Category Archives: Eric Tymoigne

Can we spend our way out of the recession? Is the fiscal deficit unsustainable? And is it time to cut government spending?

Posted on January 28, 2010 by | 3 comments

By Eric Tymoigne

If the reader is familiar with history, she or he will note a close similarity between the current policy debates and those of the 1930s; the latest similarity is the proposed spending freeze by the Obama Administration. In the early 1930s, President Roosevelt first criticized President Hoover for engaging in deficit spending and driving the country down the road to ruin, and then proceeded to implement policies that further increased the fiscal deficit of the federal government to about 5% of GDP (a historical record at that time). These policies greatly helped the economy to get out of the Great Depression, but were the subject of ferocious attacks on the ground that the “massive” deficits would lead to the insolvency of the country, uncontrollable inflation, wasteful spending, the taking over of the economy by the government, and, ultimately, the rise of Communism. A cartoon in the Chicago Tribune says it all. Those criticisms were so ferocious and effective at frightening the population that Roosevelt decided to return to a balance budget during the election year of 1936, just like President Obama wants to do.

Did any of those problems actually materialize? As the saying goes “the proof is in the pudding.” There was no government takeover, no rise of Communism, and no insolvency. In fact, Roosevelt proceeded to increase government deficit over 20% of GDP during WWII without any of those problems arising. The non-sense about insolvency and government takeover of the economy have been explained elsewhere on this blog (here and here) and on Bill Mitchell’s blog and no additional time needs to be devoted to that subject. Instead, let us see what the actual consequences of rising federal government deficit (current government outlays minus current government receipts) and rising public debt (the sum of all past and current federal government deficits and surpluses) were.

Staying in the pre-WWII period, unemployment went down steeply to about 10% of the economy, once one removes people employed by government programs from the unemployment data. Even if one just follows the official BLS data (the gray line in Figure 1), unemployment rate was down to 15%. Far from great but much better than 25%. Unemployment would have declined much further if Roosevelt had let the government spending grow. However, political pressures pushed him to limit government spending and government deficit and to actually reduce them massively. This generated a recession in 1937, followed by rising unemployment.

Figure 1. Annual Unemployment Rate in the U.S.: 1890-2009.

The main argument used for counting people employed by the CCC, WPA and other government programs as unemployed, is that those jobs were makeshift jobs not driven by the needs of the private sector. They were wasteful employment not justified by the profit motive. However, while they probably were not profitable, they were extremely beneficial for the welfare of the US population and provided the foundation for the long period of stability after WWII. Here are some of the achievements through June 1940, 3 years before most employment programs ended (NRPB is the National Resources Planning Board’s Security Work and Relief Policy):

Work Projects Adminitration (WPA)
“Through December 31, 1940, some of the tangible accomplishments of WPA projects were as follows: over 560,000 miles of highways, roads and streets constructed or improved; almost 5,000 schools built and 30,000 improved; 143 new hospitals provided and almost 1,700 improved; over 2,000 stadiums, grandstands, and bleachers built; 1,490 parks, 2,700 playgrounds, and more than 700 swimming pools constructed; 19,700 miles of new storm and sanitary sewers laid; over 2,000,000 sanitary privies built. Conservation work included the planting of more than 100,000,000 trees, and the construction or improvement of over 6,000 miles of fire and forest trails. The work in airport and airway facilities included some 500 landing fields and over 1,800 runways. During January 1941, 1,000,000 adults and 37,000 children were enrolled in classes and nursery schools; over 280,000 persons received music instruction and over 67,000 art instruction; and attendance at concerts reached almost 3,000,000 people. Participant hours in various recreational activities totaled almost 14,000,000. Since the beginning of the WPA, welfare activities have included a total of 312,045,000 garments completed by sewing projects and of 85,270,000 other articles, while more than 57,000,000 quarts of food have been canned and almost 600,000,000 school lunches were served.” (NRPB 1942: 342, n.4)
National Youth Administration (NYA)
“Through June 30, 1940, the accomplishments of youth workers on the out-of-school program had included the following: New construction or additions to more than 6,000 public buildings, such as schools, libraries, gymnasiums, and hospitals, and addition to or repair or improvement of about 18,300 others; construction of almost 4,000 recreational structures, such as stadiums, bandstands, and park shelters, and repair or improvement of nearly 6,000 others; construction of 350 swimming or wading pools and 3,500 tennis courts. About 1,500 miles of roads had been constructed and 7,000 repaired or improved; nearly 2,000 bridges had been built. Seven landing fields had been constructed at airports. 188 miles of sewer and water lines had been laid, and 6,200 sanitary privies built. Over 6.5 million articles of clothing had been produced or renovated, nearly 2 million articles of furniture constructed or repaired, and 350,000 tools or other mechanical equipment constructed or repaired. 77.5 million school lunches had been served by NYA youth; nearly 4 million pounds of foodstuffs had been produced and nearly 7 million pounds canned or preserved. Conservation activities had included the construction or repair of 127 miles of levees and retaining walls and 15,700 check and storage dams.” (NRPB 1942: 342, n.5)

Civilian Conservation Corps (CCC)
“Through June 30, 1940, the accomplishments on these [CCC] projects included: The construction of 37,203 vehicle bridges, 21,684,898 rods of fence, and 79,538 mileage of telephone lines; the development of almost 21,000 springs waterhole, and small reservoirs; the building of more than 5 million permanent and temporary check dams in connection with treating gullies for erosion control; as well as the planting, seeding, or sodding of 114 million square yards of terraces for protection against erosion; the planting or seeding of almost 2,000,000 acres of forest land with an average of 1,000 trees to the acre; 5,741,000 man-days spent in fighting forest fires and 5,392,000 man-days in fire presuppression and prevention work; forest-stand improvement on 3,694,930 acres; development of about 55,000 acres of public camp and picnic grounds; stocking lakes, ponds, and streams with 9.3 million fish.” (NRPB 1942: 343, n.8)

The overall cost of running those programs was extremely small, less than 1% of GDP. Despite their limited scope, they helped millions of people to make a living, helped to avoid waste of resources (if they had been left idle), and promoted the growth of U.S. infrastructures. In addition, the large deficit spending flooded the private sector with cash; thereby, restoring profitability and willingness to employ. War deficit spending reinforced this trend by flushing banks and private businesses with money and by creating a long period of financial stability. All this without any sign of insolvency of the federal government.

A final complaint is usually that government deficit always creates huge inflation and even hyperinflation. There is here a ton of data going against this argument. One just needs to look at Japan over the past 20 years: massive debt, very low interest rate, deflation or stable prices. But we do not have to go that far. Here is the United States, the “massive” deficits of the 1930s and 1940s did not generate high inflation.

Figure 2. Annual CPI Growth in the US.

In the 1930s, inflation stayed moderate at about 3%, after WWII inflation did spike to 15% for one year but that was it. And this spike is explained by the disturbances in the production system induced by WWII. After the production capacities were reoriented toward meeting the demands of a peaceful economy, inflation declined tremendously even though public debt was still very high relative to GDP. Today for the first time since 1955, the US economy experienced deflation despite rapidly rising deficits. Thus, there is no automatic relationship between government spending and inflation. It all depends on the state of the economy. If the economy is at full employment, any type of spending (private domestic consumption, private domestic investment, exports, and government spending) leads to inflation. If production capacities are underemployed, as they are today, companies can meet all the additional private or public demand without increasing their prices.

So can we spend our way out of a recession? Yes we can; provided that spending is high enough. Will a sovereign government go bankrupt by doing so? No, it will not. Does government spending lead to inflation? No, it does not. Does bigger government spending mean that the government will take over the economy? No, it does not. Does it mean that all types of spending are equally beneficial? Definitely not. Government spending can be wasteful if there is no improvement in the welfare of society through infrastructure spending, better social programs, and other government spending, preferably employment-enhancing, that improve the standard of living of the population. That is the major critique that one can make about the Obama administration under the guidance of Geithner and Summers. Far too much money was spent on wasteful financial rescues and far too few dollars were used for the benefits of the overall population. The clear example of this is that, while unemployment as leveled off it has not declined significantly. Even more telling is what has happened to the employment-population ratio. The latter has been dropping so much that all the gains of the past 25 years have been eliminated.

Figure 3. Employment-Population Ratio

We need a second “stimulus.” Even better, we need a permanent employment policy that provides a buffer against unemployment through employment-government programs. Those who promote small government do so on the basis of a value system, not on the basis of sound economic arguments or historical data. Unfortunately, this value system is highly dangerous for the well-being of the U.S. population. The alternative is not government takeover but rather using the government in a productive fashion to improve economic well being. Make your voice heard, not just by hanging passively signs in the streets and going to vote, but through massive organized protests and, if necessary, strikes. This is how a healthy democracy works. This is what happens all the time in other democratic countries and this is what this country did in the 1930s with the Bonus Marchers, industrial strikes, and the peasant movements. Want a few ideas to fight for? What about increasing healthcare benefits, eliminating the payroll tax, engaging in massive green infrastructure programs, providing free education in the fields in need (definitely not finance)? Those were the sort of commitments made during the 1930s and they have been hugely popular among the U.S. population, have contributed to the rise of US economic power, and have not affected at all the solvency of the United States. Again the proof is in the pudding: just look at the popularity of Medicare, Social Security, the air transportation system, the highway system and many other achievements of the New Deal and post-WWII policies.

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Some Things to Consider Before Reappointing Bernanke

Posted on December 21, 2009 by | 4 comments

By Eric Tymoigne

Chairman Bernanke has been praised for his handling of the crisis. Nobody disputes the fact that the massive emergency lending programs of the Federal Reserve helped to stabilize the financial system in the short-term; however, judging the first term of the Chairman purely on this ground is rather narrow minded.

It is important to remember that the preamble of the Federal Reserve Act lays out a dual mandate for the Federal Reserve System: (1) provision of “an elastic currency” and (2) “effective supervision.” While the former provides short-term stability in the form of a lender of last resort (during crises) and of a reliable refinancing channel for banks (in normal times), the latter is intended to promote long-term stability.

Unfortunately, supervision has always been seen as a secondary duty of the Federal Reserve System. The Fed, which is now overwhelmingly populated by economists (probably the least qualified to supervise banks), has too often ignored its dual mandate in favor of a single policy objective — managing price stability – which, importantly, was never the intended role of the Fed. Chairman Bernanke continues this tradition.

First, he (along with Governor Mishkin) is the main proponent of inflation targeting. Since 1999, he has been a strong advocate of purely focusing interest-rate settings on meeting an inflation target, while ignoring output growth and asset-price volatility. The models “showed” that price stability is the holy grail of policy goals that guarantees high (and stable) economic growth and financial stability. During his tenures as Governor and Chairman, this view has been at the core of his policy choices, and financial fragility has been largely left aside. Thus, from 2006, he continued Greenspan’s policy of raising policy rates to fight a presupposed looming “high” inflation, without any regard for an economy already extremely fragile. These policy actions contributed tremendously to systemic risk by pushing financial institutions and households into more leveraged positions (the worst mortgage originations occurred in 2005 and 2006, when the fed funds rate target was rising fast) and by creating large payment shocks on exotic mortgages. In addition, Chairman Bernanke did not consider the relevance of systemic risk until mid-2008, while many economists, journalists and bloggers from the financial community had been warning about the huge problems since 2005 at least.

Second, Chairman Bernanke has been a proponent of market-oriented regulation in the spirit of Basel II, and of the financial innovations that have been at the heart of the crisis. Mega financial institutions are supposed to know their business better and so, with some light oversight from the government, are supposed to be able to regulate themselves. Risk management, financial innovations and credit rating agencies are supposed to provide the proper signals and buffers against risks. This regulatory philosophy has failed miserably to prevent not only this crisis but also previous crises, and has contributed to growing financial instability over the past 30 years. In addition, the Federal Reserve has been unwilling to apply existing regulations to handle problematic banks and the Chairman has backed the shameless stress tests implemented under TARP. As Bill Black noted elsewhere, federal regulators are mandated to force recapitalization or to place in receivership insolvent institutions no matter how big they are. Receivership was done during the S&L crisis in a very smooth and competent way and it should be done today.

Third, the way the lender of last resort policy of the Federal Reserve has been implemented during the crisis has been flawed. The emergency lending programs have been highly opaque, creating suspicions of favoritism and unfair competitive practices. SIGTARP, US COP, and Bloomberg have been pushing hard for greater transparency (Bloomberg won a court battle but the Fed is now appealing). All those programs should have been done through the discount window, which should be destigmatized by making it the main way the fed intervenes on a daily basis.

Overall, Chairman Bernanke is not the right person to deal with the main concern that the Federal Reserve should, above all else, strive to maintain financial stability. Before the crisis, Chairman Bernanke ignored (or simply missed) the many warning signs until it was too late, and after the crisis he will likely return to his favored policy of targeting expected inflation.

One may wonder who the President should appoint as Fed Chairman. While I am not in the position to name anybody in particular, I can suggest some criteria. First, the Chairman should be a person who is old enough not to be concerned about finding a job once he or she leaves the Chairmanship. Second, she or he should be someone who is known for his or her independence of mind. Third, she or he should be someone that puts financial stability above all other criteria (because that is what the Fed was originally mandated to do and because it is the best way the Fed can promote price stability and stable economic growth). Finally, he or she should be someone who does not try to please the financial sector, and who involves much more other sectors of the economy in policy decisions.

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Another Take on the Financial Balances

Posted on July 24, 2009 by | 5 comments
By Eric Tymoigne

First, regarding the identity itself, for a domestic economy we have, in terms of economic flows:

GFB + PDFB + RWFB ≡ 0

With PDFB the private domestic financial balance, RWFB the financial balance of the Rest of the World, and GFB the government financial balance. This identity holds all the time, in any domestic economy (in a world economy RWFB disappears). For economic analysis, it is insightful to arrange this identity differently in function of the type of monetary regime.
In a country that is monetarily sovereign the federal government has full financial flexibility. By monetary sovereignty, one means that there is a stable and operative federal/national government that is the monopoly supplier of the currency used as ultimate means of payment in the domestic economy, and that the domestic currency is not tied to any asset (like gold) or foreign currency. Other posts have already explained the implications of this in terms of federal government finance (taxes and T-bonds do not act as financing sources for federal government spending, the federal government always spends by creating monetary instruments first, etc.) and banking (bank advances create deposits, credit supply is endogenous and is created ex-nihilo (i.e. banks do not need depositors to be able to provide an advance of funds to deficit spending units), higher reserve ratios do not constrain directly the money supply process in a multiplicative way, etc.). All this also has implications in terms of accounting and in terms of modeling.

First, in terms of accounting identity, in a monetarily sovereign country, the government financial balance (GFB), through the federal government financial balance, is the ultimate means to accommodate the changes in holdings of the domestic currency by other sectors (private domestic sector and the Rest of the World). This means that, for a monetarily sovereign country, the most insightful way to arrange the national accounting identity is:

-GFB ≡ PDFB + RWFB

or

-GFB ≡ NGFB

Where NGFB is the non-government financial balance (the sum of the financial balance of the private domestic sector and the Rest of the World). This way of arranging the identity shows well that the government sector (through its federal branch) is the ultimate provider/holder of domestic currency: government fiscal deficit (surplus) is always equal to non-government financial surplus (deficit). The graph below shows the identity for the US.

Fiscal balances for the United State (billions of dollars)

Source: BEA (Table 5.1).
Note: Statistical discrepancy was distributed evenly among the three sectors (Private Domestic, Rest of the World, and Government).

Any net injection of dollars (i.e. financial deficit) by any sector must be accumulated somewhere else (i.e. financial surplus). As the monopoly supplier of ultimate domestic means of payment, usually the US government sector is the net injector of dollars, while the private domestic sector and the Rest of the World usually accumulate the dollars injected. For a while, like from 1997 to 2007 in the US, the private domestic sector and the Rest of the World may transfer the domestic currency among each other while the government runs a surplus; however, this cannot last because ultimately one of them (private sector or Rest of the World) will run out of domestic currency and/or will have to become highly indebted in domestic currency leading ultimately to a Ponzi process that collapses. Only the federal government has a perfect creditworthiness and can always meet its financial obligations denominated in the domestic currency (that is why US Treasury bonds are not rated, default rate is zero).

In addition, one may note that the Rest of the World and the private sector cannot accumulate any domestic currency unless the government sector injects them in sufficient quantity in the first place. Stated alternatively, the Rest of the World (e.g., the Chinese) does not help to finance the deficit of the federal government (US federal government). On the contrary, the federal government deficit allows the Rest of the World to accumulate dollars. This pressure to generate a deficit is all the more strong on the dollar that it is the reserve currency of the world, so there is a net demand for the dollar from the Rest of the World.

This also works the other way around, i.e. if the Rest of the World disaccumulates the domestic currency the government must be the ultimate acquirer of this domestic currency and so must run a surplus if the private domestic sector does not accumulate it in a large enough quantity.
Once it acquires the domestic currency, the government may destroy them (federal government has huge shredders or they are deleted from the computer memory), or store them into a safe/computer for later use (especially true for state and local governments). Destruction of bank notes occurs usually because they are in bad shape. Hundreds of millions of dollars worth of bank notes are destroyed every month at the Fed banks in the US; then they are used as compost (during my last tour of the San Francisco Fed last March, I was told that about $56 million worth of bank notes are destroyed every day at the SF Fed, and then are spread on the fields of California). If you go visit a fed bank this will be the main attraction.

Besides the poor condition of some bank notes, the destruction of dollars by the federal government may also occur for other reason, e.g., because there is a lack of storage capacity (safe is too small, computer memory is too small). One central point is that the dollars that are accumulated by the federal government do not increase its financing capacity because the federal government created those dollars in the first place. It chooses not to destroy them all because it takes time and it is costly to destroy and to make monetary instruments, and because it has the storage capacity.

For the moment, we stayed at the level of the identity, which basically tracks where the domestic currency comes from and where it goes. Every dollar comes from somewhere and must go somewhere. There is no dollar floating around that is not held by a sector. No desire/behavioral equation were included in the analysis above. However, even that basic identity provides us a powerful insight. Indeed, it shows us that it is impossible for all sectors to be in surplus; at least one of them must deficit spend and usually it is the government sector because of its monetary sovereignty. The reverse is also true, i.e. not all sectors can be in deficit at the same time; at least one of them must be in surplus (usually the private domestic sector). As Randy noted in a previous post, this is probably not understood well; even the Wall Street Journal did not make the connection in early the 2000s between the federal government surplus and the households’ negative saving. It is often assumed that if they wish, all sectors could be in surplus; one just needs to work hard enough at it (note that this is one of the promises that is always made during presidential campaigns: “we should save more, reduce our trade deficit and reach a fiscal surplus”). Economic reality does not work that way.

In terms of the model (where one includes desires and so behavioral aspects as well as an explanation of the adjustment mechanisms to those desires in relation to the state of the economy), for the analysis of a monetarily sovereign country, I would rather put the desired financial balance of the Rest of the World with the desired private domestic financial balance and call the sum the desired financial balance of the non-government sector (NGFBd). The model does not deal with stocks at all and their relation to flows (IS-LM did try but failed to do it correctly; read Hicks’s own account in his JPKE article “IS-LM: An explanation”); however, the financial-balance model is a good place to start in Econ 101. If students can understand the model, the identity and how they relate to each other, it would be a HUGE step forward in terms of removing this counterproductive phobia of government fiscal deficits (then one would have to learn about government finance and the monetary creation process, which, like many other things, are all taught backward in textbooks).

If the Rest of the World has too many dollars relative to its taste it and cannot bring them back into the domestic economy, by buying enough goods and services or financial assets from the private domestic and government sectors, the currency depreciates and/or long-term interest rate falls. This boosts exports and reduces imports. This may also promote investment and consumption if the state of expectations is stable.

If the non-government sector desires to save more, then, unless the government sector increases its spending propensity or reduces tax rates, the economy will enter a slump; possibly a debt-deflation process if debt levels are far too high. All this was done nicely in previous posts.
Before, during, and after the adjustment processes (variation of flows, levels and prices) the identity holds and the actual financial balance always sum to zero. The sum of GFBd and NFGBd will be different from zero except when the adjustment is completed, i.e. when actual and desired balances are equal (“at equilibrium” if you want to call it that way, even though markets may not be cleared).

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Can Better Risk Management Techniques Prevent “It” From Happening Again?

Posted on July 14, 2009 by | 1 comment

by Eric Tymoigne

The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.

Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.

Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.

Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).

Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.

The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”

To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.

All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).

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BIS Report Warns That Main Problems Have Not Been Solved

Posted on July 6, 2009 by | Comments Off on BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

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Question: “How big is the debt problem?” Answer: “ENORMOUS”

Posted on June 17, 2009 by | 1 comment
By Eric Tymoigne

The U.S. now has the highest ratio of debt-to-GDP in its history: nearly 5. And, while much has been made of the public sector’s growing debt levels, private finance has been the leading contributor to this massive growth of indebtedness. Two other contributors are GSEs (private/public financial sector) and households.

Figure 1: Total Financial Liabilities by Sectors Relative to GDP
Sources: Historical Statistics of the United States: Millennium Edition, Historical Statistics of the United States: Colonial Times to 1970, NIPA, Flow of Funds (from 1945).

Securitization, together with internationalization of finance, has been the main driver of those tendencies, enabling the financial sector to reap large profits…until recently.

Figure 2: Proportion of Corporate Profit Received by the Financial Sector*

*Excludes Federal Reserve Banks.
Source: BEA. Tables 6.16B, 6.16C, and 6.16D. Corporate profit with inventory valuation and net of capital consumption.

Interestingly, debt levels in the 1980s rivaled those of the Great Depression, which gave a hint that the quality of indebtedness matters as much as the quantity of debt. Take mortgages for example: IO mortgages were a major problem during the Great Depression, which led to a reform of the mortgage industry toward long-term fixed, fully-amortized mortgages. Until the early/mid 2000s, IOs and other exotic mortgages were of limited proportion or non-existent, but as the quality of mortgage deteriorated so did the capacity to sustain a given level of indebtedness.

Solving the debt problem is going to take many years and radical steps (some of them on the distributive and employment sides rather than the financial side). Already financial institutions are cutting the amounts due on credit cards (sometimes in half!) if customers are willing to repay in full at once. Creditors are beginning to understand the enormous problem posed by massive indebtedness. Policymakers should take note: a sustainable economic recovery cannot take place without first allowing private sector balance sheets to recover.

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