Category Archives: Marshall Auerback

The President Remains Trapped In the Talons of Deficit Hawks

Posted on February 1, 2010 by admin | 8 comments

Last Friday Mr. Obama and the GOP staged the equivalent of a British Parliamentary Question Period in front of the TV cameras. It showed the quick-thinking, articulate President at his best. Unfortunately, the subsequent Saturday morning national radio address showed him at his worst. Obama reiterated the need for job creation, even as he decried government deficits, which allegedly imperil our long term economic prosperity. It’s like calling for an open house policy, whilst simultaneously putting explosives on the door knobs.

“As we work to create jobs, it is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now”.

Give Obama credit. He packs a veritable trifecta of innocent, but deadly, frauds into one sentence – government debt is bad, markets determine interest rates, deficits represent a form of “intergenerational theft”– and then adds several new ones to boot.

Unfortunately, he’s got it backwards. The deficits he decries actually help to sustain demand, and create jobs, thereby supporting the economy – not destroying it. And he reflects a commonly held belief that growing government debt represents a burden on our children and grandchildren, implicitly suggesting that future generations will have to reduce consumption in order to pay the taxes required to pay off the outstanding debt. Related to this is the fallacy that too much bond issuance will create a “debtors’ revolt”, whereby “the markets” will force the country to pay higher interest rates in order to “fund” its spending.

Where to begin? Since the days of George Washington’s administration, national budget deficits and increased public debt have been the rule on all but about six very short occasions. And the US has generally prospered. Why? Far from being a burden, the deficits, and the corresponding government bonds, constitute the foundation of private financial wealth in any nation that creates its own sovereign currency for use by its citizens. Debt owed by the government yields net income to the private sector, unlike all purely private debts, which merely transfer income from one part of the private sector to another. In basic national accounting terms, government deficits equal non-government savings surpluses.

Another important other angle that is often overlooked is that private holdings of government bonds also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the Government retires debt it reduces private incomes, just as when it runs budget surpluses, it constrains private sector demand directly by reducing private income and access to adequate currency. Just ask any pensioner if he/she is happy when their income stream from annuities has declined.

Take away that debt, and you take away income. It is no coincidence that the budget surpluses of the Clinton years (wrongly trumpeted as a great fiscal triumph by President Obama) subsequently led to recessions: government budget surpluses ultimately restrict private sector demand and income growth and force greater reliance on PRIVATE debt. Does anybody think it is a coincidence that two of the longest and largest periods of budget surpluses in America history – the periods of 1997-2000 and 1927-1930 – were followed by calamitous economic collapses?

There are ample analyses which explain how government surpluses drain aggregate demand (here, and here). Suffice to say, a government budget surplus has two negative effects for the private sector: the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and private disposable income also falls as tax demands exceed income. And, as Stephanie Kelton has noted, the case of Japan illustrates that despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either.

Furthermore, now that we’re off the gold standard, Chinese and other Treasury buyers do not “fund” anything for us, contrary to the completely false and misguided scare stories that deficit hawks and, and now Obama, implicitly endorse. (See here for an explanation). Legions of economists, investment advisors, Wall Street practitioners and policy makers continue to peddle such gold-standard thinking to their citizens nationwide. To paraphrase Churchill, “It is as though a vast Gold Standard curtain has descended across the entire body of public thinking.”

Let’s consider a real world example to demonstrate the President’s conceptual confusion on government deficits. We’re in a recession. Our American citizen who was working in a pie shop has lost his job even though his productivity was just as high during the boom years. The problem is that as the recession intensified, pie demand fell as did consumer demand in general. For a variety of reasons, households perceive their wealth holdings are not going to appreciate as quickly as they did in prior periods, so they are saving more money out of their income flows.

The pie guy wants to exercise his freedom to work hard for money. So too do 152 million other people. But there are jobs available for only 138 million of them given current business perceptions of money profit prospects from production now and in the future. The pie guy is stuck with over 15 million other people who would like to exercise their freedom to work hard for money. Over 6 million of those people have been trying to exercise that freedom for over half a year, with no luck. They are dumpster diving for leftover pie scraps.

In desperation, the pie guy has gone back to the pie shop to offer his services for a lower money wage, but unit pie demand is still down, even though the owner has cut pie prices. However, the pie owner, facing lower prices per pie, decides to hire the pie guy back at a lower wage and fires one of his other workers to scratch his way to a little higher profit. Are we all any better off? I suppose pies are cheaper, but then so too are incomes earned by pie makers lower.

In that situation, someone else has to take up the spending slack. Fortunately, we live in an economic system in which a government can freely spend and fill the gap left by the private sector. It has the unique capacity to spend without the constraint of a private firm on productive job creation, thereby increasing output, not just redistributing it. Just giving the pie firm a payroll tax cut on new hires is not going to generate more jobs. Rather giving it to all employees will lead to more pie sales. And the government can do that. Rather than decrying the government deficits, then, the President should be celebrating them as a form of economic salvation.

The problem obviously isn’t about money which a government can always create. The ultimate irony is that in order to somehow ‘save’ public funds for the future, as the President appears to be advocating, what we do is cut back on expenditures today, which does nothing but set our economy back and cause the growth of output and employment to decline. Worse yet, the great irony is that the first thing governments generally cut back on is education- the one thing the mainstream agrees should be done that actually helps our children 50 years down the road. Education cutbacks – as any Californian can tell you – are something that does hurt us, as well as harming our children AND our grandchildren down the road. This is the true “intergenerational theft”, not “runway” government spending.

Like many other people who embrace the nostrums of the Concord Coalition, the President continues to view government spending through a failed household budget analogy:

“There are certain core principles our families and businesses follow when they sit down to do their own budgets. They accept that they can’t get everything they want and focus on what they really need. They make tough decisions and sacrifice for their kids. They don’t spend what they don’t have, and they make do with what they’ve got.”

Yes, it’s true: If households spend more than their income now, they have to borrow. To pay the loan back they have to ensure that they can dedicate adequate income in the future, either by increasing incomes somehow or diverting existing income from consumption. If a household borrows too much, it will face major corrections in its balance of income and expenditure and consequently may have to seriously forgo spending later.

That is the logic that the users of the currency have to consider every day. They have to finance every $ they spend and so planning is required to ensure they don’t blow out their personal balance sheets. If all households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then private sector incomes and real output will decline absent an increase in government spending.

But it’s not the same for a government, as the President wrongly suggests, as the government is the creator of a currency. They can spend now. They can also spend later as well as service and pay back the debt without compromising anything. And a government, unlike a household or a private business, can choose to exact greater tax revenues by imposing new taxes or raising tax rates.

Notwithstanding the obvious reality that sovereign governments have no solvency risk because they create their own currency, most financial commentators (and the President’s own advisors) still waste their time talking about sovereign default risks and the President implicitly legitimizes this sort of talk when he talks about the need for government to embrace budgeting like a household does. This is what we presume he has in mind when he discusses the long term dangers of government deficits. Firms, households, and even state and local governments require income or borrowings in order to spend. But the federal government’s spending is not constrained by revenues or borrowing. It is constrained only by what our population chooses as national goals.

Suffice to say, we would all rather live in a world where profit prospects are so abundant that business investment spending is high enough to insure full employment given household preferences to save out of income flows. But historical and current experience suggests that is a rare configuration indeed. Ideally, that would be the business sector investing more than it retains in earnings. But in recent decades, such appears to only be the case during asset bubbles, and we know how that story ends. Alternatively, the foreign sector could deficit spend – the US could run a trade surplus. But the reality is US firms have chosen to reinvest in low cost production centers abroad (or would prefer to use free cash flow to engage in short run shareholder value maximization through various financial engineering efforts, including M&A) so the US based production structure no longer matches foreign demand very well. Ironically that leaves government fiscal deficit spending as the sole remaining mechanism to insure the freedom of its citizens to work hard for money.

The President, unfortunately, has yet to put the pieces of the puzzle together. He also fails to understand the idea that a government like the United States – i.e. one that issues a non-convertible sovereign currency (i.e. one the government doesn’t promise to convert into gold or other currencies at a fixed price) – can meet any and all outstanding financial obligations, provided the debts are denominated in its national currency. In this regard, the size of the national debt is irrelevant. This myth, and this myth alone, underpins arguments by orthodox economists against government activism in macroeconomic policy. The President does his Administration and the country no service by continuing to jump on this mythical bandwagon. Myth may constitute good grounds for literature, but is a horrible foundation for sound economic policy.

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Tagged Fiscal Policy, Government's IOU, Marshall Auerback, The Federal Government Deficit

“Deficit Terrorism Could Kill the Euro”

Posted on January 21, 2010 by admin | 2 comments

By Marshall Auerback *
Marshall Auerback has a proposal for how to save the euro – before it’s too late.

On more than a few occasions, we have discussed the insanity of self-imposed political constraints which limit the range of fiscal policy. As well as imparting a deflationary bias to an economy (and thereby preventing full employment), these kinds of constraints preclude the adoption of prompt counter-cyclical policy, which would otherwise cushion an economy when confronted with a genuine financial crisis, as we are experiencing today.

The constraints under which the US operates are more apparent than real. As we have discussed before, these constraints are largely based on 19th century gold standard concepts, which have no applicability in a fiat currency world. Tomorrow, if the US wanted to run a budget deficit equivalent to 20 per cent of GDP, it could do so, politics and demagoguery aside.

Such is clearly not the case in the euro zone.

There, countries like Spain, that have 20 per cent unemployment are being forced into further belt tightening. And the news just keeps getting worse: Expansion in Europe’s service and manufacturing industries unexpectedly slowed in January, adding to signs the pace of the economy’s recovery may weaken.

A composite index based on a survey of purchasing managers in both industries in the 16-nation euro region fell to 53.6 from 54.2 in December, London-based Markit Economics said today in an initial estimate. Economists expected an increase to 54.4, according to the median of 15 estimates in a Bloomberg survey. A reading above 50 indicates expansion.

The euro-region economy may lose momentum as the effect of government stimulus measures tapers off and rising unemployment erodes consumers’ willingness to spend. More significantly, the very viability of the currency is now being called into question even within the councils of the European Monetary Union (EMU), where fears of a euro breakup have reached the point where the European Central Bank (ECB) itself feels compelled to issue a legal analysis of what would happen if a country tried to leave monetary union.

A currency vaporizing before our very eyes! All for what? Some misguided anti-inflation fear? A desire to maintain the euro as a “store of value”? What’s the point of having a “store of value” in your pocket when you don’t have enough of it to buy anything because you’re unemployed?

We have long viewed the principles underlying Europe’s monetary union as profoundly misconceived. In particular, the so-called Stability and Growth Pact is economically flawed and politically illegitimate, given the power of unelected bureaucrats within the euro zone to ride roughshod over the clearly expressed preferences of national electorates. A law that governs economic decisions — yet is economically illiterate — cannot stand for long. It merely invites non-compliance and worse, as we are witnessing today. And the problem is not restricted to the so-called “PIIGS” countries (Portugal, Ireland, Italy, Greece and Spain). The larger — and wealthier — European economies however have never reduced their unemployment rates below 6 per cent and the average for the EMU since inception is 8.5 per cent (as at July 2009) and rising since. The average for the EMU nations from July 1990 to December 1998 (earliest MEI data for the EMU block available) was 9.7 per cent but that included the very drawn out 1991 recession. Underemployment throughout the EMU area is also rising , reaching 20% in Spain and double digits in Portugal, Italy, Ireland, and Greece.

Until now, the Eurocrats have either remained in denial about the mounting stress fractures within the system, or forced weaker countries to impose even greater fiscal austerity on their suffering populations, which has exacerbated the problems further. And there has been a complete lack of consistency of principle. When larger countries such as Germany and France routinely violated spending limits a few years ago, this was conveniently ignored (or papered over), in contrast to the vituperative criticism now being hurled at Greece. The EU’s repeated tendency to make ad hoc improvisations of EMU’s treaty provisions, rather than engaging in the hard job of reforming its flawed arrangements, are a function of a silly ideology which is neither grounded in political reality, nor economic logic. As a result, a political firestorm, which completely undermines the euro’s credibility, is potentially in the offing.

So what are the alternatives? Exit from the currency union would be the most logical, but also potentially the most economically and politically disruptive. As Professor Bill Mitchell notes, to exit the EMU a nation and regain currency sovereignty, the following changes would occur:

• The nation would have to introduce a new/old currency unit under monopoly issue. Within this currency the national government could purchase anything that was for sale in that currency including domestic unemployed labour.

• The central bank of the nation would receive a refund of the capital it contributed to the ECB.

• The central bank would also get all the foreign currency reserves that it moved over into the EMU system.

• The nation’s central bank would then regain control of monetary policy, which means it could set the interest rates along the yield curve and also add to bank reserves if needed.

There is clearly the additional problem of debt which is now denominated in euros, because, as Mitchell notes, the problem exists because the nation that wanted to exit would have to deal with a foreign currency debt burden, and might find itself involved in a painful adjustment process in which the departing nation is forced to experience a punitive negotiated settlement (unless of course it was able to engineer payment in the new local currency).

Personally, we think the whole euro zone system is an abomination and would prefer to see all euro zone states go back to national currencies and thereby get their respective economies back on track with renewed fiscal capacity. But there is also a short term expedient which might prove minimally disruptive to the European Monetary Union’s current political and institutional arrangements, but could well succeed in restoring growth and employment in the euro zone.

Within the euro zone, short of leaving, the most elegant adjustment mechanism is for the ECB to distribute 1 trillion euro to the national governments on a per capita basis, as our friend, Warren Mosler , has suggested. This proposal would operate along the lines of the revenue sharing proposals we recently advocated for the American states. The nation states of the euro zone would the instructions from European Council of Finance Minister (ECOFIN) and the ECB would then change the balances in all of the national member bank accounts, in effect increasing their assets, and thereby reducing debt as a percentage of GDP.

Within the euro zone, this sort of a proposal would likely give the respective EMU nations more bang for their respective euros, given the more elaborate social welfare programs in the EU. There would be less pressure to “reform” them (i.e., cut them back) if the EU nation states debt ratios are correspondingly lower and “compliant” within the bounds of the SGP.

The per capita criteria deployed here means that we are neither discussing a bailout per se of one individual country, and nor a ‘reward for bad behavior.’ All countries would receive funds from the ECB on a per capita basis, which means that Germany would, in fact, become the biggest beneficiary. The fact that all countries are in the euro zone means there’s no possibility of Germany losing competitive ground to Spain or other low wage countries. It would immediately adjust national govt. debt ratios substantially downward and ease credit fears.

If there is no undesired effect on aggregate demand/inflation/etc., which there should not be, given the prevailing high levels of unemployment in the euro zone, it can be repeated as desired until national government finances are enhanced to the point where they can all take local action to support aggregate demand as desired.

The proposal advanced is the most institutionally elegant solution because it maintains the current arrangements, as flawed as they are, and preserves the euro. Yes, a weaker euro would almost certainly result from this action. However, as “national solvency” is an issue for the euro countries (in a way that it is not for the US or Japan or the UK, given that the euro zone nation states are functionally more like American states than independent countries with their own freely floating non-convertible currencies), the resultant higher export growth that comes from a weaker euro is actually benign for everybody, as it minimizes the markets’ solvency concerns.

The formation of the European Union has been largely driven by the extremism of inter-European conflicts that caused millions of people to be slaughtered during two disastrous world wars. Ironically, the political and economic arrangements that have arisen in response to these horrors are creating a different kind of social devastation which is both wholly self-inflicted and profoundly misconceived. Europe’s very currency could well blow up. The US might well preserve its currency, but the EU’s current situation provides a salutary warning of what can happen in a system that prevents individual member’s from using fiscal policy to improve the circumstances of their citizens.

*This post was first published on New Dew 2.0

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President Obama: It’s Not Just The Words!

Posted on January 20, 2010 by admin | 2 comments

By Marshall Auerback

The post-mortems following the Massachusetts Senate by-election are coming in fast and furiously, but by far the most instructive remarks come from the President himself. He clearly doesn’t get it.

A majority of Obama voters who switched to Brown said that “Democratic policies were doing more to help Wall Street than Main Street.” A full 95 percent said the economy was important or very important when it came to deciding their vote. Surprise, surprise, policies do matter.

But what was the President’s reaction? ABC News reported, “President Obama said today that he feels he lost a direct connection to the American people in his first year in office because he focused too heavily on policy-making.”

“If there’s one thing that I regret this year is that we were so busy just getting stuff done and dealing with the immediate crises that were in front of us that I think we lost some of that sense of speaking directly to the American people about what their core values are and why we have to make sure those institutions are matching up with those values,” Obama told ABC News’ George Stephanopoulos in an exclusive interview at the White House.

The arrogance and presumption of the statement is remarkable. Mr. President, the American people have core values, and they don’t encompass political cronyism and tolerance of fraud and corruption. And they go beyond mere reminders that “change takes time”.

Having persuaded himself that his powers of oratory can solve any problem (even minus the teleprompter?), the President patronizingly suggests that his “change” policies were not the problem, but that he failed in the presentation of them. It’s more likely that people were profoundly upset that with the “stuff” that the President and Congress were getting done, and his failure adequately to address the immediate crises that he faced in his first year in office.

When Obama continued the Bush/Paulson moves on the bank bailouts, that was the beginning of the end of his “change” Presidency. Health care was simply the confirmation as large proportion of his base was prepared to cut him slack waiting to see what he would do with the issue. In the end, we got a terrible bill, and no amount of salesmanship or nice speeches will change the substance. It does not even deliver on the promise that got most people prepared to hold their collective noses and vote for it, that of eliminating the practice of rescinding policies on the basis of “pre-existing condition”. Read the bill. As Yves Smith has highlighted, it allows an out for fraud. Guess what? Not telling your insurer of a preexisting condition, EVEN ONE YOU DID NOT KNOW ABOUT, is fraud! Unbeknownst to most, fraud is the means under current law that insurers deny coverage. The bill preserves the status quo here. A nursing organization with 150,000 members opposed the bill for this very reason.
We have major problems in this country: rising unemployment, a stagnating economy, overly expensive health care and a large group of uninsured, which adds to the costs of the latter. How is further enriching insurers and Big Pharma (which the bill does) going to solve the cost problem? Similarly, how has throwing ample financial subsidies at Wall Street, helped the average citizen on Main Street?

The President expended so much political capital and goodwill placating the likes of Jamie Dimon and Lloyd Blankfein. Now that they’ve got their government checks, they can do whatever they like and continue to poison the polity. The health insurance and pharmaceutical industries have followed the playbook, and used the political process the same way.

I am sure there are some people angered by too much government spending (aka, “socialism”) and others who are genuinely peeved that Obama is not spending enough. But more than that, there remains a profound sense of anger, mixed with helplessness amongst most people. The only means by which these people can manifest this anger (without resorting to riots and burning buildings) is via the ballot box. They will likely continue to take it out on people perceived to be the “ins”, the main feeders at the trough, versus the “outs”, who have got nothing, but the promise of a lot more economic misery. Massachusetts was the first significant political manifestation of this trend, and if his immediate comments are anything to go by, I doubt Obama will interpret the election result correctly, since his faux populism and reliance on “speaking directly to the American people” merely shows how contrived his Administration has become.

President Obama is providing increasingly disturbing parallels with one of Robert Redford’s memorable characters, Bill McKay, from “The Candidate”. If you recall how that movie ended, McKay escapes the victory party and pulls Lucas into a room while throngs of journalists clamor outside. McKay then asks his political spin doctor, Marvin Lucas, who engineered the victory: “Marvin … What do we do now?” The media throng arrives to drag them out at that moment and McKay never receives an answer. Today’s electorate is waiting for an answer from the President which encapsulates something beyond a mere “change” slogan. Judging from the policies, they’ve been getting, they aren’t happy with the answers.

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Why Bernanke Must Go

Posted on December 20, 2009 by admin | 7 comments

By Marshall Auerback

There are any number of reasons why Ben Bernanke should not be reconfirmed, notwithstanding the vote in his favor by the Senate committee last week.

1. Let’s start by using some criteria laid out by Bernanke himself. When first nominated as chairman of the Federal Reserve, Mr. Bernanke promised a greater degree of transparency than his predecessor, but has completely stonewalled anybody seeking to obtain clarification of the events surrounding the credit crisis and more specifically, the role of the Federal Reserve. Any information disclosed would have facilitated a proper assessment of Bernanke’s job performance (which is probably one of the reasons the Fed chairman doesn’t want it released) and, more importantly, would have created a foundation for useful forensic work to prevent recurrences going forward.

Understanding what the decision-making was prior to and during the crisis is key to evaluating Bernanke’s performance and to improving performance in general. Post mortems are standard in sports and medicine. Why not here? And, more importantly, why does Bernanke continue to oppose it? Even the Swiss National Bank has provided a higher level of disclosure and transparency on the banking crisis to its public than has hitherto been agreed by the Bernanke Fed.

2. The Fed chairman claims unique expertise on the grounds of his scholarship of the Great Depression. Few have actually challenged him on the basis of these academic credentials, yet Bernanke holds these out as if they are manifest proof of his appropriateness for the position as head of the Federal Reserve. Ironically, even though Bernanke drew heavily on the work of both Milton Friedman and Anna Schwartz for his own scholarship of the period, Ms Schwartz herself has been enormously critical of the Fed’s conduct both pre-crisis and in seeing providing liquidity as the primary solution. She also warned explicitly against drawing comparisons between the gold standard era Depression and now. Additionally, Bernanke’s reading of the Depression (which is pretty conventional, that the Fed blew it by not providing more liquidity) ascribed little significance to fiscal policy, which has led Bernanke toward wrongheaded “solutions” such as “quantitative easing” and an alphabet soup of lending facilities, none of which did anything to enhance aggregate demand. Consistent with that, the Fed chairman been on the wrong side of fiscal policy, urging the Congress to balance the budget, at least longer term, which suggests that he learned nothing of the fiscal successes of the New Deal.

3. Bernanke’s consistent advocacy of “quantitative easing” perpetuates the silly notion that the Fed has had something to do with the economic “recovery” (a line which Time Magazine had readily embraced in its selection of the Fed Chairman as “Person of the Year”). He has ascribed little importance to the existence of the automatic stabilizers and indeed has persistently fed the misguided notion that the Federal government had limited fiscal resources.

The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. But as Bill Mitchell as pointed out, quantitative easing merely involves the central bank buying longer dated higher yielding bonds in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts: “[QE] is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates.” In the real world, the creation of a loan and (concurrently) a deposit by a bank are in no way constrained by the quantity of reserves. Instead, the terms set by the central bank for acquiring reserves (which then also affects the rates banks borrow at in money markets) affect a bank’s profit margin on a newly created loan. Thus, expanding its balance sheet can create a potential short position in reserves, and thus the profitability of newly created loans, not the bank’s ability to create the loan.

Banks, then, lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. Even the BIS recognizes this. Unfortunately our Federal Reserve chairman either does not know this (in which case his ignorance disqualifies him for another term in office) or he deliberately misrepresents the actual benefits of QE (duplicity being another good ground for disqualification for a 2nd term). The current incoherence of our economic policy making could diminish if we had a Fed chairman who understood the importance of fiscal policy, rather than one who downplays its significance. Which leads to point 4 below.

4. The Fed chairman continues to demonstrate a tremendous conceptual confusion at the heart of the current crisis, particularly in regard to the banking sector. He actively supported TARP on the grounds that repairing the banks balance sheets would somehow “unblock” credit flows and thereby enhance economic activity. The whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. This will never happen as long as this apologist for Wall Street remains head of the Fed. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by, amongst others, the Federal Reserve Chairman.

For all of these reasons, Bernanke must go.

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Obama’s New-Found Populism: All Hat, No Cattle

Posted on December 13, 2009 by admin | 5 comments

By Marshall Auerback

President Obama is taking a sharp, populist tone with Wall Street and scolding the ways of Washington as he once again looks to the Senate to follow the House and pass one of his top legislative priorities: sweeping financial regulatory reform. It might feel satisfying to hear the President criticize “reckless”, “fat cat” bankers, but the financial reform legislation passed by the House last Friday (and lauded by the President) provides little incentive to change their behavior. In reality populism, with nothing of substance behind it, is just cynical posturing designed to mask genuine failure. Like everything else with this President, he is again showing himself to be (to use an expression of his predecessor), all hat, no cattle.

Appealing to the peanut gallery at this stage is an insult to the voters’ intelligence. The current bill is yet another in a series of major disappointments. The most telling comment on the latest reforms came from the stock market: Bank stocks ended the day higher last Friday (when the House bill was passed to great fanfare), with the KBW Banks index slightly outperforming the benchmark Dow Jones industrial average.

At its most basic level, a bank is an entity that has a reserve account at the Fed, which makes loans and takes deposits. That is its primary public purpose, and we should not be allowing activities which undermine this central function, especially seeing as it is the government which guarantees the public’s deposits via the FDIC. (As an aside, even though the government creates all reserves and guarantees deposits, we do not want it to be directing lending activity because, as “Winterspeak” notes, “we do not want the Government to make credit decisions, they are too likely to dole out money to politically connected constituencies, while starving worthwhile, but unconnected borrowers”.

However good the political optics of resorting to name-calling and demonization of Wall Street, the legislation itself does nothing to recognize that the behavior criticized is a direct consequence of incentives built into the current institutional structure. It completely misses the point because it does nothing to ban activities which were at the heart of the crisis and which will likely be perpetuated as a consequence of the new legislation. All the new legislation does is institutionalize tax payer bailouts and, in so doing, continues the process of privatizing profits and socializing losses. There is no attempt to ban activities that were central to this crisis. The problem is that insolvent institutions have a habit of “betting the bank” through control fraud and the new legislation will not prevent this.

Even positive aspects of the bill, such as the establishment of the Consumer Financial Protection Agency, were significantly watered down. New Democrats – the people we used to call “Republicans” – won concessions that give federal regulators more scope to preempt state consumer-protection laws deemed to “significantly interfere with or materially impair a national bank’s ability to do business.” The change was sponsored by Congresswoman Melissa Bean, who is the most bought for and paid member (by bankers) in the House , not an inconsiderable political achievement amongst our current political profiles in courage in Congress. Bean justified the change on the basis of having, “robust national standards and enforcing them uniformly”, which sounds good until one considers the history of federal regulators, none of whom have historically moved when they plainly should have done so. How many federal regulators do you recall actually blocking the most egregious excesses in the mortgage market over the past 15 years? Preventing the states from moving proactively means that we will likely repeat the experience of the 1990s. Historically, the reform impetus has emanated from the states, not the Federal Government, Governor Eliot Spitzer’s administration being a prominent illustration.

More and more voters are beginning to believe this façade of reform is deliberate – a cynical act of kabuki theatre by the President to mask his own reticence to deal with the problem in an honest manner. It was clear to many of us that the President may not have been serious about reform when he picked Tim Geithner and Larry Summers as the leaders of his economic team a year ago, and essentially relegated any genuine progressive to the Cabinet equivalent of Siberia, as Matt Taibbi recently highlighted Yes, Summers and Geithner both have ample experience: but does that mean that they were qualified to take on the positions they were granted in the Administration? I suppose that depends on whether you think a doctor who botched your surgery ought to be given the role for the next one, simply because he has greater familiarity with your body than another surgeon.

Some on the left have attacked Taibbi very hard for the attacks on Obama, and Matt is no conservative. More importantly, he is correct: Taibbi calls the President for what he is, a sweet talking man who cannot fulfill one single promise he made to the public to get elected. So we have this incompetent financial reform bill, which will not place any limits on another systematic collapse. We have a health bill with no means of sensibly restraining cost pressures within the private health insurance industry. We are still fighting two wars, one of which is being escalated. The economy is still struggling and jobs are being lost.

Far easier to resort to cheap populism that actually do something about it. If the President were serious, he would be pointing out that the bankers have been undercutting every effort at reform, and have been paying off Congress to put loopholes into all legislation. If he were genuinely upset, he would be channeling the country’s anger constructively, by calling on the population to take to the streets in mass protests against Wall St with a view to shutting down the biggest banks and breaking their power once and for all. Of course the President would never do anything so “irresponsible”. Far better to throw a few bones to the peasants and hope that the appearance of reform pacifies them.

The economist Hyman Minsky argued that the Great Depression represented a failure of the small-government, laissez-faire economic model, while the New Deal promoted a Big Government/Big Bank highly successful model for capitalism. The current crisis just as convincingly represents a failure of the Big Government/Crony Capitalist model that promotes deregulation, reduced oversight, privatization, and consolidation of market power. Yet the very people, who have shredded the New Deal reforms and replaced them with self-supervision of markets, are the champions of today’s financial “reform”. As appealing as the story of Paul on the road to Damascus might be, there is no certainly no evidence of any Damascene conversion here amongst the policy makers of the Obama Administration. It’s business as usual, along with the championing of monetary and fiscal policy that is biased against maintenance of full employment and adequate growth to generate rising living standards for most Americans.

We must return to a more sensible model, with enhanced supervision of financial institutions and with a financial structure that promotes stability by aligning the banks’ activities with public purpose, rather than abetting speculation and then bailing the financial sector out after the fact. President Roosevelt proved that we could reform the financial system, rescue homeowners, and deal with the unemployed even as we mobilized and then fought World War II. By contrast, this is an Administration that defines reform as muddled compromise within a profoundly broken polity.

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Posted in Marshall Auerback, Policy and Reform, Uncategorized

Tagged Marshall Auerback, Policy and Reform

Should America Kowtow to China?

Posted on November 17, 2009 by admin | 3 comments

By Marshall Auerback
First Published on New Deal 2.0.

Do the Chinese really fund our deficit? Or is this more Neo-classical money mythology?

Another Presidential junket to Asia and another one of the usual lectures from China, decrying our “profligate ways”. Today’s Wall Street Journal reports:, “China’s top banking regulator issued a sharp critique of U.S. financial management only hours before President Barack Obama commenced his first visit to the Asian giant, highlighting economic and trade tensions that threaten to overshadow the trip.”

According to Liu Mingkang, chairman of the China Banking Regulatory Commission, a weak U.S. dollar and low U.S. interest rates had led to “massive speculation” that was inflating asset bubbles around the world. It has created “unavoidable risks for the recovery of the global economy, especially emerging economies,” Mr. Liu said. The situation is “seriously impacting global asset prices and encouraging speculation in stock and property markets.”

Well, “them’s fightin’ words”, as we say over here. And of course, the President and his advisors are supposed to accept this criticism mildly because in the words of the NY Times, the US has assumed “the role of profligate spender coming to pay his respects to his banker.”

The Times actually does believe this to be true. They refer to China’s role as America’s largest “creditor” as a “stark fact”. They do not seem to understand that simply because a country issuing debt which it creates, it does not depend on bond holders to “fund” anything. Bonds are simply a savings alternative to cash offered by the monetary authorities, as we shall seek to illustrate below.

It is less clear to us whether the Chinese actually believe this guff, or simply articulate it for public consumption. China has made a choice: for a variety of reasons, it has adopted an export-oriented growth strategy, and largely achieved this through closely managing its currency, the remnimbi, against the dollar.

One can query the choice, as many would argue that it is more economically and socially desirable for China to consume its own economic output. According to Professor Bill Mitchell, for example, “once the Chinese citizens rise up and demand more access to their own resources instead of flogging them off to the rest of the world…then the game will be up. They will stop accumulating financial assets in our currencies and we will find it harder to run [current account deficits] against them.”

But there have undoubtedly been certain benefits that have accrued to the Chinese as a consequence of this strategy. The export prices obtained by Chinese manufacturers are about 10 times as high as the prices obtained in the more competitive domestic markets, and the challenge of competing in global markets has forced Chinese manufacturers to adhere to higher quality standards. This, in turn, has improved the overall quality of Chinese products. In the words of James Galbraith:

“Is there a way for the Chinese manufacturing firm to turn a profit? Yes: the alternative to selling on the domestic market is to export. And export prices, even those paid at wholesale, must be multiples of those obtained at home. But the export market, however vast, is not unlimited, and it demands standards of quality that are not easily obtained by neophyte producers and would not ordinarily be demanded by Chinese consumers. Only a small fraction of Chinese firms can actually meet the standards. These standards must be learned and acquired by practice.” (”The Predator State, Ch. 6, “There is no such thing as free trade”, pg. 84).

What about the US government? What should it do? Should it actually respond to China’s complaints by trying to “defend the dollar”?

I hear this recommendation all of the time in the chatterplace of the financial markets, but seldom do those who fret about the dollar’s declining level actually suggest a concrete strategy to achieve the objective. In fact, it is unclear to me that there is any measure the Fed or Treasury could adopt which might support the dollar’s external value.

And why should they? Given the horrendous unemployment data, and 65% capacity utilization, it is hard to view imported inflationary pressures via a weaker dollar actually becoming a serious threat.

But wait? Don’t the Chinese (and other external creditors) “fund” our deficit? And won’t they demand a higher equilibrating interest rate in order to offset the declining value of their Treasury hoard?

Again, this displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, the Chinese, and other Treasury buyers, do not “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.

This claim is seldom challenged, but our friend, Warren Mosler, recently gave an excellent illustration of this fact in an interview with Mike Norman. Mosler provides a hypothetical example in which China decides to sell us a billion dollars’ worth of T-shirts. We buy a billion dollars’ worth of T-shirts from China:

“And the way we pay them is somebody pays China. And the money goes into their checking account at the Federal Reserve. Now, it’s called a reserve account because it’s the Federal Reserve, and they give it a fancy name. But it’s a checking account. So we get the T-shirts, and China gets $1 billion in their checking account. And that’s just a data entry. That’s just a one and some zeroes.

Whoever bought them gets a debit. You know, it might have been Disneyland or something. So we debit Disney’s account and then we credit China’s account.

In this situation, we’ve increased our trade deficit by $1 billion. But it’s not an imbalance. China would rather have the money than the T-shirts, or they wouldn’t have sent them. It’s voluntary. We’d rather have the T-shirts than the money, or we wouldn’t have bought them. It’s voluntary. So, when you just look at the numbers and say there’s a trade deficit, and it’s an imbalance, that’s not correct. That’s imbalance. It’s markets. That’s where all market participants are happy. Markets are cleared at that price.

Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, which is nothing more than a savings account. You give them money, you get it back with interest. If it’s a bank, you give them money, you get it back with interest. That’s what a savings account is.”

The example here clearly illustrates that bonds are a savings alternative which we offer to the Chinese manufacturer, not something which actually “funds” our government’s spending choices. It demonstrates that rates are exogenously determined by our central bank, not endogenously determined by the Chinese manufacturer who chooses to park his dollars in treasuries (credit demand, by contrast, is endogenous).

Here is how the mechanics actually work: government spending and lending adds reserves to the banking system because when the government spends, it electronically credits bank accounts.

By contrast, government taxing and security sales (i.e. sales of bonds) drain (subtract) reserves from the banking system. So when the government realizes a budget deficit (as is the case today), there is a net reserve add to the banking system, WHICH BRINGS RATES LOWER (not higher). That is, government deficit spending results in net credits to member bank reserves accounts. If these net credits lead to excess reserve positions, overnight interest rates will be bid down by the member banks with excess reserves to the interest rate paid on reserves by the central bank (currently .25% in the case of the US since the Fed started to pay interest on these reserves). If the central bank has a positive target for the overnight lending rate, either the central bank must pay interest on reserves or otherwise provide an interest bearing alternative to non interest bearing reserve accounts. But this is a choice determined by our central bank, not an external creditor.

Yet we are constantly being told by the financial press that the dollar’s weakness was supposed be the factor that would “force” the Fed to raise rates, since the Chinese supposedly “fund” our deficits.

So far, that thesis hasn’t been borne out. And it won’t be, because this isn’t how things operate in a post gold-standard world.

And a second and equally salient point: what would those who fret about the dollar, have the Fed do? Should they raise rates to defend it? It is unclear that this would work. The relationship between a given level of interest rates offered by the central bank and the external value of a currency is tenuous. Consider Japan as Exhibit A. The BOJ has been offering virtually free money for 15 years and yet the yen today remains a strong currency (much to the chagrin of the likes of Toyota or Sony).

Of course, higher rates can have an offsetting beneficial income impact (what Bernanke calls the “fiscal channel”), but it does not follow that a decision to raise rates would actually elevate the value of the dollar (and the benefits of higher rates from an income perspective could just as easily be achieved via lower taxation).

The reality is that private market participants could well view the move as something akin to a panicked response by the Fed, and the decision could well trigger additional capital flight, which could weaken the value of the dollar.

So it is unclear to me what the Tsy or Fed should be doing about the dollar. My view is that this is a private portfolio preference shift and I don’t think central banks should be responding to every vicissitude of changing market preferences. The US government should simply ignore the market chatter and idle threats from the Chinese and do nothing.

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Posted in Marshall Auerback, Taxes, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Marshall Auerback, Taxes, The Federal Government Deficit, The National Debt, The Trade Deficit

Happy Halloween: Pay Curbs Are a Trick on The Taxpayer, Not a Treat

Posted on October 25, 2009 by admin | Comments Off

By Marshall Auerback

How appropriate that with Halloween just around the corner, the Fed and Treasury have announced a coordinated effort that will put the central bank at the forefront of pay regulation on the zombie firms now kept alive courtesy of US government largesse. Trick or treat for the US taxpayer?

The new pay regulations are ostensibly designed try to align the financial incentives of managers with the longer-term performance of their firms. The Federal Reserve will have direct oversight over the pay of tens of thousands of executives, bankers, and traders. The oversight is being justified as a “safety and soundness issue”, according to Fed Chairman, Ben Bernanke.

Would that the Fed and Treasury had demonstrated similar concerns about the overheating housing market, the degeneration of lending standards, the proliferation of dangerous Over The Counter (OTC) derivatives during the past 10 years, areas where more aggressive moves by the nation’s central bank and the Treasury could have done much to alleviate today’s still profound financial instability.

This measure, by contrast, reeks of bogus populism. In the words of Reuters’ columnist, Jeffrey Cane:

By making executives at seven companies wear hair-shirts, some of the populist anger over bonuses and Wall Street may be assuaged — anger that should rightly be channeled into calls to prevent banks from engaging in risky activities. There’s no reason that banks that are back-stopped by the government should be in the securities business. Taxpayers — voters — should ignore the media fascination with pay and urge that Congress heavily regulate and tax such risky activities.

As Cane acknowledges, the curbs only apply to the newest wards of the state, the likes of AIG, Chrysler, GM, Bank of America, and Citibank. The more than 700 banks and other companies that have directly benefited from the government’s largesse are not affected — even those who are minting profits from credit markets propped up by trillions of dollars of the taxpayers’ money, and who continue to benefit from government largesse as a consequence of the FDIC guarantees of their commercial paper, which substantially reduced (subsidized?) borrowing costs at a time of uniquely high financial stress. And we’re still neither proposing any kind of serious regulation, nor any kind of resolution mechanism to deal with the problem of “too big to fail” banks.

The Fed has other big ideas: Federal Reserve Chairman Ben S. Bernanke has also called on Congress to ensure that the costs of closing down large financial institutions are borne by the industry instead of taxpayers. He has called for a “credible process” for imposing losses on the shareholders and creditors, saying “any resolution costs incurred by the government should be paid through an assessment on the financial industry.” That would be the very same financial industry that has already received trillions of dollars in financial guarantees and aid by the Federal Government, wouldn’t it? The left hand giveth, and the right hand taketh away. It’s all a big shell game. Given the absence of structural changes in the industry, this will simply increase the cost of credit, so the taxpayer will end up paying again.

What’s with the Fed’s newfound populism? It’s as if Ben Bernanke has started to channel his inner Huey Long. Well, there could well be other motivations at play here.

The Federal Reserve, as we know, is now under uncomfortably high public scrutiny and its hitherto secretive actions are being subject to the greatest degree of Congressional and press scrutiny that the institution has experienced in its 96 year history. True, in the 1970s, the then Chairman of the Committee of Financial Services, Henry Reuss, sought to challenge the constitutionality of the Federal Open Market Committee’s ultimate decision making power on monetary policy, but he was denied standing, so the Supreme Court never ruled on the issue. But now, like so many other things, the Fed’s privileged status in our society is again being queried, so a healthy dose of skepticism in regard to their actions is well merited.

And what of the Obama Administration itself? It demonstrates a similar kind of cognitive dissonance evinced by the Federal Reserve. Having left open the gates of the asylum, the President and his main economic advisors profess shock, (“shock!”) that the sociopaths who run our investment banks are back to their old tricks, daring to gamble in a totally uninhibited manner with the taxpayers’ dollars Those dollars, which have been all but guaranteed by Treasury Secretary Geithner, who promised that there would be “no more Lehmans”. The very same tax dollars now being deployed to lobby against financial reforms which will mitigate the practices that created the mess in the first place. The next time these same banks are likely to leave a catastrophe far scarier than any Halloween costume. Having been duped, the President now seeks to deploy a cheap political trick, attacking an easy political target, but as usual, doing nothing concrete to ameliorate credit conditions and, indeed, will likely act to increase the cost of credit.

Just over the weekend, the President again lambasted the banks for failing to enhance credit availability. During his weekly address, the President said banks should return the favor of their recent taxpayer-financed bailout by lending more money to small businesses. As a taxpayer, I don’t recall ever granting this “favor”, but that aside, the President still demonstrates huge conceptual confusion when it comes to the economy. Under the guidance of Larry Summers and Timmy Geithner, policy has continued to preserve the interests of big financial companies, rather than implementing government programs that directly sustain employment and restore states’ finances. To make matters worse, the Obama Administration remains preoccupied with how to “fund” these expenditures, since he claims we are “running out of money”.

All of which collectively will serve to cause incomes to stagnate, personal balance sheets to deteriorate, thereby diminishing creditworthiness. Repeat after me, Mr. President: “Enhance creditworthiness and improved credit conditions will follow; personal balance sheets before bank balance sheets.” You improve aggregate demand, and incomes will rise, as will the borrowers’ capacity to borrow. All of which makes it easier for lenders to lend. It’s so simple that even a banker can figure it out.

And here is why the whole model of securitization itself precludes improving credit conditions. In the words of L. Randall Wray and Eric Tymoigne,

When a commercial bank makes a loan, the loan officer wonders “how will I get repaid”. Because the loan is illiquid and will be held to maturity, it is the ability to repay that matters—and it is most prudent to rely on income flows rather than potential seizure and forced sale of the asset at some time in the possibly distant future and in unknown market conditions. On the other hand, when an investment bank makes a loan, the loan officer wonders “how will I sell this asset”. The future matters only to the degree that it enters the value of the asset today because it will be sold immediately. (“It isn’t Working: Time for More Radical Policies” http://www.levy.org/ )

And you can’t sell any securitized asset today.

It’s Halloween at the end of this week, so it wouldn’t be right to conclude this post without a bit of Halloween imagery. Last week, I described the bankers as vampires (with full tribute to Matt Taibbi and the banks as zombies. I have also noted (as has my colleague, Anat Shenker) the tendency of many deficit terrorists (many of whom the largest beneficiary so far of taxpayer bailouts, but who still claim we “can’t afford” to help the vast majority of Americans) to deploy imagery relating to our government spending as something unnatural or unhealthy. We hear characterizations of the budget deficit as a “national cancer” (former Illinois Senator, Paul Simon – http://www.moslereconomics.com/mandatory-readings/soft-currency-economics ), or government spending as something akin to a heroin addiction (a description I heard last week at a Financial Forum in Denver, Colorado). True to my love of Hammer Film horror classics, I prefer a different image to describe our government spending. It’s a necessary blood transfusion, without which the patient (in this case, the US economy) dies.

But like any blood transfusion, you want to give it to a sick patient who has a chance to get better, not a terminally ill one (i.e. like our TBTF banks), who are being propped up by phony accounting (what we might call a life support system, where the government steadfastly refuses to pull the plug). Unfortunately, these “blood transfusions” have hitherto been misallocated. No amount of populist grandstanding by the President or the Fed can change that. The aid conferred to the banks is like using our blood to feed vampires, who in turn prey on the rest of us, rather than people who could genuinely use a transfusion to recover their (economic) health. By the same token, introducing pay restrictions on the likes of AIG, BofA, or Citi, is akin to complaining about the quality of the clothing being worn by the zombies as they rampage and munch away on the living. Happy Halloween everybody.

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How a Financial Balances Approach Can Keep Wall Street Honest

Posted on October 19, 2009 by admin | 1 comment

By Marshall Auerback

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

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

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

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

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

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

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

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

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

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

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

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

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

On balance, since I tend to share many of the gloomier predictions of the SocGen crowd (albeit for different reasons), I would be inclined to construct an investment portfolio geared toward deflation and Japanese style stagnation, as opposed to inflation and surprisingly high GDP growth. Obviously, I don’t tend to share the belief expressed by certain members of the Federal Reserve that a 10% official unemployment rate might be the “natural rate” in the US. The upshot is that a portfolio that has lots of 5 year treasuries, gold, some Norwegian Krona (although I’m not sure what happens to the Krona if the euro comes under a lot of strain) and stuff like natural gas stocks, and probably countries which own a lot of natural gas like Canada seem eminently rational to me. Natural gas is the perfect transitional green tech fuel. Not as sexy as solar or wind, but way more economic and a realistic alternative (Al Gore doesn’t seem to understand the laws of basic thermodynamics). My friend, Robert Bryce ), (author of “Gusher of Lies: The Dangerous Delusions of ‘Energy Independence’) is writing a new follow-up book on this theme and and basically comes out with a “natural gas to nuclear” proposal, which is probably right if we’re serious about clean energy and less dependence on Middle Eastern oil (although I have my doubts about whether the latter is feasible, given oil’s fungibility). At the very least, it’s a more intelligent proposal than the Obama Administration’s horrible “cap and trade” policy, another boondoggle to Wall Street to ensure that our environmental policies are financialised as well.

Keeping on this theme, one other conspicuous omission by SocGen (surprising, given that it’s a French bank): nuclear energy related and uranium stocks. When the next market downdraft comes I’d load up on these types of companies as well, although tactically it’s probably advisable to start buying 5 year Treasuries now on the basis that I think the dollar is very oversold and, equally significant, oversold for the wrong reasons (i.e. the US is “going broke” and we’ll have to raise rates “to attract funding from the foreigners”). Of course if the stock market tanks (as I suspect it might soon given that the thrust of US policy has been great for banks and disastrous for everybody else) bonds could start doing well much sooner. In any event, given the extent to which we have hitherto misallocated our fiscal resources (virtually ensuring no growth surprise to the upside in my opinion), I’d much rather own bonds than stocks over the next 12 months. As I said earlier, US national solvency is not an issue.One final point. For those of you who think that a gold standard system of some form would create “honest money” I would recommend that you read a paper from Marc Lavoie from the University of Ottawa (“Credit, Interest Rates and the Open Economy”, Essays on Horizontalism, Ch. 10, “The Reflux Mechanism and the Open Economy”, Marc Lavoie, Edward Elgar Publishing, 2001) The paper highlights that when looking at year to year changes in the period before the First World War – the heyday of the gold standard – the foreign assets and domestic assets of central banks moved in opposite directions 60 per cent of the time. Foreign assets and domestic assets moved in the same direction only 34 per cent of the time for the 11 central banks under consideration. The prevalence of a negative correlation therefore demonstrates that the so-called Rules of the Game were violated more often than not, even during the heyday of the gold standard. Indeed, according to A.I. Bloomfield (“Monetary History under the International Gold Standard: 1880-1914″, Federal Reserve Bank of New York, 1959),”In the case of every central bank, the year-to-year changes in international and domestic assets were more often in the opposite than in the same direction.” To state the obvious, the “honest money” types believe that inflation is theft from savers, and by implication, anyone who is not for “sound” money is a pinko favoring redistribution. It’s a class warfare posture in disguise. But among the many disingenuous (or just plain wrong) aspects of their argument is that they contend that sound money = no inflation, meaning price stability. This essay by Marc explodes that myth. As anyone who has looked at the record knows, inflation was highly variable during the gold standard years, swinging from deflation to inflation, and in not trivial amounts to boot.

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Schwarznegger to Obama: Watch and Learn

Posted on July 12, 2009 by admin | 14 comments

By Marshall Auerback

According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU’s acceptable as payment of state taxes, it instantly imparts value to them (see here and here). In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it, and as they do so, some of the true nature of contemporary money is being revealed. It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements.

Contrary to most conventional economic thought, whereby people think we pay taxes to create revenue, in fact, it works the other way around under a fiat currency system. The government doesn’t need money to spend, but in fact uses tax to manipulate aggregate demand, not raise funds to “pay” for government. The tax is what gives the currency its value insofar as taxes function to create the demand for federal expenditures of fiat money, not to raise revenue per se. Value has been given to the money by requiring it to be used to fulfill a tax obligation, but the money is already in existence, not “created” by the revenue.

Most significantly, the Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications. It certainly means considerably less muni bond issuance in the first instance, if the proposal passes constitutional muster.

It will be interesting to see what the exchange rate is between California IOU and US currency – the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

This is like some sort of return to the 13 colonies with all kinds of ersatz currency floating about. It’s hard to believe the Rubinite wing of the Democrats will just let it be, given the threat it represents to Wall Street’s prevailing economic interests, but it is an understandable response to a federal government which continues to champion the interests of the rentier class above the vast majority of Americans by emphasizing “fiscal sustainability” and destroying aggregate demand in the process.

There are political benefits for Obama, as Mike Norman has noted, to rid himself of the shackles of conventional (and wrongheaded) economic thinking: If the Federal government allows this proposal of the state of California to go unchallenged, it would relieve the President of a major political quandary, which is, does he help California and then open himself to aid requests from other states? (Which his advisor, David Axelrod doesn’t want), or, does he let California go and lose 56 electoral votes in the next election?

By allowing them to “solve” their own problem in the manner proposed by the legislation he avoids the quandary. And given that, from a money paradigm at least, he and his team probably don’t know how destabilizing (to the current system) this is, they just might let them do it until the import is fully understood.
It is true that this legislation represents a profound break from all federal laws. It is almost bound to incur some sort of constitutional challenge, representing as it does, a profound threat to the Federal government’s currency monopoly powers. But this is another instance where Obama’s inattentiveness to the ramifications of the states’ respective fiscal crises has come back to haunt him. This situation would not have arisen had Obama embraced a simple revenue sharing plan with the states (so that the states’ respective fiscal policies would be working in harmony with his proposals, rather than mitigating the impact of the Federal fiscal stimulus), as recommended by any number of prominent economists, such as James K. Galbraith of the University of Texas.

It will be interesting to see how this plays out. As California goes, will the nation follow? Will we ultimately be confronted with the spectacle of “President Schwarzenegger” trying to legalize the drug output of the Emerald Triangle so he can tax it, thereby enabling us to shut the borders on the rest of this mess? Arnold always wanted to be President, but Constitution would need to be changed. Maybe this is his path to President of the 8th largest nation?