New Economic Perspectives

By L. Randall Wray

Voters in Iceland have rejected their government’s attempt to foist on them the costs of bailing out foreign creditors. Iceland’s oversized big banks had made bad loans throughout Euroland and when they failed uninsured depositors were on the hook. Governments in countries like the UK and the Netherlands bailed out their depositors and demand that Iceland reimburse them. However, Icelandic voters have now rejected that proposition twice. They feel they have suffered enough already from a financial crisis created by largely unregulated financial institutions that lent indiscriminately in foreign currency. Iceland does not use the euro and its tiny economy cannot be expected to cover all the euro-denominated debt run-up by private financial institutions. Those foolish foreigners who took risks by holding uninsured euro-denominated deposits in Icelandic banks with no access to a government back-stop in euros should take the loss. In my view, the voters have responded in a rational and responsible manner. After all, that is what market discipline and sovereignty are all about. If a saver does not like risks, she should hold only safe assets guaranteed by a sovereign power.

What about Ireland—which is now facing a similar situation—should its voters reject a taxpayer bailout of foreign creditors? Like Iceland, it faces a crushing debt because its government took on the liabilities of its oversized banks who also had lent indiscriminately throughout Euroland. However, unlike Iceland, Irish bank liabilities are denominated in the currency used in Ireland, the euro.

Ireland abandoned its sovereign currency when it joined the Euro. Effectively, it became like a US state—think Louisiana—within the EMU. This means it has little domestic policy space to use monetary or fiscal policy to deal with crisis. If we go back to 2005, Ireland’s government had the second lowest ratio of debt to GDP (national output or income) in the EU-15, with only Luxemberg having a lower debt ratio. The government paid an interest rate similar to that paid by the French and German governments; it had a strong AAA rating on its debt. In fact, it was running a huge government surplus of 2.5% of GDP (similar to that run by the Clinton administration in the late 1990s in the US).

Fast forward to this spring. The government deficit ratio was about 12.5% of GDP and credit default spreads on the government’s debt (equivalent to betting on default) reached almost 43 basis points over those of Germany, and it paid 6 percentage points higher to borrow than Germany did (on March 22 the spread on two year bonds hit a record 835 basis points—8.35 percentage points—over the rate on equivalent German debt).

Here’s the problem. There is a fundamental relation between economic growth and ability to pay interest to service debt. To be safe, a non-sovereign government should not pay an interest rate that significantly exceeds its growth rate. (A country that pegs its currency, operates a currency board, adopts a dollar standard, or adopts a foreign currency is by my definition “non-sovereign”.) If we compare Ireland today to the situation of Germany, because the Irish government pays 6 percentage points more, it needs to grow 6 percentage points faster than Germany does. To be sure this is a rough rule of thumb and there is some leeway. But the prospects for Ireland to grow that much faster than Germany—say 8 percent growth rate for Ireland versus 2 percent for Germany—approach a zero probability.

Indeed, the conventional way to generate government revenues needed to service debt is to cut government spending and raise taxes—which will only hurt Irish growth. Further, what Ireland needs is to increase the flow of euros in its favour through its foreign balance, i.e. by reducing imports and increasing exports to the EMU. The conventional prescription is slow domestic growth to reduce imports and enhance international competitiveness. This, too, further reduces domestic growth even further below the interest rate paid on government debt.

And that is precisely the plan adopted by Europe’s policy elite: the “Review of Labour Cost Competitiveness” released by Forfas on 29 October 2010 makes wage reduction its primary goal, while a report, “Ireland-Stability Programme Update”, was presented to the European Commission last month with a plan to “restore order to the public finances” through “an ambitious programme of structural reform” by increasing “competitiveness”. It is clear that the plan is to crush the economy to reduce living standards sufficiently to make Ireland a low-cost producer relative to the rest of Europe.

However, with the exception of the BRICs (Brazil, Russia, India and China) recent economic data across the globe have not been good. That makes it harder for Ireland to export its way out of debt—which is the least painful path. I do not see alternatives means of earning the needed euros that are without substantial suffering. Yet, many other EU nations are in a similar situation (even if some are less dire)—and will be competing with Ireland’s rush to the bottom. This is not a battle Ireland is likely to win.

Unfortunately, slow growth of the economy usually means slow growth of tax revenue. It is fairly easy to imagine a scenario in which domestic austerity actually makes the budget deficit worse, which raises interest rates on government debt. A vicious cycle can be created, with debt service blowing up as growth continues to slow and interest rates rise with credit ratings agencies downgrading government debt.

What I am going to say next will sound quite controversial. Ireland transitioned from a government budget surplus of 2.5% of GDP to a deficit of 12.5% of GDP, which I am arguing is a disaster. The US government has had a nearly identical transformation (from 2.5% surplus in the late 1990s to a deficit near 12.5% of GDP today) but it faces no insolvency constraint and no default risk. The reason this is controversial is because we do face deficit hysteria in the US and a threat by credit ratings agencies to downgrade US government debt. Congress nearly refused to extend the self-imposed debt limit on the federal government—and it is still possible that the government might get shut down if Congress refuses to raise the limit in the future. So it might look like the US and Ireland are in a similar pickle.

But they are not. All problems in the US are self-imposed. Irish problems are largely imposed by “markets”—by market assessment that there is a very real chance of involuntary default. That is why Irish borrowing rates are rising, while US government interest rates actually fell (!) after the threatened downgrade. The only path to US default is political—failure of Congress to raise debt limits. The path to Irish default is “economic”—spiralling interest rates with low growth rates.

If Ireland had its own sovereign currency, the size of the government deficit or debt ratio would not be relevant to ability to pay. I will return to that below. But since Ireland gave up its currency in favour of the euro, it is not in the position of a USA or a Japan or a Turkey. It has far less domestic policy space—to run up budget deficits to boost growth, and to set low domestic interest rates. Nor can Ireland devalue the currency—the value of its euro is set at equal to the euro used throughout the EMU. As we have seen, crises in various EMU nations (Greece, Portugal, Spain, Ireland) do not cause the euro to depreciate. That might sound counterintuitive but what matters is that there are relatively safe havens for those who want to buy euro-denominated debt, such as Germany. The “periphery” nations have to pay big premiums over the interest rates paid by Germany—and the euro remains (too) strong.

But let us look at how Ireland got into this mess. As I mentioned earlier, Ireland was the “paragon of virtue” just 6 years ago—its total outstanding government debt was just 8 months of tax revenue (publicly held debt was only 21% of GDP) and it was actually running budget surpluses. Then the financial crisis hit. That would have worsened the budget balance significantly—and probably would have generated a budget deficit. However, the government chose to guarantee its banks—which were vastly oversized relative to the size of the economy. That “busted the budget” and generated the current problems. In important respects, Ireland reproduced the Icelandic problem, with similar results. As we know, the people of Iceland have recently voted to undo the bank bail-out.

The question is how Ireland might respond to the will of its voters. Any rational response should try to undo the mess created by guaranteeing bank debt.

A recent report by Finnish bank expert Peter Nyberg avoids naming names (by contrast, the US official report on the crisis—the Financial Crisis Inquiry Report does so) but says that guaranteeing the banks was based on “insufficient information”. Well, that information is now sufficient to conclude that the bail-out was a mistake. It needs to be unwound. The documents must be made public. The guilty need to be prosecuted. Funds need to be recovered. Guarantees of crooks need to be withdrawn.

The case for Ireland to withdraw guarantees of bank liabilities is even stronger than the case for Iceland. Iceland wanted to guarantee only the deposits of its domestic residents, while allowing banks to default on those held by foreigners. In the case of Ireland, foreign creditors held large sums of subordinated debt and uninsured deposits. For years they had received higher returns on those inherently risky claims; but when the chickens came home to roost, foreign governments like the UK and the Netherlands chose to bail-out these holders (in many cases, their banks were the holders). That is bad policy, but it was their choice. Obviously, it rewards excessive risk taking, that presumably was already once rewarded by high returns. But now those governments want the Irish government to reimburse them for their foolish policy.

I do not (yet) want to recommend outright default on government debt. Public hearings on the bail-outs need to be undertaken immediately to determine what role fraud played in creating the government debt crisis. I’m not a lawyer, but government actions based not just on “insufficient information” but rather on “fraudulently constructed information” need to be undone. Exactly how that will play out through the courts I cannot forecast. As for the foreign government claims, Ireland ought to welcome them to pursue their case in court. Their claims appear to me to be without merit—but one never knows how courts will rule. At the very least, Ireland could buy a lot of time by going to court.

Meanwhile, Ireland needs jobs. A universal job guarantee is the best approach. The jobs would pay basic wages and benefits with a goal to provide a living wage. It would take all comers—anyone ready and willing to work, regardless of education, training, or experience. Adapt the jobs to the workers—as the late Hyman Minsky said, “take the workers as they are” and work them up to their ability, and then enhance their ability through on the job training.

The program needs to be funded by the central government. Wages would be paid directly to the bank accounts of participants for working in the program. Some national government funding of non-wage costs could be provided. I would decentralize the program, to allow local governments and not-for-profit service organizations to organize projects.

Now here is the problem. A sovereign government with its own currency can always financially afford such a program. Ireland could fund such a program with its own sovereign currency. In current circumstances this is problematic because Ireland abandoned its currency in favour of a foreign currency, the euro.

The big advantage of a sovereign currency is that government can “afford” anything for sale in its own currency. To keep our analysis simple, government then spends through “keystrokes”, crediting bank accounts.

Before all the Zombie Zimbabwean hyperinflation warriors attack, let me say that too much government spending can be inflationary and can create pressures on the currency. But by design a job guarantee program only hires people who want to work because they cannot find higher paying jobs elsewhere. It sets a wage floor but does not drive wages up. As such, it can never cause hyperinflation—it hires “off the bottom” at the program fixed wage, only up to the point of full employment. It never drives the economy beyond full employment.

What is the best way to guarantee long-term stability for the Irish economy? Full employment with reasonable price stability—something a universal job guarantee program can deliver.

For a sovereign currency nation the interest rate is a policy variable and has no impact on solvency. Government can keep rates low (it sets the overnight rate directly, and can if it desires issue only short maturity bonds near to that rate) and pays interest through “keystrokes” by crediting bank accounts with interest. It can never run out of keystrokes so will never fail to make interest payments unless it chooses to do so for noneconomic reasons.

For Ireland, this is a very serious problem. It does not have a sovereign currency. It cannot control its borrowing rates, which are set in markets. Nominal interest rates should not exceed nominal GDP growth rates. But as we know, markets have pushed rates to 10%. For Ireland to service debt at 10% interest rates, it will need Chinese growth rates. That seems unlikely.

So how should the government deal with loan repayments to the EU? As I discussed, I would encourage the government to unwind its guarantees of bank debt. If this cannot be done, then Ireland must have a bail out and debt relief provided by the ECB or the EMU through some other entity. That is actually in the interest of the EMU since much of the bank debt guaranteed by Ireland’s government is held externally by EU banks. The last resort alternative is default on debt and possible expulsion from the EMU. That will be painful. There isn’t anything Ireland can be expected to do without support from the EU—except for default.

So Ireland can learn from the Icelandic example. Both are heavily indebted because their banks were far too large and made too many foreign loans. A difference is that Iceland still has its own currency; however its banks made loans in foreign currencies. But in important respects, so did Irish banks since the euro is a foreign currency from the perspective of Ireland. Iceland’s citizens are pressuring its government to undo the bail outs. Ireland’s population can learn by example.

The Irish voters should demand accountability of government, including investigation of the bail out of banks. Government should pursue debt relief on all fronts. Voters should resist austerity programs. If all else fails, they should demand either default or withdrawal from the EMU (in practice these probably amount to the same thing).

And they demand jobs at decent pay. A Universal Job Guarantee program either funded by a newly sovereign Irish government, or funded by the ECB or other EMU institution is necessary to help revive the economy and to relieve suffering caused by high unemployment.

William Black was interviewed recently on KCRW’s Le Show with Harry Shearer.  Listen below.

http://www.kcrw.com/etc/programs/ls/ls110501le_show_-_may_01_201/embed-audio

By William K. Black

(cross-posted with Benzinga.com)

Greetings from Monaco. My colleague Professor Stephanie Kelton and I have just presented at the 9th Annual meeting of CIFA (Convention of Independent Financial Advisors). One of the other speakers in Monaco was Daniel Mitchell, a Senior Fellow at Cato. Dan and I come from very different views of economics, so we agreed that the fact that we agreed about a great number of things we believed were grave flaws in our financial system is a sure sign that the Mayan forecast of imminent catastrophe is likely to be correct.

One of the points Dan made about benefit-cost analyses and financial regulation sparked me to do some research. That research prompted this column. Dan urged that financial regulation should not be adopted unless it passed a formal benefit-cost test. SEC Commissioner Troy Paredes has been a strong advocate of requiring every proposed SEC rule to pass such formal tests. Dan implied that financial regulations are not normally subjected to formal benefit-cost tests and urged that no rules be adopted that did not pass a formal benefit-cost analysis. I taught how to conduct benefit-cost analyses for years when I was a professor at the LBJ School of Public Affairs at the University of Texas at Austin. There are several valid critiques of relying on formal benefit-cost analyses to decide regulatory policy. The next column will focus on a new critique arising from a nugget unearthed by my research into the extraordinary narrative that the most prominent proponent of benefit cost tests used to try to promote the use of such tests. I will show how revealing that narrative was in unintentionally demonstrating the great truth of the theme of CIFA’s 9th annual meeting – ethics are essential in preventing policy disasters.

Theoclassical Economists Despise Government Programs, particularly Successful Regulation

Benefit-cost tests are used as a device to give theoclassical economists extraordinary power to block regulations disfavored by the ruling administration. A regulation on pollution, for example, is typically shaped by scientists and engineers because they have the relevant expertise and they use that expertise and experience to reach a judgment that the policy they are recommending will benefit the nation. Economists, however, are the purported experts on formal benefit-cost analyses and they can and do use that expertise to kill rules the scientists believe to be vital.

Theoclassical economists are implacably hostile to regulation, so benefit-costs reviews could serve as a “choke point” to protect their dogmas – no matter how irrational and anti-empirical those dogmas prove. The core, defining dogma of theoclassical economists is that government is the problem, not part of the solution. They believe government is rarely necessary, that it proves a grave danger to personal liberty, and that virtually all governmental programs are economically illiterate and harm the intended beneficiaries as well as the economy. In short, they are potentially the perfect hanging jury when it comes to judging regulation. Indeed, the economists get to set the rules of the trial and via cost-benefit analysis they can override the agency decision-makers through their ex parte analyses. That makes them potentially more akin to a star chamber, able to condemn vital regulations essential to deal with about matters they do cannot comprehend.

Consider the cognitive dissonance a theoclassical economist would have to endure if he conceded that a proposed rule would provide large net benefits. The theoclassical economist would have to repudiate everything he believed, professed, and admit that his dogma was false and had caused grave harm to the nation. Research has confirmed that cognitive dissonance creates powerful biases – and that we are typically unaware of and deny the existence of those biases. Theoclassical economists are infamous for claiming that there are pure “positive” “scientists” devoid of dogma – the most dangerous and self-deceptive form of intellectual denial.

The implicit intellectual proposition underlying this choke point is: economists have a universal, superior methodology for judging the desirability of public policies even in fields in which they are hopelessly ignorant. (Hint: those claims of superiority have never been subjected to scientific analyses or even non-circular benefit-cost analyses. They have failed the predictive test spectacularly again during the current crisis. The superiority proposition is implicit because if economists were to state it explicitly outside their own departments they would be laughed out of the room. False, implicit assumptions pose grave dangers because we do not even consider whether they are accurate.)

Failed economic dogma leads to failed amateur climatology

With regard to policies to counter human-generated global climate change, theoclassical economists have no relevant expertise, no relevant experience, and a raft of unacknowledged personal biases arising from their anti-regulatory ideologies – a trifecta of tragic ignorance and arrogance. In other writings these same economists denounce policy makers who substitute their economic judgments for those of professional economists, so the theoclassical economists posing as amateur climatologists are also hypocrites.

The only thing more pathetic, arrogant, and dangerous than theoclassical economists purporting to be superior, objective judges of the net benefits of programs in which they lack relevant scientific expertise and experience is the theoclassical economists trying to play amateur climatologists. They don’t even stop to consider why they are engaged in such a facially absurd endeavor, one that, under their theories, imposes severe opportunity costs on them and society. I call it the theory of comparative disadvantages, a condition economists are supposed to abhor. Theoclassical economists are drawn to climate change denial, however, because it is an example of a devastating negative externality that a theoclassical economy will produce and cannot address successfully. It is a myth that lemmings commit mass suicide by jumping off cliffs, but theoclassical economists would do so if we didn’t stop them. The broader problem is that they would drag us over the cliff with them. Theoclassical economists must deny human-induced global climate change, or at least deny its harms. They can’t deny that greenhouse gasses can raise heat levels. They can’t deny that what they describe as a “successful” “free market” would cause greenhouse gas releases to increase enormously. They cannot meet the weakest straight-face test if they deny that this would logically lead to climate change. They cannot meet the weakest straight-face test if they deny that this would create large, negative externalities. They cannot meet the weakest straight-face test if they claim there is a successful “Coasian” “solution” to these negative externalities.

The theoclassical economists are left with only two possible ways of addressing the growing crisis, which is insoluble by the pure “free market.” Only one of those possibilities does not require them to engage in apostasy – an inherently benevolent nature self-regulates Earth. The search for some natural self-regulating analog to Adam Smith’s “invisible hand” has led some theoclassical economists to hope that the visible cloud might save the now dangerously errant “invisible hand” that is guiding the economy in the direction of global climate change. The climate change deniers’ best hope is that as the world heats up more clouds will be generated. The clouds will raise the Earth’s albedo and increase the reflection of some of Sol’s radiation back into space. Our great grandchildren may never see the sun again, but Seattle’s residents already have to learn to love unbroken gray skies for 200 days every year. They have to drink a lot of high caffeine coffee to escape the resultant torpor, but some sacrifices must be made.

Life does exist because some aspects of physics are self-regulating even over exceptionally long time periods. A star of the size and elemental composition of Sol is remarkably stable – or evolution would never have had time to produce us. Sol’s thermonuclear generated expansionary pressures have balanced the contracting pressures of gravity for billions of years, and should continue to do so for billions of more years. (Sol still has hydrogen to burn.) Argentines have a saying that God puts right each night all the things Argentines screw up each day. Perhaps that’s how nature works when it comes to greenhouse gasses.

Go tell it to the Venusians. It’s a preposterous gamble to take. Neoclassical economists’ desperate attempt to save their failed, lethal, and ultimately suicidal faith-based economics model has required their descent into faith-based science.

Benefit-Cost Studies are Not Objective Computational Exercises

Second, benefit-cost analyses reinforce theoclassical economists’ illusion that they are engaged in a value-free, objective, and scientific exercise. Benefit-cost analyses of regulations are not objective, computational exercises. Every nation employing benefit-cost tests is subjective and biased in what programs it subjects to benefit-cost analyses. One might think that if formal benefit-cost analyses were really scientific and a critical discipline on policy-makers we would be particularly vigilant in requiring its use the more important the policy was. The opposite is often the case. No one conducts formal benefit-cost analyses before deciding to go to war or avoid doing so (e.g., the decision not to intervene in Rwanda to try to prevent the genocide). No one in the U.S. government requires our endless “drug wars” or aspects of our “wars on terror” to pass a formal benefit-cost analysis. No one does a formal benefit-cost analysis before launching a successful raid to kill Osama bin Laden. Commanders carefully considered the benefits and costs of launching the raid, but they correctly understood that relying on formal benefit-cost studies by economists would harm the decision-making process.

The drug wars provide a useful case study. Theoclassical economists, like criminologists overwhelmingly think the drug war is insane. It cannot succeed. The phrase “war on drugs” declares an endless war we can never “win.” The direct costs this unwinable war imposes on the U.S. in terms of economics, mass imprisonment of disfavored minorities, and loss of liberty are extreme. The war imposes catastrophic costs on other nations. The drug war makes our enemies in the (also perpetual) “war on terror” wealthy and able to kill us and our allies. The drug war is a failure. No one serious who studies the subject thinks it can be won, which is why no one even bothers to define what it would mean to “win” the “war on drugs” or the “war on terror.”

Again, I emphasize that theoclassical economists are generally strong opponents of the drug war and many of America’s attacks on other nations apparently undertaken under the rubric of the “war on terror.” The point is that they know that benefit-cost analysis is used selectively to kill regulations and is never used to kill these disastrous wars. The Koch brothers are good with this asymmetry and the hundreds of theoclassical economists they and their allies support are willing to let the asymmetry continue and pretend that the benefit-cost process is objective.

Benefit-cost analysis of important public policies is never a computational exercise. One is always operating in conditions of uncertainty. The data are always incomplete and imperfect. The indirect costs and benefits are typically neither known nor knowable and are not quantifiable. The indirect costs and benefits will often be far larger than the direct costs and benefits. Estimates, even if made in good faith, of long-term projects, are particularly suspect. The Bush administration’s estimates of the costs of invading and pacifying Iraq ended up being wrong by several orders of magnitude. The benefits of invading Iraq are bitterly contested. One could make credible arguments that there were none, but some former Bush officials have argued that while there were no weapons of mass destruction in Iraq and the Iraqi government did not support anti-U.S. terrorists, our invasion triggered the ongoing Arab popular revolts. The benefits of those revolts are also sharply contested. Did our invasion of Iraq increase Iran’s regional hegemony and spur a decision to develop nuclear weapons? If so, how would one measure those costs? The truth is that these numbers are uncertain and that economists are more likely to detract than add to the reliability of numbers if they start substituting their judgment for the generals’ judgments. All of these uncertainties mean that the regulators, if they wish to game the benefit-cost analysis, can do so by assigning values to the benefits and costs that assure a net positive benefit. If the economists reject the result on the basis that the agency has failed to provide a reliable basis for estimating the benefits and costs, then virtually every benefit cost study on a serious policy issue should be rejected. There typically is no reliable basis for estimating benefits.

The harm of benefit-cost tests is often mitigated and redirected by politics

The Office of Management and Budget (OMB) economists who conduct the benefit-cost reviews generally cannot block the rules they review. The head of OMB is one of the most important members of the administration he serves and is expected to be a warrior for the administration. Politically, the OMB cannot regularly block the rules its administration supports. The administration appoints the heads of almost all the regulatory agencies, so the great bulk of rules the OMB’s economists review are rules supported by the administration. In practice, then, even the OMB’s theoclassical economists can rarely act as a “hanging jury” or “star chamber” and kill rules they despise. OMB economists are political beasts; they don’t stay if they can’t stand to approve programs. OMB economists know that benefit-cost analysis is theater. If the rule has the support of powerful administration officials OMB will not block it on the grounds that it fails to produce net benefits. OMB economists will work with the agency to game the benefit-cost analysis to ensure that it shows net benefits. Benefit-cost analysis becomes yet another bureaucratic hoop that adds cost and delay without providing benefits.

OMB’s benefit-cost analysts occasionally reject a rule on the grounds that it produces net costs, thereby “proving” that it saves the government money and “quantifying” those major savings. Of course, if the rejected rules’ benefit-cost studies been slightly tweaked by the agency or OMB’s economists the supposed benefits of benefit-cost studies would disappear.

The real function of OMB’s benefit-cost analyses is to squash agency heads the administration does not trust – even if it appointed them. It’s all about maximizing the administration’s power over the agencies, particularly the “independent” regulatory agencies in order to minimize their independence – another undesirable feature of the selective use of benefit-cost analysis. If OMB had the power to block the Federal Home Loan Bank Board’s reregulation of the savings and loan industry under the leadership of Chairman Gray it would have done so and the roughly 300 accounting control frauds would have continued to grow at 50% annually, which would have produced over a trillion dollars in losses. OMB, however, would have claimed that its benefit-cost analyses proved that it had saved millions of dollars by blocking our reregulation.

By William K. Black

August 23, 2011 will bring the 40th anniversary of one of the most successful efforts to transform America. Forty years ago the most influential representatives of our largest corporations despaired. They saw themselves on the losing side of history. They did not, however, give in to that despair, but rather sought advice from the man they viewed as their best and brightest about how to reverse their losses. That man advanced a comprehensive, sophisticated strategy, but it was also a strategy that embraced a consistent tactic – attack the critics and valorize corporations! He issued a clarion call for corporations to mobilize their economic power to further their economic interests by ensuring that corporations dominated every influential and powerful American institution. Lewis Powell’s call was answered by the CEOs who funded the creation of Cato, Heritage, and hundreds of other movement centers.

Confidential Memorandum:
Attack on the American Free Enterprise System

DATE: August 23, 1971
TO: Mr. Eugene B. Sydnor, Jr., Chairman, Education Committee, U.S. Chamber of Commerce
FROM: Lewis F. Powell, Jr.

http://www.pbs.org/wnet/supremecourt/personality/sources_document13.html

Lewis Powell was one of America’s top corporate lawyers and President Nixon had already sought to convince him to accept nomination to the Supreme Court before he wrote his memorandum. Powell was famous for his successful efforts on behalf of the Tobacco Institute. The Institute was desperately seeking to prevent the government from alerting consumers to the lethal effects of tobacco and to prevent its customers from holding the tobacco corporations legally responsible for their premature deaths. The Institute played the critical role in covering up the lethality and paying for junk science designed to mislead consumers about the lethal effects of tobacco products. They were literal merchants of death, selling a product that when used as intended was likely to kill the customer.

“For the past 45 years,” Attorney General Janet Reno said at a news conference, “the companies that manufacture and sell tobacco have waged an intentional, coordinated campaign of fraud and deceit. As we allege in the complaint, it has been a campaign designed to preserve their enormous profits whatever the cost in human lives, human suffering and medical resources. The consequences have been staggering.”

http://www.nytimes.com/1999/09/23/us/tobacco-industry-accused-of-fraud-in-lawsuit-by-us.html

Powell’s confidential memorandum begins by explaining that he wrote it at the request of the U.S. Chamber of Commerce. Powell’s first substantive sentence is that business is under assault – and anyone who disagrees with him on that point is incompetent. “No thoughtful person can question that the American economic system is under broad attack.”

Powell then explained why business was losing the public debate.

“The most disquieting voices joining the chorus of criticism come from perfectly respectable elements of society: from the college campus, the pulpit, the media, the intellectual and literary journals, the arts and sciences, and from politicians. In most of these groups the movement against the system is participated in only by minorities. Yet, these often are the most articulate, the most vocal, the most prolific in their writing and speaking.”

Among these articulate voices, the person that Powell most feared was Ralph Nader, who he described as “the single most effective antagonist of American business.” Powell cited a Fortune article to explain why Nader was the great danger.

“The passion that rules in him — and he is a passionate man — is aimed at smashing utterly the target of his hatred, which is corporate power. He thinks, and says quite bluntly, that a great many corporate executives belong in prison — for defrauding the consumer with shoddy merchandise, poisoning the food supply with chemical additives, and willfully manufacturing unsafe products that will maim or kill the buyer. He emphasizes that he is not talking just about ‘fly-by-night hucksters’ but the top management of blue chip business.”

One can understand why Powell felt so personally threatened by Nader. “Willfully manufacturing unsafe products that will maim or kill the buyer” describes the tobacco industry and Powell was that industry’s most prestigious apologist.

The issue I wish to emphasize, however, is why Powell and Fortune viewed Nader’s statements as evincing “hatred” of the enterprise system. Focus on what Fortune (a virulent opponent of Nader) says that Nader argued. Nader believed that the CEOs leading anti-consumer control frauds should be imprisoned where they (1) defrauded the consumer with shoddy merchandise, (2) poisoned the food supply, or (3) willfully manufactured unsafe products that will maim or kill the buyer. Powell and Fortune view these beliefs as radical, dangerous, and hostile to what Powell refers to in his memorandum as the “enterprise system.”

I submit that Powell and Fortune are not simply incorrect, but as wrong as it is possible to be wrong – and that Powell was blind to reality despite his intellectual brilliance in corporate law. First, is Nader the only one who believes that CEOs who commit control frauds are criminals? Anti-customer control frauds have defrauded, maimed, and killed hundreds of millions of people. In my prior columns I have focused on accounting control frauds because they are the “weapon of choice” in finance. One way of classifying variants of control frauds is by their principal intended victims. Accounting control frauds target creditors and shareholders. Anti-public control frauds target the general public, e.g., tax fraud, the illegal dumping of toxic waste, or illegal trading in endangered plants and animals. Anti-employee control frauds target employees, e.g., by not paying workers wages they are due or exposing them unlawfully to unsafe working conditions.

Anti-customer control frauds target customers. The seller may deceive the customer as to the quality, quantity, or safety of the good or service or the legal authority of the seller to convey the good and/or the promised security interest in the good. Cartels are another variant of anti-customer control fraud. The fraud is that the firms purport to be competitive rivals when they are secretly co-conspirators acting against the customers. Examples of recent anti-customer control frauds that maim and kill include the recurrent counterfeit infant formula scandals (which killed six infants and hospitalized 300,000), various lead toy scandals, counterfeit cough syrup (made with toxic anti-freeze), defective body armor for U.S. soldiers, unsafe water for U.S. troops, unsafe showers for U.S. soldiers (electrocution), counterfeit medicines including anti-malarial drugs, dwellings falsely certified to comply with seismic codes that pancake in earthquakes and kill tens of thousands. Then there are cigarettes, which were actually sold via fraud, are addictive, and lethal if used as intended. This form of fraud, addiction, and lethality was so effectively marketed that it became immune from normal laws and legal restrictions for centuries. Cigarettes have killed millions of customers and others subjected to second hand smoke.

Many anti-customer frauds do not routinely maim and kill. Misrepresenting the quality of a car to a customer can cause him a serious financial loss, but most of the hidden defects will not cause him or others physical injury. (Defects involving the brakes or safety equipment can imperil the customer, passengers, and the general public.) We call a terrible quality car a “lemon” and George Akerlof’s famous article on “lemon’s” markets was published one year before the Powell memorandum. It was this article that led to the award of the Nobel Prize in economics to Akerlof in 2001.

The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. Akerlof, George A., The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), pp. 488-500.

http://links.jstor.org/sici?sici=0033-5533%28197008%2984%3A3%3C488%3ATMF%22QU%3E2.0.CO%3B2-6

Economists have a Pavlovian response to any mention of Akerlof’s seminal article on lemon’s markets – “asymmetric information.” The committee that awards the prize in economics in honor of Nobel cited Akerlof and his co-awardees’ work in developing the economic implications of asymmetric information. Economists have tended to ignore, however, the context of Akerlof’s famous article. The specific examples of the sale of goods that Akerlof discusses are frauds. More particularly, each is an anti-customer control fraud – a fraud instigated by the person(s) controlling a seemingly legitimate entity where the primary intended victims were the customers. Akerlof did not discuss the variants of anti-customer control fraud that maim or kill – he focused solely on examples of economic injury due to fraudulent misrepresentations by the seller of the quality or quantity of the goods sold. More precisely, two of Akerlof’s examples – the fraudulent sale of defective cars and rice deliberately intermixed with stones – do maim and kill some customers, but Akerlof did not discuss this aspect. (Biting down on a stone can easily shatter a tooth. That causes excruciating pain, but it also exposes an Indian peasant – the fraud victims Akerlof was discussing – to a greatly increased risk of dental infection, which causes an increased risk of severe cardiac illness.) Akerlof had appropriately large ambitions in his article. He sought to provide a “structure … for determining the economic costs of dishonesty” (p. 488). Goods that maim and kill the customer impose the primary economic costs of dishonesty.

So, the first problem with Powell and Fortune’s horror that Nader believed we should prosecute those CEOs who caused the sale of the goods they knew would maim and kill their customers (and others) is that Nader was obviously correct – prosecuting those CEOs should be a top priority – globally. Prosecuting the fraudulent CEOs who “merely” cause their customers financial losses by deceptive sales of defective goods and services should be a significant priority.

Second, Powell and Fortune believe that prosecuting criminal CEOs is terrible for businesses, terrible for CEOs, and terrible for “free enterprise.” They conflate support for prosecuting criminal CEOs with “hatred” for “corporate power” and they conflate “corporate power” with “free enterprise.” Recall that this is their conclusion about Nader:

“The passion that rules in him — and he is a passionate man — is aimed at smashing utterly the target of his hatred, which is corporate power.

Powell and Fortune cite Nader’s call for criminal CEOs to be prosecuted as their proof of this conclusion. But why would prosecuting criminal CEOs be bad for “free enterprise?” Powell and Fortune don’t even attempt to explain why this would be true. It is self-evident to them that a world in which criminal CEOs do not enjoy impunity from the law is a world in which “corporate power” will have been ”smash[ed]” and that absent hegemonic “corporate power” “free enterprise” is impossible. Their “logic” and rhetoric are revealing, but absurd. Wanting to prosecute criminal CEOs is not hostile to “free enterprise,” but rather essential to the success and continued existence of “free enterprise.” Akerlof explained why in his 1970 article.

“Gresham’s law has made a modified reappearance. For most cars traded will be the “lemons,” and good cars may not be traded at all. The “bad” cars tend to drive out the good” (p. 489).

“[D]ishonest dealings tend to drive honest dealings out of the market. There may be potential buyers of good quality products and there may be potential sellers of such products in the appropriate price range; however, the presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence” (p. 495).

When cheaters prosper, market mechanisms become perverse and can drive the honest from the marketplace. The market becomes dominated by cheats because they obtain a competitive advantage. The most common reason that firms can cheat with impunity is that their CEOs are cronies of powerful politicians. The defining characteristics of crony capitalism are that the cronies receive subsidies, favors, and immunity from normal rules and laws. The cronies dominate the big corporations and provide reciprocal benefits to controlling politicians. Managerial incompetence and wealth flourishes under crony capitalism. Merit and efficiency suffer, income inequality surges, and class and who one knows become the primary determinants of economic and political success and power. The elites become pervasively corrupt.

Crony capitalism is the antithesis of “free enterprise.” The best way to destroy free enterprise is to allow CEOs to commit control fraud with impunity because that maximizes the perverse Gresham’s dynamic. Only big business had the power to destroy “free enterprise” in America – and Powell’s strategic plan was the best way to destroy free enterprise. As the left had long argued, it was the purported capitalists who would destroy capitalism.

“When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.” (Frederic Bastiat)

Powell’s memorandum sought to glorify plunder with impunity, but he went beyond Bastiat’s warnings. Powell glorified CEOs who killed and maimed customers.

Third, and Powell is rolling over in his grave as I write this, Nader was one of the leading defenders of “free enterprise” when Powell wrote his memorandum in 1971. That was not Nader’s intent, but it was Nader’s efforts against control fraud that helped stave off for a time Powell’s embrace of a system in which elite frauds go free. That system, crony capitalism, destroys “free enterprise.” The regulators and the prosecutors are the “cops on the beat” who are essential to preventing the cheats from gaining a competitive advantage over honest businesses.

Powell could have, far more logically, characterized Nader’s position as “crusader against criminal CEOs” or “crusader on behalf of honest businesses.” Powell would never have referred to an individual calling for blue collar criminals to be prosecuted as a man determined to destroy liberty. He would have said that such an individual was increasing liberty – for criminals and crimes impair our liberty. President Nixon personally convinced Powell to accept the nomination to the Supreme Court to counter the decisions of the Warren Court, particularly the decisions adding to the constitutional protections of blue collar criminal defendants. Powell, particularly as head of the American Bar Association (ABA), was famous for his campaign against street crime. Powell’s biographer, John Calvin Jeffries, wrote that:

“Powell argued that “a root crisis of the crime crisis which grips our country is excessive tolerance by the public generally – a tolerance of substandard, marginal and even immoral and unlawful conduct.” It had reached the point of “moral sickness.”

He worried that the pendulum may have swung too far in favor of the rights of criminals. Even Little Orphan Annie quoted the ABA chief: “There are valid reasons for criminals to believe that crime does pay, and that slow and fumbling justice can be evaded.” Justice Lewis F. Powell, Jr.,(2001: p. 210.

Powell, in his address to the ABA at the end of his term as President, argued that making Americans free from crime should be the nation’s “first priority” (Jeffries & Jeffries, p. 211). (Note the phrase “the rights of criminals” instead of “the rights of those accused.”) Powell conflated criminal CEOs with honest businesses – and was blind to the fact that he did so. Had he shown any logical consistency in how he dealt with criminals, Powell would have praised Nader’s efforts to have criminal CEOs prosecuted. But Powell could not see beyond class and his own experience in aiding CEOs who were “willfully manufacturing unsafe products that will maim or kill the buyer” do so with impunity. Can there be any greater betrayal by a CEO than using deceit to willfully manufacture cigarettes that maimed and killed his customers and those exposed to their customers’ smoke – for the sole purpose of making the CEO wealthy through such sales? Powell did not normally smoke, but according to his biography he posed with fellow members of the board of directors of one of the world’s largest cigarette companies in the firm’s publicity photographs with a cigarette to demonstrate his support for smoking. He showed more than “tolerance” for “immoral and unlawful conduct” – he provided them with aid and comfort. Through his famous memorandum he created a criminogenic environment in which control fraud “does pay” because he helped remove the regulatory cops from their beat and claimed that those who wanted to prosecute criminal CEOs posed such a threat to “free enterprise” that business must show “no hesitation” in marshalling its unmatched economic and political power to “attack” them and ensure that they were “penalized politically.”

Powell derided corporations that gave aid and comfort to the enemy by failing to use their dominant economic power against those who wanted to hold corporations and their senior officials accountable for “defraud[ing],” “poison[ing],” and willfully manufactur[ing] unsafe products that will maim or kill the buyer.”

“One of the bewildering paradoxes of our time is the extent to which the enterprise system tolerates, if not participates in, its own destruction.

The campuses from which much of the criticism emanates are supported by (i) tax funds generated largely from American business, and (ii) contributions from capital funds controlled or generated by American business. The boards of trustees of our universities overwhelmingly are composed of men and women who are leaders in the system.

Most of the media, including the national TV systems, are owned and theoretically controlled by corporations which depend upon profits, and the enterprise system to survive.”

In Powell’s telling, business interests were the political naïf in politics. Other lobbyists were “special interests” while business was dedicated to the public interest. Special interests made self-interested demands on politicians, business did not.

“Business, quite understandably, has been repelled by the multiplicity of non-negotiable “demands” made constantly by self-interest groups of all kinds.

While neither responsible business interests, nor the United States Chamber of Commerce, would engage in the irresponsible tactics of some pressure groups, it is essential that spokesmen for the enterprise system — at all levels and at every opportunity — be far more aggressive than in the past.”

Corporations and the Chamber of Commerce did not make demands on legislators and did not act as special interests. Powell was not naïve enough to believe his own propaganda, but he knew that the Chamber of Commerce and its members CEOs would delight in even the most oleaginous praise. A corporate lawyer becomes expert in pandering to power.

Powell’s solution was for corporations to act like real corporations by using their wealth and ownership to take control of the universities and media and use that control to further corporate interests by causing the universities and media to extol the virtue of corporate dominance and by influencing the law to support corporate interests. But his central theme was that business must cease its “appeasement.” CEOs should show:

“no hesitation to attack the Naders … who openly seek destruction of the system. There should not be the slightest hesitation to press vigorously in all political arenas for support of the enterprise system. Nor should there be reluctance to penalize politically those who oppose it.”

Powell’s specific prescriptions for how corporations should use their economic power to achieve dominance are filled with hortatory expressions about quality.

“Essential ingredients of the entire program must be responsibility and “quality control.” The publications, the articles, the speeches, the media programs, the advertising, the briefs filed in courts, and the appearances before legislative committees — all must meet the most exacting standards of accuracy and professional excellence.”

But Powell knew corporations’ real strength – manipulating the public through advertising and marketing.

“It is time for American business — which has demonstrated the greatest capacity in all history to produce and to influence consumer decisions — to apply their great talents vigorously to the preservation of the system itself.”

American corporations didn’t demonstrate “the greatest capacity in all history to produce and to influence consumer decisions” through advertising that was limited to “the most exacting standards of accuracy.” Remember, Powell’s most important experience was representing the interests of tobacco companies. Tobacco marketing had four dominant motifs – smoking was cool, smoking was adult, smoking made you sexy, and even more dishonest efforts to minimize smoking’s health risks. The advertising, marketing, and lobbying efforts on behalf of smoking were based on deception, and they did succeed in “produc[ing] and influenc[ing] consumer decisions” that were literally suicidal and potentially fatal to their loved ones.

Again, Powell’s apparent naiveté about the propaganda campaign that he was proposing that the Chamber of Commerce unleash was pure sham. He knew that businesses frequently created demand for their products through deception and he knew that if business followed his recommendation to unleash its marketing gurus on attacking those who wanted to prosecute criminal CEOs they would do so with as much regard for accuracy as they found useful for the particular attack. If misleading voters and demonizing opponents through deceptive statements worked better as a means of attack, then Powell knew that marketing specialists would have no more scruples lying about Nader than they had against lying about smoking – but he also knew that the memorandum would eventually become public and that it should be written in as self-serving and self-glorifying a manner as possible. Advertising specialists are a cynical lot, so I’m sure they got a great laugh reading the portion of Powell’s memorandum where he conflates of “the most exacting standards of accuracy” in advertising with “professional excellence” in advertising.

Powell ended his substantive arguments with the claim that regulating business destroyed freedom.

“The threat to the enterprise system is not merely a matter of economics. It also is a threat to individual freedom.

It is this great truth — now so submerged by the rhetoric of the New Left and of many liberals — that must be re-affirmed if this program is to be meaningful.

There seems to be little awareness that the only alternatives to free enterprise are varying degrees of bureaucratic regulation of individual freedom — ranging from that under moderate socialism to the iron heel of the leftist or rightist dictatorship.

We in America already have moved very far indeed toward some aspects of state socialism, as the needs and complexities of a vast urban society require types of regulation and control that were quite unnecessary in earlier times. In some areas, such regulation and control already have seriously impaired the freedom of both business and labor, and indeed of the public generally.”

It is a measure of how successful Powell’s strategy was in spreading the ideology of corporate dominance and impunity that some of his statements would now be anathema to business. He concedes in his conclusion that: “most of the essential freedoms remain: private ownership, private profit, labor unions, collective bargaining….” In 1971, even prominent Republicans hostile to unions considered the rights to join a union and engage in collective bargaining to be “essential freedoms.” As a Supreme Court Justice, Powell proved to be a disappointment to President Nixon and movement conservatives because he remained a moderate conservative.

Powell exemplifies the limits of even exceptional intellect and great courtesy. He did not set out to harm the public. He felt he epitomized intellectual consistency, but he was blind to how his class bias on behalf of CEOs made him totally inconsistent in his view of crimes of the street and the suite.

The “areas” in which Powell warned that regulation had already “seriously impaired the freedom of both business and labor” – that language is code for rules restricting discrimination in employment based on race, gender, etc. The Civil Rights Act of 1964 and the EEOC were anathema to Powell and the CEOs of many members of the Chamber of Commerce. The anti-discrimination laws applied to unions as well as employers. Powell, careful lawyer that he was, knew not to make that nostalgia for bigotry explicit in his memorandum.

(Excerpts from this article were posted originally in Benzinga.  This article was posted originally in the UMKC-economics blog:  NewEconomicPerspectives.)

By L. Randall Wray

The claims about “unsustainable deficits” gained new urgency this week as S&P warned that it was downgrading US federal government debt from stable to negative (see here for recent debate).

This appeared to be a blatantly political move, designed to influence the debate in Washington, adding fuel to the fire to cut budget deficits.

The deficit hysteria has nothing to do with economics, government solvency, or involuntary default. A sovereign government can always make payments as they come due by crediting bank accounts—something recognized by Chairman Bernanke when he said the Fed spends by marking up the size of the reserve accounts of banks.

Similarly Chairman Greenspan said that Social Security can never go broke because government can meet all its obligations by “creating money” (see here).

Instead, sovereign government spending is constrained by budgeting procedure and by Congressionally-imposed debt limits. In other words, by self-imposed constraints rather than by market constraints.

In addition, government needs to be concerned about pressures on inflation and the exchange rate should its spending become excessive. Finally, it should avoid “crowding out” private initiative by moving too many resources to our public sector. However, with massive unemployment and idle plant and equipment, no one can reasonably argue that these dangers are imminent.

Ironically, the ratings agencies recognized long ago that sovereign currency-issuing governments do not really face solvency constraints. A decade ago Moody’s downgraded Japan to Aaa3, generating a sharp reaction from the government. (more here) The raters back-tracked and said they were not rating ability to pay, but rather the prospects for inflation and currency depreciation. After ten more years of running deficits, Japan’s debt-to-GDP ratio is 200%, it borrows at nearly zero interest rates, it makes every payment that comes due, its Yen remains strong, and deflation reigns. In other words, the ratings agencies got it all wrong—as they usually do.

So, as I predicted two days ago, the market reacted to the US government’s credit downgrade with a big “Ho-Hum”.

Is the Government Running Out of Money?

The Federal Government has been handed a temporary reprieve by Congress: it won’t be shut down just yet. That gives the Democrats and Republicans more time to haggle over which items to cut. The premise is that the government is “running out of money” as President Obama has put it so eloquently in numerous speeches. Let us first examine that claim and then move on to the real subject of debate: Can a sovereign government run out of money?

The answer is easy: No!

Indeed, a sovereign government neither has nor does not have money (see here). The money government uses to spend is created as it spends. That might sound bizarre or even dangerous. But, in fact, on that score it is not so different from any other spender. (see previous discussion)

Can Your Bank Run Out of Money?

Look at it this way. As economists who adopt the (French-Italian) “Circuit” approach have long argued, when a firm wants to spend it approaches a bank . The bank accepts the firm’s IOU (called a loan on the bank’s balance sheet) and creates its own IOU (in the form of a demand deposit). From the firm’s perspective, the loan is its debt and the demand deposit is its asset. The bank “intermediates” because its IOU (the demand deposit) is more widely accepted in payment than is the firm’s IOU.

Of course, the firm is not going to hold the demand deposit since the whole object of borrowing was to spend. The demand deposit will then get shifted to the seller. Now, it is of course possible for the firm to finance its spending by using a sales receipt—a credit to its demand deposit and matched by a debit to the seller’s account.

But at the aggregate level, all the demand deposits were created as the accounting offset to loans. In other words, sales receipts in the form of demand deposits required some previous bank loan. At the aggregate level, bank “money” is created and therefore equal to bank loans—that is where bank money comes from.
Can the bank “run out of money”? No. It neither has, nor does not have money. It creates the money when it makes a loan; and the purpose of this activity is to finance some kind of spending—on goods, services or assets.

Can this money creation be “excessive” in the sense of causing prices to rise? Yes. Can it be “speculative” in the sense that it helps to fuel an asset price bubble? Yes. Can it be “foolish” in the sense that the borrower defaults and the bank ends up holding a worthless IOU? Yes. Can bank lending and thus money creation be constrained by government regulations and supervision? Yes. Finally, can—and should—the bank exercise self-restraint? Yes.

So, just because we say the bank can always create money “out of thin air” by making a loan and creating a demand deposit that does not mean that it should lend “until the cows come home”, or that it does not face regulatory or self-imposed constraints.

Ultimately, good banking practice requires good underwriting—to ensure it does not end up with too many trashy IOUs; and from the macro perspective, government wants to limit bank “money creation” to finance spending in order to prevent inflationary conditions in markets for goods, services and assets.

Is Sovereign Government Different? Users and Issuers of the Curency

Almost everything that has been said above about the finance of the spending of a private firm applies to a government. Government spending occurs simultaneously with a credit to a private bank account—that is to a demand deposit at a bank. The offsetting liability on the government’s books is a credit to the bank’s reserves at the central bank (which is the “private” bank’s asset). The government cannot “run out of money” because the “money” is created when it spends.

I have detailed many times how the government actually does this—following rules for spending that Congress, the Treasury, and the Fed have worked out—and will discuss the details a bit below. But first let us compare government and nongovernment spending through “money creation” in general terms.

Government spending and hence “money creation” has all the same potential drawbacks listed above (most importantly, inflationary consequences when excessive), save one. A private borrower might fail to make payments on loans through no fault of his own. Of course, there are also deadbeat borrowers who choose not to pay. But private firms (and households) need income, or saleable assets, to raise funds to pay their debts. Default is a possibility.

Sovereign government is somewhat different. We usually say that its “income” is tax revenue—a bit different from wages or profits since taxes are at least in some sense discretionary. Further, the government’s potential “customer base” is the whole economy and potentially all economic activity—anything that can be taxed.
However, that really does not get to the more important difference: government is the sovereign issuer of the currency.

A sovereign government cannot be forced into involuntary default—it cannot go bankrupt in its own currency. Let us see why, comparing a sovereign government with the situation of a “user” of the currency.

As my professor Hyman Minsky used to argue, anyone can “create money” in the sense that anyone can issue an IOU to make purchases. In other words, you can spend by issuing an IOU to your bank, with the bank crediting your demand deposit—which you use for the purchase. The “money” is created simultaneously with the spending.

When we talk about a private borrower/spender (household or firm), the bank is concerned with credit-worthiness. There are, indeed, additional constraints facing the bank, including reserve ratios and capital ratios—plus whatever other regulations and oversight government puts on its regulated banks. In practice, reserve ratios do not constrain banks because the development of inter-bank lending markets (called the fed funds market in the US) plus access to the central bank’s discount window ensure that banks can always get reserves—at a price.

Capital ratios can bind, although again in practice the constraint is loose since a bank faced with a good borrower can move assets off the balance sheet, seek additional capital, or use creative accounting to finesse the requirements.
And, as I argued above, growing lending and spending can have consequences at the aggregate level: inflation and currency depreciation should spending be too large relative to capacity. That is why governments use a range of policies to try to constrain lending and spending—monetary and fiscal policy as well as direct limits on bank lending and (in rare cases) wage and price controls.

When government refuses to oversee and regulate private banks, underwriting standards tend to fall—which allows lending and spending to grow quickly, which can have inflationary consequences. But worse, it can lead to a catastrophic financial crisis—as we are witnessing.

What is particularly strange is the way that we treat sovereign government. The treasury’s bank is the central bank—which handles its payments and receipts. The treasury writes checks on its demand deposit at the central bank and moves tax receipts from its accounts at private banks to the central bank when it wants to spend. In the US, the Treasury tries to end each day with a deposit of $50 million at the Fed. In all these respects, the Treasury and Fed relation is much like that between a household or firm at its bank. With one big exception: the credit worthiness of the sovereign issuer of a currency cannot be called into question by financial markets because it can always make payments as they come due.

The Strange Constraints Put on Treasury

We put two constraints on our Federal Government that we do not put on private firms and households:

a) The Treasury cannot issue IOUs to its own bank;
b) Congress imposes a debt limit on Treasury

Amazingly, we do not constrain any household or firm in such a manner. We do not prevent firms or households from issuing IOUs to their banks—indeed, we would argue that such a constraint would be silly. Nor do we directly impose a specific debt limit on households or firms or even state and local governments, because we believe that “markets” can determine how much any nonsovereign entity ought to issue.

But we do impose these limits on the sovereign government that issues the currency. These constraints are adopted on the misguided belief that they will prevent the government from “spending too much”, which would cause inflation and currency depreciation. Hence, it is supposed, we cannot trust Congress and the President to keep spending under control—the budgeting process alone is not a sufficient constraint. They would happily spend so much that we’d quickly become the next Zimbabwe. Thus, we will prevent the Treasury from “borrowing” directly from the Fed since that would result in “printing money”, and if Congress could pay for everything by “printing money” it would approve every pork barrel project constituents dreamed-up. And without a debt limit, Congress would bury government under a crushing debt load that would threaten its solvency.

Let’s examine these constraints in order.

The first constraint means that Treasury can sell its IOUs (bills or bonds) to anyone EXCEPT its own bank. It can sell bonds to households, firms, or private banks but NOT to the Fed (there is a small exception that we need not go into here). So when the Treasury is deficit spending (meaning it needs to write checks for more than its deposit at the Fed), it cannot simply issue an IOU to the Fed. It must instead sell its bills and bonds to private households, firms or banks.

Here’s the problem. To spend, the Treasury must have deposits in its account at the Fed. It does no good to sell its bonds to the private sector, receiving a demand deposit at a private bank—because it cannot write a check on that account. Just as you can only write checks against your account at your bank the Treasury can write checks only on its account at its bank—the Fed. So, for example, it can sell a bond to Bank XYZ and receive credit to an account it holds at Bank XYZ. To spend it needs to transfer the demand deposit to its account at the Fed. This is accomplished by debiting the Treasury’s account at Bank XYZ, and simultaneously debiting that bank’s reserves at the Fed. The Fed then credits the Treasury’s demand deposit.

In normal times, banks do not hold excess reserves. (These are not normal times—banks in the aggregate now hold a trillion dollars of excess reserves thanks to “Helicopter Ben’s quantitative easing. We will ignore that for now.) In that case, Bank XYZ would find itself short of reserves after the Treasury transferred its deposit. There are several ways a bank can get the reserves it needs: borrow in the fed funds market, borrow from the Fed at the discount window, or sell bonds to the Fed. Note that if there are no excess reserves in the banking system, turning to the fed funds market will only cause the fed funds rate to rise. This is the signal the Fed responds to—either lending reserves at the discount window or engaging in an open market purchase to relieve the pressure in the fed funds market. Ultimately, the Fed is the source of reserves banks need.

Note that if the Fed lends reserves to banks, we end up in a position in which banks have essentially borrowed reserves from the Fed in order to “lend” to the Treasury (holding government bonds). If on the other hand the Fed buys the bonds in an open market operation, we end up in a position in which the Fed holds the Treasury’s bonds, so has effectively “lent” to the Treasury—but only indirectly because it used Bank XYZ as the intermediary. Recall that all these operations are required because we prevent the Fed from buying the bonds directly from the Treasury, thereby providing the Treasury with the demand deposits it needs to write checks. So it is doubly ironic that this prohibition then requires either that the Fed lend reserves to banks so they can buy the bonds, or that it buy the bonds from the banks.

Now, in normal times it really does not matter that we have adopted such a roundabout method of allowing the Treasury to do what any other spender can do—issue an IOU to its own bank. It all operates smoothly with the Fed using a private bank as intermediary to do what Congress prohibits it from doing directly. That is to say, what prevents the Treasury from spending its way toward Zimbabwe land is that it has a budget that must be approved by Congress and the President. The prohibition on Fed purchases of bonds directly from the Treasury is not a constraint at all. If we got a Congress and President that wanted Zimbabwean inflation, they could produce that result by agreeing on a budget of quadrillions of dollars of spending. So in normal times, we rely on rationality in Washington to constrain spending.

But these are not normal times. For two reasons. First because we are trying out Chairman Bernanke’s pet theory: quantitative easing—which is based on the belief that if you buy up all the earning assets held by banks and stuff them full of excess reserves that pay only 25 basis points, they will decide to lend. No, they won’t. Instead, they buy Treasury bonds, and then sell a portion on to the Fed that buys them through quantitative easing.

Second, we keep bumping up against the self-imposed debt limit imposed on the Federal government—not by markets but by Congress. We need to understand that the overall debt limit is repeatedly approached because we are running persistent deficits. And that is because tax revenue has been destroyed by the economic downturn caused by Wall Street’s excesses. So Congress must repeatedly raise the debt limit so that the Fed, Treasury and private banks can perform their little charade to allow the Treasury to spend the budgeted amounts. With a few brief exceptions, total outstanding Treasury debt has grown since the founding of the nation—with Congress raising the debt limit as required to let Treasury issue the bonds that banks, households, and firms want to buy.

This is usually done as a matter of routine. But the Republicans want to hold the debt limit hostage to politics—following Rahm Emmanuel’s dictum that a “crisis” should never be wasted. They intend to gut the social programs they do not like on the pretense that this will reduce the budget deficits that threaten the US with bankruptcy. In fact, cutting the social programs will not significantly reduce overall spending (because they are too small) and the US government cannot be forced into involuntary bankruptcy. Hence, neither argument follows on from the facts.

Indeed, if the US does default on any of its payment commitments, it will be because Republicans force it to do so—by forcing government to shut down because Congress will not raise the debt limit. That is the nuclear option that party politics run amuck could lead to.

Conclusion: The Only Thing to Fear is Fear Itself

I realize that whenever the actual operating details are made clear, the response always is: OMG if the government can spend simply by “keystrokes” then we are doomed to Zimbabwean inflation and eventual default on debt. Hence, we need to limit government’s ability to spend—and this can be done by preventing it from “borrowing from” the Fed, and setting a debt limit.

In reality, it is Congress that holds the fate of the US in its hands. The budgeting procedures are what keep inflation at bay, and the normal financing “triangular” operation that uses the balance sheets of the Treasury, Fed and private banks ensure the government meets its payment commitments.

Unfortunately, by using the debt limit as its hammer to destroy social programs, Congress is now threatening to disrupt financing—raising a possibility (albeit very small) that government might be forced by politicians to do what markets CANNOT force it to do: default on its commitments.

So, ironically and through the backdoor, the Republicans might actually bring on a Greek-style debt crisis on the argument that they are defending us from a Zimbabwean-style hyperinflation.

L. Randall Wray participated in a New York Times Opinion Pages debate monday: “Is Anyone Listening to S.&P.?” See here for the complete discussion.

1.  If you don’t look; you don’t find
2. Wherever you look; you will find

President Obama established the interagency Financial Fraud Enforcement Task Force to wage an aggressive, coordinated and proactive effort to investigate and prosecute financial crimes. 

By Eric Tymoigne

Yesterday morning S&P released the following information:

“Although we believe these strengths currently outweigh what we consider to be the U.S.’s meaningful economic and fiscal risks and large external debtor position, we now believe that they might not fully offset the credit risks over the next two years at the ‘AAA’ level,” said Standard & Poor’s credit analyst Nikola G. Swann. […] “Our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” Mr. Swann said.

So the credit risk of the US is potentially growing according to S&P so it threatens to downgrade the US credit rating. In order to understand how S&P arrived to this conclusion let’s have a look at how credit risk is defined in its 2007 sovereign debt primer:

QUOTE 1: “A sovereign rating is a forward-looking estimate of default probability. […] The key determinants of credit risk [are economic risk and political risk]. Economic risk addresses the government’s ability to repay its obligations on time and is a function of both quantitative and qualitative factors. Political risk addresses the sovereign’s willingness to repay debt. Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly because creditors have only limited legal redress, a government can (and sometimes does) default selectively on its obligations, even when it possesses the financial capacity for timely debt service.”

S&P has two ratings, a local currency rating (default risk on domestic-currency-denominated debt) and a foreign currency rating (default risk on foreign-currency-denominated debt). The primer notes:

QUOTE 2: “A sovereign government’s ability and willingness to service local currency debt are supported by its taxation powers and its ability to control the domestic monetary and financial systems, which give it potentially unlimited access to local currency resources. To service foreign currency debt, however, the sovereign must secure foreign exchange, usually by purchasing it in the currency markets. This can be a binding constraint, as reflected in the higher frequency of foreign than local currency debt default. The primary focus of Standard & Poor’s local currency credit analysis is on the government’s economic strategy, particularly its fiscal and monetary policies, as well as on its plans for privatization, other microeconomic reform, and additional factors likely to support or erode incentives for timely debt service. When assessing the default risk on foreign currency debt, Standard & Poor’s places more weight on the impact of these same factors on the balance of payments and external liquidity, and on the magnitude and characteristics of the external debt burden.”

S&P provides a table that shows the number of defaults on foreign-denominated sovereign debt and notes that: “Defaults on sovereign foreign currency bonds occurred repeatedly, and on a substantial scale, throughout the 19th century and as recently as the 1940s.” Interestingly, however, it does not provide such a table for the domestic-denominated sovereign debt. The primer continues by noting:

QUOTE 3: “One might ask why, if sovereigns have such extensive powers within their own borders—including the ability to print money—sovereign local currency ratings are not all ‘AAA’. The reason is that while the ability to print local currency gives the sovereign, and the sovereign alone, tremendous flexibility, heavy reliance upon such an expansionary monetary stance may bring the risk of hyperinflation and of more serious political and economic damage than would a rescheduling of local currency debt. In such instances, sovereigns may opt to reschedule their local currency obligations.”

So overall here is the view of S&P:

• Credit risk = economic risk (capacity to pay) + political risk (willingness to pay)
• There are two type of sovereign debt: Domestic-currency denominated and foreign-currency denominated
• Governments that can tax and issue their own currency have the full capacity to pay domestic-currency-denominated debt
• Inflation risk is a form of default risk

Now let’s look if all this makes sense in the case of the US. First, note that the US is a monetarily sovereign country: the federal government issues its own currency, the federal government has no foreign-denominated debts outstanding, and the federal government does not peg its currency in anyways (and so does not promise to convert US dollars into another currency or gold on demand). This means that the US federal government can always meet payments that are due to its creditors anytime (today or in the future) and anywhere (in the US or abroad) by crediting bank accounts. Stated alternatively, there is NO possible risk of default for economic/technical reasons. The federal government cannot run out of money, it has a perfect capacity to pay: economic risk is zero.

The problem with S&P is that it has a shifting definition of economic risk. As quote 3shows, S&P is aware of the absence of economic risk in the case of the US but it proceeds to argue that there is one by changing the definition of default risk to include risk of hyperinflation. OK…hold on… are we talking about default or inflation risk? These are two completely different risks.

In terms of default risk, higher inflation (if revenues of borrowers are indexed to it) increases the capacity of repayment and so LOWERS default risk rather than increases it. If, following S&P’s logic in quote 2, one considers taxes a form of revenues that helps to pay debt, then tax revenues rise with inflation and so lower the risk of default.

In terms of inflation risk, inflation pressures on the demand side are very low and the risk of uncontrollable hyperinflation that S&P refers to in quote 3… give me a break! But there is a deeper misconception at play. S&P (and all politicians in Washington) seems to think that they have some meaningful control over the fiscal balance of the federal government. They do not; as the UK experience, among others, is painfully showing us. The fiscal balance of the government is ultimately driven by the net saving of the private domestic sector and of the rest of the world, as was explained many times on this blog. The following identity holds at the aggregate level:

(G – T) ≡ (S – I) + (J – X)
Government deficit ≡ Net domestic saving + net foreign saving

Stated alternatively, the US government must deficit spend currently and in the near future in order for the private sector to repay its outstanding debt and for foreigners to accumulate dollars. It is only if the private sector as a whole decides to dissave (spends more than what it earns) and/or foreigners decide to dissave (import more than they export to the US) that the government can lower its deficit and potentially run a surplus. Any attempts to go against the desires of the two sectors will lead to a recession. The deficit will go down by itself as the private and foreign sector gain confidence and decrease their net saving.

By conflating inflation risk and default risk in their rating, S&P (and probably other CRAs) creates confusions in financial markets and promotes dangerous ideas. Sounds familiar? Remember all those toxic mortgage products that were rated AAA? One more time, S&P is showing how silly it is to extend a rating methodology that was developed for corporate bonds to other sectors of the economy. Even for corporate bonds, results are far from perfect (remember all those financial institutions that had an AAA rating or so right before they failed?)

So overall there is zero default risk due to economic risk in the US, as an issuer of the currency in which sovereign debt is denominated, the US (like the UK and Japan but contrary to Eurozone countries) can always repay dollar-denominated debts it issued. But what about credit risk due to political risk, i.e. unwillingness to pay?

First and foremost, cases of voluntary default by a monetarily sovereign government on its domestic-currency-denominated date are extremely rare. Following Rogoff and Reinhart, it looks like Japan is a candidate in 1942, a very unusual political and economic situation (and probably a means to limit inflationary pressures by not adding purchasing power to the private sector, so default could be a good policy). It is hard to detect more countries given that the authors do not give us any background about the monetary system at the time of default. The US is not experiencing any massive war exhausting its resources (even that is not enough to increase the risk much), its political system is stable, and Geithner has told us many times that the debt ceiling will be raised that any chance of political problem is at best remote. True, the Congress may tie its own hands and decide not to raise the debt limit, but how realistic is that possibility?

Bottom line, credit risk is remotely remote. You have more chance to be hit by lightening twice during your life than to experience a default of dollar-denominated sovereign US debt. The only really worrisome variable is the stupidity of US congress and its willingness to try to fix something that is not broken. People love Medicare (by far the most popular program of the government), they love social security, and automatic stabilizers are working as predicted. Let them be.

By William K. Black

In the Savings and Loan (S&L) debacle Speaker Wright became enraged at the Federal Home Loan Bank Board and the Department of Justice when he learned that the FBI was investigating 400 individuals, most of them Texans, for their possible role in the S&L control frauds that were causing the regional bubble in commercial real estate (CRE) to hyper-inflate. (Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit” discussed the major contribution the S&L frauds made to expanding that regional bubble.) Legend has it that an FBI agent accidentally left the list of investigative targets with an interviewee who copied it. Whatever the truth of the legend, Speaker Wright eventually reviewed a copy of the list and noticed that it had the names of many contributors to the Democratic Party. He and several senior Democratic colleagues and a staffer responded to the list by dividing up telephone calls to the FBI, Justice Department and the Federal Home Loan Bank Board (Bank Board). Wright was enraged and concluded immediately that the investigation was politically motivated. He wanted the investigation killed.

Wright began intervening with the Bank Board on behalf of a series of Texas S&L control frauds in 1986 and 1987. He eventually held the bill to “recapitalize” the Federal Savings and Loan Insurance Corporation (FSLIC) (the “FSLIC recap” bill) hostage to extort more favorable regulatory treatment for these frauds’ CEOs. Wright’s extortion focused on preventing agency actions against three Texas executives. Each of the executives shared two traits – they had voted for President Reagan in 1980 and they were now contributing to the Democratic Party. When we met with Speaker Wright in early 1987 his primary argument was the extreme fragility of Texas’ economy. (The meeting was set up by Bob Strauss, the grand old man of Texas Democrats, as a “peace meeting.”) I was the agency’s “point man” seeking to get FSLIC recap passed. The meeting was a disaster, Wright ended up claiming (incorrectly) that the head of our agency had lied to him and let loose in a swearing tirade aimed at me.

What Wright never understood was that the most politically active Texas S&Ls were so active because they were frauds and desperately needed protection from being closed by us. In particular, we intended to use the additional funds we would receive under FSLIC recap to close the worst control frauds and those frauds were located primarily in the states with the weakest regulation and supervision. Texas was the most criminogenic environment because it had the earliest extensive deregulation and the most complete state desupervision. (The top State of Texas S&L regulator later admitted to using prostitutes provided by Vernon Savings (aka “Vermin)). Vernon was the second worst control fraud in the nation and had 96% of its loans in default when it was finally placed in receivership despite Wright’s extortion. We had been so aggressive in closing the control frauds that by early 2007 we had roughly $500 million in the FSLIC fund – to insure an (insolvent) industry with $1 trillion in liabilities. We were running on fumes. Wright knew this and knew that holding the FSLIC recap bill hostage would give him exceptional leverage over our agency. Unfortunately for Wright, the result of the failed peace meeting was that we were able to convince the head of our agency that we had to take on Speaker Wright rather than continuing to capitulate to his ever increasing extortion. Doubly unfortunately, I was assigned the task of explaining to the public how the Speaker was extorting us on behalf of frauds and endangering the public. Thereafter, he tried repeatedly to get me fired. (One of the proposed ethic charges by the independent counsel for the House ethics committee investigating Speaker Wright was those attempts.)

Speaker Wright cultivated an image designed to terrorize opponents. He was nasty, asking us to fire our top supervisor in the Texas region on the “grounds” that he Wright had heard he was a homosexual. Wright had exceptional leverage over us because we were desperately short of funds and he held our access to funds hostage. Our agency (over several of our objections) gave in to many of his demands, including terminating a civil suit against a lender who had defaulted on his debts to roughly a dozen S&Ls. At no time, however, did we even consider giving in to Speaker Wright’s desire that we back off of criminal referrals, investigations, or prosecutions.

Later, under Bank Board Chairman Danny Wall, the agency’s head of enforcement wrote a “side letter” promising Charles Keating’s Lincoln Savings that the agency had no present intention of filing additional criminal referrals. (We, the Federal Home Loan Bank of San Francisco (FHLBSF), had filed criminal referrals based on the findings of a formal investigation that established that Lincoln Savings had forged thousands of signatures and scores of documents and had stuffed the files with purported underwriting files. Those files were actually created by Arthur Andersen years after the junk bonds were purchased for the sole purpose of deceiving the examiners into believing that the S&L had underwritten the bonds before purchasing them.) The FHLBSF had discovered evidence of additional likely crimes by Lincoln Savings, but had not completed the referrals, at the time the “side letter” was written. Danny Wall and Bank Board member Roger Martin removed our (the FHLBSF’s) jurisdiction over Lincoln Savings (an unprecedented act) because we refused to withdraw our recommendation that Lincoln Savings be placed in conservatorship despite the political intervention of the five U.S. Senators who became known as the “Keating Five” and Speaker Wright on behalf of Keating. The Bank Board made no criminal referrals against Lincoln Savings after it removed our jurisdiction despite finding new evidence of likely fraud. The FHLBSF was not informed of the existence of the side letter and while the deal documents detailing the Bank Board’s de facto surrender to Keating were provided to us the side letter was not. I learned accidentally about the existence of the side letter in preparing for the House hearings on the scandal of the successful political intervention on behalf of Keating – the most notorious S&L control fraud. I then exposed the side letter and its import in my testimony. The side letter sealed Danny Wall’s fate. The Committee, on a bipartisan basis, was outraged by it. Wall resigned in disgrace.

I set forth this history because of the disclosures in Gretchen Morgenson and Louise Story’s April 14 article in the New York Times “In Financial Crisis, No Prosecutions of Top Figures.”

Morgenson and Story’s reporting revealed that Timothy Geithner discouraged criminal investigations of suspected accounting control frauds. I was asked to comment on this “elite felons go free” policy by Kai Ryssdal, Marketplace’s business journalist.

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?

Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

When more junior officials took actions discouraging criminal investigations against Charles Keating that were considerably less harmful than Geithner’s actions the Congress, the administration, and the media treated those actions as infamous and the head of the Office of Thrift Supervision, Danny Wall, had to resign. Why aren’t Geithner’s and Holder’s far more harmful and unprincipled actions, and failures to act, with regard to the elite criminals that caused the Great Recession a national scandal? Why isn’t Attorney General Mukasey, who was even more derelict than Holder, considered a national embarrassment? Have we lost our capacity as a nation for outrage? Are these elite ethical failures too powerful to hold accountable?