sale by thelenders of the fraudulent loans.   Thisform of fraud required endemic false “reps and warranties.”  Roughly 90 percent of liar’s loans were sold,so this second level of fraud also constitutes millions of federal and statefelonies and roughly $1 trillion in fraudulent sales.

TheFrauds involved in Pooling Fraudulent Loans to Create and Sell Fraudulent CDOs

The third level of fraud is the sale of collateralized debtobligations (CDOs) “backed” by fraudulent liar’s loans through falsedisclosures.  This level of fraudconstitutes tens of thousands of federal felonies and roughly $1 trillion infraudulent sales.

ForeclosureFraud

The fourth level of fraud is foreclosure fraud.  The best known of these frauds involved thecommission of hundreds of thousands of felonies through the filing of falseaffidavits to secure foreclosures (inaptly called “robo signing”).

MassiveForeclosure Fraud Generated the Global Settlement Discussions

It was this last level of fraud that prompted the settlementdiscussions.  What one must keepconstantly in mind when dealing with lenders that are control frauds is thatthey and their senior officers will be represented by the best criminal defenselawyers.  America still does many thingssuperbly, and we do lawyers really well. The fraudulent officers who control banks engaged in control fraud willspend bank funds like water for their defense lawyers.  The old joke is that when one is dealt lemonsone should make lemonade.  In law school,however, we consider that the “C minus” answer. When dealt lemons; the best lawyers seek to make Dom Perignon. 

Consider the setting – you represent a systemicallydangerous institution (SDI) that was the beneficiary of a federal bailout.  Your client has made hundreds of thousands offraudulent liar’s loans and fraudulently sold the great bulk of them.  If your client is held responsible for thesefrauds it will have to reveal that it is massively insolvent and facereceivership.  Your client is also one ofthe largest mortgage loan servicers in the world.  A small law firm representing a borrower hastaken the deposition of one of your client’s key employees who signed theaffidavits necessary to support roughly ten thousand foreclosures a month – andadmitted that the key statements she has made in each of those affidavits isfalse.  The somnolent federal governmenthad finally been forced to admit that the banks have engaged in endemic foreclosurefraud.  The states are alsoinvolved.  This would be a nightmarescenario for any normal client.  For anSDI, however, it was an opportunity. 

L’audace,encore l’audace, toujours l’audace!
(Audacity,more audacity, always audacity: the white collar defense lawyer’s creed)

One of the secrets to being an extraordinarily effectiveelite criminal is also true of their lawyers – audacity.  Elite white-collar criminals can frequently getaway with grotesque criminal conduct if they use their exceptional advantagesprovided by wealth, privilege, and seeming legitimacy.   Even within the ranks of elite white-collarcriminals, however, the CEOs who control SDIs – particularly during a financialcrisis that they caused – are unique in their power to commit crimes withimpunity.  They hold the national, evenglobal, economy hostage.  TreasurySecretary Geithner has made this strategy simple by displaying the “StockholmSyndrome.”  He has fallen in love withthe criminals that are holding our economy hostage.  Geithner claims that the fraudulent SDIs areso fragile that they would collapse if they were even investigated seriouslyfor fraud.  He conveniently ignores thefact that the primary reason for the SDIs’ fragility is that their CEOs lootedthe banks.  

They can also use “their” bank to buy the modern equivalentof indulgences for even the most destructive frauds.  There are two non-exclusive means of buyingindulgences.  The most obvious means ispolitical contributions.  The financeindustry is the leading funder of both political parties. The less obvious means of buying immunity arises from thedysfunctional nature of DOJ policies for (not) prosecuting major firms forserious felonies and the ability of the CEO to use corporate funds to purchasepersonal immunity from criminal prosecutions. Five facts about the criminal defense of large firms must be keptprominently in mind when considering the defense of banksters.  First, the CEO will gladly trade off billionsof dollars in payments by the bank and its liability insurers in order tosecure immunity from criminal charges against the CEO and the senior officerswho could implicate the CEO.  


Second, the Department of Justice (DOJ) has essentiallyceased to prosecute large firms for serious felonies.  DOJ was so traumatized by the consequences ofprosecuting Arthur Andersen that it has decided to allow large firms to enterinto “deferred prosecution” agreements (in which prosecution is, in reality,perpetually deferred).  Arthur Andersenhad entered into two deferred prosecution agreements, and DOJ offered it athird, when AA refused the agreement and went to trial.  

Third, while I have referred to the firm as the “client” andthe firm and its insurers typically pay for the attorney fees and fines, it isthe CEO that can hire and fire outside counsel. Outside counsel, therefore, are chosen by fraudulent CEOs because theyare willing to aid and abet the CEO in looting the real client (the firm).  This is a classic example of the fraudulentbank CEO deliberately creating a Gresham’s dynamic in which the least ethicalmembers of the “independent” profession drive the most ethical out of lucrativerepresentations.  In criminology jargon,control frauds are criminogenic. Fraudulent CEOs use their ability to make compensation for officers,employees, and independent professionals perverse in order to createenvironments that cause widespread frauds that aid and abet the lender’s fraudscheme.  To put it in plainer, biblicalEnglish:  fraud begets fraud.

Fourth, the settlement payments are typically deductiblefrom taxes.  This means that thedefendant’s actual burden of paying the fine is much smaller than the announcedamount of the fine.

Fifth, defense counsel typically promise to pay some portionof the fines to the victims of the fraud. This is a brilliant tactic.  Itmakes the government attorneys feel good about the settlement and it allowsthem to bash opponents of the settlement as blocking relief for the victims.  The tactic, of course, is cynical and dishonest.  The weak settlement is what prevents a fargreater recovery for the victims of the fraud. The government does not have to wait for a settlement to aid the victimsof foreclosure fraud.   
Settlement discussions by counsel for control frauds withthe government and shareholders are all about exceptionally able and zealouslegal representation of the CEO at the expense of the client, its shareholders,and the public.  Only vigorous regulatorsand prosecutors can protect the firm, shareholders, and public from looting bythese CEOs and the allies they generate.    

TheProposed Deal: The $1 Trillion Lagniappe

The obvious deal that criminal defense counsel for banksalways seek is to trade a showy amount of fines for de facto or even formal immunity for the CEO and other seniorofficers who led the frauds and became wealthy through the frauds.  Here, the defense counsel were far moreaudacious – they are demanding immunity not only from prosecution, but even frominvestigation, and they are demanding immunity for crimes they committed thathave never been investigated by the state and local prosecutors.  The foreclosure fraud cases, while enormous,are by far the least of the banksters’ worries. The potential loss exposure from the foreclosure fraud is measured inthe tens of billions of dollars.  Thepotential loss exposure from fraudulent home loan originations is in thetrillions of dollars – and a trillion is a thousand billion.  The banks’ CEOs are demanding, for a puny $25billion, a release from liability for foreclosure fraud.  That is obscene on multiple levels.  Even President Obama concedes that the bankstreat such fines as a mere “cost of doing business” (by which he means the“small tax on the wealth obtained by elites through doing fraudulentbusiness”).  The senior officers involvedin the fraud should be imprisoned. Giving them immunity, allowing them to keep their bonuses “earned”through fraud, and keeping them in leadership roles are all despicable actsthat should be anathema to every prosecutor. 

But what came next went beyond scandal as usual.  The banks then demanded a lagniappe – a little something extra,for free, in a New Orleans restaurant – they wanted immunity for loanorigination fraud.  The slight differenceis that this lagniappe is worthtrillions of dollars to the frauds.  Itsickens me to inform the reader that the Obama administration is eager toprovide the frauds with this lagniappe.  The Department of Housing and UrbanDevelopment (HUD), led by Secretary Shaun Donovan, is actively pushing thisscandalous deal, with strong support in the background from Treasury SecretaryGeithner.  The silence of AttorneyGeneral Holder, and President Obama, on this travesty is exceptional.

Worse, the banks are seeking immunity even frominvestigation of the over trillion dollars in mortgage origination fraud – andthe Obama and Bush administrations’ supposed “investigations” of mortgageorigination fraud by the large lenders that made the mass of liar’s loans areall unworthy of the word “investigations.” It would take roughly 100 investigators, working for years, to do aserious investigation of any of the largest liar’s loan lenders.  There has never been, remotely, such aninvestigation by the federal government of the any large liar’s loan lender.  The Obama administration is reported tosupport the fraudulent financial CEOs’ dearest dream – de facto immunity even from investigation of over a trilliondollars in fraudulent liar’s loans origination.  

The Republican Party and its candidates for the Party’spresidential nomination are not criticizing Obama’s proposed formal surrenderto crony capitalism.  They only wish theywere in complete power and could cash in even more heavily on the tidal bore ofcampaign contributions flowing out of the finance industry.   

Miller,and everyone involved, knows there was endemic origination fraud

Miller no longer denies that he has joined theadministration in favoring the banks’ most cherished dream – amnesty fororiginating a trillion dollars in fraudulent home loans.   Indeed, the settlement is designed toprevent even investigations of themortgage origination fraud.

I confess that I am so naïve that I would have believed itimpossible that any federal or state governmental entity would enter into suchan abject surrender to crony capitalism. Once I learned that they were seriously contemplating such a travesty Icould not believe that Miller would support it. I believed his lieutenant’s (Mr. Madigan’s) denunciation of criticism ofthe proposed amnesty.  (I have reviewedMadigan’s comments in preparing this piece and I see that they were artfullycrafted to be disingenuous.)
The testimony of Thomas J. Miller, Attorney General of Iowa, at a 2007Federal Reserve Board hearing shows that he knows that the lenders engaged inmassive origination fraud.

Over the lastseveral years, the subprime market has created a race to the bottom in whichunethical actors have been handsomely rewarded for their misdeeds and ethicalactors have lost market share…. The market incentives rewarded irresponsiblelending and made it more difficult for responsible lenders to compete. Strongregulations will create an even playing field in which ethical actors are nolonger punished.
Despite thewell documented performance struggles of 2006 vintage loans, originatorscontinued to use products with the same characteristics in 2007.
[M]anyoriginators … invent … non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. A review of 100 statedincome loans by one lender found that a shocking 90% of the applicationsoverstated income by 5% or more and almost 60% overstated income by more than50%. Importantly, our investigations have found that most stated income fraudoccurs at the suggestion and direction of the loan originator, not theconsumer.


Miller, T.  2007.  “Comments to the Federal Reserve Board ofGovernors on Adopting Regulations to Prohibit Unfair and Deceptive Acts andPractices under the Home Ownership and Equity Protection Act (HOEPA).” (August14).  Miller was correct.  We know that it was overwhelmingly lenders andtheir agents that put the lies in “liar’s” loans.  We know that 90 percent of liar’s loans werefraudulent.  We know that the industrymassively increased the number of liar’s loans after warnings that the loanswere endemically fraudulent.  The growthrate of liar’s loans was so rapid (over 500% from 2003-2006) that thesefraudulent loans caused the housing bubble to hyper-inflate.  We know that no government entity ever causedany entity to make or purchase (and that includes Fannie and Freddie) liar’sloans.  Indeed, the government repeatedlywarned of the dangers of liar’s loans. We know that by 2006 roughly one-third of all home loans made that yearwere liar’s loans – which means there were millionsof fraudulent loans made annually and, collectively, trillions of dollars in fraudulently originated home loans.

Whatmust be done

Our economy and our democracy cannot succeed under cronycapitalism.  Please join me in writing toCongress, the administration, your state attorney general, the media, and anycourt that must approve this proposed settlement.  It is a disgrace.  President Obama is, of course, correct thatsome actions can be illegal but exceptionally unethical and damaging.  He is about to take precisely such an actionin derogation of his oath of office to defend and protect the constitution ofthe United States of America.  Thefraudulent CEOs of the banks that became wealthy by causing the financialcrisis and the Great Recession are treating us as fools who will give trilliondollar plus gifts to the least deserving, most arrogant, and least ethicalelites.  Have we fallen so low as apeople that we will allow this to happen? 


Please join me in supporting the Attorney Generals of NewYork, Delaware, and California who have opposed this settlement.  


As for President Obama, I hope that he will make this NewYear’s resolution:  “I resolve to honormy oath of office and faithfully execute the laws of the United States anddefend its constitution, which is premised on justice and the rule of law.  No person, no matter how elite, is above thatlaw.  I have today asked Messrs.Bernanke, Geithner, and Donovan for their resignations because oftheir support for bailing out the elite banks and granting de facto amnesty to fraudulent financial CEOs.  I, and my new Attorney General and newSecretary of the Treasury, have mutually resolved to make the vigorousprosecution of the elite financial frauds that drove the ongoing crisis ourmission. ”

 

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Did OFHEO Fix Fannie and Freddie’s Compensation Systems after discovering their Frauds?

Posted on December 29, 2011 | Comments Off on Did OFHEO Fix Fannie and Freddie’s Compensation Systems after discovering their Frauds?

By William K. Black


I have been chastised by a friend and former colleague forwriting:

“Here is the crazy thing – theSEC, OFHEO, and Department of Justice all failed to demand that Fannie andFreddie end their perverse executive compensation system that made theexecutives wealthy through fraud and put the entities and the government atrisk.”

My friend notes that Fannie, under pressure from OFHEO andwith its prior approval, changed its compensation system after the initialaccounting fraud.  

My sentence would beclearer if it was revised to read as follows:

“Here is the crazy thing – theSEC, OFHEO, and the Department of Justice all failed to prevent Fannie andFreddie from using perverse executive compensation systems that made theexecutives wealthy through fraud and put the entities and the government atrisk.”

The new compensation systems at Fannie and Freddie remainedexceptionally perverse after the changes. Their CEOs continued to cause them to engage in systematic accountingfraud by not providing remotely adequate loss reserves and allowances for loanlosses despite purchasing massive amounts of fraudulent liar’s loans andfraudulent subprime liar’s loans.  The samescam that made the officers rich was certain to destroy Fannie and Freddie.

I have alsoexamined a number of statements by both of OFHEO’s leaders during the relevantperiod, concerning compensation and the initial Fannie accounting fraud.  James Lockhart issued a hard hitting releaseon May 23, 2006 accompanying OFHEO’s report on its investigation of Fannie entitled:  “FANNIE MAE FAÇADE: Fannie MaeCriticized for Earnings Manipulation.” The release begins with this passage that directly ties the accountingfraud to the controlling officers’ desire to trigger bonuses.  

“The report details an arrogant andunethical corporate culture where Fannie Mae employees manipulated accountingand earnings to trigger bonuses for senior executives from 1998 to 2004. Thereport also prescribes corrective actions to ensure the safety and soundness ofthe company.”

Note that the release emphasizes that the OFHEO report “prescribescorrective actions.”  The purpose of therelease, of course, is to emphasize the most important aspects of the lengthyOFHEO report.  The release makes it clearthat executive compensation drove the fraud.

 “The combination of earnings manipulation,mismanagement and unconstrained growth resulted in an estimated $10.6 billionof losses, well over a billion dollars in expenses to fix the problems, andill-gotten bonuses in the hundreds of millions of dollars.”    
   

“By deliberately andintentionally manipulating accounting to hit earnings targets, seniormanagement maximized the bonuses and other executive compensation theyreceived, at the expense of shareholders. Earnings management made asignificant contribution to the compensation of Fannie Mae Chairman and CEOFranklin Raines, which totaled over $90 million from 1998 through 2003. Of thattotal, over $52 million was directly tied to achieving earnings per sharetargets.”

When it comes to the steps that Lockhart consideredcritical, however, executive compensation was not specifically mentioned.

The report ends with recommendations fromOFHEO’s staff to [Lockhart], which he has accepted. Some of the keyrecommendations include:

Fannie Mae must meet all of its commitments forremediation and do so with an emphasis on implementation – with dates certain –of plans already presented to OFHEO.

Fannie Mae must review OFHEO’s report todetermine additional steps to take to improve its controls, accounting systems,risk management practices and systems, external relations program, dataquality, and corporate culture. Emphasis must be placed on implementation ofthose plans.

Fannie Mae must strengthen its Board ofDirectors procedures to enhance Board oversight of Fannie Mae’s management.

Fannie Mae must undertake a review ofindividuals currently with the Enterprise that are mentioned in OFHEO’s report.

Due to Fannie Mae’s current operational andinternal control deficiencies and other risks, the Enterprise’s growth shouldbe limited.

OFHEO should continue to support legislation toprovide the powers essential to meeting its mission of assuring safe and soundoperations at the Enterprises.

Similarly, on June 6, 2006, Lockhart testified before theHouse on Fannie’s fraud.  He explainedhow Fannie’s executive compensation system created the perverse incentives thatdrove the massive accounting fraud.  Heended by listing how OFHEO responded to the frauds by ordering changes atFannie.  None of these changes discussedexecutive compensation.  The failure ofthis excerpt to discuss executive compensation is particularly striking.

“Fannie Mae must takeadditional steps to improve its internal controls, accounting systems,operational and other risk management practices and systems, data quality, andjournal entries. Emphasis must be placed on implementation with dates certain.”

Executive compensation, the most critical problem at Fannieand Freddie, the problem that drove their accounting control frauds, receivedminimal attention from OFHEO’s head. Fannie and Freddie’s CEOs proceeded to become wealthy through bonuses“earned” through business strategies that were sure to destroy Fannie andFreddie.  OFHEO took no effective actionto remove these perverse incentives.

Armando Falcon, Lockhart’s predecessor as head of OFHEO,achieved the remarkable – his revulsion for Fannie’s controlling officersexceeded Lockhart’s.  “While all of thispolitical power satisfied the egos of Fannie and Freddie executives, itultimately served one primary purpose: the speedy accumulation of personalwealth by any means.”  Testimony ofArmando Falcon, submitted to the Financial Crisis Inquiry Commission (April 9,2010).  His testimony details howFannie’s controlling officers used accounting fraud to attain massive bonuses.

TheTerrible Cost of Failing to Understand Accounting Control Fraud

The sad irony is that immediately after Falcon explained theperverse incentives arising from Fannie’s compensation system he went on to beonly half right in his analysis of Fannie and Freddie’s eventual failure.  The half he got wrong stemmed from hisfailure to understand the interplay of accounting control fraud and perverseexecutive compensation. 

“Your letter also asked me about the impact of the affordablehousing goals on the enterprises’ financial problems. In my opinion, the goalswere not the cause of the enterprises demise. The firms would not engage in anyactivity, goal fulfilling or otherwise, unless there was a profit to be made.Fannie and Freddie invested in subprime and Alt A mortgages in order toincrease profits and regain market share. Any impact on meeting affordablehousing goals was a byproduct of the activity.”

In addition, OFHEOmade it very clear to both enterprises that safety and soundness was always ahigher priority than the affordable housing goals. They should not take onexcessive risk in order to meet any one of the goals.”

Falcon almost gets this right, but his failureto understand the most destructive financial fraud mechanism leads him to misswhat happened at Fannie and Freddie even with the benefit of hindsight.  His analytical failures exemplify OFHEO’scentral analytical failure.  He iscorrect that only the exceptionally naïve could believe that Fannie andFreddie’s controlling officers based their business decisions on meeting theaffordable housing goals.  He isgrotesquely incorrect in assuming that their controlling officers only engagedin an activity if “there was a profit to be made.”  His error is bizarre given the fact that hehad explained that Fannie’s controlling officers engaged in activity thatcaused large losses and then used accounting fraud to transmute real lossesinto fictional gains in order to maximize their bonuses. 

Falcon is correct that Fannie’s controllingofficers had “one primary purpose” at all times – “thespeedy accumulation of personal wealth by any means.”  What he fails to understand is thataccounting control fraud is a “sure thing” and that the formula for maximizingfictional income (and real bonuses) maximizes real losses.  Fannie and Freddie’s controlling officers“one primary purpose” was making themselves wealthy.  Accounting fraud was their “weapon of choice”to produce great wealth very quickly. Purchasing large amounts of “liar’s” loans guaranteed that Fannie andFreddie would suffer massive losses. Purchasing large amounts of subprime liar’s loans guaranteed that theywould suffer catastrophic losses.  Liar’s(home) loans create such intense “adverse selection” that they have a sharplynegative “expected value.”  In plainEnglish, the purchaser will lose money. It’s equivalent to betting against the House, except that the odds areso bad that the expected value is more negative than playing the lottery.  Liar’s loans can only fail to produce obvioussevere losses temporarily while the bubble is expanding.  Refinancing hides the losses during the rapidexpansion phase of the bubble.  Thesaying in the trade is that “a rolling loan gathers no loss.”  Bubbles, however, are only temporary andliar’s loans will begin blowing as soon as the bubble starts inflating, whichcan be over a year prior to the bubble bursting. 

Fannie and Freddie’s CEOs chased higher nominal yields, notreal “profit” for the firms.  Theirstrategy exemplified the logic of George Akerlof and Paul Romer’s famous 1993article, captured in their title (“Looting: the Economic Underworld ofBankruptcy for Profit”).  The firm fails,but the controlling officers walk away rich because the frauds they leadproduce fictional income and real bonuses. (Akerlof and Romer’s use of the word “profit” is ironic.  It refers to gains to the controllingofficers from fraudulent business strategies that cause fatal losses to thefirm.)  Akerlof and Romer aptly termedthe accounting control fraud strategy a “sure thing.”

Fannie and Freddie’s risk officers alerted their CEOs to thefact that nonprime loans were likely to produce far greater losses, that therapid rise in home prices was temporarily suppressing default rates, and thatthe rapid rise in home prices could not continue indefinitely.  It is inconceivable that Fannie and Freddiedid not know of the FBI’s September 2004 warning that there was an “epidemic”of mortgage fraud and their prediction that the fraud epidemic would cause aneconomic “crisis” if it were not contained. Fannie and Freddie’s purchase of liar’s loans that cause severe lossesoverwhelmingly occurred after the FBI’s warning.  “The government” never required any entity tomake or purchase liar’s loans.  Most ofthe liar’s loans that caused Fannie and Freddie’s severe losses were purchasedafter MARI’s five-part warning to the mortgage industry in April 2006.  “The Mortgage Asset Research Institute’s(MARI) EIGHTH PERIODIC MORTGAGE FRAUD CASE REPORT TOthe MORTGAGE BANKERS ASSOCIATION.”  (Itis inconceivable that Fannie and Freddie’s controlling officers, or OFHEO, wereunaware of these warnings.  Louis Freeh,former head of the FBI, joined Fannie’s board of directors in mid-2007.) 

MARI paired it first two warnings:

“Stated income and reduceddocumentation loans speed up the approval process, but they are open invitationsto fraudsters. It appears that many members of the industry have littlehistorical appreciation for the havoc created by low-doc/no-doc products thatwere the rage in the early 1990s. Those loans produced hundreds of millions ofdollars in losses for their users.”

MARI’s third warning quantified the incidence of fraud insuch loans.  It paired these data withits fourth warning dealing with the revealing label the industry usedinternally for such loans.

“One of MARI’s customersrecently reviewed a sample of 100 stated income loans upon which they had IRSForms 4506. When the stated incomes were compared to the IRS figures, theresulting differences were dramatic. Ninety percent of the stated incomes wereexaggerated by 5% or more. More disturbingly, almost 60% of the stated amountswere exaggerated by more than 50%. These results suggest that the stated incomeloan deserves the nickname used by many in the industry, the “liar’s loan.””

MARI’s fifth warning reported the views of federal bankingregulators.

Federal regulators of insuredfinancial institutions have expressed safety and soundness concerns over theseloans with lower documentation requirements and other “nontraditional” loans.

To summarize, MARI warned every member of the MortgageBankers Association (MBA) in writing in early 2006 that so-called “statedincome” loans:

  1. Were “open invitations to fraudsters”
  2. Had produced hundreds of millions of dollars of losses when they became common in the early 1990s
  3. Had a fraud incidence of 90%
  4. Deserved the industry term for such loans:  “liar’s loans”
  5. Were opposed by federal banking regulators because of safety and soundness concerns
It was in this context that (1) lenders moved massively toincrease their origination of fraudulent liar’s loans and to sell such loansthrough fraudulent “reps and warranties” (2) Fannie and Freddie (and theirinvestment banker counterparts) moved massively to purchase these endemicallyfraudulent loans, and (3) OFHEO did nothing meaningful to prevent Fannie andFreddie from purchasing fatal amounts of fraudulent liar’s loans. 

Fannieand Freddie (and the FHFA) still get it wrong

Indeed, even after the second wave of accounting controlfraud caused the failure of Fannie and Freddie, OFHEO failed to end theirperverse executive compensation practices. Steve Linick, the FHFA’s Inspector General (FHFA is the successor agencyto OFHEO) reported:

“Linick said the FHFA rejected his recommendationthat it test and independently verify the annual pay packages, which are set bythe boards of Fannie and Freddie and approved by the agency in consultationwith the Treasury Department.


The FHFA “lacks key controls necessary to monitorthe enterprises’ ongoing executive compensation decisions under the approvedpackages,” the inspector general wrote. “FHFA has neither developed writtenprocedures to evaluate the enterprises’ recommended compensation levels eachyear, nor required FHFA staff to verify and test independently the means bywhich the Enterprises calculate their recommended compensation levels.”


Further, the agency “lacks independent testingand verification of the Enterprises’ submissions in support of executivecompensation packages,” the report said.”

The federal “pay czar” heavily criticized all but one of theexecutive compensation plans submitted by the bailed-out firms still subject tospecial regulation.  Executivecompensation is so typically perverse that it is one of leading causes ofcriminogenic environments for accounting control fraud.  The intellectual father of modern executivecompensation, Michael Jensen, has decried the results, which he concedesincludes rampant earnings manipulation. Fannie and Freddie are simply the most expensive failures to date causedby accounting control fraud.   

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What if the SEC investigated Banks the way it is investigating Mutual Funds?

Posted on December 27, 2011 | Comments Off on What if the SEC investigated Banks the way it is investigating Mutual Funds?

By William K. Black 

The Wall Street Journal ran a story today (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.”

“Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.

The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won’t say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the “aberrational performance initiative.””The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds). 

The SEC has, inevitably, discovered that accounting fraud is common among hedge funds. It is unlikely that the SEC system is really “high-tech” in information science terms. Low-tech information systems have been capable of identifying “aberrational performance” for at least thirty years. We did not have to create any pioneering software in 1984 in order to identify aberrational performance. The cost and time to create our “red flags” was trivial (a few hours of programming time by an agency staffer). (We were collecting the data and computing the necessary ratios anyway. One simply decides the level of a few key variables worthy of being flagged. There’s nothing magic about a “flag.” All it means is that suspicious levels are highlighted on the computer screen and on physical copies of the periodic reports so that they capture the reader’s attention.)

The SEC took two years to create its “aberrational performance” system and is embarrassed enough about the cost that it wants to keep it secret. The two year development process allowed the SEC to make a major advance relative to our system – they invented a title consisting of two words and eight syllables. Devising a title that recondite doubtless accounts for six months of the time it took the SEC to develop its flags.

The most interesting aspects of the WSJ story, however, are two unexamined topics that should have been central to the story. First, there is not a word in the article about criminal prosecutions for the frauds the SEC has identified. The frauds, as described in the article, are so blatant that they would make relatively simple to prosecute. There is no indication that the SEC wanted the WSJ to know that they had made well over a hundred criminal referrals against hedge fund CEOs and senior officers. There is no indication that the WSJ reporters were interested in whether the SEC had made criminal referrals against these moderately elite felons. As a result, we have no information on whether the SEC has in fact made hundreds of criminal referrals against the senior officers at the hedge funds that they have identified as having engaged in likely fraud. Indeed, we have no evidence that they have made any criminal referrals. Neither the SEC nor the WSJ reporters indicated that any prosecutions, or even Department of Justice investigations, resulted from the SEC hedge fund investigations.

Second, why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)? The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis. The SDIs pose by far the greatest risk to the economy and investors of any entity. Their frauds reached “epidemic” proportions and drove our ongoing crisis and the Great Recession. The SEC, however, applied its “aberrational performance” system to its smallest entities and is now expanding it to mutual funds. There is no indication that the SEC intends to use the system to spot fraudulent SDIs. There is no indication that the SEC has even contemplated using the system to spot fraudulent SDIs. There is no indication that the WSJ reporters asked why the SEC was failing to use its system where it was most needed.

Applying the SEC system to the SDIs would have led the SEC to develop a more sophisticated analytical approach to identifying fraud. There is no indication that the SEC has any familiarity with the criminology, economics, and regulatory literature about how to identify accounting fraud. Admittedly, the SEC (finally) has taken seriously the warning that generations of parents have impressed upon their children – “if it’s too good to be true; it probably isn’t true.” The Achilles’ heel of the SEC analytics is that it assumes fraud must be aberrational and its flags are (at least as described in the story) all tied to identifying aberrations premised on the implicit assumption that fraud cannot be endemic. The SEC official told the WSJ reporter that they looked for “outliers.” Accounting control fraud, however, can become endemic, particularly in a product line, because it produces a “Gresham’s dynamic” in which bad ethics drives good ethics out of the market. Accounting control frauds report results that are too good to be true, but they all report extraordinary results because accounting fraud is a “sure thing” (George Akerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy for Profit, 1993). Accounting control fraud was far more common among the SDIs than the SEC system has identified among hedge funds.

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MMP Blog #29: What about a country that adopts a foreign currency? Part Two

Posted on December 25, 2011 | 2 comments

By L. Randall Wray

Yet another rescue plan for the EMU is making its waythrough central Europe—with the ECB acting as lender of last resort toEuro-banks. It is trying the tried-and-failed Fed method of rescue. As we nowknow the Fed lent and spent over $29 TRILLION trying to rescue (mostly) USbanks. It did not work. The biggest banks are still insolvent, and havecontinued their massive frauds trying to cover up their insolvencies. Youcannot paper-over insolvency through massive lending by the central bank. Andthe Euroland problems are compounded by the insolvencies of virtually all theirmember states.

To be sure, we also have probable insolvencies of some ofour US states—but we’ve got a sovereign government that will eventually do theright thing (as Mr. Churchill famously said, Americans get around to that,after trying everything else first). But the Euro states do not have anysovereign backing them up. And note that the ECB remains unwilling to do thejob. A disastrous financial collapse and possible Great Depression 2.0 remainsthe most likely scenario.

How Did Euroland Get Into Such A Mess? PartOne: Private Debt

We all knowthe favourite story told: profligate-spending Mediterranean governments blew uptheir budgets, causing the crisis. If only they had followed the example ofGermany—as they were supposed to do once they joined the Euro—the EMU wouldhave worked just fine.

While thestory of fiscal excess is a stretch even in the case of the Greeks, it doesn’teasily apply to Ireland and Iceland—or even to Spain—all of which had lowbudget deficits (or even surpluses) until the crisis hit. In truth, there weretwo problems.

First, likemost Western countries, private sector debts blew up in many Euroland countriesafter the financial system was de-regulated and de-supervised. To label this asovereign debt problem is quite misleading. The dynamics are surely complex butit is clear that there is something that is driving debt growth in thedeveloped world that cannot be reduced to runaway government budget deficits.Nor does it make sense to point fingers at Mediterraneans since it is (largely)the English-speaking world of the US, UK, Canada and Australia that has seensome of the biggest increases of household debt—the total US debt ratio reached500%, of which household debt alone is 100%, and financial institution debt isanother 125% of GDP.

Take a lookat this graph, which shows the debt-to-GDP ratios for the private andgovernment sectors:
Clearly, upto 2007 the really big debt ratios were in the private sector. The story isvery similar to that of the US. But note that the problem tends to be worse in those countries with smallergovernment debts—there is an inverse relation between private debt ratios andgovernment debt ratios. Now why is that?

And as weknow from previous MMP sections, the sectoral balance identity shows thedomestic private balance equals the sum of the domestic government balance lessthe external balance. To put it succinctly, if a nation (say, the US) runs acurrent account deficit, then its domestic private balance (households plusfirms) equals its government balance less that current account deficit. To makethis concrete, when the US runs a current account deficit of 5% of GDP and abudget deficit of 10% of GDP its domestic sector has a surplus of 5%; or if itscurrent account deficit is 8% of GDP and its budget deficit is 3% then theprivate sector must have a deficit of 5%–running up its debt.

{An aside: Abig reason why much of the developed world has had a growth of its outstandingprivate and public sector debts relative to GDP is because we have witnessedthe rise of BRIC (and others—especially in Asia) current account surpluses—matchedby current account deficits in the developed Western nations taken as a whole.Hence, developed country budget deficits have widened even as their privatesector debts have grown. By itself, this is neither good nor bad. But overtime, the debt ratios and hence debt service commitments of Western domesticprivate sectors got too large. This was a major contributing factor to the GFC.}

Our Austerianssee the solution in belt-tightening, especially by Western governments. Butthat tends to slow growth, increase unemployment, and hence increase the burdenof private sector debt. The idea is that this will reduce government debt anddeficit ratios but in practice that does not work due to impacts on thedomestic private sector. Tightening the fiscal stance can occur in conjunctionwith reduction of private sector debts and deficits only if somehow thisreduces current account deficits. Yet many nations around the world rely oncurrent account surpluses to fuel domestic growth and to keep domesticgovernment and private sector balance sheets strong. They therefor react tofiscal tightening by trading partners—either by depreciating their exchangerates or by lowering their costs. In the end, this sets off a sort of modernMercantilist dynamic that leads to race to the bottom policies that few Westernnations can win.

Germany,however has specialized in such dynamics and has played its cards well. It hasheld the line on nominal wages while greatly increasing productivity. As aresult, in spite of reasonably high living standards it has become a low costproducer in Europe. Given productivity advantages it can go toe-to-toe againstnon-Euro countries in spite of what looks like an overvalued currency. ForGermany however, the euro is significantly undervalued—even though most euronations find it overvalued. The result is that Germany has operated with acurrent account surplus that allowed its domestic private sector and governmentto run deficits that were relatively small. Germany’s overall debt ratio is at200% of GDP, approximately 50% of GDP lower than the Euro zone average.

Notsurprisingly, the sectoral balances identity hit the periphery nationsparticularly hard as they suffer from what is for them an overvalued euro, and lowerproductivity than Germany enjoys. With current accounts biased toward deficitsit is not a surprise to find that the Mediterraneans have bigger government andprivate sector debt loads.

Now, if Europe’s center understood balance sheets, it wouldbe obvious that Germany’s relatively “better” balances rely on the periphery’srelatively “worse” balances. If each had separate currencies, the solutionwould be to adjust exchange rates so that our debtors would have depreciationand Germany would have an appreciating currency. Since within the euro this isnot possible, the only price adjustment that can work would be either risingwages and prices in Germany or falling wages and prices on the periphery. But ECB,Bundesbank and EU policy more generally will not allow significant wage andprice inflation in the center. Hence the only solution is persistent deflationarypressures on the periphery. Those dynamics lead to slow growth and hencecompound the debt burden problems.

How Did Euroland Get Into Such A Mess? PartTwo: Government Debt

To be sure, the private debt problem—related to the internalEuropean dynamics of a strong mercantilist Germany in the center—would be veryhard to resolve. But Euroland has an even more fatal problem: the Euro, itself.So let us turn to that second problem.

The fundamentalfault with the set-up of the EMU was the separation of nations from theircurrencies. It was a system designed to fail. It would be like a USA with noWashington—with each state fully responsible not only for state spending, butalso for social security, health care, natural disasters, and bail-outs offinancial institutions within its borders.  In the US, all of those responsibilities fall under thepurview of the issuers of the national currency—the Fed and the Treasury. Intruth, the Fed must play a subsidiary role because like the ECB it isprohibited from directly buying Treasury debt. It can only lend to financialinstitutions, and purchase government debt in the open market. It can help tostabilize the financial system, but can only lend, not spend, dollars intoexistence. The Treasury spends them into existence. When Congress is notpreoccupied with Kindergarten-level spats over debt ceilings that arrangement worksalmost tolerably well—a hurricane in the Gulf leads to Treasury spending torelieve the pain. A national economic disaster generates a Federal budgetdeficit of 5 or 10 percent of GDP to relieve pain.

That cannothappen in Euroland, where the Euro Parliament’s budget is less than one percentof GDP. The first serious Euro-wide financial crisis would expose the flaws.And it did.

Member states became much like US states, but with two keydifferences. First, while US states can and do rely on fiscal transfers fromWashington—which controls a budget equal to more than a fifth of US GDP—EMUmember states got an underfunded European Parliament with a total budget ofless than 1% of Europe’s GDP. (To make it even worse, the Parliament’s fundingcomes from the member states!)

This meant that member states were responsible for dealingnot only with the routine expenditures on social welfare (health care,retirement, poverty relief) but also had to rise to the challenge of economicand financial crises.

The second difference is that Maastricht criteria were fartoo lax—permitting outrageously high budget deficits and government debtratios.  Most of the critics hadalways (wrongly) argued that the Maastricht criteria were too tight—prohibitingmember states from adding enough aggregate demand to keep their economieshumming along at full employment. It is true that government spending was chronicallytoo low across Europe as evidenced by chronically high unemployment and rottengrowth in most places. But since these states were essentially spending and borrowinga foreign currency—the Euro—the Maastricht criteria permitted deficits anddebts that were inappropriate.

Let us take a look at US states. All but two have balancedbudget requirements—written into state constitutions—and all of them aredisciplined by markets to submit balanced budgets. When a state finishes theyear with a deficit, it faces a credit downgrade by our good friends the creditratings agencies. (Yes, the same folks who thought that bundles of trashmortgages ought to be rated AAA—but that is not the topic today.) That wouldcause interest rates paid by states on their bonds to rise, raising budgetdeficits and fueling a vicious cycle of downgrades, rate hikes and burgeoningdeficits. So a mixture of austerity, default on debt, and Federal governmentfiscal transfers keeps US state budget deficits low.

(Yes, I know that right now many states are facingArmageddon—especially California—as the global crisis has crashed revenues andcaused deficits to explode. This is not an exception but rather demonstrates myargument.)

The following table shows the debt ratios of a selection ofUS states. Note that none of them even reaches 20% of GDP, less than a third ofthe Maastricht criteria.
Alaska
15.7
Montana
12.2
Connecticut
12.1
New Hampshire
13.0
Hawaii
12.2
New York
10.5
Maine
11.0
Rhode Island
16.9
Massachusetts
16.5
Vermont
12.6
By contrast, Euro states had much higher debt ratios—withonly Ireland coming close to the low ratios we find among US states (the redline is drawn at the Maastricht criterion of 60%).












To be clear, none of these debt ratios would be too high fora sovereign government that issues its own currency. Remember that Japan’sgovernment debt ratio is 200%–and its interest rate has been close to zero fortwo decades. But they are too high for nonsovereign nations that use a foreigncurrency.


Those who follow Modern Money Theory believed that market“discipline” would eventually impose debt and deficit limits far belowMaastricht criteria—to ratios closer to those imposed on US states. And with nofiscal authority in the center to match the US Treasury, the first seriouseconomic or financial crisis would expose the flaws of the design of the euro. Becausethe crisis would cause member state deficits and debts to grow. At the sametime markets would begin to realize that these member states are much like USstates but without the backstop of a European Treasury.
And that is precisely what has happened.

To be sure markets have not reacted simultaneously againstall member states. If you think about it, this makes sense. There is a desireto hold euro-denominated debt—the euro is a strong currency and much of theworld wants to buy European exports. So markets run out of Greece and Irelandand now Italy but need to get into other euro debt. Since Germany is thestrongest member and by far the biggest exporter, it benefits the most from arun against the periphery.

Yet as Germany is a net exporter with a relatively smallbudget deficit, it is hard to get German debt. The biggest issuer of debt wasItaly, and there was a strong belief in markets that because Italy’s debt is solarge, it is like a Bank of America—too big to fail. And ditto for France andSpain. So spreads widened for Greece and Ireland and Portugal, but have onlyrecently increased for Spain and Italy.

But after the agreement to accept a “voluntary” haircut of50% on Greek debt, no prudent investor can any longer pretend that Italy, Spainor even France and Germany is a safe bet. Faith based investing in Euro debt isover. And note that if the stronger nations really do bail-out a Spain or anItaly, our friendly credit rating agencies will quickly downgrade the strongnations (they are now threatening France) for contributing funds to rescuetheir neighbors. Even Germany will not be safe if it participates in a bailoutof Italy by committing funds.

There is thus a damned-if-you-do and damned-if-you-don’tdilemma. A bail-out by member states threatens the EMU by burdening andeventually bringing down the strong states; and allowing too-big-to-fail Italyto default would prove to markets that no member state is safe.

And this is why it does not matter how much the ECB lends toEurobanks—the banks would be crazy to buy up government debt. And it is hard tobelieve that any US money managers can make a case that it is still prudent toinvest in euro debt.

Many critics of the EMU have long blamed the ECB forsluggish growth, especially on the periphery. The argument is that it keptinterest rates too high for full employment to be achieved. I have alwaysthought that was wrong—not because I do not agree that lower interest rates aredesirable, but because even with the best-run central bank, the real problem inthe set-up was fiscal policy constraints. Indeed, several years ago, Claudio Sardoniand I demonstrated that the ECB’s policy was not significantly tighter than theFed’s—but US economic performance was consistently better. The difference wasfiscal policy—with Washington commanding a budget that was more than 20% ofGDP, and usually running a budget deficit of several percent of GDP. By contrast,the EU Parliament’s budget could never run deficits like that. Individualnations tried to fill the gap with deficits by their own governments, thesecreated the problems we see today—as the chickens came home to roost, so tospeak.

Is There Any Solution?

Once the EMU weakness is understood, it is not hard to seethe solutions. These include ramping up fiscal policy space of the EUparliament—say, increasing its budget to 15% of GDP with a capacity to issuedebt. Whether the spending decisions should be centralized is a politicalmatter—funds could simply be transferred to individual states on a per capitabasis.

It can also be done by the ECB: change the rules so that theECB can buy, say, an amount equal to 6% of Euroland GDP each year in the formof government debt issued by EMU members. As buyer it can set the interestrate—might be best to mandate that at the ECB’s overnight interest rate targetor some mark-up above that. Again, the allocation would be on a percapita basisacross the members. Note that this is similar to the blue bond, red bondproposal discussed above. Individual members could continue to also issue bondsto markets, so they could exceed the debt issue that is bought by the ECB—muchas US states do issue bonds.

One can conceive of variations on this theme, such ascreation of some EMU-wide funding authority backed by the ECB that issues debtto buy government debt from individual nations—again, along the lines of theblue bond proposal. What is essential, however, is that the backing comes fromthe center—the ECB or the EU stands behind the debt.

No amount of faith in the European integration is going tohide the flaws any longer. A comprehensive rescue by the ECB—which must standready to buy ALL member state debt at a price to ensure debt service costsbelow 3%–plus the creation of a central fiscal mechanism of a size appropriateto the needs of the European Union is the only way out. If these actions arenot taken—and soon—the only option left is to dissolve the Union.



So, finally, returning to the “one nation-one currency” rule would alloweach nation to recapture domestic policy space by returning to its owncurrency. There was never a strong argument for adopting the Euro, and theweaknesses have been exposed. Currency union without fiscal union was amistake.

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