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Government Spending with Self-Imposed Constraints: Responses to MMP #28

Posted on December 21, 2011 | Comments Off

Comments are thankfully few and I already dealt with some ofthem. I doubt there will be many readers this week, but here we go:

Q1: Is it possible to show these transactions simply from anominal perspective?

A: Look if you buy a stick ofgum we need to show the “real”–you exchange a demand deposit forgum, your store gets the demand deposit and you get the gum. We can stick topurely “nominal” only if it is a financial transaction only. But youdo pay “money” (the gum you buy was denominated in dollars) so it is valuedin nominal terms: $1.45. If you did not think it was worth that you would notbuy it. So that is the nominal value we put on it. Kenneth Boulding had a verynice way of looking at it. You exchange your liquid savings (deposit) forilliquid assets (gum); then you dissave over time as you consume them. AsBoulding said, consumption is destruction of your assets–you chew your assetsaway. He said you get no satisfaction from consumption=destruction of assets.Tires on your car are a clearer example. You “consume” them over 5years as you wear them out. You’d rather that they do not wear out, but theywill. That is destruction of assets. It is a stock-flow consistent model.Boulding was among the most clever and greatest of economists.

Q2 by WH: You wrote in Blog #24, referring to foreigner’saccumulation of reserves, such as China’s:
“Neither of these activities will force the hand of the issuinggovernment—there is no pressure on it to offer higher interest rates to try tofind buyers of its bonds… Government can always “afford” larger keystrokes, but markets cannot force thegovernment’s hand because it can simply stop selling bonds and thereby letmarkets accumulate reservesinstead.” In world with self-imposed constraints like the US’s, it doesn’thave the option to stop selling bonds if it wants to deficit spend. However, like you mention, bonds are an interest-earning alternative toreserves. So: 1) If bonds are an interest-earning alternative toreserves, is there an economic reason why the ultimate holder of reserves(whether it’s China or whoever China sells dollars to) would not place theirreserves into US debt and at an interest rate consistent with the future pathof FFRs? In other words, it’s generally understood interest rates on USdebt follow the expected future path of FFRs. Why would this change ifforeigners hold the debt (even a majority portion of the debt)? 2) Let’s assumeforeigners arbitrarily abstain from buying the debt. Could the US and itsholding of reserves as well as credit creation abilities still fund the US debtat rates consistent with the path of expected FFRs?

A: First, sovereign governmentcan target any interest rate it wants—overnight, short-term, long-term. It canrefuse to offer long-term debt and instead stay at short end of market. Thus itcan offer Chinese 0.50% on 30 days, or 0% on overnight. Period. They’ll takethe 30 days, but if they decide not to, so what? And in any case, all themonetary ops undertaken to let the Treasury spend have nothing to do withChinese—it is the special banks in the US.

Q3: wh10 It seems if we take foreigners out of the picture, then there is a smalleramount of reser Q ves/treasury debt with which to buy/rollover into newdebt. However, in sort of a reversal from my alien scenario, why couldn’tthe US just hold smaller but more frequent auctions to overcome any ‘funding’ issues?

A: It is not a funding issueand yes, the US can do whatever it wants. The foreigners are never in the“funding” part—it is special domestic banks.

Q4: Paul Krueger Thanks, this is a nice exposition of the (at least partial) equivalence ofdifferent views of the process. To really prove a complete functionalequivalence it seems to me that you would need to show that the interest ratepaid on government bonds was the same in any of the cases. Is that a correctassumption or does that not matter for some reason?

Q5: wh10 I believe at the end of Fullwiler’s paper, he also comments that bank primarydealers can take on the govt’s tsys in a manner similar to your case 3 (asopposed to non-bank primary dealers having to engage in repos to obtain thedeposits to purchase the tsy). Is there a practical difference betweenthese two types of primary dealers? Can bank primary dealers handle a greater
govt debt load or do it more easily? What is the ratio of these bankprimary dealers to non-bank primary dealers? Secondly, Fullwiler has commentedto me that it is possible that a tsy auction could fail if the govt conducted atsy auction, say, 2-3x the size of what it normally does (or some conceivablesize). This is because investors do have to secure financing toparticipate in the auction, and they might not be able to do it readily enoughwith such a large issuance. Although, he says, the next time around,they’d likely have no problem getting things together. Though thisdoesn’t present an issue to a
govt normally, I think it does underscore a real difference between a govt beingable to simply spend first whatever it pleases (e.g. if it had overdraftsfromthe Fed) and a govt needing to tax/sell debt to the private sector in order tospend. That is, the private does have to secure financing for a govt debtauction to succeed. So just because the final balance sheet position isthe same, the path to get there may be more obstructive in the realworld. Usually, it is not an issue at all, but it seems it couldconceivably be. I just think these types of qualifiers are worthmentioning when teaching MMT to others who may be skeptical about ‘govt spendsfirst,’ since it paints a more accurate picture
and clarifies why the real world doesn’t operate exactly like the general case ofa consolidated Fed/Tsy.

Q6: Neil Wilson S is there any benefit from all those extra transactions? Or is this, likeallegedly private pensions that ‘invest’ in Treasuries, simply a Job Guaranteescheme for financial sector workers?

LRWray Answers:

Paul: A treasury that understands what bonds are would only sell bills and sowould have no impact on interest rates; that said, there might be an impact iftreasury tries to sell too many long term bonds into mkts. Solution: don’t selllong term bonds.

WH: Scott is the expert and I won’t disagree. And aliens might explode asupernova at some distant place in the universe precidely when the treasurytries to auction, causing a temporary hiccup. We cannot possibly deal withevery unlikely event. Treas and Fed converse every morning to go over plans.They aren’t going to try to auction of 3x what the mkt can handle. In any case,the primary dealers are “banks” so not sure what you are getting at. While thepath could be more difficult in practice it is not. Except when Congressrefuses to raise debt limit!

And that leads to Neil: NO, obviously all the intermediate transactions justintroduce the possibility that something could possibly go wrong. You can be amuch better boxer if you do not tie your hands behind your back and your shoestogether. These constraints arise because Congress doesn’t understand monetaryoperations.

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Solvency Starts with the ECB

Posted on December 20, 2011 | Comments Off

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President Obama’s view of fraud “from 40,000 feet” (without an oxygen mask)

Posted on December 20, 2011 | Comments Off

By William K. Black
(Cross-posted from Benzinga)

Sixty Minutes’ December 11, 2011interview of President Obama included the following gem:

KROFT: One of the things that surprised me the mostabout this poll is that 42%, when asked who your policies favor the most, 42%said Wall Street. Only 35% said average Americans. My suspicion is some of thatmay have to do with the fact that there’s not been any prosecutions, criminalprosecutions, of people on Wall Street. And that the civil charges that havebeen brought have often resulted in what many people think have been slap onthe wrists, fines. “Cost of doing business,” I think you called it inthe Kansas speech. Are you disappointed by that?

PRESIDENT OBAMA: Well, I think you’re absolutelyright in your interpretation. And, you know, I can’t, as President of theUnited States, comment on the decisions about particular prosecutions. That’sthe job of the Justice Department. And we keep those things separate, so that there’sno political influence on decisions made by professional prosecutors. I cantell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.

That’s exactly why we had to change the laws. Andthat’s why we put in place the toughest financial reform package since F.D.R.and the Great Depression. And that law is not yet fully implemented, butalready what we’re doing is we’ve said to banks, “You know what? You can’ttake wild risks with other people’s money. You can’t expect a taxpayer bailout.

Hallucinations occur at high altitude when you become oxygen deprived. Let’s review the bidding on theBush/Obama record in prosecuting the elite control frauds that drove theongoing crisis. There are noconvictions of the Wall Street elites that made, purchased, packaged, and soldmillions of fraudulent liar’s loans. There are no federal prosecutions of the major banks that committed over100,000 fraudulent foreclosures. There are a few settlements that sound like large dollar amounts, butare merely what even Obama concedes to be the (deeply inadequate) “cost ofdoing (fraudulent) business.” Fraud pays – it pays enormously and our elites now commit it withimpunity as a means of becoming wealthy. We have just witnessed the travesty of Wachovia admitting to criminalconduct in their (grotesquely weak) settlement with the Department of Justice(which has a policy of no longer prosecuting large corporations that commitcrimes) – and having the SEC refuse to require Wachovia to make similaradmissions in its settlement. Allthis, the President implicitly or even explicitly concedes.

But the President asserts: “Ican tell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.” Kroft, sadly, didnot follow up on this incredible and, if true, extraordinarily importantassertion. Obama’s statementsabout fraud and ethics are inaccurate on multiple levels.
Obama’s factual assertions about the failure to prosecute fraud areunresponsive to the question, false, and logically inconsistent. Note the artful manner in which Obamaevaded answering Kroft’s question. Kroft asks why there are no prosecutions of the Wall Street frauds thatdrove the crisis. Obama answersthat “some” unethical Wall Street actions were not illegal. Obama’s answer implicitly admitted thatmost Wall Street actions that causedthe crisis were criminal. Hesimply argues that some highlyunethical behavior by Wall Street that was not illegal contributed to thatcrisis. As David Cay Johnstonemphasized in his column about Obama’s response to Kroft’s question, Obama’s answeris a non-answer. Why has he failedto prosecute any of the criminal conduct by Wall Street that drove thefinancial crisis? The (alleged)fact that “some” destructive Wall Street conduct was highly unethical, but notillegal, obviously provides no basis for not prosecuting what Obama concedeswas primarily criminal conduct.

Obama claims that the purported legality of Wall Street’s (unspecified)“least ethical behavior” is “exactly why we had to change the laws.” He then describes the two specificchanges in the Dodd-Frank law that he asserts make illegal that “least ethical behavior” for the firsttime. Obama claims that Dodd-Frankmakes it illegal to “take wild riskswith other people’s money” and for bankers to “expect a taxpayer bailout.” Obama is a lawyer and former lawprofessor, so these are matters as to which he is capable of precision. Dodd-Frank does not make it illegal for bankers to take “wildrisks.” Banks inherently takerisks “with other people’s money” so that bit of rhetoric issuperfluous.
Dodd-Frank does not make it illegal for a banker to “expect a taxpayerbailout.” Dodd-Frank does not makeit illegal (and could not constitutionally do so) for bankers to lobby for abailout. We have all seen thesuccess of such lobbying with the Bush and Obama administrations. Both administrations have refused toorder an end to the “systemically dangerous institutions” (SDIs) (inaccuratelyreferred to as “too big to fail”). Both administrations asserted that when the next SDI failed it was likelyto cause a global systemic crisis. (It is a matter of “when”, not “if” they will fail, or more precisely,when we will admit that they failed.)

The SDIs are also too big to manage – they are inefficiently large. We can increase efficiency,dramatically reduce global systemic risk, and reduce the SDI’s exceptionalpolitical dominance by ordering them to shrink over the next five years to apoint that they no longer pose a systemic risk. Instead, the Obama administration continues the Bushpractice of referring to the SDIs as “systemically important” (as if theydeserved a gold star for putting the world’s economy at risk). The Bush and Obama administrations haveallowed, even encouraged, the SDIs to grow larger. That policy is insane. It poses a clear and present danger to the U.S. and global economy andto our democracy. The SDIs will be“bailed out” when they fail. Indeed, they are being bailed out continuously by policies the Fed andTreasury follow that are designed to provide massive governmental subsidiesprimarily for the benefit of the zombie SDIs that have already failed in realeconomic terms, e.g., Bank of America and Citi.

“Wild risks” are not remotely Wall Street’s “least ethicalbehavior.” It is impossible, givenObama’s generalities and Kroft’s failure to probe to know what “wild risks”Obama is talking about, but none of the (supposed) risky loans banks made evenapproach lenders’ “least ethical behavior.” The riskiest loans that banks made were liar’s loans toborrowers with bad credit histories. Credit Suisse reported in early 2007 that, by 2006, 49 percent of loansthat lenders called “subprime” (because they were made to borrowers with known,serious credit defects) were also liar’s loans (loans made without prudentunderwriting). I agree with Obamathat making a subprime liar’s loan is exceptionally “damaging.” Such loans damaged the lender, theborrower, the purchaser of such loans, and the purchaser of the collateralizeddebt obligations (CDOs) that were backed by subprime liar’s loans. (Of course, “backed” deserves to be inquotation marks.) Such loans wouldbe dumb, but they wouldn’t be among the banks’ “least ethical” actions if theloans were lawful. Indeed, ifmaking subprime liar’s loans were merely risky, one could argue morepersuasively that the banks were acting altruistically when they made suchloans.

What Obama missed, and Kroft failed to call him on, is that “wildrisk” by banks are typically frauds. I have explained these matters at length in previous posts, so I willprovide the ultra short version here. Honest home lenders do not make liar’s loans. In particular, honest lenders do not make subprime liar’sloans. Honest home lenders do notmake such loans because they create intense “adverse selection” and create a“negative expected value” (in plain English, they will lose money). No government (here or abroad),required any lender or other entity (i.e., Fannie and Freddie) to make oracquire liar’s loans. In fact, thegovernment repeatedly criticized liar’s loans. The FBI warned of an “epidemic” of mortgage fraud inSeptember 2004. The mortgagelending industry’s own anti-fraud body (MARI) warned every member of theMortgage Bankers Association (MBA) in writing in the 2006 that “stated income”loans were “an open invitation to fraudsters,” had a fraud incidence of 90percent, and deserved the term the industry used behind closed doors todescribe them – “liar’s” loans. Despite these warnings, lenders massively increased the number of liar’sloans they made.

Home lenders made subprime liar’s loans because they were“accounting control frauds.” Subprimeliar’s loans were ideal “ammunition” for accounting fraud. They reduced the paper trailestablishing that the lender knew the loan was fraudulent and they optimizedthe four-ingredient “recipe” for a lender engaged in accounting controlfraud. (Grow rapidly by making badloans at a premium yield, while employing extreme leverage and providing onlygrossly inadequate allowances for loan and lease losses (ALLL)). The CEOs of lenders that made subprimeliar’s loans as part of this recipe were not taking risks in the conventionalmanner we discuss in finance (uncertainty). As George Akerlof and Paul Romer explained in their famous1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”),accounting control fraud is a “sure thing.” The lender is guaranteed to report record (albeit fictional)profits in the near term, which makes the CEO wealthy when he uses modernexecutive compensation to loot the lender. Unfortunately, the same recipe that creates extremefictional income produces massive real losses.

Making liar’s home loans inherently requires lenders tocreate perverse incentives for widespread mortgage fraud. It was lenders and their agents thatoverwhelmingly put the lies in liar’s loans. The CEOs of the lenders who made subprime liar’s loanscompounded their initial mortgage origination fraud by making fraudulent repsand warranties to sell the endemically fraudulent mortgages. The growth in liar’s loans (roughlyhalf of them were also subprime loans) was so extreme – over 500% from 2003 to2006 – that it caused the bubble to hyper-inflate). Making fraudulent loans that placed millions of workingclass borrowers in loans that they frequently could not afford to repay andwere deeply underwater caused them a massive loss of wealth and wasdistressingly unethical. Theofficers controlling the lenders that made fraudulent liar’s loans were evenmore unethical because they caused this devastation in order to become exceptionallywealthy. The most morally depravedof the CEOs running accounting control frauds sought out the least financiallysophisticated borrowers, often minorities, as their victims.

Obama has unintentionallyproved the accuracy of the plurality of survey responders who concluded that heserves Wall Street’s interests at the expense of the public. He cynically evaded responding to theprimary reason why the public “gets it” – the abject failure of his administrationto prosecute the elite financial frauds that drove the financial crisis and theGreat Recession. Obama offered thepathetic (and factually inaccurate) non-excuse that “some” unethical conductmight be legal. It is time forObama (and Attorney General Holder) to “man up.” If they refuse to do so and are going to continue to be lapdogs for the elite financial frauds they should at least change the name of theJustice Department.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

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MMP Blog #28: Government Spending with Self-Imposed Constraints

Posted on December 18, 2011 | 4 comments

By L. Randall Wray

In the Primer we discussed the general case of governmentspending, taxing, and bond sales. To briefly summarize, we saw that when agovernment spends, there is a simultaneous credit to someone’s bank deposit andto the bank’s reserve deposit at the central bank; taxes are simply the reverseof that operation: a debit to a bank account and to bank reserves. Bond salesare accomplished by debiting a bank’s reserves. For the purposes of thesimplest explication, it is convenient to consolidate the treasury and centralbank accounts into a “government account”.

To be sure, the real world is more complicated: there is acentral bank and a treasury, and there are specific operational proceduresadopted. In addition there are constraints imposed on those operations. Twocommon and important constraints are a) the treasury keeps a deposit account atthe central bank, and must draw upon that in order to spend, and b) the centralbank is prohibited from buying bonds directly from the treasury and fromlending to the treasury (which would directly increase the treasury’s depositat the central bank). The US is an example of a country that has both of theseconstraints. In this blog we will go through the complex operating proceduresused by the Fed and US Treasury. Scott Fullwiler is perhaps the mostknowledgeable economist on these matters, and this discussion draws veryheavily on his paper. Readers who want even more detail should go to his paper,which uses a stock-flow consistent approach to explicitly show results.

First, however, let us do the simple case, beginning with aconsolidated government (central bank plus treasury) and look at theconsequences of its spending. Then we will look at the real world example ofthe US today. Readers have asked for some balance sheet examples, so I am usingsome simple T-accounts here. It might take some readers a bit of patience towork through this if they have not seen T-accounts before. (Note: these arepartial balance sheets—I am only entering the minimum number of entries to showwhat is going on.)

Let us assume government buys a bomb and imposes a taxliability. This is shown as Case 1a:

The government gets the bomb, the private seller gets ademand deposit. Note that the tax liability reduces the seller’s net worth and increasesthe government’s (after all, that is the purpose of taxes—to move resources tothe government). The private bank gets a reserve deposit at the government.

Now the tax is paid by debiting the taxpayer’s deposit andthe bank’s reserves:

And so the final position is:

The implication of “balanced budget” spending and taxing bythe government is to move the bomb to the government sector—reducing theprivate sector’s net worth. Government uses the monetary system to accomplishthe “public purpose”: to get resources such as bombs.

Now let us see what happens when government deficit spends.(Don’t get confused—we are not arguing that taxes are not needed; remember“taxes drive money” so there is a tax system in place but government decidesthat this week it will buy a bomb without imposing an additional tax).

Here, the bomb is moved to the government, but the deficitspending allows net financial assets to be created in the private sector (theseller has a demand deposit equal to the government’s financialliability—reserves). However, the bank is holding more reserves than desired.It would like to earn more interest, so government responds by selling a bond(remember: bonds are sold as part of monetary policy, to allow the governmentto hit its overnight interest rate target):

And the end result is:

The net financial asset remains, but in the form of atreasury rather than reserves. Compared with Case 1a, the private sector ismuch happier! It’s total wealth is not changed, but the wealth was convertedfrom a real asset (bomb) to a financial asset (claim on government).

Ah, but that was too easy. Government decides to tie itshands behind its back by requiring it sell the bond before it deficit spends.Here’s the first balance sheet, with the bank buying the bond and crediting thegovernment’s deposit account:

Now government writes a check on its deposit account, to buythe bomb:

The bank debits the government’s deposit and credits theseller’s. The final position is as follows:

Note it is exactly the same as case 1b: selling the bondbefore deficit spending has no impact on the result, so long as the privatebank is able to buy the bond and the government can write a check on itsdeposit account.

That, too, is too simple. Let’s tie the government’s shoestogether: it can only write checks on its account at the central bank. So inthe first step it sells a bond to get a deposit at a private bank.

Next it will move the deposit to the central bank, so thatit can write a check.

We have assumed the bank had no extra reserves to be debitedwhen the Treasury moved its deposit, hence, the central bank had to lendreserves to the private bank (temporarily, as we will see). Now the treasuryhas its deposit at the central bank, on which it can write a check to buy thebomb.

When the treasury spends, the private bank receives a creditof reserves, allowing it to retire its short term borrowing from the centralbank (looking to the private bank’s balance sheet, we could show a credit ofreserves to its asset side, and then that is debited simultaneously with itsborrowed reserves; I left out the intermediate step to keep the balance sheetsimpler). The private bank credits the bomb seller’s account. The finalposition is as follows:

What do you know, it is exactly the same as Case 2 and Case1b! Even if the government ties its hands behind its back and its shoestogether, it makes no difference.

OK, admittedly these are still overly simple thoughtexperiments. Let’s see how it is really done in the US—where the Treasuryreally does hold accounts in both private banks and the Fed, but can writechecks only on its account at the Fed. Further, the Fed is prohibited frombuying Treasuries directly from the Treasury (and is not supposed to allowoverdrafts on the Treasury’s account). The deposits in private banks come(mostly) from tax receipts, but Treasury cannot write checks on those deposits.So the Treasury needs to move those deposits from private banks and/or sellbonds to obtain deposits when tax receipts are too low. So let us go throughthe actual steps taken. Warning: it gets wonky.

*The following discussion is adapted from Treasury Debt Operations—An Analysis IntegratingSocial Fabric Matrix and Social Accounting Matrix Methodologies, by ScottT. Fullwiler, September 2010 (edited April 2011),http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1874795

The Federal Reserve Act now specifies that the Fed can onlypurchase Treasury debt in “the open market,” though this has not always beenthe case. This necessitates that theTreasury have a positive balance in its account at the Fed (which, as set inthe Federal Reserve Act, is the fiscal agent for the Treasury and holds theTreasury’s balances as a liability on its balance sheet). Therefore, prior to spending, the Treasurymust replenish its own account at the Fed either via balances collected fromtax (and other) revenues or debt issuance to “the open market”.

Given that the Treasury’s deposit account is a liability forthe Fed, flows to/from this account affect the quantity of reserve balances.For example, Treasury spending will increase bank reserve balances while taxreceipts will lower reserve balances. Normally, increases or decreases to bankingsystem reserves impact overnight interest rates. Consequently, the Treasury’sdebt operations are inseparable from the Fed’s monetary policy operationsrelated to setting and maintaining its target rate. Flows to/from the Treasury’s account must beoffset by other changes to the Fed’s balance sheet if they are not consistentwith the quantity of reserve balances required for the Fed to achieve itstarget rate on a given day. As such, theTreasury uses transfers to and from thousands of private bank deposit (bothdemand and time) accounts—usually called tax and loan accounts—for thispurpose. Prior to fall 2008, theTreasury would attempt to maintain its end-of-day account balance at the Fed at$5 around billion on most days, achieving this through “calls” from tax andloan accounts to its account at the Fed (if the latter’s balance were below $5billion) or “adds” to the tax and loan accounts from the account at the Fed (ifthe latter were above $5 billion). (The global financial crisis and the Fed’sresponse, especially “quantitative easing” has led to some rather abnormalsituations that we will mostly ignore here.)

In other words, timelinessin the Treasury’s debt operations requires consistency with both the Treasury’smanagement of its own spending/revenue time sequences and the time sequencesrelated to the Fed’s management of its interest rate target. As such, under normal, “pre-global financialcrisis” conditions for the Fed’s operations in which its target rate was setabove the rate paid on banks’ reserve balances (which had been set at zeroprior to October 2008, but is now set above zero as the Fed pays interest onreserves), there were six financial transactions required for the Treasury toengage in deficit spending. Since it isclear that current conditions for the Fed’s operations (in which the targetrate is set equal to the remuneration rate) are intended to be temporary and atsome point there is presumably a desire (by Fed policy makers) to return to themore “normal” “pre-crisis” conditions, these six transactions are the base caseanalyzed here (though the “post-crisis” operating procedures do notsignificantly impact conclusions reached).

The six transactions for Treasury debt operations for thepurpose of deficit spending in the base case conditions are the following:

The Fed undertakes repurchase agreement operations with primary dealers (in which the Fed purchases Treasury securities from primary dealers with a promise to buy them back on a specific date) to ensure sufficient reserve balances are circulating for settlement of the Treasury’s auction (which will debit reserve balances in bank accounts as the Treasury’s account is credited) while also achieving the Fed’s target rate. It is well-known that settlement of Treasury auctions are “high payment flow days” that necessitate a larger quantity of reserve balances circulating than other days, and the Fed accommodates the demand.

The Treasury’s auction settles as Treasury securities are exchanged for reserve balances, so bank reserve accounts are debited to credit the Treasury’s account, and dealer accounts at banks are debited.

The Treasury adds balances credited to its account from the auction settlement to tax and loan accounts. This credits the reserve accounts of the banks holding the credited tax and loan accounts.

(Transactions D and E are interchangeable; that is, in practice, transaction E might occur before transaction D.) The Fed’s repurchase agreement is reversed, as the second leg of the repurchase agreement occurs in which a primary dealer purchases Treasury securities back from the Fed. Transactions in A above are reversed.

Prior to spending, the Treasury calls in balances from its tax and loan accounts at banks. This reverses the transactions in C.
The Treasury deficit spends by debiting its account at the Fed, resulting in a credit to bank reserve accounts at the Fed and the bank accounts of spending recipients.

Again, it is important to recall that all of thetransactions listed above settle via Fedwire (T2). Also, the analysis is much the same in thecase of a deficit created by a tax cut instead of an increase in spending. That is, with a tax cut the Treasury’sspending is greater than revenues just as it is with pro-active deficitspending.

Note, also that the end result is exactly as stated aboveusing the example of a consolidated government (treasury and central bank):government deficit spending leads to a credit to someone’s bank account and acredit of reserves to a bank which are then exchanged for a treasury toextinguish the excess reserves. However, with the procedures actually adopted,the transactions are more complex and the sequencing is different. But thefinal balance sheet position is the same: the government has the bomb, and theprivate sector has a treasury.

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Posted on December 16, 2011 | Comments Off

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Dante’s Divine Comedy: Banksters Edition

Posted on December 15, 2011 | Comments Off

By William K. Black
(Cross-posted from Benzinga)

Sixty Minutes’ December 11, 2011 interview of President Obama included a claim by Obama that, unfortunately, did not lead the interviewer to ask the obvious, essential follow-up questions.

“I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn’t illegal.”

Obama did not explain what Wall Street behavior he found least ethical or what unethical Wall Street actions he believed was not illegal. It would have done the world (and Obama) a great service had he been asked these questions. He would not have given a coherent answer because his thinking on these issues has never been coherent. If he had to explain his position he, and the public, would recognize it was indefensible. I offer the following scale of unethical banker behavior related to fraudulent mortgages and mortgage paper (principally collateralized debt obligations (CDOs)) that is illegal and deserved punishment. I write to prompt the rigorous analytical discussion that is essential to expose and end Obama and Bush’s “Presidential Amnesty for Contributors” (PAC) doctrine. The financial industry is the leading campaign contributor to both parties and those contributions come overwhelmingly from the wealthiest officers – the one-tenth of one percent that thrives by being parasites on the 99 percent.

I have explained at length in my blogs and articles why:

Only fraudulent home lenders made liar’s loans
Liar’s loans were endemically fraudulent
Lenders and their agents put the lies in liar’s loans
Appraisal fraud was endemic and led by lenders and their agents
Liar’s loans could only be sold through fraudulent reps and warranties
CDOs “backed” by liar’s loans were inherently fraudulent
CDOs backed by liar’s loans could only be sold through fraudulent reps and warranties
Liar’s loans hyper-inflated the bubble
Liar’s loans became roughly one-third of mortgage originations by 2006

Each of these frauds is a conventional fraud that could be prosecuted under existing laws. Hundreds of lenders and over a hundred thousand loan brokers were “accounting control frauds” specializing largely in making fraudulent liar’s loans. My prior work explains control fraud, why accounting is the “weapon on choice” for fraudulent financial firms, and why liar’s loans were superior “ammunition” for committing massive accounting fraud. These accounting control frauds caused greater direct financial losses than any other crime epidemic in history. They also drove the financial crisis that produced the Great Recession and cost millions of Americans their jobs.

In considering my scale of unethical conduct it is important to keep in mind that it is highly likely that anyone that causes very large numbers of people to lose their homes will cause multiple suicides and indirect deaths that arise from the greater vulnerability of the homeless and the blue collar crime effects of destroying neighborhoods inherent to widespread foreclosures. I ignore for this purpose the fact that the fraudulent loans caused the bubble to hyper-inflate and drove the financial crisis that caused millions of people to lose their jobs. The financial accounting control frauds are the weapons of mass destruction of wealth, employment, and happiness. I also ignore the fact that the frauds described here made the perpetrators wealthy. My scale, therefore, systematically and dramatically understates the perpetrators’ moral turpitude. I have also excluded the massive foreclosure frauds from my scale because they did not cause the underlying crisis. When Obama reveals the bankers actions he claims to be legal but highly unethical readers should keep my conscious understatement of the moral depravity of the illegal acts by bankers that drove this crisis in mind when they compare the relative ethical failings.

As a criminologist, I do not favor sentencing criminals to the fates they richly deserve. I would never torture prisoners or place them at risk of assault, rape, or psychological trauma. I do not believe that extremely longer terms of imprisonment are desirable except in rare circumstances. As a lawyer and a criminologist I emphasize that any sentence should come only after a conviction in a trial providing due process protections or a guilty plea.My scale provides a label for the comparative moral depravity of the perpetrator, the deserved punishment (which when vicious is not the far more humane one I would actually impose), and a brief description of the specific frauds that are characteristic of this level of immorality and the number of perpetrators falling in each category. My inspiration was Dante’s circles of hell as described in his Divine Comedy.

The Scale of Ethical Depravity by the Frauds that Drove the Ongoing Crisis

Level 10: Septic tank scum

Eternal Hell: these banksters deserve a physical hell of infinite torment and duration

Officers that directed control frauds that involved making predatory loans to more than 10,000 homeowners who lost their homes as the result of the frauds. Predatory loans in this context mean deliberately seeking out the elderly or minorities for such loans because they were easier to con into taking loans they could not repay – at a premium yield (interest rate). Dozens of CEOs fall in this category.

Level 9: Pond scum

Time in Hell: These banksters deservea term in hell

Officers that directed control frauds that led to more than 10,000homeowners losing their homes. Hundredsof CEOs fall in this category.

Level 8: Generic scum

Gitmo: Hell’s starkest suburb

Officers that directed control frauds that led to more than 1,000 homeownerslosing their homes. Thousands of CEOsfall in this category.

Level 7: Dante’s deserved denizens

Supermax: No view, and no way out

The professionals that aided and abetted the overall control frauds byinflating appraisals, giving “clean” audit opinions to fraudulent financialstatements, “AAA” ratings to toxic waste, and accommodating legal opinions tothe frauds. Thousands of professionalsfall in this category.

Level 6: Aspiring to great wealththrough fraud

Alcatraz: Great view, but no way out

The senior lieutenants of the control frauds who committed the frauds thatcaused more than 10,000 homeowners to lose their homes. Thousands of senior officers fall in thiscategory.

Level 5: A large cog in a smallerfraud

Generic Hardcore Prison: A life ofboredom and the almost total loss of freedom

The senior lieutenants of the control frauds who committed the frauds thatcaused more than 1,000 homeowners to lose their homes. Thousands of senior officers fall in thiscategory.

Level 4: The banksters who cost usour money instead of our homes – Goldman Sachs & friends

Generic Prison: A life of boredom anda severe loss of freedom

The officers that led the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product. Dozens of officers fall in this category.

Level 3: The banksters’ seniorlieutenants who cost us our money instead of our homes

Prisons designed for serious, but less physically dangerous felons

The senior officers of the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product. Scores of senior officers fall in thiscategory.

Level 2: Banksters who defraudedother bankers (who were willing to be defrauded)

Privatized prisons: Let them enjoythe consequences of their odes to privatization

The largest control frauds sold tens of billions of dollars of fraudulentloans to each other through fraudulent “reps and warranties.” The kicker here, as Charles Calomiris hasemphasized, is that the control frauds on both sides of the transactions knew thatthey were engaged in a mutual fraud. Hundreds of senior officers fall in this category.

Level 1: Small fraudulent fry

Catch and release: Convict them andput them on probation if they cooperate with the investigations

The small fry are the loan officers, loan broker employees, and borrowerswho knowingly participated in making fraudulent mortgage loans. Over 100,000 individuals fall in thiscategory.

We Need to End the PAC Doctrine

To date, Bush and Obama have prosecuted none of the mortgage frauds in the top nine levels. I urge reporters to ask him to explain three things about his statements to 60 Minutes.

Why are there no prosecutions of the felons that drove the crisis and occupy the nine worst rungs of unethical and destructive acts?

Explain the five unethical acts by elite financial institutions that you consider the most destructive and least ethical – but which you believe to be legal. How do you rank the degree of unethical conduct and destruction in those acts?

What specific statutory provisions did you propose to make those five unethical acts illegal? As enacted, which provisions of the Dodd-Frank Act made those five unethical acts illegal? Who has been prosecuted for those formerly legal but seriously unethical and destructive acts that were made illegal by the Dodd-Frank Act?

Reporters will have to be persistent in coordinating their follow-up questions to get Obama to provide direct answers to these questions.

I request that private citizens write President Obama to ask him to provide specific, written answers to these three questions. I will be proposing a series of questions that I will urge citizens to demand answers to because it is clear that the regular media will rarely ask demanding questions of elite politicians or bankers. It is up to us to hold them accountable and end the doctrine of Presidential Amnesty for Contributors.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

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Response to Comments: Retrospective on MMT

Posted on December 14, 2011 | Comments Off

By L. Randall Wray

Of course, I didn’t expect comments this week on the keynote talk. I know many will agree with the comment on Billyblog—I’m sure many of you found our site after following Bill’s posts.

There was one substantive and flawed comment, so I will deal with that here.

Comment: The “Sotty” principle. That’s twice Prof. Wray has used the term. Referring, it would seem unknowingly, to the radiochemist Frederick R. Soddy, who demonstrated that interest continues to compound on the books after the bank money that offsets it is destroyed. Directly contravening the MMT notion that inside debts net to zero.

The money sovereign isn’t, as financial institutions have the power of money creation and leverage. That’s the power imbalance — a mathematical and financial imbalance — this piece is futilely attempting to deny.

Response: Yes, sorry, Soddy not Sotty, Nobel Winner in chemistry who also wrote a lot on economics. Michael Hudson has used Soddy’s ideas in his own approach to debt and debt cancellation.

But the commentator is in way over his/her head on balance sheets.

First, here is Soddy’s idea:

Debts are subject to the laws of mathematics rather than physics. Unlike wealth, which is subject to the laws of thermodynamics, debts do not rot with old age and are not consumed in the process of living. On the contrary, they grow at so much per cent per annum, by the well-known mathematical laws of simple and compound interest … For sufficient reason, the process of compound interest is physically impossible, though the process of compound decrement is physically common enough. Because the former leads with the passage of time ever more and more rapidly to infinity, which, like minus one, is not a physical but a mathematical quantity, whereas the latter leads always more slowly towards zero, which is, as we have seen, the lower limit of physical quantities.

You cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest], against the natural law of the spontaneous decrement of wealth [entropy]

And so the fundamental problem is that “real” economic growth cannot match compounded interest growth—so debts increase faster than ability to pay.

Now I don’t want to get into a debate about the links between “real” and nominal, laws of entropy applied to economics, and so on. The idea is rather simple: if the nominal interest rate is higher than growth of ability to pay debt, then we’ve got a problem. And there is indeed a tendency for that—it is hard to achieve income growth rates that are consistently above nominal interest rates. Problems are compounded as debt ratios grow, as they have done.

But to return to the Commentator’s claim that this violates MMT: at a point in time, inside debts = inside credits. Every financial I owe U is offset by a financial U owe Me. It is an identity that is violated only by an arithmetic error.

Any theory that holds that the two are not equal is just plain wrong. You do not have to accept MMT to accept identities—they hold regardless of theory.

Here is the Soddy claim: over time, those debts will grow faster than ability to pay. That does not mean that debts don’t equal credits. When one defaults on a debt, the credit is also written down. If IOU $100 but can only pay $50, your credit against me is no longer $100—it is $50.

Debt cancellation wipes out the debts and the credits; at the same time; by the same amount.

It is elementary, dear commentator. It does not violate MMT—or any other theory.

Nor does bank leveraging violate MMT. Indeed, MMT has much to say about banks leveraging the state’s high powered money. You have not been paying attention!

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A Scribbler’s Response to Marc Lavoie on MMT

Posted on December 14, 2011 | Comments Off

By Philip Pilkington
(Cross-posted from Naked Capitalism)

Recently the eminent monetary economist Marc Lavoie published a paper engaging with Modern Monetary Theory (MMT). The paper was interesting for a number of reasons, not least the discussion of the European banking system; speculation about which in the media has generated much mythology in the past few months.

Lavoie is largely supportive of MMT and sees it as being essentially correct. However, he also finds that it has much ‘excess baggage’ that he thinks it needs to do away with. At the same time Lavoie notes that MMT has succeeded in appealing to a broad non-academic audience (Naked Capitalism being mentioned by name) which post-Keynesian economics has so far failed to do.

Unfortunately, Lavoie does not consider that what he calls the ‘excess baggage’ of MMT may well be the reason for its embrace by non-academics. In this Lavoie may well be sidestepping the underlying ideological issues that must be taken into account when considering the embrace of a given economic doctrine.

Excess baggage

While I will not go into too much detail about the arguments that Lavoie raises in what follows (the interested or critical reader can weigh my assertions against Lavoie’s paper themselves if they wish), I can sum up Lavoie’s gripes with MMT quite easily: he distinguishes between where the MMTers see what ‘is’ and where they see what ‘ought to be’.

This distinction revolves around the consolidation of the government sector in MMT – which basically means that the MMTers claim that it is theoretically valid to see the Treasury and the Central Bank as a single entity which they refer to as ‘the government’.

Lavoie raises criticisms against this which have been raised oftentimes in the past before – not least by the MMTers themselves. Basically what he is saying is that many governments that operate under their own currencies create institutional arrangements that separate the actions of the Treasury and the Central Bank.

This may seem like a nuanced point to the outside observer, but much of the MMTers rhetoric about taxes not funding spending and about governments spending by crediting bank accounts flows from here. If we accept a strict division between the Treasury and the Central Bank we can no longer make certain rhetorical claims about how the monetary system works.

MMTers consider the institutional arrangements facilitating such divisions to be ‘voluntary restraints’ imposed by ill-informed central bankers and policymakers and in this, so far as I can tell, Lavoie does not disagree. But this is where we see a distinction between what ‘is’ and what ‘ought to be’.

In academic fashion Lavoie insists that we must simply describe existing institutional arrangements and we should not prescribe what we think should, in fact, be the case. And it is on this point, I think, that he is fundamentally in disagreement with the MMTers.

MMT as a political program

My central point is that it is such rhetoric that gives MMT its strength. Ideally, MMT would like to see these constraints – which are weak and fairly inconsequential anyway –be done away with as they are viewed as leftovers from the gold standard-era. With these constraints out of the way all the MMTers rhetoric would be perfectly true.

Every heterodox economist should recognise what gives neoliberalism its strength. It is not its perfect logical consistency or fidelity to the real world (far from!), but its prescriptive capacity. It has, since the mid-1970s, given policymakers the world over – from both the right and the so-called left – a prism through which they could view the world. MMT turns this prism upside-down and that is what makes it so appealing to people who have seen the world economy led into such destruction through misguided neoliberal ideology.

Neoliberalism operates in a very similar manner to MMT in that it essentially gives policymakers a vision for what the world should be like and a toolkit to achieve this. In this regard MMT is far more humble and, rather than chasing the spectre of self-equilibrating markets or some other such imaginary entity, it merely asks that we reform the monetary system so that a functional finance approach can be taken to policymaking.

In this, MMT sees a far more stable and prosperous world in which policymakers understand that, among other things, taxation should be used as a means to stabilise aggregate demand rather than to raise funds for government spending. Without changing the very terms of debate – as the MMTers seek to do – such would be impossible, as it is clear to anyone today that politics is largely dominated by soundbites and ideology.

In my experience MMTers are aware of this and in this they are far more politically savvy than their academic post-Keynesian colleagues. If the frame of reference is not changed there is simply no hope that we can ever change the direction taken by government.

Policymakers and opinion-makers (and many economists) are not rational people. When they hear the term ‘government spending’, for example, it triggers a reflex in their mind that activates the term ‘inflation’. This is never going to be changed through rational argument – as I said a moment ago: these are not strictly rational people. Instead it has to be changed by shifting the very terms of debate.

In the past politically savvy economists recognised this. Certainly Keynes spent as much, if not more of his life trying to shift the terms of debate than he did writing academic treatises. And Abba Lerner, I think, was clearly aware of this need – and this was one of the reasons for formulating his functional finance approach (note that when examined carefully, this approach is mainly about a change in nomenclature rather than a new theoretical approach).

Where does post-Keynesianism fit in?

Post-Keynesian economists must be praised with being easily the most rational in their discipline. They should also be credited with doing some of the most impressive work undertaken in many fields – from theories of capital to monetary economics. However, they have failed to reach an audience beyond their own immediate group. Indeed, they have failed to even have their critiques and constructions taken seriously by their own colleagues and, from the point of view of an outside observer, seem to spend a great deal of time squabbling amongst themselves (which is probably more so an effect of isolation than a cause).

Every one of them can formulate a reason why this has been the case. And I suspect many will think that politics and ideology plays more than a minor role. If they are smart they will see in MMT something that they can hang their flag on – and, possibly, have their theories taken seriously by the mainstream.

Already MMT oriented blogs have begun to pay attention to post-Keynesian theory more generally (I wrote a popularised exposition of the Kalecki profit equation for this site, for example) and things will likely continue in this direction given MMT’s ever-growing popularity.

Put simply: the shift from a broadly defined post-war Keynesianism to neoliberalism was long and complex, but it was undoubtedly a key feature that its main proponents (especially Milton Friedman) had a clearly defined ideological program for governments. This program – based as it was on tenuous assumptions and philosophical trickery – now lies in ruins and there stands nothing ready to take its place.

Something will have to step in to fill this intellectual vacuum and I suspect that, should the academic cloisters be left to themselves, I can confidently predict what this ‘something’ will be: namely, a new Samuelsonian Keynesianism that will be as weak and as watery as its post-war cousin (most likely with someone like Paul Krugman as its leading media light). If this occurs all the fine work of the post-Keynesians will again be confined to the dustbin of history and the ISLM model – which Lavoie rightly presents in the paper as the guiding principle for the majority of the profession – will remain king.

When Friedman stepped into the breach he was largely ignored by his colleagues. “Keynes,” they all assured themselves confidently, “had proved him wrong years ago”. But through a careful refining of his message – together with a formulation of a broad new program for society – he found himself well-placed to fill the intellectual vacuum leftover from ISLM-Keynesianism in the inflationary 1970s (even though, in retrospect, his arguments were at best a sideshow as to what were truly the causes of the inflations of the 1970s).

It was the moral clarity that Freidman gave that found him an audience. And while the MMTers (thankfully) do not construct the sorts of metaphysical systems that Friedman peddled, they do allow us to once again raise fundamental questions about the role of government in advanced capitalist economies. They allow us to raise these questions in a fundamentally popular, interesting, but also eminently post-Keynesian way. To retreat from this because MMTers currently have no say in obscure institutional practices between certain Treasuries and their Central Banks, is a gross error; the equivalent of Freidman fleeing from his prescriptions for controlling the money supply because central bankers were then not adopting this approach.

For too long one gets the impression that, closed in upon themselves and shunned by the outside world, the point of being a post-Keynesian was to win the argument. Today, as this fine tradition gradually emerges from out of the shadows, the point is to win more generally. And one cannot win unless one has a clearly formulated game plan. MMT is the only positive game plan currently being put forward.