Category Archives: Policy and Reform

A thorough investigation of the financial collapse

The original Pecora investigation documented the causes of the economic collapse that led to the Great Depression. It was named after Ferdinand Pecora, lead counsel for the Senate Banking and Currency Committee investigation, whose inquiries established that conflicts of interest and fraud were common among elite finance and government officials.

The Pecora investigations provided the factual basis that produced a consensus that the financial system and political allies were corrupt. They did not divide the nation or divert its response to the economic crisis. The investigations discredited the elites that benefited from that system and were blocking reform. By identifying the most acute problems, Pecora provided the basis for Congress to draft specific legislation that restored public confidence in the financial markets and helped honest bankers. This staved off future crises in the U.S. for 45 years until the protections were removed by deregulation and desupervision.

The Pecora investigation teaches us how to create a successful investigation that can provide the basis for the fundamental reforms necessary to protect the nation from future economic collapses. Pecora was a prosecutor in New York that had brought cases against “bucket shops” (fraudulent sellers of securities) and corrupt politicians (primarily Democrats). He was not a financial specialist. These are the key factors that made Pecora successful and that need to replicated today:

Leadership and accountability

Pecora lead the investigation and conducted the questioning. There was no “bipartisan” fiction or friction: Pecora was in charge. A professional with expertise in investigations must conduct the questioning, as members of Congress cannot do so effectively. Pecora picked his aides, not Congress.
Pecora was non-partisan and known to be non-partisan.
Pecora was fearless.
Pecora was relentless and confrontational.
President Roosevelt personally and strongly supported Pecora.

Power

The broadest subpoena authority is essential.
No one, and no subject, is off limits to the investigation.
No special treatment for elites. Everyone testifies under oath.
No time limits that will encourage the subjects of the investigation and their political allies to stall. Pick a top investigator that wants to get the work done effectively and promptly but is willing to commit to stay as long as at takes to conduct a thorough investigation.
Conduct hearings that do not permit interference by witnesses’ counsel. Counsel can obstruct an investigative hearing if they are not limited to their proper role in such a setting (where evidentiary rules are not at issue). Witness counsel’s function at such a hearing is to advise their client as to whether they should assert their Fifth Amendment right against self-incrimination. Their function is not to make statements, ask purportedly clarifying questions, or assert objections. The Committee members must back up the new Pecora (and, of course, avoid similar interventions of their own that would disrupt the questioning). In this era, this will require tremendous, non-partisan self-restraint by Committee members.

Resources

Ample budget appropriated for multiple years. This must be done so that opponents of the investigation cannot impede it through the appropriations process


No political limits on how that budget can be used. No limits on the number of staff that can be hired.

Time to Foreclose the Mortgage Companies

One thing that puzzles many people is how on earth could a relatively small problem with subprime mortgage loans in America have generated a global financial and economic calamity that is already (arguably) rivaling the Great Depression of the 1930s. After all, the total residential mortgage backed securities universe was only $7.1 trillion at its peak, of which just $1.3 trillion were subprimes. Other asset-backed securities were $2.5 trillion, with home equity loans amounting to $600 billion of that. Yes these are big numbers, but US home values were worth $20 trillion. If real estate prices fell by 30%, values would still be worth twice as much as the securities based on homes. And even if defaults reached 50% on subprime loans, it would appear that losses on the securities that used them as collateral could not amount to much more than a hill of beans ($650 billion of defaults, of which 70% is recovered through sale of the home generates losses of less than half a trillion). Even if we add losses on Alt A’s and prime mortgages, plus home equity loans, how could banks have already lost many trillions of dollars, requiring a federal government commitment of $23 trillion to try to resolve the crisis?

Here are three answers offered in partial explanation:

1. In the right conditions, a relatively small perturbation can generate huge fluctuations—like the flapping of a butterfly’s wings in India that creates a tornado in Kansas. Many point to the 1929 stock market crash as the trigger that began the Great Depression because speculators had to meet margin calls, thus, began to sell assets and default on liabilities. Yet, as John Kenneth Galbraith argues in his “The Great Crash”, the total number of players in that stock market boom could not have been a million people. It was the fragile condition of the entire financial system (and of the economy itself, in part due to a grossly unequal distribution of income) that allowed the crash to trigger a depression. As Hyman Minsky argued, over the entire postwar period, the US and even the Global financial system were evolving toward fragility, making “it” (another great debt deflation) possible. The trigger happened to be subprimes, but there were any number of other possibilities waiting to happen. Add onto that a distribution of income that is as bad as it was in 1929 and you have a recipe for disaster.

2. That leads to the second point: the problem was not just with subprimes. All kinds of debts—including those associated with other kinds of mortgages, with commercial real estate, with credit cards, with auto finance, with small business loans, and so on—were structured in a similar manner. To put it bluntly, much of the finance was “Ponzi”—pyramid schemes that make Bernie Madoff look like a piker. As soon as asset prices stopped rising, the pyramid collapsed—so the losses are across all asset classes, and all over the globe.

3. The same financial institutions that created this mess are preventing resolution because it is far more profitable for them to ride out the collapse. They made money hand over fist on the way up, and plan to continue to do so as they drive the economy to hell. Much of the profits are illusory or are provided by government handouts. But there is real money to be made squeezing debtors, as reported in today’s NYT.

Let me give just one example, based on that NYT article and some research done by UBS (UBS Investment Research. 2007. “Investment Strategist” Digital newsletter, November 27). Keep in mind that when we destroyed the thrifts in the 1980s, we transitioned to a new “market-based” home finance model that involves independent mortgage brokers, property appraisers, risk raters, title companies, mortgage insurers, credit default swap sellers, mortgage servicers, securitizers, accounting firms, commercial banks, investment banks, and pension funds and other managed money that hold the securities. In this “originate to distribute” model, almost all concerned live on fee income rather than on the interest and principal payments of homeowners (which service the securities). Of course, this is part of the reason that no one ever bothered to check whether the homeowner would actually be able to make the mortgage payments.

It is also the reason that almost no one in the home finance food chain cares about resolving the home mortgage crisis—it is far more profitable to most concerned parties if the homeowner cannot and does not make any payment. When the homeowner stops making payments, the mortgage company that services the loan makes the payments that are then distributed to the securities holders. In return, the mortgage company collects its normal servicing fee, plus late fees of 6% of the monthly payment. As the NYT reports, these late fees alone can amount to 12% of the total revenue received by loan servicers. (Of course, it is no different in the video rental business or in the credit card business—better late than on time!) It is in the interest of the mortgage companies to maximize the number of delinquencies as well as the amount of time each household is delinquent.

When a house is finally foreclosed, the mortgage servicer has first dibs on the revenue from sale of the house. According to the UBS study, foreclosure can take up to two years (depending on the state and on complications) and total costs—including paying off the servicer—can eat up 90% of the revenue from the home sale. This is why the total losses on home mortgages (absorbed mostly by the securities holders) are so huge even if home values fall by “only” 30%.

As the NYT reports, these mortgage companies actively interfere to ensure that homeowners are not able to renegotiate terms of mortgages instead of going into foreclosure. They prefer a “purgatory—neither taking control of houses and selling them, nor modifying loans to give homeowners a break.” When the foreclosure proceeds, the mortgage companies not only accumulates late fees, but also pay for many other services– often to their own subsidiaries–such as title searches, insurance policies, appraisals, and legal findings. That is all recouped with the property sale. This explains why none of the government policies to date have been able to keep people in their homes by negotiating better mortgages. Indeed, even though the government is trying to bribe mortgage companies with $4000 to modify a loan, they make more money if they drive the owner out of the home. Ideally, they will accumulate claims on the house up to the total market value!

It is time to foreclose on the mortgage companies. As I have explained before, we ought to adopt the plan proposed by Warren Mosler and Dean Baker: allow people to stay in their homes, paying fair market rent. Put the homes through a simple and quick foreclosure with the government standing ready to buy the houses at either current market value or at the value of the outstanding mortgage (whichever is less). The former owners would then have first right of refusal to repurchase the home in two years, at market value and with good mortgage terms. We also need to get back to a more sensible home finance system, based on simple mortgages that are held to maturity by lenders, and with far fewer fees. That means shutting most players out of the home finance business.

A similar story can be told for other sectors, where parasitic financial market participants are making out like bandits (yesterday I discussed Black Rock’s new scheme to bilk investors by selling them the toxic waste Wall Street doesn’t want). Washington is facilitating this by contracting with the same firms that caused the crisis to deal with the fall-out. The longer and deeper the crisis, the more money there is to be made. As long as Wall Street runs government, do not expect resolution.

Your Cash for Trash Redux

By L. Randall Wray

The Money Managers have come up with a new way to lose your money. Recall that Wall Street banks are sitting on, perhaps, a gazillion dollars worth of trash assets, and that our government has so far lent, spent, or provided guarantees to them in an amount recently calculated at $23.7 trillion.) A big chunk of the government’s largesse has gone to provide much deserved bonuses to the geniuses who have so far lost forty or fifty percent of the value of your pension. Wall Street knows that makes you angry. You have only experienced the downside costs of an economy run by and for the money managers: you lost your pension, your job, and your house.

So here is what Black Rock proposes to do for you: it will let you buy into a new fund that will purchase garbage assets from Wall Street. The federal government will kick in some more money to capitalize the fund (that way Black Rock won’t need to put its own money at risk). If the trash then sends out some green shoots, you win twice: once as a taxpayer with capital at risk and once as an investor with your remaining life’s savings at risk. Please don’t think about the alternative scenario, in which your trash assets continue to rot on the vine. Wall Street is optimistic and you ought to be, too. Its bankers will sleep a whole lot better if you would just buy the assets they do not want to hold.

After all, what is good for Wall Street is good for you. Isn’t it?

The government still has to approve Black Rock’s plan. But that should be a done deal because no firm save Goldman Sachs is so well connected to Washington. As reported in today’s NYT, those two firms essentially controlled the Federal Pension Benefit Guarantee Corporation when it was headed by Charles Millard—who is now being investigated for improper conduct. Black Rock was pretty confident it would get a contract to invest PGBC funds in toxic waste: “It sounds like we may have a tiger by the tail here,” one Black Rock executive purred in an e-mail message, referring to Millard. Not to be outdone with metaphors, another Black Rock executive wrote, “This is a very big fish on the line.” Even as Millard was rewarding Goldman and Black Rock with the lucrative contracts they expected, he was looking for jobs with the firms. On one hand, it is comforting to learn that it is not just Goldman that benefits from what James Galbraith calls our Predator State. On the other, as Arianna Huffington says, it is yet another example of more pigs at the government trough.

Now, that is the real swine flu we ought to be worried about—a pestilence that some years from now will be remembered as the worst scandal in human history. Assuming that we can somehow wrest control of our government and our economy from the clutches of Wall Street so that there will be a future from which we can look back to the past with amazement.

An Interview with Prof. L. Randall Wray

1- Historically, it seems the financial capital has a second wave from the 1970s. Peter Drucker referred the Pension Fund Revolution of the 1970s but it seems we have a convergence of trends, beginning with the closing of the gold window with Nixon and the progressive growing of a rent-seeking system gaining hegemony in the developed countries. Which fact or clustering of facts do you think are more symbolic of this shift?

Early last century, Hilferding identified a new stage of capitalism characterized by complex financial relations and domination of industry by finance. He argued the most characteristic features of finance capitalism is rising concentration which, on the one hand, eliminates ‘free competition’ through the formation of cartels and trusts, and on the other, brings bank and industrial capital into an ever more intertwined relationship. Veblen, Keynes, and, later, Minsky also recognized this new stage of capitalism: for Keynes, it represented the domination of speculation over enterprise while Veblen distinguished between industrial and pecuniary pursuits. Veblen, in particular, argued that modern crises can be attributed to the “sabotage of production” (or “conscientious withdrawal of efficiency”) by the “captains of industry”.

Much of this description of the finance capitalism stage can be applied to the current phase of capitalism—the money manager stage. Indeed, the intervening years, from the New Deal until the early 1970s, should be seen as an aberration. That phase of capitalism was unusually quiescent—the era of John Kenneth Galbraith’s “New Industrial State”, when the interests of managers were more consistent with the public interest. Unfortunately, the stability was interpreted to validate the orthodox belief that market processes are naturally stable—that results would be even better if constraints were relaxed. As New Deal institutions (broadly defined) were weakened, a new form of finance capitalism came to dominate the US and global economies. This is what Minsky called money manager capitalism—and what I am arguing is simply a return to finance capitalism. Finance capitalism is the normal version of modern capitalism. The Golden Age of capitalism was not normal.

2- Most of the analysts refer to a neo-liberalism approach dominant from the emergence of the monetarist school. But it seems – particularly since the end of the 1980s – that this second wave of the financial capital was driven by a “mix” of neo-keynesian and monetarist thoughts, an interesting new species in economic and financial though and ideology, whose “agent” of excellence was the Maestro Mr Greenspan. The acceleration of this second financial wave is “transversal” to Reagan and Clinton, to rightwing and left. Particularly at the end of Clinton Administration we saw the most important reversal of the legislative heritage from the 1930s. From a political-economic angle how we can deal with this “anomaly”?

In his new book, James K. Galbraith synthesizes Veblen’s notion of the predator with John Kenneth Galbraith’s new industrial state. The result is what the younger Galbraith terms the predator state. He argues the “industrial state”—related to Minsky’s notion of paternalistic capitalism– has been replaced by a predator state, whose purpose is to empower a high plutocracy that operates in its own interests. I link the Veblen/Galbraith notion of predators to the take-over of the state apparatus in the interest of money managers by neoconservatives (or what are called neoliberals outside the US). I wrote a piece on the neoconservatives, available as:
Public Policy Briefs August 2005 The Ownership Society Public Policy Brief No. 82, 2005, www.levy.org

Yes, I do agree that monetary policy was guided by a “new monetary consensus” that combined elements of monetarism, the old ISLM approach of “bastard” Keynesians, and the so-called New Keynesian approach. It supposedly put policy in the hands of the central bank and downplayed fiscal policy. I wrote about that in a brief available as:
Public Policy Briefs December 2004 The Fed and the New Monetary Consensus Public Policy Brief No. 80, 2004, www.levy.org

In reality, fiscal policy was still used, but in the interests of money managers. And now we know that the new monetary consensus policy never really worked. Monetary policy is in complete disarray.

3- Most of these “heroes” of the money manager capitalism, like Greenspan or Bernanke, thought that policies, particularly monetary manipulation and a growing rent-seeking system, can “moderate” the business or even the long cycles and that continuous growth was the perpetual horizon. This high qualified people has a weak memory from history?

Obviously, it was purely fantasy: the belief that the central bank can fine-tune the economy merely by controlling expectations of inflation. The central bank cannot control expecations, and it cannot control inflation. And, as everyone now recognizes, monetary policy has very little impact on the economy. That is why we have turned to fiscal policy. See my piece:
Public Policy Briefs March 2009 The Return of Big Government: Policy Advice for President Obama Public Policy Brief No. 99, 2009, www.levy.org

4- Which was the “Minsky moment” that triggered the present crisis? Which fact will you choose in 2007 to mark the bust of this crisis?

Hyman Minsky’s work has enjoyed unprecedented interest, with many calling this the “Minsky Moment” or “Minsky Crisis”. I am glad that Minsky is getting the recognition he deserves, but we should not view this as a “moment” that can be traced to recent developments. Rather, as Minsky had been arguing for nearly fifty years, what we have seen is a slow transformation of the financial system toward fragility. It is essential to recognize that we have had a long series of crises, and the trend has been toward more severe and more frequent crises: REITs in the early 1970s; LDC debt in the early 1980s; commercial real estate, junk bonds and the thrift crisis in the US (with banking crises in many other nations) in the 1980s; stock market crashes in 1987 and again in 2000 with the Dot-com bust; the Japanese meltdown from the early 1980s; LTCM, the Russian default and Asian debt crises in the late 1990s; and so on. Until the current crisis, each of these was resolved (some more painfully than others; one could argue that Japan never successfully resolved its crisis) with some combination of central bank or international institution (IMF, World Bank) intervention plus a fiscal rescue (often taking the form of US Treasury spending of last resort to prop up the US economy to maintain imports).

Minsky always insisted that there are two essential propositions of his “financial instability hypothesis”. The first is that there are two financing “regimes”—one that is consistent with stability and the other in which the economy is subject to instability. The second proposition is that “stability is destabilizing”, so that endogenous processes will tend to move a stable system toward fragility. While Minsky is best-known for his analysis of the crisis, he argued that the strongest force in a modern capitalist economy operates in the other direction—toward an unconstrained speculative boom. The current crisis is a natural outcome of these processes—an unsustainable explosion of real estate prices, mortgage debt and leveraged positions in collateralized securities in conjunction with a similarly unsustainable explosion of commodities prices. Unlike some popular explanations of the causes of the meltdown, Minsky would not blame “irrational exuberance” or “manias” or “bubbles”. Those who had been caught up in the boom behaved “rationally” at least according to the “model of the model” they had developed to guide their behavior.

Following Hyman Minsky, I blame money manager capitalism—the economic system characterized by highly leveraged funds seeking maximum returns in an environment that systematically under-prices risk. See my piece:
Public Policy Briefs April 2008 Financial Markets Meltdown Public Policy Brief No. 94, 2008, www.levy.org

With little regulation or supervision of financial institutions, money managers have concocted increasingly esoteric instruments that quickly spread around the world. Contrary to economic theory, markets generate perverse incentives for excess risk, punishing the timid. Those playing along are rewarded with high returns because highly leveraged funding drives up prices for the underlying assets—whether they are dot-com stocks, Las Vegas homes, or corn futures. Since each subsequent bust only wipes out a portion of the managed money, a new boom inevitably rises. However, this current crisis is probably so severe that it will not only destroy a considerable part of the managed money, but it has already thoroughly discredited the money managers. Right now, it seems unlikely that “business as usual” will return. Perhaps this will prove to be the end of this stage of capitalism—the money manager phase. Of course, it is too early to even speculate on the form capitalism will take.

5- Basle is obsolete?

Basle helped the money managers to create the conditions that led to collapse. I actually wrote in late 2005 that Basle II would generate financial fragility, and presented a paper in Brazil making that argument. It was published by the Levy Institute as:

Public Policy Briefs May 2006 Can Basel II Enhance Financial Stability? Public Policy Brief No. 84, 2006, www.levy.org

And it was also published in Portuguese in Brazil. Basle requirements operated on the belief that higher capital ratios would reduce risk; and further that greater market efficiency could be achieved by adjusting those ratios based on the riskiness of assets purchased. And, finally, it was believed that “markets” are best able to assess risk. In practice, larger institutions were allowed to asses the riskiness of their assets. We now know that failed completely—because all the incentive was for institutions to underestimate risks.

We must recognize, as Minsky did, that banking is a profit-seeking business that is based on very high leverage ratios. Further, banks serve an important public purpose and thus are rewarded with access to the lender of last resort and to government guarantees. What this means is that as soon as capital ratios decline toward some minimum (zero in the case of an institution subject only to market discipline, or some positive number set by government supervisors as the point at which they take-over the institution), management will “bet the bank” by seeking the maximum, risky, return permitted by supervisors. In any event, there is always an incentive to increase leverage ratios to improve return on equity. Given that banks can finance their positions in earning assets by issuing government-guaranteed liabilities, at a capital ratio of 5% for every $100 they gamble, only $5 is their own and $95 is the government’s. In the worst case, they lose $5 of their own money; but if their gamble wins, they keep all the profit. Imagine if you walked into a casino and the government gave you $95 to gamble with, for every $5 of your own—and you get to keep all the winnings. What would you do? Gamble! If subjected only to market forces, profit-seeking behavior would be subject to many, and frequently spectacular, bank failures. The odds are even more in their favor if government adopts a “too big to fail” strategy—although exactly how government chooses to rescue institutions will determine the value of that “put” to the bank’s owners.

Note that while the Basle agreements were supposed to increase capital requirements, the ratios were never high enough to make a real difference, and the insitutions were allowed to assess the riskiness of their assets for the purposes of calculating risk-adjusted capital ratios. If anything, the Basle agreements contributed to the financial fragility that resulted in the global collapse of the financial system. Effective capital requirement would have to be very much higher, and if they are risk-adjusted, the risk assessment must be done at arms-length by neutral parties. I think that if we are not going to closely regulate financial institutions, capital requirements need to be very high—maybe 100%. We used to have “double indemnity”: owners of banks were personally liable for twice as much as the bank lost. That, plus prison terms, would perhaps give the proper incentives.

6- Do you think we need a strict regulation of the financialisation of commodity markets (particularly oil) as Sarkozy, Gordon and the US regulator claimed, or this is a window for non-commercial investors that came to stay?

As implied above, any institution that has explicit or implicit government guarantees—either through deposit insurance or “too big to fail” policy absolutely must be closely regulated.

7- Do you think the sovereign wealth funds and the Asian banks from high liquidity countries (now the 3 top banks in capitalization are Chinese) will be dragged down by the crisis or they can lead a new financial capital wave?

No, I do not think they will lead a new financial wave over the next few years. There is little doubt that the Chinese economy will continue to become important and in the near future will displace the US economy as the largest in the world. It is certainly possible that its currency will eventually displace the dollar as the global reserve currency–but I think that is a long way off. I do not think it is even a role that the Chinese authorities would want right now. Finally, China uses markets where they work, but happily intervenes where markets do not fulfill the public purpose as defined by the government. Hence, I do not believe they would let their own domestic money managers “run wild” in the same way that the more market-oriented (neo-liberal) governments have done. After all, the Premier of China has no fear of being labeled a “socialist”–unlike President Obama!

Obviously, global financial losses are already huge, and will grow much larger over the coming years. Only the debt of sovereign nations is safe. Again, I hope, and expect, that we are seeing an end to this phase of finance capitalism. It will, of course, rise again—eventually. But with proper responses by governments around the world, we might be able to develop the conditions necessary for another “golden age”. Still, as Minsky said, stability is destabilizing so a golden age will allow finance capital to return. There is no “final solution” to the fundamental flaws of capitalism: an arbitrary and excessively unequal distribution of income and wealth, an inability to generate full employment, and a propensity toward financial instability.

A Third Stimulus Package and Job Creation

Our own L. Randall Wray and Lawrence Mishel say that additional stimulus is needed to create jobs immediately.

http://www.reuters.com/resources/flash/include_video.swf?edition=US&videoId=108026

Read more here, here, here, and here.

Washington Finally Proposes Real Help to Deal with Foreclosures

By L. Randall Wray

The Washington Post reported on Friday that Washington is finally considering meaningful steps to deal with the on-going foreclosure crisis. The article reports:

“A top Treasury Department official told a Senate panel yesterday that the government is considering a proposal to allow homeowners to stay in their home as renters after a foreclosure.”

The administration appears to be conceding that all of its proposals to date have been complete flops. The report goes on:

“Under the federal program known as Making Home Affordable, lenders are paid to lower borrowers’ mortgage payments. About 160,000 loans have been modified into lower-cost loans so far. The administration has said the federal effort has already been more successful than previous programs.”


That program was designed by the lenders, who wanted yet another government hand-out. But it was doomed to fail because mortgages that have been packaged into complex securities cannot be modified easily. If, instead, the government had directed aid to homeowners from the very beginning, it could have slowed the downward spiral of real estate markets. Reports yesterday put the number of foreclosures this year at another 2 million, with similar projections for next year. What is needed now is relief for the millions of families who have lost, or will soon lose, their homes.

Allowing families to stay on as renters after a foreclosure is a step in the right direction. However, the government should go further by following the plan put forward by Warren Mosler, as I summarized previously:

When banks begin to foreclose, the government would step in to purchase the property at the lower of market price or outstanding mortgage balance. Establishing market price in a glut is not simple, but it is not impossible. Mosler proposes that the federal government would rent homes back to the dispossessed owners (Dean Baker has a similar plan) for a specified period (perhaps two years) at fair market rent. At the end of that period, the government would sell the home, with the occupant having the right of first refusal to buy it. Reducing evictions by offering a rental alternative will help reduce the pain of foreclosure. It might also allow the process to speed up (with smaller losses for banks) since many families would choose to stay-on as renters, with the possibility that they could later buy their homes at more reasonable prices.

Gift-Wrapping the White House for the GOP

by Stephanie Kelton

It looks like Christmas has come early for one of President Obama’s most vocal critics. Rush Limbaugh said he hoped the president would fail, and the GOP is doing everything it can to make sure he does. The party stands united in its opposition to a (much-needed) ramping up of the federal stimulus effort. And, at the moment, the president is playing right into their hands.

Sen. Jon Kyl, R-Ariz., has called the $787 billion stimulus effort a “flop,” adding:

“The reality is, it hasn’t helped yet. . . Only about 6.8 percent of the money has actually been spent. What I propose is, after you complete the contracts that are already committed, the things that are in the pipeline, stop it.”

In other words, he thinks the stimulus isn’t working because the government isn’t spending the money FAST enough. And, with the lion’s share of the spending about to kick in, he wants to scrap the entire effort, just to make sure it won’t work.

The only thing more disappointing than hoping the president – any president – will fail is actively working to keep millions of Americans unemployed in order to score political points in the coming election. But that’s exactly what’s happening, and the president may be painting himself into a losing corner.

President Obama has insisted that: (1) the stimulus is working as planned; (2) a second stimulus is not needed; and (3) he will cut the deficit in half by the end of his first term.

If he sticks to his guns, I believe he will dig his own political grave (not to mention prolonging the agony for millions of Americans). He cannot have it both ways. He cannot reverse the effects of the worst economic downturn since the Great Depression and do it on a shoestring.

That isn’t to imply that $787 billion is chump change, but it pales in comparison to the losses that have already been borne by homeowners, businesses and investors. As Dean Baker recently pointed out, annual consumption is down about $700 billion (due to the loss of roughly $16 trillion in real estate and stock market wealth). Add to that “a reduction in annual rates of construction of about $450 billion” and a decline of “approximately $200 billion” in demand due to losses in the non-residential sector, and Baker says we’re looking at an annual loss of about $1,350 billion. And we’re trying to offset it with $300 billion or so (the annual stimulus) in spending by the federal government! It’s like using an umbrella to stop an avalanche. It won’t work.

But it gets worse, because Baker’s figures don’t account for the void that has been created by state and local governments, where expenditures have fallen by more than $64 billion in the last two quarters alone. And, with virtually every state bracing for even bigger cuts next year, we could easily lose another $100 billion or so in fiscal 2010. Then, of course, there’s the multiplier, which has been hard at work, exacerbating the magnitude of these cuts and costing us untold trillions in lost GDP.

But the president seems convinced that $787 billion will do the trick – at least according to his definition of the trick. You see, the Obama administration has not set the bar very high, and this seems to be why the president believes the stimulus has “worked as intended.” As he explained, it “wasn’t designed to restore the economy to full health on its own, but to provide the boost necessary to stop the free fall.” And this is why even bad news – e.g. 565,000 people filing first time jobless claims – can be interpreted as an indication that the stimulus is working as intended. (Recall that this was the smallest number since January 2009.)

Indeed, the president’s top economic advisors have always been careful to use the words “create or save” when describing the objective of the stimulus plan. And this means that net job creation isn’t the goal. The economy can continue to lose jobs faster than it creates them, and the policy will be described as “working” because the stimulus money helped at least some workers keep their jobs.

So the stimulus may be working “as intended,” but I don’t think the president can rely on semantics to carry him to victory in 2012. If President Obama wants a second term, he must join the growing chorus of voices calling for another stimulus and press forward with an ambitious program to create jobs and halt the foreclosure crisis. I have outlined my twelve-step recovery program, and others on this blog have put forward similar ideas. A payroll tax holiday that cuts FICA contributions to zero will provide immediate relief to millions of working families and their employers, boosting take-home pay as well as business profits. An additional $1,000 per capita will help ease the on-going budget crisis so that states can avoid further cuts to education and social services. A job-guarantee program, modeled on the WPA, will provide useful work and retraining opportunities for the many Americans who will not find jobs even after the economy recovers. Investing in our nation’s infrastructure – roads, bridges, transmission lines, etc. – will address years of neglect and improve the safety and security of all Americans.

These are the kinds of tangibles the American people will think about when they decide for themselves whether the stimulus was a success. At the end of the day, President Obama must cut loose the deficit bogy and abandon any date-specific goal for cutting the deficit in half. It is his Achilles heel. Let the deficit (and the debt) go where it will. With a sufficiently flexible fiscal response, GDP will explode, tax receipts will pour in, and the dreaded debt-to-GDP ratio will drop like a rock.

Why Negative Nominal Interest Rates Miss the Point, Part II—Understanding the Excess Reserve Tax

By Scott Fullwiler

My previous post critiquing Scott Sumner’s (and others’) proposal for negative nominal interest rates brought a most welcome response from Prof. Sumner in the comments section. The comments section has a character limit that I’m sure to go over in response to his response, however; hence this post. The core of my reply and critique here is twofold: first, Sumner misunderstands the Fed’s monetary operations, particularly the details of reserve accounting (that is, the dynamics of changes to the Fed’s balance sheet); and second, the proposal assumes the textbook money multiplier when in fact this doesn’t apply to the U.S. or any other nation not operating under a fixed exchange rate policy such as a gold standard or currency board.

Sumner’s original proposal, as he notes in the comments, can be found here. The basics of the proposal are that the Fed would set a modestly negative rate to be paid on bank excess reserves (ERs; he has discussed rates -2% and -4% on his blog); given this penalty, banks would then be encouraged via the monetarist “excess cash balance” mechanism, as he describes it (i.e., the money multiplier) to create deposits that would thereby transform these ERs into required reserves that would not be subject to the penalty. The problem the proposal supposedly solves is that banks are “sitting” on their excess balances (currently around $700 billion) and need an incentive to “move [ERs] into cash in circulation.”

Turning to reserve accounting, consider Sumner’s comment on my original post:”The proposal would not drive interbank loan rates significantly negative, as banks could always exchange ERs for T-bills. And T-bill yields could not go significantly negative because non-bank holders of T-bills can always hold cash.”
As a small aside, I’m puzzled why he would think my critique centered on the interbank rate or T-Bill rate, as my critique was instead directed at the “excess cash balance” mechanism or money multiplier; that these rates might turn negative is not necessarily problematic in my opinion, but that’s what will happen, so I noted as much. But I digress.

Sumner’s statement “banks could always exchange ERs for T-bills” misses an important point . . . namely because this transaction would not extinguish the reserve balances, but rather move them to the (in the case of a non-bank seller) seller’s bank. So, let’s assume that the seller’s bank had no undesired ERs prior to the sale. Now, after the sale, it DOES have undesired ERs (while, yes, the non-bank seller can now hold deposits or CDs or whatever).

The fundamental point here is that ONLY changes to the Fed’s balance sheet can change the aggregate quantity of reserve balances held by banks. In other words, the Fed is the MONOPOLY supplier of net reserve balances to the banking system. This is not an opinion or a theory, but rather a FACT of double-entry reserve accounting . . . aggregate reserve balances are on the liability side of the Fed’s balance sheet, only a change somewhere else on the Fed’s balance sheet can alter them. And the T-bill purchase Sumner describes does not involve the Fed’s balance sheet.

In fact, the only way a T-bill purchase would extinguish reserve balances as Sumner proposes is if the purchase is done at auction (from his quote, clearly not what he was intending), which would in fact be a roundabout way of having the Fed simply add balances to the Treasury’s account (again, I’ll assume he wasn’t intending this with his proposal).

So, if we have an aggregate banking system with some undesired excess balances, the banks individually can trade these among themselves however they want (fed funds market, T-bill transactions, repos, and so forth), but the undesired excess simply moves from bank to bank, never going away. It’s well established in the academic literature on the fed funds market that this brings the fed funds rate down toward the level paid to banks on reserve balances (which Sumner’s wants negative). Hopefully it’s clear, though, that my criticism in this case is not and was not about the fact that the interbank rate would fall, but rather about the inherent misunderstanding of reserve accounting in the proposal (and, alas, in Sumner’s comment above).Very briefly to his point on T-bill rates, any individual bank will purchase T-bills at yields higher than its marginal return on ERs at the Fed. These purchases move those reserves to other member banks, which then do the same, thereby driving T-bill rates down to or even below the Fed funds rate. Furthermore, negative T-bill rates have for technical reasons in fact been a common occurrence in both Japan and the U.S.

For a little more detail, consider Sumner’s following comment from his original proposal: “We also know that banks hold very low levels of ERs any time the opportunity cost (in terms of the T-bill alternative) is even modestly positive. Thus in the summer of 2008 when the target rate was only 2%, ERs were still very low.”
Wrong. Banks DESIRE to hold low levels of ERs when the opportunity cost is even modestly positive. But they will by definition in the aggregate hold as many as the Fed leaves circulating, since the Fed is the monopoly supplier of aggregate reserve balances. Prior to September 2008, the Fed ACCOMMODATED banks’ desire to hold low levels of ERs by draining any additional balances via reverse repos and such—a process that had become very complicated starting in August 2007 (but that’s a long story in itself). Virtually every other central bank does the same under normal circumstances.

After September 2008, circumstances were not normal, as the Fed (in its view, at least) no longer had enough purchased assets to sell or repo to drain any undesired ERs created via its various standing facilities. Consequently, while banks individually actually may have DESIRED to hold lower levels of ERs (though their desired quantity was admittedly increased above normal given substantial concerns about counterparty risks), in the aggregate, they had no choice but to hold a larger quantity (again, though, the Fed’s repeated flubs with instituting payment on reserve balances kept the fed funds rate well below the target and thereby minimized any opportunity cost that might have existed).

I don’t want to dwell on this particular point too much, as it moves a bit too far ahead given that, for Sumner’s proposal, at issue isn’t the aggregate quantity of reserve balances but rather how to transform the ERs to required reserves. But clarity on reserve accounting in monetary operations is absolutely essential, as we’ll see again below.

As for transforming the ERs to required reserves, Sumner writes in his original post that “from a monetarist excess cash balance perspective, the problem is the hoarding of ERs by banks.” So, now quoting from his comments on my post, his excess reserve tax proposal is intended “to move ERs into cash in circulation . . . [as it] . . . relies on the monetarist ‘excess cash balance’ mechanism.” From his original post, “a penalty rate on ERs of say 4% should bring ERs down to extremely low levels.”

That is, penalizing banks for holding ERs is proposed in order to encourage banks to create more deposits, thus raising reserve requirements and lowering the relative quantity of ERs among existing reserve balances.

This is the money multiplier framework, which is inapplicable to the US monetary system, as noted above. So what this errant view does is cause Sumner to get the problem wrong.

To see why, consider a bank with no ERs at all. Suppose a credit worthy customer comes through the door and wants a loan and the bank deems the loan profitable. Does the bank have the operational ability to create the loan? In EVERY country not operating under a fixed exchange rate system such as a gold standard or a currency board, the answer is YES. As I have explained in previous posts (here and here), if the bank ends up short on its reserve requirements, it incurs an overdraft automatically from the Fed at a stated penalty rate as a matter of accounting. In practice, this wouldn’t actually occur for at least 2.5 weeks given lagged reserve accounting in the US, by which time the bank’s liquidity manager would have raised any required funds via any number of sources, but that’s not really the point.

The point is that the reserve requirement can only impose a “cost” penalty on the bank, not constrain it from lending. Further, in the aggregate, central banks act to avoid such additional costs which would cause the interbank rate to trade above the central bank’s target rate by ACCOMMODATING the banking system’s demands for balances to meet reserve requirements before such overdrafts occur. They do this out of necessity since leaving banks in the aggregate short of meeting requirements would mean that deficient banks would bid the interbank rate up as they tried to entice other banks to lend, pushing the rate up above the central bank’s target until it reached the central bank’s stated penalty for a reserve deficiency. At this point, banks would be theoretically indifferent between borrowing from another bank and simply incurring the overdraft at the same rate.

Now consider a bank with substantial ERs. Does it have any more operational ability to create a loan than the bank in the previous example? Certainly not, as the bank in the previous example has NO operational limits to its abilities to lend–it will obtain any necessary reserves from other banks and the central bank will provide more to the aggregate system should that be necessary to achieve its target rate.

The only instance in which the previous bank might change its plans is where a central bank does not accommodate its interest rate target but instead provides the overdraft at a penalty to a deficient bank. But all this would do is raise the interest rate the bank would be willing to lend at (since its own costs would have risen via the penalty). So, again, the bank would not be constrained by reserve availability. It just means that infinite funds would still be available but at a higher interest rate. Again, this has not been the practice of modern central banks (even for the Fed during its so-called “monetarist experiment”).

As an aside, let’s state this another way. That is, a central bank that attempts to target the quantity of aggregate reserve balances such that it forces individual banks to meet reserve requirements via overdrafts at a penalty is NOT targeting directly the quantity of reserve balances but rather setting a de facto target at its stated penalty rate. As Warren Mosler says, central bank operations are ALWAYS about price, not quantity, as a matter of institutional structure.

Now assume that the excess reserve tax is imposed on the bank holding the ERs. Does this make it more likely to lend? Given that the ERs don’t give it any more ability to create a loan in the first place, unless the tax somehow gets the bank to lower its lending standards (not necessarily the best idea given the current status of banks), the answer is clearly NO.

What the tax DOES do is encourage the bank to get rid of its ERs by lending in the interbank market. But because only changes to the Fed’s balance sheet can alter the aggregate quantity of reserve balances (as I said, reserve accounting would be shown to be important yet again), lending in the interbank market can only shift existing balances from bank to bank. If the aggregate banking system is left holding undesired excess balances that the Fed does not drain, the fed funds rate is bid down, at the limit to the rate paid to banks for holding ERs, which because of the excess reserve tax has been set below zero.

Again, the fact that the fed funds rate has fallen isn’t the point. The point is that the money multiplier, or “excess cash balance” mechanism is NOT applicable to our monetary system.

In my previous post, I pointed out that another of this tax’s effects would be to reduce bank profits for those left holding the ERs. Sumner’s counter was this: “Another mistake is to assume it would hurt bank profits. It could, but need not if the Fed doesn’t want it to. They could simply pay positive interest on RRs to offset the negative interest on ERs. All this is explained in this post”

In his original post, he gives as an initial example an excess reserve tax of 4% and payment on required reserves of 4%.

But again, the bank with no ERs has the same ability to create a loan as the bank with ERs. So, to stimulate lending, the only thing the ER tax can possibly do is encourage banks left holding the undesired ERs (assuming they aren’t drained by the Fed) to lower lending standards below those of banks without ERs in the hope that more would-be borrowers come though their doors.

All the evidence from volumes of empirical research on bank reserve behavior is very clear—banks don’t make an “asset allocation” decision between ERs at below market rates (lots of experience in the real world with these, as it’s been the normal state of affairs) and lending to willing, creditworthy borrowers. The two are unrelated as explained above (or at least mostly explained . . . one could be a great deal more technical about payment settlement-related motives for holding ERs and how this is also unrelated to lending), though the excess reserve tax tries to make them related by forcing banks in the aggregate to hold undesired balances, imposing a tax if they don’t create loans/deposits, and then paying them to make more loans/deposits.

So, again, the banks left holding the ERs would see their profits fall.

Banks could in fact avoid the excess reserve tax and receive the interest payment on required reserves by making NO loans at all if they instead found ways to incentivize, entice, or even force customers currently holding non-reserveable liabilities (savings, CDs, money market accounts) to shift these to reserveable liabilities (deposits). In fact, rather than lending, this sort of reclassification of existing balances is probably the outcome of the excess reserve tax plus payment for required reserves.

For instance, banks would probably cease all operations related to moving customer deposits into retail sweep accounts previously intended to avoid reserve requirements. This alone would reclassify about $600 billion or so in money market accounts as deposits and create somewhere around $50 billion in reserve requirements. As banks continued to “encourage” deposit accounts over non-reserveable accounts to reflect their own incentive to convert excess balances to required balances, still more balances could be reclassified.

So again, like the currency tax, we just get a reclassification of existing balances . . . this time toward deposits rather than away from them as the currency tax would do. Also like the currency tax, then, we don’t get any more spending and we therefore don’t get more aggregate demand. In other words, just as my spending plans didn’t change as I moved away from deposits to avoid Buiter’s proposed tax on transaction balances in the previous post, my spending plans also don’t change as I move toward transaction balances to avoid banks’ newly imposed disincentives for holding savings-type of accounts resulting from the mix of excess reserve tax/reserve requirement incentive they are facing.

A better way to increase aggregate demand than going to all these disruptive extremes that can only work if they reduce lending standards or reduce savings desires would be to raise household incomes and business profits directly and thereby increase both consumption and the likelihood loans can be paid back. I suggested a payroll tax holiday as one way to do this . . .this and other complementary proposals have been repeatedly discussed by L. Randall Wray, Stephanie Kelton, and Pavlina Tcherneva on this blog (and Warren Mosler and Mike Norman have done the same on theirs).

In closing, I ended the previous post by writing “unfortunately, those recommending penalties on currency, deposits, or reserves don’t fully understand monetary operations given that their basic framework is inapplicable to a modern monetary system such as ours.” Given that my conclusions here—that the excess reserve tax is based upon a lack of understanding of monetary operations (and reserve accounting in particular) and the inapplicable money multiplier—are much the same, there is no reason to alter that initial assessment.

The Fed As Super Duper Regulator? Will We be Duped Again?

By L. Randall Wray

Treasury Secretary Geithner is floating a plan that would consolidate more power in the hands of the Fed. The idea is that because it failed so miserably over the past decade to recognize a series of asset bubbles and growing systemic risk, it should be placed in charge of assessing and controlling systemic risk. You’ve got to love the logic. Could it have anything to do with the fact that Geithner came from the NY Fed where he used to cozy-up to Wall Street banks?

Three economists with widely different perspectives trashed the idea in hearings before the Subcommittee on Domestic Monetary Policy and Technology, Committee on Financial Services, U.S. House of Representatives, July 9, 2009.

“I do not know of any single clear example in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures,” said Allan H. Meltzer, professor of political economy at Carnegie Mellon University and the author of a history of the Fed.

John Taylor went on: “The administration proposal would grant to the Fed significant new powers, more powers than it has ever had before,” he told lawmakers. “My experience in government and elsewhere is that institutions work best when they focus on a limited set of understandable goals.”

James Galbraith, a long time Fed critic weighed in:

“Chairman Greenspan actively encouraged consumers to sign up for the innovative adjustable-rate mortgage products that would, eventually, destroy the system. Right up to July, 2007 in public statements and testimony before Congress, Chairman Bernanke continued to say that problems in the housing sector were manageable, and that the “predominant risk” was inflation. No doubt this emphasis reflected the macroeconomic priorities of the Federal Reserve at the time. Perhaps there was, also, a calculated desire to maintain public confidence. But that is precisely the problem. An effective systemic-risk regulator would not have those conflicting considerations.”

Those who followed the 1980s Savings and Loan fiasco will recall how that crisis was created by Chairman Volcker’s decision to raise interest rates to historic levels no matter how much that devastated the nation’s thrifts plus a hands-off treatment by regulators—who actually encouraged them to take on big risks to try to grow their way back to profitability. Indeed, top regulators saw their role as something akin to “cheerleading”, best represented by FDIC Chairman William Seidman’s enthusiastic statement that “bankers are our friends”, so encouraged his agency to operate like a “trade association” for the industry. Needless to say, cheerleaders do not make good regulators. (See my article here)

To be sure, the FDIC has done a much better job in recent years (and Chairwoman Sheila Blair has been a thorn in the side of both Geithner and previous Treasury Secretary Paulson). In his testimony Galbraith makes a good case for putting the FDIC—not the Fed–in charge of regulating systemic risk. The reason is that bankers more easily capture the Fed for the simple reason that most decision-making takes place in Washington at the FOMC meetings, where the regional Fed presidents take turns voting on monetary policy. Many of these come directly out of the banking sector (of course Chairman Bernanke does not), and all represent the interests of their member banks. Don’t forget, the private banks own the Fed, although the Fed is legally a creature of Congress. Imagine the outcry if we sold the Treasury to the highest bidder to create a similar Frankenstein creature. (A cynic might argue that “Government Sachs” already bought the Treasury—but let’s not go there.)

Whether the Super Duper Regulator is placed under the auspices of the FDIC, the Fed, or elsewhere, however, I am skeptical that it will do much good in the absence of thorough-going reform of the financial system. The fact is that the biggest financial institutions are too big to supervise, too powerful to regulate, and too big to fail. Practically by definition, anything that hurts the profitability of one of these behemoths will increase systemic fragility. Further, as students of the S&L crisis know, powerful financial institutions are able to buy lots of friendship in Congress (think Charles Keating and Senator John McCain).

Thus, it appears that the proposal for a Super Duper Regulator is an attempt to make a run around any real reform, which would have to start with the recognition that any institution that is too big to fail and too big to manage and too big to supervise and too big to regulate is also too big to save, thus, too big to retain.

Time For the Third Stimulus Package

by L. Randall Wray

According to Paul Krugman “voices calling for stronger stimulus are, may I say, sorta kinda respectable — several Nobelists in the bunch, plus a large fraction of the prominent economists who predicted the housing crash before it happened.”

Professor Krugman provides a link to those who argued that the second stimulus was too small, as well as to those who are already calling for a third stimulus. Three UMKC-affiliated professors are listed, including yours truly. With some immodesty, I’d like to point out that Wynne Godley and I were already calling for a stimulus package in 1999. We were worried that a tightening fiscal stance forced our economy to rely on unsustainable private sector deficits. We said:

“Growing government budget surpluses combined with growing trade deficits have generated record private sector deficits. Unless households continue to reduce their saving—creating an increasingly unsustainable debt burden—the impetus that has driven the expansion will evaporate.”

Of course the economy did quickly collapse into recession, but emerged due to restoration of a budget deficit plus a growing domestic private sector deficit. Over the years, many of us continued to warn that the budget remained too tight while private sector deficits were unsustainable. It all went on far longer than we expected, which does not prove us wrong but rather means that the slump will be immensely worse than it would have been had it come to an end earlier. That is why many of us believe the stimulus is orders of magnitude too small. The private sector is left with a monumental debt overhang and things will not get better until private balance sheets recover.

The best thing that the government can do now is to stop the job losses and to start creating jobs. We are not talking about a couple of million new jobs at this point—we need 6.5 million to replace those already lost, plus another 1-2 million to provide jobs for those who would have entered the labor force (high school and college graduates, for example) if the economy had not collapsed. Reports this morning show that President Obama’s approval rating is falling—below 50% in the swing state of Ohio—and job loss is a big part of the reason. Pessimism is setting in and it will be hard to overcome because it is well-founded. Job losses are devastating for communities—retailers are hit, real estate prices continue to fall, and state and local governments are forced to cut spending.

Many are looking back to 1937, when fiscal policy inappropriately tightened and threw the economy back into depression; indeed the collapse in 1937 was faster than the original crash that started the Great Depression off. To some extent that is not the correct analogy because most of the second stimulus package has yet to be spent, and recent data reported by Mike Norman shows that the federal deficit has actually increased in recent days. But it is still not enough, as evidenced by the growing economic stress around the country.

I realize that it is important for Congress to settle on some dollar figures for a third stimulus because that is the way that budgeting works. But in truth it is impossible to say beforehand how much we will need to stop the carnage. As James Galbraith has been warning, it is better to err on the upside. So far we have done the opposite—with the predictable result that the economy continues on a path toward another great depression.