Marshall Auerback on Fox Business: Obama Closer to Tea Party than Democrats

Posted on July 29, 2011 by | 2 comments

Here is Marshall Auerback’s latest appearance on Fox Business, where he makes the argument that Barack Obama’s deficit cutting ambitions place him closer to the Tea Party than his own Democrats.

Watch the latest video at video.foxbusiness.com

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Two Theories of Prices

Posted on July 27, 2011 by | 25 comments
By Eric Tymoigne
Last May, John T. Harvey wrote a wonderful post about the quantity theory of money (QTM). This post picks up where John stopped, presenting a different theory of the price level and inflation. It’s a bit technical (so bare with me), but many readers have asked us to elaborate on price theory.
First, a quick recap. The QTM starts with the identity MV ≡ PQ, where M = the money supply, V = the velocity of money, P = the price level, and Q = the quantity of output (Fisher’s version is broader and includes all transactions: T). The identity is a tautology, it just says that the amount of transactions on goods and services (PQ) is equal the to the amount of financial transactions needed to complete those transactions. To get a theory of price (the QTM), one must make some assumptions about each variable. The QTM assumes that:
·         M is constant (or grows at a constant rate) and is controlled by the central bank through a money multiplier
·         V is constant
·         Q is constant at its full employment level (Qfe) or grows at its natural rate (gn)
Given this set of assumptions, we get (note the equality sign to signal causality):
P = MV/Qfe
Or, in terms of the growth rate (V is constant so its growth rate is zero):
gp = gm – gn
This is the QTM, which holds that price changes (inflation and deflation) have monetary origins, i.e. if the money supply grows faster than the natural rate of economic growth, there is some inflation.  For example, if gm = 2% and gn = 1% then gp = 1%.  If the central bank increases the money supply, then inflation rises.

John’s post explains the problems with this theory. M is endogenous, V is not constant, and the economy is rarely at full employment. If you want to know more, you should read John’s post.

Let’s move to an alternative theory of the price level and inflation by starting with another identity based on macroeconomic accounting:
PQ ≡ W + U
This is the income approach to GDP used by the Bureau of Economic Analysis. It says that nominal GDP (PQ) is the sum of all incomes. For simplicity, there are only two incomes: wage bill (W) and gross profit (U). Both are measured before tax.
Let’s divide by Q on each side:
P ≡ W/Q + U/Q
We can go a bit further by noting that W is equal to the product of the average nominal wage rate and the number of hours of labor W = wL (for example, if the wage rate is $5 per hour, and L is equal to 10 hours, then W is equal to $50). Thus:
P ≡ wL/Q + U/Q
Q/L is the quantity of output per labor hour, also called the average productivity of labor (APl) therefore:
P ≡ w/APl + U/Q
w/APl is called the unit cost of labor and data can be found at the BLS. The term U/Q will be interpreted a bit later.
Ok let’s stop a bit here. For the moment all we have done is rearranged terms, we have not proposed a theory (i.e. a causal explanation that provides behavioral assumptions about the variables.)  Here they are:
·         The economy is not at full employment and Q (and economic growth) changes in function of expected aggregate demand (this is Keynes’s theory of effective demand).
·         w is set in a bargaining process that depends on the relative power of workers (the conflict claim theory of distribution underlies this hypothesis)
·         U, the nominal level of aggregate profit, depends on aggregate demand (Kalecki’s theory of profit underlies this hypothesis)
·         APl moves in function of the needs of the economy and the state of the economy.
Thus we have:
P = w/APl + U/Q
Thus the price level changes with changes in the unit cost of labor and the term U/Q. What is this last term? To understand it let’s express the previous equation in terms of growth rate. This is approximately:
gp = (gw – gAPl)sW + (gU – gQ)sU
With sW and sU the shares of wages and profit in national income (sW + sU = 1).
Thus, inflation will move in relation to the growth rate of the unit labor cost of labor, which itself depends on how fast nominal wages grow on average relative to the growth rate of the average productivity of labor. As shown in the following figure, in the United States, a major source of inflation in the late 1960s and 1970s was the rapid growth of the unit cost of labor, with the rate of change between 5 and 10 percent.

Major Sector Productivity and Costs Index (BLS)

Series Id:  PRS85006112
Duration:   % change quarter ago, at annual rate
Measure:    Unit Labor Costs
Sector:     Nonfarm Business
Inflation will also move in relation to the difference between the growth rate of U and the growth rate of the economy (gQ). U follows Kalecki’s equation of profit, which broadly states that that the level of profit in the economy is a function of aggregate demand. Thus the term, (gU – gQ) represents the pressures of aggregate demand on the economy. If gU goes up and gQ is unchanged, then gP rises given everything else. However, to assume that gQ is constant is not acceptable unless the economy is at full employment, so a positive shock on aggregate demand will usually lead to a positive increase in gQ.
Thus, overall, there are two sources of inflation in this approach, a cost-push source (here summarized by the unit labor cost) and a demand-pull source (here summarized by the aggregate demand gap). Note that the money supply is absent from this equation. Money does not directly affect prices. Assuming that a drop of money from the sky leads to inflation, first, does not understand how the money supply is created (it is at least partly created to produce goods and services), second, assumes that people will automatically spend rather than hoard the addition funds obtained (people do hoard for all sorts of reasons and do derive “utility” from hoarding money), third, assumes that the economic output cannot respond to additional demand. If more people suddenly go to the store, producers usually produce more rather than raise prices. Output is not a fixed pie that involves allocation to one group at the expense of another group. The size of the pie increases and decreases with the number of people demanding pie.
A version of this theory has been used in many different models that have endogenous money, liquidity preference, demand-led theory of output and other non-mainstream characteristics. Godley’s and Lavoie’s Monetary Economics as well as Lavoie’s Foundation of Post Keynesian Economics are good books to get more modeling. Of course, modern mainstream monetary economics is rejected in those books; income effect dominates over substitution effect, production is emphasized over allocation, monetary profit affects economic decisions, etc. Be prepared for a change of perspective in which scarcity is not the starting point of economics.

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RESPONSE TO BLOG 8: MORE ON TAXES DRIVE MONEY

Posted on July 27, 2011 by | 22 comments
By L. Randall Wray
Thanks again for well-focused questions and comments. Here we are concerned with why government “fiat”currency is accepted. The short answer was that “taxes drive money”: since you have a tax liability that must be cleared by delivering the government’s own currency back to government, you want to obtain government currency. So in that sense, it is the tax liability that drives the desire to obtain government currency.
I did leave a couple of teasers, which some touched on in their comments. First, does it have to be a tax? Clearly the answer is “no”: if government imposes a fine on you in the form of five Dollars, you need five Dollars in the form government is willing to accept to pay your fine—sovereign currency. Until the 20th century, taxes were relatively less important; what mattered more were fines and tithes and fees.
To go further, let us say government monopolizes the water supply (or energy supply, or access to the gods, etc); it can then name what you need to deliver to obtain water (energy, religious dispensation, etc). In that case, if it says you must obtain a government IOU, then you want government IOUs—currency—to obtain water in order to avoid death by dehydration. In early 19th century England, almost all activities necessary to keep your family alive were illegal by dictate of the crown. You had to pay a fine after you killed game to feed your family. You needed the crown’s currency to pay the fine—hence “fees drove money”. You get the picture.
All you need to drive a currency is a more or less involuntary obligation to deliver the currency—and that can be a tax, fee, fine, or even religious tithe. Or a payment to obtain water or any other necessity. We can go into this later, but at UMKC students need buckaroos to pay a “tax” to pass their courses—that drives the buckaroo currency—it creates a demand for buckaroos (the sovereign currency at UMKC).
That answers the question: yes it is not enough to impose the obligation (fee, fine, tax); the obligation must also be enforced. A tax liability that is never enforced will not drive a currency. A tax that is only loosely enforced can create some demand for the currency, but it will be somewhat less than the tax liability for the simple reason that many will expect they can evade the tax.
We can next move on to the second teaser: why would those who do not have tax liabilities also be willing to accept currency?
That leads us to the Tobin, “snowball” point: if some segment of society owes the tax (or fee or fine) denominated in the currency, others will accept it. Note this is not an infinite regress argument. It is the tax standing behind the currency. But it is not necessary for every individual to owe the tax.
Let us say that Bill Gates owes $1.5 trillion in taxes. I’d be happy to accept Dollars since I know Gates will accept them when I purchase Microsoft software. And that explains why foreigners want dollars—not because they owe taxes, but because a sufficient number of Bill Gates do.
From inception we know that if the total tax liability in dollars is, say, $100 billion, the taxpayers will want a minimum of $100 billion. (How much more? $120 billion? $180 billion? We will investigate that later.) Government can spend into the economy at least that amount.
How much will the Dollar be worth? Well, that depends on what must be done to obtain it. We will have much more to say about that in coming weeks.
A commentator did hit on this point: what if the tax liability is too low? Let us say the tax liability is $100 billion but government tries to spend $1000 billion. This is ten times what the taxpayers need to cover their liabilities. It is possible—even probable—that government will not be able to find takers for the $1000 billion. It can bid the price it is willing to pay (for labor, finished output, or resource inputs) up, but still find no takers. We could register “inflation” and still find government cannot spend as much as it wants.
A better solution—obviously—is to raise the tax liability toward $1000 billion, rather than to increase the price government is willing to pay. Again, that is something we will come back to, but it also sheds some light on what determines the value of the currency. As I said last week, we need to separate the willingness to accept currency from the value of the currency. Raising the tax liability will increase the desire to obtain currency although that does not tell us exactly how much the value of currency (in terms of labor or other resources) will rise.
Valuing something like a bridge is very difficult—especially if we are talking about a bridge already in place. Fortunately, it is also a question that is not very important, so long as the bridge is public—not owned by some profit seeking entity. There really is very little reason to value public infrastructure once it is in place, except perhaps in terms of all the pleasure it provides to the population. That is probably something that cannot be and should not be measured in money terms.
But, yes, raising the tax liability while holding government issue of the currency constant is likely to lead to what we might call unemployment: those willing to work to get the currency in order to pay taxes, but who cannot find work or demand for output to obtain the currency.
We will later go through the accounting to answer the question raised by a commentator: what about the reserve effects of tax payments? But, briefly, yes, paying taxes will all else equal reduce outstanding bank reserves. In practice, if the central bank targets overnight interest rates, it will replace lost reserves if they were desired or required—by lending at the discount window or through open market purchases of treasuries.
There were several questions/comments that were not comprehensible to me: what about interest, which requires one to repay more than what is owed. I do not see the relevance to this week’s topic. What about issuing money with no offsetting debt? Well, all money “things” are IOUs hence are debts, hence there is no possibility of issuing money that is not a debt. What about socio/political ramifications of who pays the tax? Yes very important, but I do not see the relevance to the topic at hand.

OK I hope I have covered the main comments and questions. More next week.

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The High Price of the President’s Council of Economic Advisors’ Failure to Read Akerlof & Romer

Posted on July 25, 2011 by | 2 comments
By William K. Black

(Cross-posted from Benzinga.com)

By reviewing the annual reports (2005-2007) of President Bush’s Council of Economic Advisors (CEA) I learned that the Council had some interest in fraud, but no understanding of elite fraud and its implications for the economy.  The reports make sad reading.  They deny the developing crisis entirely and they do so for reasons that reflect badly on economics and economists. 

The CEA’s reports’ analysis of the developing fraud epidemics and crisis reveal critical weaknesses in theory, methodology, empiricism, candor, objectivity, and multi-disciplinarity.  Overwhelmingly, the reports ignored the developing crises and their causes.  Worse, as late as 2007, they denied – even after the bubble had popped – that there was a housing bubble.  When the nation and the President vitally needed a warning from its Council of Economic Advisors the CEA did not simply fail to warn, but actually advised that those who warned of a coming crisis were wrong. 

This column does not focus on the CEA’s claims that there was no housing bubble.  Like the National Association of Realtors’ top economist who became known to the trade press as “Baghdad Bob” (the mocking nickname journalists gave Saddam Hussein’s press flack after he denied U.S. troops were in Baghdad), the CEA’s specious bubble denial is an obvious embarrassment.  Their Japanese counterparts did far better in warning of the developing real estate bubble in the 1980s.  The collapse of the twin Japanese bubbles in 1990 and the resultant “lost decade” should have caused the CEA to recognize the gravity of the risk bubbles pose and importance of identifying them promptly.  Instead, the CEA gave in to the temptation to claim that the President’s brilliant policies had produced a wonderful economy.  The reality was that the economy was headed over the precipice.

The focus of this column is on the portion of the CEA’s annual report for 2006 that discussed the theory of financial intermediation and financial regulation.  Indeed, the column focuses on a small subset of the defects in those portions of the report.  I write to emphasize how a theory (“control fraud”) developed two decades ago by regulators, criminologists, and economists could have saved the CEA from analytical and policy errors with regard to financial crises and regulation and led it to identify the crisis and recommend effective measures to contain it.  The tragedy is that the CEA discussion of the theory of financial regulation embraces three of the most useful theoretical insights – adverse selection, lemon’s markets, and the centrality and criticality of sound underwriting to the survival of lending institutions.  These theories are interrelated and they are essential components of control fraud theory.  

Had the CEA understood the true import of these three economic theories it could have gotten the crisis right instead of making things worse.  White-collar criminologists and economists share these three theories (among others) and employ a (limited) “rational actor” model.  (Criminologists never made the mistake of assuming purely rational behavior.  Even neoclassical economists now generally acknowledge that behavioral economics research demonstrates that economic behavior can be irrational in important settings.)  In the 1980s and early 1990s, the efforts of a small group of criminologists, economists, and regulators to understand the causes of the developing S&L debacle led them to develop a synthetic theory that criminologists refer to as “control fraud theory.”  Unfortunately, the typical theoclassical economic treatment of these three theories, exemplified by the CEA’s 2006 report, ignores control fraud.  The result is that the 2006 CEA report misstated the predictions of each of the three theories that it discussed and concluded “no problem here.”  In reality, the three theories predicted that there were epidemics of accounting control fraud 
that were leading inevitably to a catastrophic crisis.

The context of the 2006 CEA report’s discussion of the three theories is a treatise on the theory of financial intermediation and its implications for financial regulation.  The treatise is over the top in its praise of the U.S. financial industry.  The CEA claimed that the U.S. financial deregulation gave its financial sector a “comparative advantage” over other nations.  The CEA cited the financial sector’s rapid growth in size and profits as proof of this comparative advantage and asserted that the financial sector’s rapid growth led to more rapid U.S. economic growth and increased financial stability.  The CEA’s theory of financial intermediation posited that banks exist to minimize the informational difficulties that beset lending and investment.  The CEA concluded that U.S. banks were growing rapidly because deregulation made them ever more efficient in minimizing these informational defects.

Adverse Selection
The CEA addressed three forms of informational defects that banks helped reduce.  The CEA began by discussing “adverse selection.”  Adverse selection was the key to understanding and preventing the developing crisis.  In the lending context, adverse selection arises when a lender’s policies selectively encourage lending to borrowers who pose greater credit risks that are unknown or underestimated by the lender.  Adverse selection can be one of the consequences of “asymmetrical information.”  (Adverse selection also poses a serious risk to honest insurance companies.) 

Because the lender does not know (and therefore is not compensated for) the full extent of the risk of default adverse selection produces a “negative expected value” for lenders.  In plain English, they lose money.  For a residential mortgage lender, adverse selection is fatal because the loans are so large and the loan proceeds are fully disbursed at closing.  It is essential to understand that adverse selection is not equivalent to credit risk.  A mortgage lender makes money by taking prudent credit risks.  Banks “underwrite” prospective borrowers and collateral in order to identify, understand, quantify, and price credit risk.  Prudent underwriting minimizes adverse selection.  Mortgage lenders that fail to underwrite create severe adverse selection and fail.  Honest home lenders would never gut their underwriting standards and create adverse selection.    

The existence of a secondary market does not change an honest home lender’s incentive to engage in prudent underwriting.  Neoclassical theory predicts that the ultra sophisticated investment banks that ran the secondary market would only purchase loans they had prudently underwritten.  A lender that failed to underwrite effectively would be unable to sell its loans in the secondary market.  Neoclassical theory also predicts that the secondary market would only purchase loans sold with guarantees against fraud.  The first prediction, of course, proved false but the second prediction was typically true.  All of the mortgage lenders that specialized in making large numbers of loans under conditions that maximized adverse selection failed even before the cost of the guarantees would have destroyed them because their “pipeline” losses exceeded their trivial (fictional) capital.       

The most severe form of adverse selection is fraud.  The ultimate form of adverse selection is accounting control fraud.  Any experienced banker or insurer knows that adverse selection can lead to fraud.  Fraud maximizes the asymmetry of information because the information provided to the victim contains data that are false and material.  The fraud makes the loan look far less risky than it really is. 

In 2006, MARI, the anti-fraud group of the Mortgage Bankers Association (MBA), reported to MBA members that “stated income” loans were an “open invitation to fraudsters” and that they deserved the term used behind closed doors in the industry, “liar’s loans,” because the incidence of fraud in liar’s loans was 90 percent.  The defining element of liar’s loans was the failure to conduct essential underwriting.  Moreover, fraudulent nonprime lenders typically simultaneously maximized adverse selection and created deniability by creating large networks of loan brokers to prepare the fraudulent loan applications. 

The percentage of nonprime loans made without prudent underwriting is not known with precision because there were no official definitions of stated income, alt-a, or liar’s loans.  Subprime and liar’s loans were not mutually exclusive.  By the time the CEA wrote its 2006 report roughly half of the loans lenders termed “subprime” were also liar’s loans.  Credit Suisse’s March 12, 2007 study (“Mortgage Liquidity du Jour: Underestimated No More”) presented data estimates that roughly 30% of all mortgage loans made in 2006 were liar’s loans.  That frequency produces an annual mortgage fraud incidence of well over one million.  The FBI had put the entire nation on alert about the developing “epidemic” of mortgage fraud in its September 2004 House testimony.  The FBI predicted that the fraud epidemic would cause a financial “crisis” unless the epidemic was contained.  In 2006, no one believed that the epidemic was being contained. 
What everyone, including the CEA, knew in 2006 was that mortgage underwriting standards for nonprime loans were in freefall while other “layered risk” characteristics were multiplying.  This meant that nonprime lenders were dramatically increasing adverse selection while making loans that were ever more vulnerable to losses from adverse selection.  Everyone, including the CEA, knew that the only reason this could occur was the rapid growth of the three “de’s” – deregulation, desupervision, and de facto decriminalization.  Everyone, including the CEA, knew that no one was forcing the nonprime lenders to make liar’s loans.  That should have led the CEA to ask why the senior officers controlling nonprime lenders were deliberately causing the lenders to make loans that created intense adverse selection, endemic fraud, massive (longer-term) losses, and the failure of the lender.  That behavior makes no sense under the theory of financial intermediation advanced by the CEA.  No honest lender CEO would engage in that pattern of behavior.  The nonprime lender CEOs’ behavior only makes sense if they are engaged in accounting control fraud.  The recipe for maximizing fictional accounting income has four ingredients and adverse selection optimizes the first two (rapid growth through making very poor quality loans at premium yields).      
Unfortunately, the CEA’s 2006 report was devoid of any real analytics or facts related to adverse selection.  Indeed, the report’s entire discussion of financial institutions is bizarre because it is not simply removed from any factual context but based on factual assumptions that were contrary to reality and becoming ever more contrary to reality in 2006.  The discussion is a surreal theoretical exercise based on unstated factual assumptions that are the opposite of reality.  The (inevitable) result of its unstated assumptions is the worst possible financial regulatory policy advice that the CEA could give in 2006 – everything is wonderful because our financial intermediaries prevent adverse selection.  The CEA wrote to warn us of the dangers of excessive financial regulation at a time when financial regulation had been eviscerated.
The CEA’s discussion of adverse selection ignored the risk of fraud during what the FBI had aptly termed a fraud “epidemic.”  Instead, it premised its concern on managers of high quality projects being unwilling to seek commercial loans from banks because banks charged excessive interest rates for even high quality projects because of their inability to differentiate bad and high quality business projects.  In reality, interest rates on commercial loans were exceptionally low – even for poor quality business projects.  The CEA’s discussion of adverse selection was premised on an alternate universe.
Lemon Markets
The CEA discussed lemon markets in conjunction with its discussion of adverse selection.  A lemon market reaches its nadir when bad quality products drive good quality products out of the marketplace.  Control fraud theory agrees that lemon market and adverse selection are interrelated theories and provide the keys to understanding why control frauds cause such devastating injury.  George Akerlof was awarded the Nobel Prize in Economics in 2001 for his 1970 article on markets for lemons, which was a pioneering article on fraud and asymmetrical information.  As I have explained, fraud produces the epitome of adverse selection and control fraud is the ultimate form of fraud.  The examples Akerlof provided of sales of goods that posed lemon problems were anti-customer control frauds.
The CEA does not mention Akerlof in its discussion of lemon markets.  This was deeply unfortunate, for it reinforced the CEA’s failure to discuss the epidemic of control fraud by nonprime lenders.  The CEA also failed to explain one of Akerlof’s most important theoretical contributions in his 1970 article, the “Gresham’s” dynamic.  Akerlof used Gresham’s law (bad money drives good money out of circulation in hyperinflation) as a metaphor to explain why market forces became perverse in the presence of asymmetrical information.  The anti-customer control fraud that sells an inferior good through the claim that it is a high quality good gains a large cost advantage over its honest competitors.  If they are driven into bankruptcy or emulate the fraudulent practices good quality goods – and honest sellers – will be driven from the marketplaces by competition.  This happened recently in the Chinese infant formula market, where honest manufacturers were driven out of the market, six infants were killed, and over 300,000 were hospitalized.  The perverse effects of extreme executive compensation largely driven by short-term reported earnings have now created a perverse Gresham’s dynamic in many firms, particularly in the finance industry.  The CEA did not mention the perverse incentives produced by control fraud and modern executive compensation and why markets make the environment even more criminogenic rather than restraining fraud.  Implicitly, however, the CEA recognized that there was some perverse market dynamic that could drive lemon markets to their nadir where “only the worst-quality” good would be sold. 
The CEA compounded its error of not discussing Akerlof’s 1970 analysis of control fraud and the Gresham’s dynamic by failing to address George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Their 1993 article analyzed accounting control frauds.  The CEA’s discussion of financial intermediaries also included a discussion of “moral hazard.”  As with its discussion of adverse selection, the CEA’s discussion of moral hazard implicitly excluded all fraud.  There is no theoretical basis for this exclusion.  Economics (and reality) has long recognized that moral hazard can lead to excessive risk or fraud.  Fraud is often a superior strategy (in terms of expected value – not morality).  As Akerlof & Romer stressed, accounting control fraud is a “sure thing” (1993: 5).  “Gambling for resurrection” is a near sure thing, but in the opposite direction.  The economic theory of how the insolvent or failing bank’s owners maximize the value of their “option” predicts that they will engage in such extraordinary risk that their gamble will nearly always fail. 
But Akerlof & Romer endorsed another point that S&L regulators and criminologists stressed – the manner in which S&Ls purportedly engaged in honest gambling due to moral hazard made no sense for a rational (honest) actor.  Please read their explanation with particular care for its obvious application to our ongoing crisis should be glaring.
“The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:  maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.*  Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem.  They were right (1993: 4).”
Akerlof & Romer went on to explain that accounting control frauds optimize fictional income by making loans with a negative expected value and by deliberately seeking out borrowers with poor reputations (1993: 17).  Their logic relies implicitly on the deliberate creation of adverse selection by the lender and the creation of a Gresham’s dynamic both among borrowers and those that aid and abet the CEO’s frauds, e.g., the appraisers when they inflate appraisals.

There is no good explanation for why the CEA would cite the Akerlof’s famous theory on lemon markets yet ignore the FBI’s 2004 warning, the experience of the S&L debacle (and the public administration literature on the successful regulatory fight against the control frauds), the Enron era accounting control frauds, Akerlof & Romer’s theory of accounting control fraud, and criminology’s theory of control fraud.  The basic fraud mechanisms had so many parallels that one is forced to the conclusion that the CEA and its staff never read the most important modern economic article on bank failures.  Akerlof & Romer explicitly noted that accounting fraud created perverse “lemon” projects (1993: 29).  It is bizarre that the CEA wrote in 2006 for the express purpose of opposing essential financial regulation and thought that the best way to make its case was to cite theories most closely associated with George Akerlof while ignoring his application of those theories to financial regulation and his research findings on the reality of accounting control fraud.  Note that Akerlof & Romer were writing about precisely the point the CEA was discussing – the role of banks with respect to information asymmetries.  Worse, Akerlof & Romer’s point was that one could not assume that banks acted to reduce information asymmetries because banks engaged in accounting control fraud did the opposite.  Akerlof & Romer also explained how accounting control frauds caused Texas real estate bubbles to hyper-inflate.  If there was one economics article the CEA needed to read carefully it was Akerlof & Romer.  Akerlof was a Nobel Prize winner well before the CEA wrote its 2006 annual report.   
But the CEA could have learned the same vital facts about fraud and financial crises had it read the criminology literature, the regulatory literature on the S&L debacle, or the public administration literature.  The CEA had experienced recently the Enron-era accounting control frauds and the S&L debacle was relatively recent.  The CEA’s failure to even consider the role of fraud in financial crises, particularly after the FBI’s stark warning in 2004, was unconscionable.  Akerlof & Romer went out of their way to warn economists of the dangers of control fraud.
“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself (1993: 60).”
My criminology colleagues and I sent the same warnings, as did the S&L regulators and public administration scholars.  The FBI sent an explicit warning.  None of us were able to get through to the Clinton, Bush, or Obama administrations.  They have all ignored the epidemic of accounting control fraud that hyper-inflated the real estate bubbles and drove the financial crisis.    
The Necessity and Centrality of Effective Underwriting
The CEA report continues its triumphal “just so” story approach to financial services by explaining how banks develop expertise in evaluating credit risk and use collateral as a means of inducing borrowers to “truthfully” rather than “strategically” release information on the true value of the real estate to the lender.  By 2006, the nonprime industry was notorious for deliberately inflating appraisal values so that it could make more and larger fraudulent loans.  Surveys of appraisers showed widespread efforts by lenders and their agents to coerce appraisers to inflate valuations.  No honest lender would ever coerce an appraiser to inflate a collateral valuation.  Only lenders and their agents can engage in widespread appraisal fraud.  Appraisal fraud is a “marker” of accounting control fraud.  The “strategic” behavior with regard to appraisers was by fraudulent lenders and their agents.  It relied on endemic, deliberate deceit.  Appraisal fraud is particularly egregious in residential home lending because it can lead borrowers to overpay for their home and to fail to understand the risks of purchasing a home. 
The greatest analytical defect in this section of the CEA report, however, is its false dichotomy between economic efficiency and financial regulation.  The CEA was on to something important.  A well run banking system does reduce adverse selection and make markets less inefficient.  A well run banking system does so by engaging in expert underwriting of significant loans such as home loans.  A bank that does not engage in expert underwriting poses a grave danger.  At best, it is incompetent.  Far more dangerously, it is often engaged in accounting control fraud.  A regulation that requires a lender to engage in prudent underwriting imposes no costs on honest banks and it saves society from vast amounts of damage.  When the regulatory agencies gutted the underwriting rules by turning them into guidelines they set us on the road to the Great Recession.  Effective financial regulation begins with mandating prudent underwriting.  Rules mandating prudent underwriting make financial markets far more efficient and stable by blocking the perverse Gresham’s dynamic that otherwise can create a criminogenic environment.  
The CEA was correct in explaining that the raison d’être of financial intermediaries is the provision of exemplary underwriting.  It is, of course, significantly insane that the CEA would implicitly assume in 2006, contrary to known facts, that nonprime lenders, the investment banks packaging CDOs, and the rating agencies were prospering because they were engaged in exemplary underwriting.  The CEA, in the two most important reports it issued in modern times (2005 and 2006), got the developing financial crisis and regulatory policy as wrong as it is possible to get something wrong. 
Conclusion
No economist should be allowed to graduate from a doctoral program without reading Akerlof & Romer.  It would also be salutary to expose any doctoral candidate interested in finance or regulation to the relevant work of criminologists and public administration scholars.  Collectively, our work on control fraud has shown great predictive strength while neoclassical economic work (both macro and micro) and “modern finance” have suffered repeated, abject predictive failures. 

Every financial regulatory agency should have a “chief criminologist.”  The financial regulatory agencies are civil law enforcement entities whose primary responsibility is to limit control fraud, but they virtually never have anyone in authority with expertise in identifying, investigating, and sanctioning control frauds.


* Black (1993b) forcefully makes this point.

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Worse than Hoover

Posted on July 25, 2011 by | 10 comments
By Marshall Auerback

It’s actually a bit over the top and unfair to compare Barack Obama with Herbert Hoover – unfair that is, to the memory of Herbert Hoover.  The received image of the latter is the dour, technocrat who looked on with indifference while the country went to pieces.  This is actually an exaggeration.  As Kevin Baker convincingly argued in his Harper’s Magazine piece, “Barack Hoover Obama”, President Hoover did try to organize national, voluntary efforts to hire the unemployed, provide charity, and sought to create a private banking pool. When these efforts collapsed or fell short, he started a dozen Home Loan Discount Banks to help individuals refinance their mortgages and save their homes.  Indeed, the Reconstruction Finance Corporation, which became famous for its exploits under FDR and Jesse Jones, was actually created by Hoover.  Often tarred with the liquidationist philosophy of his Treasury Secretary, the establishment of the RFC was, as Baker suggested, “a direct rebuttal to Andrew Mellon’s prescription of creative destruction. Rather than liquidating banks, railroads, and agricultural cooperatives, the RFC would lend them money to stay afloat.”
Hoover’s tragedy lay in the fact that whilst he recognized the deficiencies of the prevailing neo-classical laissez-faire nostrums of his day, he could not ultimately break with them and accept that the economic tenets which he had grown up with were deficient in terms of dealing with the huge unemployment challenges posed by the Great Depression.  By contrast, Roosevelt was himself instinctively a fiscal conservative throughout much of the early stages of his political career (and campaigned as a gold standard man during the election of 1932), but ultimately had the vision (or, at least, excellent political instincts) to recognize the need to cut himself off from the dogma of the past and try something new in a persistent spirit of experimentation. Not everything FDR did worked, but his lack of rigid ideology and his bold spirit of economic experimentation ultimately did much to reduce the scourge of unemployment, even though such policies brought him into significant conflict with the economic royalists of his day.

Barack Obama’s style of governing largely reflects an acceptance of the status quo.   His “economic experts” also reflects this preference.  As Baker argued, “it’s as if, after winning election in 1932, FDR had brought Andrew Mellon back to the Treasury.”

To the extent that he displays any kind of radicalism, it is to roll back the frontiers of the New Deal and Great Society, in effect gutting the Democratic Party of its core social legacy.  This assertion will no doubt inflame the diminishing Obama supporters, who insist the president would never cut Social Security or Medicare, that he’s merely been exploring every possible route to a deal with the GOP.  But the evidence increasingly suggests otherwise.

Perhaps, as Salon.com’s Joan Walsh suggests, the president sincerely believes that the intense polarization of American politics isn’t merely a symptom of our problems but a problem in itself – “and thus compromise is not just a means to an end but an end in itself, to try to create a safe harbor for people to reach some new common ground”.   One finds further support for this view within Barack Obama’s own writings. A major theme of his 2006 book The Audacity of Hope is impatience with “the smallness of our politics” and its “partisanship and acrimony.” He expresses frustration at how “the tumult of the sixties and the subsequent backlash continues to drive our political discourse.”

There appears little question, then, that the President values compromise, indeed appears to enshrine it as the apex of all great Presidencies (ironically citing Lincoln’s compromise on slavery as a perfect illustration of this ideal).  But the problem with Walsh’s supposition is that the President’s accommodation with his political enemies, his apparent infatuation with a “third way”, suggests that he is being forced to compromise on a particular set of ideals and principles which he has hitherto embraced dearly.

But what is this President’s ideal? The only time in our national discussions where Mr. Obama has evinced any kind of passion has been during the debt ceiling negotiations.  He has, since the inception of his presidency, elevated budget deficit reductions and the “reform” of entitlements as major transformational goals of his Presidency (rather than seeing deficit reduction as a by-product of economic growth).  As early as January 2009, before his inauguration (but after the election, of course), then President-elect Obama pledged to shape a new Social Security and Medicare “bargain” with the American people, saying that the nation’s long-term economic recovery could not be attained unless the government finally got control over its most costly entitlement programs (http://www.washingtonpost.com/wp-dyn/content/article/2009/01/15/AR2009011504114.html)

In other words, Obama has been on about this since the inception of his Presidency.  Recall that it was Barack Obama, NOT the GOP, who first raised the issue of cutting entitlements via the Simpson-Bowles Commission.  The President has also parroted the line of most Wall Street economists as he has persistently characterized our budget deficits and government spending as “fiscally unsustainable” without ever seeking to define what that meant.  One of his earliest pledges was to cut the deficit in half by the end of his first term, in effect paying no heed to the economic context when he made that ridiculous assertion.

In essence, the debt ceiling dispute is not forcing a compromise on this President, but is instead is viewed by him as a golden opportunity to do what he’s always wanted to do. That also explains why he won’t ask for a clean vote on the debt ceiling, why he has ignored the coin seignorage option, and why he has persistently avoided the gambit of challenging its constitutionality via the 14th amendment, even though his Democrat predecessor has already suggested that this is precisely what he would do: Bill Clinton asserted last week that he would use the constitutional option to raise the debt ceiling and dare Congress to stop him (http://www.nationalmemo.com/article/exclusive-former-president-bill-clinton-says-he-would-use-constitutional-option-raise-debt).

It also explains why President Obama remains infatuated by bigger and bigger “grand bargains”, which seem to take us further away from averting the immediate economic catastrophe potentially at hand, which is to say national default.  The Administration, then, is not going for a bipartisan compromise, but going for broke on something which the President apparent holds sacrosanct.  In reality, true compromise would start with the notion of a clean vote on the debt ceiling or, at the very least, a minimal series of spending cuts that would avert the immediate risk of a default, whilst creating less deflationary pressures.

Have you actually seen the President ever get angrier than he was at his press conference announcing the collapse of the negotiations on the debt ceiling extension? Not even on health care “reform” can we ever recall seeing Obama this engaged, and manifesting something close to real emotion as he has here.  That does suggest something beyond mere political calculation; it hints at core beliefs.

And to what end?  Neither he, nor the Congress appear to recognize the downward acceleration in GDP triggered when the spending limits are reached if the automatic stabilizers are disabled because they are no longer funded as a consequence of the debt ceiling limitations (again, a LEGAL, rather than operational constraint – the debt ceiling reflects an UNWILLINGNESS to pay, rather than an INABILITY to pay).
So spending will be further cut, debt deflation dynamics will intensify, sales will go down more, more jobs will be lost, and tax revenues will collapse even further.  Which will set the whole process off again:  more spending is cut, sales go down more, more jobs are lost, and tax revenues fall more, etc. etc. etc. until no one is left working.  All are radically underestimating the speed and extent of the subsequent damage.
Unlike President Hoover, who inherited the foundations of a huge credit bubble from the 1920s and found himself overwhelmed by it, this President is worse.  He is, through his actions, creating the conditions for a second Great Depression because of his misconceived belief that too much government spending “crowds out” private investment, and takes dollars out of the economy when it borrows. And therefore, goes the perverse logic, when the government stops borrowing to spend, the economy will have those dollars to replace the lost federal spending.
And so after the initial fall, Obama believes, it will all come back that much stronger.
Except, that as my friend Warren Mosler insists, he is dead wrong, and therefore we are all dead ducks.
As Warren notes, have you ever heard anybody say ‘I wish they’d pay off those Tsy bonds so I could get my money back and go buy something.’?
Of course not!  Notes Warren:
“Treasury borrowing gives dollars people have already decided to save a place to go. Dollars that came from deficit spending- dollars spent but not taxed. If they were spent and taxed, they’d be gone, not saved.
Treasury bonds provide a resting place for voluntary savings. They are bought voluntarily. They don’t ‘take’ anything away from anyone. 
For example, imaging two people, each with $1 million. One pays a $1 million tax. The other doesn’t get taxed and decides to buy $1 million in Treasury bonds.  Pretty obvious who’s better off, and who’s still solvent and consuming.”

Someone please explain this basic economic tenet to the President so that he can effect a genuine compromise, not a destructive “grand bargain” which will suck trillions of demand out of a still fragile economy. The predictable result is of his current stance is that, even as he claims to recognize the interlocking nature of the problems facing us and vows to “solve the problem” once and for all via a “grand bargain”, Obama is in fact tearing apart most of the foundations which were tentatively initiated under Hoover, but which came to full fruition under FDR.   If he continues down this ruinous path, $150 billion/month in spending will be cut.  Such economic thinking isn’t worthy of Mellon, let alone Herbert Hoover. 

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MMP BLOG #8: TAXES DRIVE MONEY

Posted on July 24, 2011 by | 24 comments

By L. RANDALL WRAY

Last week we raised the following question: Where currency cannot be exchanged for precious metal, and if legal tender laws are neither necessary nor sufficient to ensure acceptance of a currency, and if the government’s “promise to pay” really amounts to nothing more than exchanging one 5 Dollar note for another 5 Dollar note, then why would anyone accept a government’s currency? This week we explore the MMT answer.

Taxes drive money. One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government including fees and fines). Tax obligations are levied in the national money of account—dollars in the US, Canada, and Australia, Yen in Japan, Yuan in China, and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In all modern nations, it is the government’s own currency that is accepted in payment of taxes.


We will examine in more detail in coming blogs exactly how payments are made to government. While it appears that taxpayers mostly use checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks. Effectively, private banks intermediate between taxpayers and government, making payment in currency (technically, reserves that are the IOU of the nation’s central bank) on behalf of the taxpayers. Once the banks have made these payments, the taxpayer has fulfilled her obligation, so the tax liability is eliminated.

We are now able to answer the question posed earlier: why would anyone accept government’s “fiat” currency? Because the government’s currency is the main (and usually the only) thing accepted by government in payment of taxes. To avoid the penalties imposed for non-payment of taxes (that could include prison), the taxpayer needs to get hold of the government’s currency.

It is true, of course, that government currency can be used for other purposes: coins can be used to make purchases from vending machines; private debts can be settled by offering government paper currency; and government money can be hoarded in piggy banks for future spending. However, these other uses of currency are all subsidiary, deriving from government’s willingness to accept its currency in tax payments.

It is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot readily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes.

For this reason, neither reserves of precious metals (or foreign currencies) nor legal tender laws are necessary to ensure acceptance of the government’s currency. All that is required is imposition of a tax liability to be paid in the government’s currency.

What does government promise? What does a government IOU owe you? The “promise to pay” that is engraved on UK Pound notes is superfluous and really quite misleading. The notes should actually read “I promise to accept this note in payment of taxes.” We know that the UK treasury will not really pay anything (other than another note) when the five Pound paper currency is presented. However, it will and must accept the note in payment of taxes. If it refuses to accept its own IOUs in payment, it is defaulting on that IOU. What was it that President Bush said?

“There’s an old saying in Tennessee — I know it’s in Texas, probably in Tennessee — that says, fool me once, shame on — shame on you. Fool me — you can’t get fooled again.”

Forgive him as he probably listened to Roger Daltry a bit too much back in his partying days. What he meant is that the sovereign can fool me once—shame on government—but it cannot fool me again. (That, folks, is what led to the creation of the Bank of England! A story for another day.)

This is really how government currency is redeemed—not for gold, but in payments made to the government. We will go through the accounting of tax payments later. It is sufficient for our purposes now to understand that the tax obligations to government are met by presenting the government’s own IOUs to the tax collector.

Conclusion. We can conclude that taxes drive money. The government first creates a money of account (the Dollar, the Tenge), and then imposes tax obligations in that national money of account. In all modern nations, this is sufficient to ensure that many (indeed, most) debts, assets, and prices, will also be denominated in the national money of account.

(Note the asymmetry that is open to a sovereign: it imposes a liability on you so that you will accept its IOU. It is a nice trick—and you can do it too, if you are king of your own little castle.)

The government is then able to issue a currency that is also denominated in the same money of account, so long as it accepts that currency in tax payment. It is not necessary to “back” the currency with precious metal, nor is it necessary to enforce legal tender laws that require acceptance of the national currency. For example, rather than engraving the statement “This note is legal tender for all debts, public and private”, all the sovereign government needs to do is to promise “This note will be accepted in tax payment” in order to ensure general acceptability domestically and even abroad.

Ok we need a cliff-hanger. Here are two questions to ponder for Wednesday:

  1. Does this work only for taxes? Could other obligatory payments work? Like what?
  2. What if you do not, personally, owe taxes? Why would you accept the government’s currency?

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WHY IS CURRENCY ACCEPTED? RESPONSES TO COMMENTS ON MMP BLOG #7

Posted on July 21, 2011 by | 21 comments
By L. RANDALL WRAY
So the Telenovela trick worked: many good comments and questions, with no one destroying the plot line.
Let me briefly address them by grouping them into six general areas. And then on Monday we will give an answer to the question: why would anyone accept a sovereign currency? On the comments page I already addressed two questions so will not repeat my answers to those here.

  1. Can gold be money? No. Never. If gold could be money, why not silver? Copper? Coconuts? Fish? Domestic services? A fuller answer will have to wait. In my view, money can never be a “commodity”. For our economistic friends, recall the line from Clower: “goods buy money, money buys goods, but goods never buy goods.” If a commodity could be money, we have a case of “goods buying goods”. There is not, never has been, such a thing as a “commodity money”.
  2. Money is a “custom”, “law”, “norm”, “rule”. Ok, not specific enough for my taste. What is the nature of that custom, law, norm, rule? I do think that referring to “law” is on the right track. In my view, “custom”, “norm”, “rule” does not pin it down. This should be clear from the blogs I have posted the last two weeks. (Hint: why did I use the term “sovereignty”?) Veblen skewered the “leisure class” for its customs and norms—I love his explanation of the development of the custom of growing long fingernails (mostly, but not exclusively, on women—to prove that one is not and cannot be productive). These things are important. But they do not shed much light on money. Laws? Yes, you are getting hot (remember the game you played with your mum?–hide the thimble). But not legal tender laws—nothing but a “pious wish”, as Knapp put it.
  3. Why would those outside the US be willing to use dollars? Very good question. And, yes, it is related to a wish to “join the party” put on by the biggest economy in the world. But it really does beg the question, no? Certainly it must be related to willingness of Americans to accept dollars. But we do not want a “hot potato” or “infinite regress” argument (which Ramanan accuses us of, continuing to misstate the MMT position—her/his “MO”, unfortunately, and she/he does know better). So….why do Americans want dollars? Ah, yes, that is the question.
  4. Are all debts denominated in money, such as the schoolyard debts amongst children? No. For an excellent, and I mean really, truly excellent, book on debt broadly defined, please read Margaret Atwood’s “Payback: debt and the shadow side of wealth”. She documents that chimps keep careful records of debts and credits. If Chimp A helps defend me against an attack but I do not “payback” next time Chimp A is attacked, I cannot count on her when I need help. Yes, we are cousins of chimps, and yes we keep careful track of debts and credits. But many or most of these are not denominated in money terms. So far as we know, Chimps have never come up with the concept of a unit of account. But remember, if a chimp does you a favor, you’d better pay up.
  5. Does it have something to do with accounting systems of credits and debits, denominated in dollars? Bingo. We are onto something here. Credits and debits. Measured in a money of account. Keep that in mind for next week. Ponder this: if currency is related to the sovereign government, what debit/credit relation do we have with that sovereign? Remember the chimps. What do we owe our sovereign chimp?
  6. Soddy: the value of money is determined by the wealth given up when money is accepted. Except for some unfortunate terminology, we’ve again “struck gold”. The value of a currency depends on what we have to “give up” to get it. Be careful here—the value of the currency is not quite the same thing as willingness to accept it. Just because I am willing to accept a currency does not determine its value. “What am I willing to do to obtain it?” That is not the same as: “Why am I willing to accept it?” (Soddy was brilliant and came up with the Soddy principle: debts tend to grow faster than incomes due to compound interest, which is why we need the Year of Jubilee when all debts are forgiven. But we adopted the Roman view of time—abandoning the circular view of time that all previous societies accepted—so that we can never “go back”, debts can never be forgiven because property rights are sacrosanct, including the creditor’s right to squeeze blood out of an orange. So we have to have bankruptcy court, debtor’s prisons, and IMF sanctions. Ain’t Roman civilization grand?)  So I need dollars (why?) and am willing to “give up something” to get them (how much?). Those, as our Hamlet might say, are the key questions about money: why, and how much?

OK, so the suspense is killing you. Four long days to wait for the answer to be revealed. Plot spoilers: go ahead and do your damage.

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Scott Sumner Agrees that MMT Policy Proposals Are Not Inflationary

Posted on July 20, 2011 by | 71 comments

By Scott Fullwiler
Scott Sumner sets out to debunk theories of the price level not based on a form of the quantity theory of money, and lumps MMT in with those approaches that “deny open market purchases are inflationary, because you are just exchanging one form of government debt for another.” While this is true, what’s interesting is that from within Sumner’s own paradigm, MMT-related proposals should not be inflationary. This is clear right off the bat when he lists his first “qualifier” or exception to the quantity theory:

  1. If the new base money is interest-bearing reserves, I fully agree that OMOs may not be inflationary.  That’s exchanging one type of debt for another.

And that is about all we need to hear. As we’ve said probably gazillions of times, you can’t have discretionary open market operations beyond that which is consistent with the Fed achieving its federal funds rate target unless an interest-bearing alternative to reserve balances is offered. Traditionally, this has been Treasury securities issued by the Treasury or sold by the Fed. The only way to leave all the reserve balances circulating and achieve a positive interest rate target at the same time would be to pay interest on reserve balances.
For instance, later, when Sumner writes, “Now suppose that in 2007 the US monetized the entire net debt, exchanging $6 trillion in non-interest bearing base money for T-securities,” hopefully he realizes that this is not operationally possible without paying interest at the target rate on the excess reserve balances created unless the Fed wanted to have a zero-rate target.

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Coin Seigniorage: A Legal Alternative and Maybe the President’s Duty

Posted on July 18, 2011 by | 36 comments

By Joe Firestone
(Cross-posted from Correntewire.com.)

(Author’s Note; Many thanks to lambert strether, beowulf, and Yves Smith for their reviews of this post)

Well, the debt limit crisis is upon us. Treasury Secretary Geithner says the US Government will not be able to meet all its obligations on August 3, unless the debt ceiling is increased by Congress. The Secretary says he is out of moves to extend this date. I don’t think that’s true. I think he can use proof platinum coin seigniorage to supply all the money needed to spend Congressional Appropriations. I do not know if the Administration knows about this idea yet. It may, and it may simply have been unwilling to mention it for its own reasons. But just in case it doesn’t know, and also for the sake of the rest of us, I’m making another attempt to state the case for using coin seigniorage, so that as many people as possible know that the President has an alternative to the “shock doctrine,” make a deal approach to cutting essential spending and services including the social safety net, in return for getting $2.6 Trillion more in debt issuance authority.

The idea of using coin seigniorage to remove the need for issuing debt, and so to always stay under the debt ceiling is due to a commenter (and occasional blogger) on economics and politics blogs whose screen name is beowulf. He first presented the idea in comments and then posted the seminal blog on coin seigniorage.

Throughout the next six months, a number of other posts appeared at various sites (See here for links) with increasing frequency as the debt limit problem received more attention.

In the last few days, as coin seigniorage itself climbed up the hierarchy of public awareness, Felix Salmon and Matt Yglesias, both well-respected, mainstream, and professional bloggers, have mentioned the proposal while taking issue with it for reasons I’ll analyze below. Before, I do that however, here’s what’s involved in proof platinum coin seigniorage,

Congress provided the authority, in legislation passed in 1996, for the US Mint to create platinum bullion or proof platinum coins with arbitrary fiat face value having no relationship to the value of the platinum used in these coins. These coins are legal tender. So, when the Mint deposits them in its Public Enterprise Fund account at the Fed, the Fed must credit that account with the face value of these coins. This difference between the Mint’s costs in producing the coins and the credit provided by the Fed is the US Mint’s profit. The US code also provides for the Treasury to periodically “sweep” the Mint’s account at the Federal Reserve Bank for profits earned from these coins. Coin seigniorage is just the profits from these coins, which are then booked as miscellaneous receipts (revenue) to the Treasury and go into the Treasury General Account (TGA), narrowing the revenue gap between spending and tax revenues. Platinum coins with huge face values e.g. $2 Trillion, could close the revenue gap entirely, and technically end deficit spending, while still retaining the gap between tax revenues and spending.

Recent Comments from the Mainstream

Here’s Felix Salmon’s treatment at Reuter’s:

Even if Treasury can still sell bonds, however, that doesn’t mean for a minute that breaching the debt ceiling is something which should be considered possible for the purposes of the current negotiation. Tools like the 14th Amendment or even crazier loopholes like coin seignorage would be signs of the utter failure of the US political system and civil society. And that alone could mean the loss of America’s status as a safe haven and a reserve currency. The present value of such a loss? Much bigger than $2 trillion. (Coin seignorage, if you’re wondering, is the right that Treasury has to mint a couple of one-ounce, $1 trillion coins and deposit those coins in its account at the New York Fed. It could then withdraw cash from that Fed account to make all the payments it wanted.)

Felix Salmon does give an acceptable one sentence overview of the proposal, but doesn’t make clear that there could be even a single coin (not a “couple of coins”) of arbitrary value produced by the US Mint. More importantly, he doesn’t make clear why using coin seigniorage would be a sign “. . . of the utter failure of the US political system and civil society,” or why using it would be “. . . breaching the debt ceiling.” He also doesn’t say why he lumps in a 14th Amendment challenge to the debt ceiling with coin seigniorage as crazy ideas.

Addressing these points one by one, first, it’s true that the Congress hasn’t been able to come to agreement on the debt ceiling, but it’s hard to see why this is a sign of “the utter failure” . . . “of civil society.” Even more, the US political system has provided the tool of coin seigniorage as a legal, if not customary, way of generating revenue in addition to taxing and borrowing. Why does this count as “crazier” idea or a failure of the political system? From my point of view the only failure here is the President’s in not using coin seigniorage, or perhaps not yet even knowing about it. But if this is a failure, I don’t see that it’s a systemic one as much as it is a failure of this Administration to look for alternative views that go beyond its own knowledge and imagination.

Second, it’s hard to see why using coin seigniorage would be “breaching the debt ceiling.” Certainly, challenging the Constitutionality of the debt ceiling and overturning the legislation mandating it might be described as “breaching” it. Also, just ignoring it on grounds that it is unconstitutional might be described in the same way. However, using proof platinum coin seigniorage with very high face value coins just spends Congressional appropriations, including paying down debt so that it’s way below the debt ceiling, or even completely eliminated, using perfectly legal means. It’s hard to see how this can be legitimately described as “breaching the debt ceiling.”

And, third, why does Felix Salmon think that using coin seigniorage “. . . could mean the loss of America’s status as a safe haven and a reserve currency. ” Why should a demonstration, using coin seigniorage, of the Treasury’s power to meet US obligations even when Congress is in deadlock, lead to a loss of confidence, making investment in the US look any more dangerous than it is at present, or disturbing the status of the US dollar as the reserve currency? Surely if Felix Salmon wants to make such a serious charge he should at least give readers his reasoning.

It is possible that if coin seigniorage were used on a continuing basis to close the gap between taxes and spending, then US Treasuries would no longer be a safe haven for investing USD reserves, simply because, if no more debt is issued, then no investment in Treasuries is possible. But even if that happened, a low level of interest paid by the Fed on USD reserves would still leave US dollar reserves as safe a haven for holding “risk-free” US financial assets as short-term Treasuries are right now.

It is also hard to see why coin seigniorage, if used, would interfere with the status of USD as the reserve currency. Why should it, since continuous use of seigniorage would result in gradually eliminating the national debt? And what other reserve currency would the world use? The UK pound? The Euro, with its great potential instability? The Yuan, which if it became the reserve currency would force China to give up its peg to the Dollar and to even acquire a bit of a disadvantage in trading with us? What about the Yen? Sounds OK to me, but the world seems convinced that Japan, with its 200% debt-to-GDP ratio might have runaway inflation anytime now. So, will the world take the Yen? Probably not.

What about a market basket of freely floating currencies? Well, that would be fine, but it’s hard to see how that would disadvantage us or cost us $2 Trillion. I also wonder where Felix Salmon got that estimate from. Also, is the $2Trillion an interest cost, a reduction in GDP? Is it over one year, or a decade? Isn’t it a fact, that being the reserve currency costs us exports and jobs? How does that get factored into Salmon’s $2 Trillion cost of not being the reserve currency?

Matt Yglesias is the second popular blogger mentioning coin seigniorage last week. Matt says:

This is an idea that’s circulating in Modern Monetary Theory circles, and I believe that it’s legally mistaken.

Perhaps it is. But don’t you owe it to readers to tell them why?

That said, conceptually it highlights a very accurate point. If you think of the United States government as a consolidated entity, it’s not possible for us to “run out of money” or “go bankrupt.” The government of Ireland owes euros, but it lacks the legal authority to create Euros. Governments of small developing countries often owe dollars, but lack the legal authority to create dollars. Under a gold standard, a government might owe gold and lack the physical capacity to create it. But the United States is owed dollars, and can create dollars, so it’s absurd to think that we might not be able to pay our bills.

Matt understands this very basic point of MMT, and that puts him miles ahead of most who pronounce on solvency. But it’s also important to emphasize that Governments like our own can become insolvent voluntarily. That is, if Congress fails to raise the debt ceiling, or if, in the event they fail, the President fails to use coin seigniorage or another Treasury tool to create a positive balance in the Treasury General Account (TGA) at the Fed, then we can become voluntarily insolvent – a self-inflicted wound caused by a collective failure to understand our fiat currency and monetary system.

Now what might happen is that people lose willingness to lend us dollars in the future. We also might have inflation. Money was lent in the past on the assumption that dollars would be able to purchase real goods and services. Monetization of debt would reduce the real purchasing power of dollars, and might call into question the wisdom of agreeing to lend dollars in the future. But these are different issues.

First, if, as Matt recognizes, we can’t “run out of money” then why do we need people to lend us our own currency in the future? Why can’t we use coin seigniorage indefinitely for “deficit spending?” (From a technical point of view continuous use of proof platinum coin seigniorage would end deficit spending because it would close the gap between spending and taxes with miscellaneous receipts, a class of revenue. However, the gap between taxes and spending would remain and that “deficit” represents a surplus for the non-Government sector.) If we did that we’d avoid, as time went on, most spending on interest costs projected by CBO over the next 10 years. Indeed, if we project out to 15 years based on CBO 10-year numbers, we’d avoid nearly $12 Trillion in projected interest costs. Why borrow our own money back at all? The answer is we don’t need to. So, we don’t really have to care whether people want to lend us back our own money, or not.

Second, why would coin seigniorage in itself cause inflation? Coin seigniorage creates money to spend Congressional appropriations. As long as those appropriations are not so great that they exceed the potential productive capacity of our economy — and right now our output gap is around 30%, and there is no sign of Congress deciding to spend enough to close that gap — there will be no demand-pull inflation.

Would there be cost-push inflation? Not from coin seigniorage. The coins would just go into a Fed vault forever, and again the spending will be only what Congress appropriates. Coin seignorage will add to aggregate demand whenever spending exceeds taxes; but it will not cause cost-push inflation. That is caused by suppliers or speculators who are distorting markets. And the remedy for that is criminal investigations, price controls, rationing, and a thoroughgoing belief that markets must be very closely regulated by independent adversarial enforcers if they are to remain free.

Third, “money was lent in the past on the assumption that dollars would be able to purchase goods and services in the future.” But, again, why should the simple fact of using coin seigniorage debase the currency? Matt needs to explain the transmission mechanism from using seigniorage to spend Congressional appropriations and pay down debt, to currency debasement. Saying that “we also might have inflation” is easy. But one really has to show that the likelihood of inflation is greater if we use coin seigniorage than it is if we issue more debt instead. My view is good luck with that, because there are very good reasons for thinking that coin seigniorage would actually be less inflationary than issuing debt to close the gap between taxes and spending would be.

Fourth, “monetization” is a term that is frequently thrown around whenever the Government wants to use its Constitutional power to deficit spend and create money in the process. But “monetization of debt” has a strict meaning in modern economies. It refers to the purchase of debt instruments by the Central Bank from the Treasury. That wouldn’t be happening here.

Here’s how coin seignorage works: Legal tender, money, in the form of proof platinum coins, not legally viewed as debt, is being exchanged for USD credits in the US Mint’s Public Enterprise Fund account. The money goes into the Fed vaults, the USD credits go into the Mint’s account. The profits from seigniorage go into the TGA. This is an asset swap, between the Fed and the US Mint, of money in the form of a coin, for money in the form of bank reserves. Both sides of the swap are money; so there is no “monetization of debt” involved.

[UPDATE] I now think this might be legal after all, provided the coin is made of palladium.

Palladium coins won’t do; we need coins that can be legally given an arbitrarily high face value. The palladium coins are specified by Congress at $25 in face value. The platinum coins being discussed in the coin seigniorage proposal are proof platinum coins. The face value of these coins is arbitrary and has nothing to with the value of the metal. Platinum proof coins are strictly fiat money, and they can have as a large a face value as the Mint likes. Just like the USD reserves the Fed creates for quantitative easing, or to increase the money supply.

So, after months of blogging, commenting, and tweeting about the coin seigniorage option, it seems that enough activity has been generated in the blogo- and twitter-spheres to have attracted at least the passing attention of well-respected bloggers such as Felix Salmon and Matt Yglesias. It’s pretty clear from my analysis, however, that both of them are offering conclusions about coin seigniorage that aren’t based on careful analysis of the literature that’s developed on the subject.

Put simply, they don’t seem to have thought things through, and they don’t seem to be in a position to guide their readers in learning about the coin seigniorage option. It’s good that they’ve recognized that coin seignorage is, at least, analytically sound enough to merit attempted refutation, and have opened the door to discussion of it in the wider discourse. Thanks to both of them for that, and especially to Matt for pointing out that involuntary solvency isn’t a problem for the US. Exposure for a policy proposal is always better than just continued burial in the non-visible portion of the blogosphere. Nevertheless, it would be so much better for all of us if well-known bloggers who take up a new proposal would investigate it with care before they pronounce a verdict on it.

What harm would have been done if Felix Salmon and Matt Yglesias had just mentioned coin seigniorage and admitted that they still had to research it before deciding on whether it would work, and that they were keeping an open mind pending that research? Certainly, the potential of coin seigniorage as a solution to our revenue problem merits that kind of consideration. How important is it?

The Importance of Coin Seigniorage to the President

I’ll end this post by showing how important it is through an examination of our present situation with respect to the debt ceiling and the potential obligation of the President to use coin seigniorage to cope with it.

1. Congress has appropriated Federal spending for FY 2011 which the Executive is mandated to spend.

2. These appropriations exceed the tax revenue the Government is collecting. This was expected at the time the appropriations were passed. So Congress appropriated deficit spending.

3. Congress has mandated that whenever the Government plans to deficit spend, it must first issue and sell debt instruments in an amount a least equal to the planned deficit spending. In this connection, the Treasury is prohibited from having an overdraft in its TGA at the Federal Reserve Bank.

4. Congress has mandated a debt limit such that the Administration must stop issuing debt when that limit is reached. (The limit was reached in early May). Given the Congressional requirement that deficit spending must be accompanied by debt issuance, the debt limit, in the absence of other countervailing factors puts a stop to deficit spending, until the limit is increased. There is a very important countervailing factor. But it is not recognized or used. So, for the moment, at least, the debt limit has stopped any further deficit spending

5. The 14th Amendment, section 4, requires that the validity of the “debts” (broadly construed) of the United States never be questioned, and since the President has sworn an oath to uphold the Constitution, he is obligated to do all he can to see to it that these “debts” are paid. In fact, he’s obligated to see to it that these debts aren’t even “questioned.” His suggestion that Social Security and other key payments won’t be made on August 3, isn’t living up to his obligations. Of course, he’s not alone in this, since many law makers have been warning about the likelihood of a default for many months now.

6. Congress has provided the authority, in legislation passed in 1996, for the US Mint to create platinum bullion or proof platinum coins with arbitrary fiat face value having no relationship to the value of the platinum used in these coins. The US code also provides for the Treasury periodically sweeping the Mint’s account at the Federal Reserve Bank for profits earned from coin seigniorage. These profits are then booked as miscellaneous receipts (revenue) to the Treasury and go into the TGA, narrowing the revenue gap between spending and tax revenues. Platinum coins with huge face values e.g. $2 Trillion, would close the revenue gap entirely, and technically end deficit spending, while still retaining the gap between tax revenues and spending.

7. If used routinely to close the revenue gap, such coin seigniorage would eventually reduce the national debt to zero, and remove it as an issue in US politics. In addition, the existence of platinum coin seigniorage as an option, removes the tension between the mandated debt ceiling and the 14th Amendment. It is the countervailing factor I mentioned earlier, because it provides a way to spend Congressional appropriations without issuing further debt.

8. The President has sworn to uphold both the Constitution, which prohibits a default, and also the laws of the United States including the mandates just mentioned.

9. These mandates, along with the platinum proof coin seigniorage authority, make using seigniorage, or another option like it that allows the Treasury to create revenue without either taxing or borrowing, the only viable options to: continue spending appropriations without violating the debt limit; fulfill all the other mandates, both legal and constitutional; and still be able to spend the money Congress has appropriated.

10. So, if no action by Congress raising the debt limit is forthcoming, it will be the President’s sworn DUTY AND OBLIGATION to either use platinum coin seigniorage, or some other revenue creating tool legislated by Congress in past years, to make the money necessary to avoid default, since his failure to use an available way of creating revenue for continuing to spend appropriations, which he is mandated to do, would be a violation of his oath of office.

So, coin seigniorage isn’t some crazy idea. Instead, it is a legal instrument that the President may, depending on how things work out, have to use in a bit more than two weeks to comply with his oath of office. It may be the only way for him to avoid breaching one of the laws which he is supposed to enforce. As such, it has to be taken seriously, and treated with more than just a few dismissive conclusions, accompanied by a lack of explanation.

Many writers on the current debt ceiling crisis have been taking the view that the 14th Amendment constitutional challenge route is the best thing for the President to do if there is no agreement on the debt ceiling. In e-mail communication yesterday, beowulf offered the following opinion on why this will not work, given the existence of coin seigniorage.

. . . No federal judge — Supreme Court justices included — will take the extraordinary step of enjoining an Act of Congress if the President who asks them to had an opportunity to sidestep the constitutional issue lawfully but neglected to do so. . . . .

. . . The moral of the story is if the Court thinks there is no alternative to breaching the debt ceiling, it probably would find it unconstitutional (or rather, it would decline to hear the case on Standing grounds, leaving the President’s decision to ignore the debt ceiling in place). On the other hand, if the Court thinks the President had a lawful alternative– like coin seigniorage– but neglected to use it, they’re not going to bail him out.

This argument is compelling to me given the history of the Court. The Court defers to the legislature if it possibly can, and prefers the President to avoid constitutional challenges if he has a means of doing so. In this case, he does, and the means is platinum coin seigniorage.

Appendix: The Coin Seigniorage Idea in the Blogosphere

The idea of using coin seigniorage, the profits made from minting proof platinum coins, depositing them at the Fed, and receiving electronic credits in return, to remove the need for issuing debt, and so to always stay under the debt ceiling is due to a commenter (and occasional blogger) on economics and politics blogs whose screen name is beowulf. The first comment of beowulf’s I noticed on coin seigniorage was at New Deal 2.0 http://www.newdeal20.org/2010/11/04/obama-faces-his-own-teachable-moment-25819/#comment-9831 and I mentioned his proposal in a post I did on a possible Government shutdown due to the debt ceiling a couple of weeks later. http://www.correntewire.com/constitutional_crisis_over_debt_ceiling_does_government_have_shut_down

Beowulf continued his work on the coin seigniorage proposal as the weeks went by in various comments made at blog sites such as this one at FDL. We also began to exchange messages on coin seigniorage. On January 3, 2011, he posted the seminal blog on coin seigniorage. I followed two days later, raising the question of whether President Obama would use it to forestall an attempt to use the debt ceiling to extract cuts in the social safety net or not.

These posts were noticed by Warren Mosler, one of the originators of the Modern Monetary Theory (MMT) approach to economics, who sponsored what turned out to be a wide-ranging and very high quality discussion of the coin seigniorage option at his site. Beowulf contributed extensively and very creatively to this discussion, which remains one of the most important resources on the coin seigniorage option.

Throughout the next six months, I pushed coin seigniorage in blog posts at Correntewire, FDL, and DailyKos from time-to-time and in comments at various sites. Then, in late June and July a spate of posts on seigniorage appeared beginning, I think, with wigwam’s at FDL and DailyKos. He’s followed up since with a number of other posts including this one with a variation on how coin seigniorage might be applied by buying $2 Trillion in debt from the Fed to create “head room” relative to the debt limit. Other important posts have appeared this month by Mahilena, DC Blogger, Cullen Roche, Scott Fullwiler, and Trader’s Crucible. Accompanying the last two are extensive discussions of coin seigniorage and constitutionality of the debt ceiling with contributions from beowulf. Scott’s post also received extensive discussion with beowulf contributing at Cullen’s site. In addition, I’ve added two of my own posts, another on the President’s obligation, if no agreement on the debt ceiling is forthcoming.

So, the proposal to use coin seigniorage to both comply with the debt ceiling and still spend Congressional appropriations has by now enjoyed the support of a growing number of bloggers. It has also received a great deal of discussion; receiving 246 comments at Warren Mosler’s site; 206 comments spread over two post’s at Cullen Roche’s site, and 89 comments at Naked Capitalism. Readers checking out these discussions can see that the coin seignorage proposal has stood up very well to some very aggressive and forthright criticism.

(Cross-posted from Correntewire.com.)

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Council of Economic Advisors’ Annual Reports 2005-2007: No Crisis Here

Posted on July 18, 2011 by | 1 comment
By William K. Black
* Cross-posted from Benziga

I decided to look at what President Bush’s Council of Economic Advisors (CEA) were saying in their annual reports for 2005-2007 about the massive real estate bubble, epidemic of accounting control fraud and mortgage fraud, the resultant rapidly developing financial crisis, and the great increase in economic inequality.  Here’s what I found on these topics.
CEA Annual Report for 2005
N. Gregory Mankiw chaired the CEA.

Home ownership reached a record 69%.  Home prices were surging.  No discussion of the developing bubble.  The CEA was enthused by the housing sector. 

No mention of subprime or nonprime loans (or any variants, e.g., stated income).

There was no discussion of financial institutions’ risk.

There was no mention of Fannie or Freddie.

No mention of the FBI’s September 2004 warning that there was an “epidemic” of mortgage fraud or the FBI’s prediction that the fraud would cause a financial “crisis” if it were not stopped.  No mention of mortgage fraud.

The report contained an extensive discussion of Internet frauds.

No use of the term “inequality,” but discussion of some of the factors increasing inequality.  It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.  

CEA Annual Report for 2006
No CEA chair listed because no replacement was in place after Bernanke’s resignation when he was appointed as the Fed’s Chair.

“During the past five years, home prices have risen at an annual rate of 9.2 percent.”  The report argues that this was driven by increased demand and lower financing costs.  It does not use the word “bubble,” but it argues that there is no bubble.

No mention of subprime or nonprime loans (or variants).

Chapter 9 of the report is devoted to financial institutions.  The CEA argues that the U.S. has a “comparative advantage” in financial services.  It premises its analysis of financial institutions on information asymmetries.  It has a glaring false tone at the start of this discussion when it asks: “why do [banks] ask for so much information before making a loan….?  By early 2006, of course, the striking change was how little information banks verified.  The CEA explains the concepts of adverse selection, moral hazard.  The explanation is critically flawed in that it ignores fraud despite the fact that adverse selection and moral hazard are exceptionally criminogenic.  Again, the CEA ignores the FBI’s warnings of the growing mortgage fraud epidemic and ignores the risk of accounting control fraud by financial institutions and their agents.  It notes that banks can take steps that are known to minimize adverse selection and moral hazard, but ignores the vital fact that the officers that controlled the nonprime lenders typically refused to take such steps (even though any honest businessman would do so) and that nonprime lending was vast and growing rapidly. 

The CEA’s discussion of these topics is bizarre – it fails to recognize or address the implications of the fact that nonprime lenders are acting in a manner directly contrary to the economy theory the CEA argues explains why financial intermediaries exist.  Under the CEA’s theories, the actions of the nonprime lenders are rational only for accounting control frauds.  In conjunction with the FBI’s 2004 warnings that the growing fraud epidemic would cause a financial crisis this should have caused the CEA to issue a stark warning.  Instead, the discussion is triumphal.  The CEA even sees the tremendous increase in GDP devoted to the financial sector as desirable – proof that the U.S. has a “comparative advantage” in finance over the rest of the world.  The CEA then claims that this advantage leads to exceptional U.S. growth and stability, helping to produce the “Great Moderation.”  Deregulation and the rise of financial derivatives explain our comparative advantage in finance, the Great Moderation, and our superior economic growth.  This self-congratulatory dementia achieves self-parody when the CEA lauds “cash-out-mortgage refinancing” for purportedly having “moderate[d] economic fluctuations.”  The CEA’s discussion of “safety and soundness” regulation is overwhelmingly a highly generalized description of Basel I and II.          

Chapter 9 discusses the need to combat identity fraud as one of its prime (and rare) examples of desirable forms of consumer protection, but it primarily emphasizes the dangers of consumer protection regulation and attacks the (repealed) Glass-Steagall Act. 

Chapter 9 discusses Fannie and Freddie and their systemic risk.  More precisely, it assumes that the systemic risk arises from prepayment risk – not credit risk.  Accordingly, it explains that the administration wants Fannie and Freddie to expand their securitization of lower credit quality home loans (“for a wider range of mortgages”) while decreasing the number of home loans Fannie and Freddie hold in portfolio so that they can reduce their prepayment risk.   

The report uses the term “inequality” and ascribes the growing inequality overwhelmingly to the distribution of skills.  It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.   
CEA Annual Report for 2007
Edward P. Lazear, CEA Chair.

The report does not mention the word “bubble” and continues to argue that the price increases in housing are due to rising demand for housing and lower financing costs.  The CEA claims that the growth in home prices during the decade was “modest” in most metropolitan areas.  The growth in most metropolitan areas was materially faster than GDP and population growth.  The report admits that all housing indices fell sharply in 2006, but stresses that unemployment is falling and claims that the fall in housing may increase growth in other sectors by reducing “crowding out” effects in private investment.  
The report does not mention mortgage fraud or accounting control fraud by lenders and their agents.  It mentions fraud in two contexts.  First, it states that it is possible that regulation could reduce fraud with respect to disaster insurance.  Second, it notes that fraudulent papers can make it difficult for employers to avoid hiring undocumented immigrants.

No mention of subprime or nonprime loans (or variants).

The report does not mention Fannie or Freddie.

The report uses the term “inequality” and ascribes the growing inequality overwhelmingly to the distribution of skills.  It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.  
Conclusion
During the key period 2005-2007 when the epidemic of mortgage fraud driven by the accounting control frauds hyper-inflated the bubble and set the stage for the Great Recession the President’s Council of Economic Advisors were oblivious to the developing fraud epidemics, bubble, and the grave financial crisis they made inevitable absent urgent intervention by the regulators and prosecutors.  President Bush’s economists in this era were blind to the factors that were making the financial environment so criminogenic (e.g., deregulation, desupervision, and de facto decriminalization plus grotesquely perverse executive and professional compensation).  They typically did not make any relevant policy advice and when they did it was the worst possible advice warning of the grave dangers of regulations designed to reduce adverse selection.  They were so blind that they did not even find it worthy of reporting that there were over a million “liar’s” loans being made annually.

The only CEA report that even attempted to address financial regulation discussed a theoclassical fantasy world that bore increasingly little relationship to the reality of nonprime mortgage lending.  The tragedy is that “adverse selection” and lemon’s markets are superb building blocks for analyzing the frauds that drove the crisis and for understanding why only liars make a business out of making liar’s loans in the mortgage context.  The CEA did not warn of any credit risk at Fannie and Freddie.  Indeed, it urged them to make more loans to weaker credit risks as long as they securitized the loans.  Securitization would not have reduced Fannie and Freddie’s credit risk.

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