Let The Mea Culpas Begin, Part 2

Posted on January 6, 2010 by | 10 comments

BERNANKE’S APOLOGY FALLS FLAT
By L. Randall Wray

As discussed in Part 1 (see here), some of the policymakers responsible for this calamity have started to apologize. On January 3 Chairman Bernanke admitted that rather than using rate hikes back in 2004 to deflate the housing bubble, the Fed should have used “[s]tronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management” (see here).

There appear to be at least three reasons for Bernanke’s admission that the Fed did not do its job. First, and most obviously, Bernanke is up for reappointment (his term expires January 31)—and he will not sail through. The public is mad as hell, and politicians will have to put him through the wringer or face voter’s wrath in the next election. So Bernanke will have to appear contrite, and will apologize for his misdeeds many more times while Congress makes him sweat it out.

Second, Congress is actually considering whether it should strip the Fed of all regulatory and supervisory authority, given its miserable performance over the past decade—during which the Fed has consistently demonstrated that it has neither the competence nor the will to restrain Wall Street’s bankers. Since Greenspan took over the helm, the Fed has never seen a financial instrument or practice that it did not like—no matter how predatory or dangerous it was. Adjustable rate mortgages with teaser rates that would reset to levels guaranteed to produce defaults? Greenspan praised them (see here). Liar loans? Bring them on! NINJA loans (no income, no job, no assets)? No problem! Credit default swaps that let one gamble on the death of assets, firms, and countries? Prohibit government from regulating them! So Bernanke has to grovel and beg Congress to let the Fed retain at least some of its authority.

Third, many commentators blame the Fed for the crisis, arguing that it kept interest rates too low for too long, fueling the real estate bubble. Bernanke argues “When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment”. If he can convince Congress that the problem was lack of oversight and regulation he can shift at least some of the blame to Treasury and Congress—since it was Treasury Secretary Rubin, and his protégé Summers, as well as Barney Frank, Christopher Dodd, and many others (significantly, Democrats who will now decide the Fed’s fate) who pushed through the deregulation bills in 1999 and 2000. He figures that if the Fed now supports re-regulation, he will be forgiven and the Democrats will be too embarrassed to admit their own misdeeds. (Significantly, Dodd has announced his retirement, in recognition of the role he played in creating the crisis. Another mea culpa on the way?)

While I do believe the Fed should be stripped of all such authority, I am sympathetic to his argument about monetary policy. Low interest rates do not cause bubbles. The Fed kept interest rates low after the NASDAQ crash because it feared deflation in the face of significant downward pressures on wages and prices globally (see here). The belief was that low interest rates would keep borrowing costs low for firms and households, helping to promote spending and recovery. In truth, spending is not very interest sensitive and the economy stumbled along in a “jobless recovery” in spite of the low rates. What was actually needed was a fiscal stimulus (if anything, low rates are counterproductive because they reduce government interest spending on its debt—as Japan’s experience taught us over the past couple of decades—but that is a point for another blog).

Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!) The worst excesses in real estate markets began only after the Fed had started raising rates, and lending standards continued their downward spiral the higher the Fed pushed its target interest rate. In other words, contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets.

Why not? Two main reasons. First, recall that Greenspan had promoted adjustable rate mortgages with teasers. No matter how high the Fed pushed rates, lenders could offer “option rate” deals in which borrowers would pay a rate of 1 or 2 percent for two to three years, after which there would be a huge reset. Lenders ensured the borrowers that there was no reason to worry about resets, since they would refinance into another option rate mortgage before the reset. That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate.

Second, and this was the key, house prices would only go up. At the time of refinance, the borrower would have far more equity in the home, thus obtain a better mortgage. Further, the borrower could flip the house and walk away with cash. While I will not go into this now, public policy actually encouraged homeowners to look at their houses as assets, rather than as homes (see here) (And now that many are walking away from underwater mortgages—treating houses as assets that became bad deals—policy makers and banksters are shocked, shocked!, that borrowers are treating their homes as nothing but bad assets.)

In truth, when speculation comes to dominate an asset class, there is no interest rate hike that can kill a bubble. If one expects asset prices to rise by 20%, 30%, or more per year, an interest rate of 10% will not dampen enthusiasm. To kill the housing boom, the Fed would have had to engage in a Volcker-like double-digit rate hike (in the early 1980s, he raised short-term interest rates above 20%). There was no political will in Washington (either at the Fed or the White House) for such drastic measures. Nor was there any reason to do this. Bernanke is quite correct: the Fed could have and should have killed the real estate boom with much less pain by directly clamping down on lenders, prohibiting the dangerous practices that were rampant.

Is there any reason to believe that Bernanke is the right Chairman, or that the Fed is the right institution, to lead the effort to re-regulate and re-supervise the financial sector? Quite simply, no.

The Bernanke-led Fed still does not understand monetary operations, as indicated by its recently announced plan to unwind its balance sheet. Over the course of the crisis, the Fed invented new procedures such as auctions through which it provided reserves. Throughout, it always was focused on quantities, rather than prices, using quantitative constraints on the size of the auctions. Further, Bernanke continually promoted “quantitative easing”, reflecting the view that quantities are what matter. Now, the Fed has begun to worry about the size of its balance sheet—and also the size of reserve holdings of the banking system (the other side of the balance sheet coin, because the Fed buys assets by issuing reserves). Still following the thoroughly discredited theory of Milton Friedman, too many bank reserves are supposed to promote too much lending which then causes too much spending and hence inflation. Thus, Bernanke and many outside the Fed fret about how the Fed can reduce outstanding reserves to prevent incipient inflation. The Fed proposes to create new bonds it will sell to reverse the “quantitative easing”.

Actually, the Fed’s tool is price, not quantity, of reserves. When the crisis hit, the Fed should have opened its discount window to lend reserves without limit, to all comers, and without collateral. That is how you stop a run. The Fed’s dallying and dillying about worsened the liquidity crisis, but it eventually provided the reserves that the financial institutions wanted to hold and its balance sheet eventually grew to $2 trillion. Banks are still worried about counterparty risk and possible runs, so they remain willing to hold massive amounts of reserves. When they decide risks have declined, they will begin to reduce reserve holdings. This will not require any special practices by the Fed. Banks will repay their loans from the Fed, using reserves. This automatically reduces reserves and the size of the Fed’s balance sheet. They will offer undesired reserves in the overnight, fed funds market. Since many banks will be trying to unload reserves at the same time, this will put downward pressure on the fed funds rate. The Fed will then offer to sell assets it is holding to mop up the excess reserves (banks will use reserves to buy assets the Fed offers). This will also reduce reserves and the size of the Fed’s balance sheet. All of this will happen automatically, following the same procedures the Fed has always followed. All it needs to do is to watch the fed funds rate, and when it falls below target the Fed will drain reserves to relieve the downward pressure on overnight rates.

Quantitative easing was a misguided notion, and reversal of quantitative easing is similarly misguided. It simply indicates that Bernanke still does not understand how the Fed operates. In truth, formulating and implementing monetary policy is extremely simple and can be reduced to the following:

1. Offer to lend reserves at the discount window at 50 basis points to all qualifying institutions;

2. Pay 25 basis points on reserve holdings;

3. Perform par clearing of checks between banks, and for the Treasury.

Surely President Obama can find a chair who can do that.

The Fed’s relationship with banks is too cozy to make it a good regulator. It is, after all, owned by private banks. The Fed’s district banks are often run by bankers, and district Fed presidents take turns sitting on the policy-making FOMC. There is a particularly incestuous relationship between the NYFed and Wall Street banks—with Timmy Geithner as a prime example of the dangers posed (“I’ve never been a regulator” proclaimed the former head of the NYFed). It does not have the proper culture to closely supervise financial institutions. Its top body, the Board of Governors, are political appointees often with no experience in regulation (many are academic economists, typically mainstream and with a free market orientation). While the FDIC was also mostly asleep at the wheel over the past decade, it does have the proper culture and experience to take over responsibility for regulating and supervising the financial sector. With some management changes, and hiring of a team of criminologists tasked to pursue fraud, the FDIC is the right institution for this job.

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Let the Mea Culpas Begin, Part 1

Posted on January 5, 2010 by | 3 comments

RUBIN AND BERNANKE APOLOGIZE (SORT OF) FOR PAST SINS
Alan Greenspan has already apologized for the damage he wrought, admitting the crisis reveals that his approach to economics is fundamentally flawed.
Apparently it is now time for mea culpas from the rest of the team most responsible for creating this mess: Rubin, Summers, and Bernanke. Rubin and Bernanke just provided theirs (here and here) —albeit somewhat half-heartedly, a bit more Tiger Woods than David Letterman.
Don’t hold your breath for an apology from Summers, who never owns up to his mistakes, ranging from his proposal to use developing nations as toxic waste dumps to his argument that females suffer from congenital handicaps that render them incapable of doing science (here and here).
Still, with three out of the four acknowledging errors, this could indicate a New Year’s trend. Next we can hope that the University of Chicago—the institution most responsible for producing the theories that guided our misguided policymakers—will apologize for its indiscretions. That could set an example for all mainstream economists who, as the Queen pointedly put it, failed to foresee the crisis.
The statements by Rubin and Bernanke are quite interesting—both for what they say and for what they leave out. Rubin claims to have learned that we “need to reform the financial system to better protect against systemic risk and devastating crises in the future.” Nice deduction, Sherlock! But he goes further, admitting he has long had misgivings about the shape of the financial system: “About four years ago, a well-known London investor said to me that the only undervalued asset in the world was risk. I had the same view, as did many others, and often said that markets, including credit, had gone to excess and that would probably be followed by a cyclical downturn—perhaps a sharp one—though the timing, as always, was unpredictable.” Really? Four years ago? Did he try to warn the Bush administration’s regulators? Or his protégé, Timmy Geithner at the NYFed who was busy (by his own admission) NOT regulating banks?
At that time did he feel any guilt, since he was among the most important deregulators who had created the conditions that would ensure undervaluation of risk? Did he push for re-regulation of the financial institution he was running into the ground?
To be fair, Rubin notes other problems with the “free market” approach he used to advocate, indeed, his complaints sound remarkably similar to the arguments long made by progressives (including heterodox economists). For example, the market should not be counted on to determine income distribution:

“Even before the recession hit, our current model had displayed major shortcomings that markets, by their nature, won’t address and that need to be met through public policy. For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries.”

He even engages in a bit of class warfare:

“For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries. In the United States, median real wages have lagged behind productivity growth for more than three decades (except for the second half of the 1990s), and income has become more heavily distributed toward the most affluent.”

Hold it a second. The redistribution of income toward the affluent occurred as Wall Street “fat cat bankers” grabbed an ever rising share of corporate profits—the source of the bonuses paid to Rubin and his cronies. In 2006 Rubin received $29.4 million from Citigroup. That was four years ago, when he was supposedly fretting that the whole financial bubble was heading toward collapse (see here).
How about some clawbacks? Compensation caps? Investigations for fraud and significant jail time for fat cat bankers? Ban Goldman Sachs alum from Washington? Unfortunately, Rubin is mum on these issues.
After acknowledging the real suffering generated by Wall Street’s excesses, Rubin concludes:

“…virtually no one involved in the financial system—whether institutions, investors, regulators, analysts, or commentators—recognized the breadth of forces at work or the possibility of a megacrisis, and this included the most experienced among us. More personally, I regret that I, too, didn’t see the potential for such extreme conditions despite my many years involved in financial matters and my concern for market excesses.”

The sentiment is touching, but the attempt to share the blame is factually incorrect. Many financial market participants and commentators saw this coming. Many warned of the consequences of allowing banksters to run wild—but they were mostly ignored or even ridiculed by Rubin and his buddies. There was a very strong will to believe that when the crash came, government would be able to quickly bail-out the financial institutions, as it had so many times before over the course of the postwar period. Of course, that will to believe was bolstered by a strong financial interest in engaging in those practices that would eventually lead to crisis. Perhaps Rubin’s claim that he had not foreseen such a deep crisis is correct, but many others did. He chose not to listen to them.
There are, however, two quite disturbing arguments raised by Rubin in his apology. First, he cites a fundamentally flawed study put out by the Commission on Growth and Development (a task force founded by the World Bank and a collection of “advisors” including Rubin) that purports to prove that market liberalization is a necessary condition for growth and development:

“In the six decades since the end of the Second World War, there has been a broad movement around the world toward a model of market-based economics, public investment, and global integration. With that move came enormous economic progress in industrial countries, including the recovery of war-torn Europe and Japan and, as time went on, in various developing countries.” Further, “The commission also found that no economy anywhere in the world had been successful with largely state-directed activities and high walls against global integration. The evidence, in other words, strongly suggests that a market-based model is still the best way forward.”

Surprisingly, the countries he cites as examples of the success of the Neoliberal market model are South Korea, Singapore, China, and India. While it is true that these nations have relaxed constraints on markets, none is a good candidate for demonstrating the wondrous advantages of market-based economics. Indeed, most analysts recognize that there is a highly successful alternative Asian model of development that opens markets only as development reaches a sufficient level to compete in international markets. Development then continues almost in spite of markets, guided by the very visible hand of government.
And China? Can Rubin actually believe that China’s success is due to reliance on free markets? True, the Chinese government uses international markets when it sees an advantage. And it squelches markets when that is advantageous. Its ability to avoid any of the damages of the “market fall-out” occasioned by the crisis is proof not that markets “work” but that a sovereign government does not have to allow markets to dictate economic outcomes. China grows at an 8% pace in spite of markets. Maybe to spite them—to show off the superiority of its government-led model. And unlike Obama, its premier has no fear of being called a socialist as its government ramps up spending and reigns-in errant entrepreneurs (occasionally sentencing particularly nefarious individuals to death—a practice Rubin might want to adopt here?). It avoids financial crises by avoiding financialization of the sort that Rubin pushed onto the US economy.
The other error is even more serious, as Rubin continues his role as cheerleader for deficit hawks. Clearly he learned nothing from his term as Clinton’s Treasury Secretary, when budget surpluses killed the economy and helped to bring on the NASDAQ-led equities crash. (Memo to Rubin: a decade later, stocks still have not recovered their values.) He still, mistakenly, believes that the Clinton boom was due to budget surpluses, failing to realize that the boom created the surpluses (as tax revenue exploded) and this fiscal drag sucked so much income and wealth out of the private sector that a crash was inevitable. He now wants to prevent recovery or at least kill one should it get underway:

“Putting another major stimulus on top of already huge deficits and rising debt-to-GDP ratios would have risks. And further expansion of the Federal Reserve Board’s balance sheet could create significant problems. Second, while the measures taken were absolutely necessary, unwinding the stimulus, restoring a sound fiscal regime, undoing the expansion of the Federal Reserve Board’s balance sheet, and reducing government’s involvement in the financial system will be very difficult, both substantively and politically.”

So what we have is a former head of the Treasury, and who still plays an outsized role in advising Obama administration policy-makers like Geithner, who does not understand how the Treasury works (or, for that matter, how the Fed works). It spends by crediting bank accounts; it taxes by debiting them; and any net spending by the Treasury (called deficit spending) adds to the nongovernment sector’s net income and wealth. There are no risks that would arise from additional stimulus; but there are huge risks of not doing enough. Rather than focusing on the budget deficit—which provides no information of importance to guide policy-makers—Rubin ought to be recommending policy that could create the 25 million or so jobs we will need to restore the nation’s health.
As to unwinding the Fed’s balance sheet, that will be done simply and following normal Fed operational procedures. That is the topic for the next blog, which will also examine Bernanke’s mea culpa.

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Fixing the Small Banks

Posted on January 1, 2010 by | 3 comments

By Warren Mosler*

Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.

*First published on Moslereconomics.com

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“Fixing the Economy”

Posted on December 31, 2009 by | 7 comments

By Warren Mosler*

I was asked by a reporter to state how I’d fix the economy in 500 words and replied:

Fixing the Economy

1. A full ‘payroll tax holiday’ where the US Treasury makes all FICA payments for us (15.3%). This will restore ’spending power’ allowing households to make their mortgage payments, which ‘fixes the banks’ from the ‘bottom up.’ It also helps keep prices down as competitive pressures will cause many businesses to lower prices due to the tax savings even as sales increase.

2. A $500 per capita Federal distribution to all the States to sustain employment in essential services, service debt, and reduce the need for State tax hikes. This can be repeated at perhaps 6 month intervals until GDP surpasses previous high levels at which point state revenues that depend on GDP are restored.

3. A Federally funded $8/hr job for anyone willing and able to work that includes healthcare. The economy will improve rapidly with my first two proposals and the private sector far more readily hires people already working vs people idle and unemployed.
In 2001 Argentina, population 34 million, implemented this proposal, putting to work 2 million people who had never held a ‘real’ job. Within 2 years 750,000 were employed by the private sector.

4. Returning banking to public purpose. The following are disruptive and do not serve no public purpose:

a. No secondary market transactions
b. No proprietary trading
c. No lending vs financial assets
d. No business activities beyond approved lending and providing banking accounts and related services.
e. No contracting in LIBOR, only fed funds.
f.  No subsidiaries of any kind.
g. No offshore lending.
h. No contracting in credit default insurance.

5. Federal Reserve- The liability side of banking is not the place for market discipline. The Fed should lend in the fed funds market to all member banks to ensure permanent liquidity. Demanding collateral from banks is disruptive and redundant, as the FDIC already regulates and supervises all bank assets.

6. The Treasury should issue nothing longer than 3 month bills. Longer term securities serve to keep long term rates higher than otherwise.

7. FDIC

a. Remove the $250,000 cap on deposit insurance. Liquidity is no longer an issue when fed funds are available from the Fed.
b. Don’t tax the good banks for losses by bad banks. All that does is raise interest rates.

8. The Treasury should directly fund the housing agencies to eliminate hedging needs and directly target mortgage rates at desired levels.

9. Homeowners being foreclosed should have the option to stay in their homes at fair market rents with ownership going to the government at the lower of the mortgage balance or fair market value of the home.

10. Remove the ’self imposed constraints’ that are disruptive to operations and serve no public purpose.

a. Treasury debt ceiling- Congress already voted for the spending and taxes
b. Allow Treasury ‘overdrafts’ at the Fed. This is left over from the gold standard days and is currently inapplicable.

11. Federal taxes function to regulate aggregate demand, not to raise revenue per se, and therefore should be increased only to cool down an overheating economy, and not to ‘pay for’ anything.

*First published on Moslereconomics.com

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Fed Offers New CD; Chairman Bernanke is still confused

Posted on December 30, 2009 by | 7 comments

By L. Randall Wray

As reported in the NYT yesterday, the Fed has decided to offer banks an interest-paying CD. So far, so good. However, the argument offered by the Fed to justify this “innovation” is that it needs to start mopping up reserves in order to prevent inflation:

The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.

This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old “money multiplier” view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.

However, there is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

Finally, note that these new CDs are equivalent to Treasuries: government debt that pays interest. However, no one has castigated the Fed for proposing to bankrupt our grandchildren by running up debt. Apparently, this is because economists and policymakers recognize that the Fed is just substituting one kind of liability (reserves) for another kind of liability (CDs). But that is exactly what a sale of a Treasury bond does: it substitutes one government liability (Fed reserves) for another government liability (Treasury bonds). Operationally, it all amounts to the same thing. Once this is recognized, the Treasury can stop issuing debt, we can all stop worrying about our grandchildren, and our nation can get on with ramping up fiscal policy to get out of this economic crisis.

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A New Maestro?

Posted on December 25, 2009 by | 8 comments

By L. Randall Wray

Ok, the media is a poor judge of the performance of the Chairman of the Board of Governors. It seems like only yesterday that it anointed “maestro” status to Chairman Greenspan, right before all hell broke loose and he had to admit that his whole approach to financial markets had been dangerously wrong-headed. Now Chairman Bernanke is awarded with a magazine’s choice as “man of the year”—purportedly for saving capitalism as we know it. More importantly, the Senate is trying to decide whether he deserves reappointment. Usually these votes are little more than a rubber-stamping. Yet, something seems amiss this time around as the Senate Banking Committee voted 16 to 7 for approval—with significant opposition to reappointment. To some extent this is probably a vote of no-confidence for the Administration’s approach to dealing with the financial mess created by three decades of complete mismanagement of the banking system by a succession of Fed and Treasury officials. And, in truth, it would make more sense to fire Timmy Geithner and Larry Summers—who have done far more harm to the economy than has Ben Bernanke.

Let us suppose for a moment that Bernanke had done everything exactly right. Would he deserve accolades? In truth, the job of a Fed Chairman is pretty darn simple. So far as monetary management goes, he has one tool—the overnight interest rate target that is set in meetings of the Federal Open Market Committee. The Chairman has tremendous influence at these meetings, as we know from the transcripts that are released with a 5 year lag. While tremendous significance is believed to surround changes to the Fed’s target rate, in truth the overnight rate has little influence over the economy. As conventional thinking goes, the Fed raises rates in an inflation and lowers them in a recession. When the crisis hit, the Fed should have lowered rates, and did so. By itself, this should have had no impact; and by all accounts it had no impact. Should anyone receive man of the year designation for doing something that any Fed Chairman would have done, and which everyone agrees has virtually no impact?

Better to replace the FOMC with a rule that the overnight rate will be kept at zero from now on, a directive that the NYFed would implement. That would provide a lot more stability to the financial sector—and would go some way toward J.M. Keynes’s “euthanasia of the functionless rentier class”. But that is a story for another day.

In a crisis, the other thing the Fed does is to “provide liquidity”—that is, it lends reserves to prevent bank runs. This has been widely accepted policy since the 1840s and there is no central bank anywhere in the world that would not act as a lender of last resort in the sort of situation Bernanke faced. In fact, Bernanke was a bit slow to the gate on this, and never seemed to fully understand what he was doing. While he should have lent reserves without limit, to all comers, and against any kind of collateral, he played around with a variety of limited auctions, let a major financial institution fail due to lack of access to the Fed’s lending, and demanded good collateral for far too long. If anything, the Fed’s slow learning curve contributed to the crisis. Man of the year? I think not.

Finally, the Fed is supposed to be a regulator of financial institutions—through the thick and thin of the business cycle. Let us suppose a counterfactual: what if Bernanke had been a competent regulator from the time of his appointment? In truth, he consistently and persistently opposed any regulation that might have prevented this crisis, but in that he only followed his predecessor. And most of the damage had been done, with Greenspan at the helm since 1987 and with most of the important deregulation already accomplished by 2000. Clearly Bernanke deserves a grade of D- as a regulator (Timmy proudly earned an F when he testified before Congress that in all his years at the helm of the NY Fed he had never acted as a regulator!). So, he is certainly no worse than a Rubin or a Paulson and by 2005 when he was appointed he would not have had sufficient time or influence to overcome all the damage that had already been done. But a Man of the Year might have at least sounded a warning—rather than continually claiming even through summer 2007 that all was fine and dandy.

Bernanke will win reappointment. He has probably learned a bit as a result of this crisis so he will be a better head in his second term than he was in his first. Much is made of his scholarship that focused on the Great Depression. It is indeed a great advance over the work of Milton Friedman, who claimed the Fed caused the crisis by reducing the money supply. Bernanke also blamed the Fed for the initiation of the crisis, but the prolonged depression resulted because of the failure of financial institutions—which disrupted the relation between banks and their customers. When the bank of a farmer or entrepreneur failed, they were unable to borrow to finance operations—which collapsed production and employment. This is probably why Bernanke wants to prop up Wall Street institutions at all costs, to get “credit flowing again”. What he does not understand is that Wall Street banking has evolved—these are not lenders. They are speculators that serve no useful public purpose. If Bernanke were ever to figure that out, and would start to close down these predators, then he might deserve to be called Maestro.

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“Man of the year”

Posted on December 22, 2009 by | 1 comment

By Warren Mosler

I’m perhaps a bit harsher and more direct in my criticisms than Time Magazine when they named Chairman Bernanke their Man of the Year:
His latest speech shows he’s got ‘quantitative easing’ and monetary operations completely wrong as he believes the banks lend out reserves.
His alphabet soup of programs for the interbank lending freeze up completely missed the point that all the fed has to do is lend in the fed funds market which would have immediately solved the problem that never should have happened, and lingered for over 6 months and contributed to the last leg of the collapse.

He’s on the wrong side of fiscal policy, urging the Congress to balance the budget, at least longer term.

He’s on the wrong side of the trade issue, trying to engineer exports at the expense of domestic consumption, which is indeed happening, and causing our real terms of trade and standard of living to deteriorate.

He hasn’t even begun to consider the evidence that is showing lower rates to be deflationary rather than inflationary.

He still adheres to inflations expectations theory.

His unlimited dollar swapline program was an extraordinarily high risk policy that fortunately worked out, but never should have been done without discussion with Congress. In fact, last I read he still thinks it was low risk, not understanding that fx deposits at the foreign CB are not actual collateral.

If I had to select someone from outside the Fed for the next chairman Vince Reinhart is the only one I can think of that at least thoroughly understands monetary ops and reserve accounting, though we do have our differences on theory and policy.

*First published on Moslereconomics.com

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Who benefited, and by exactly how much?

Posted on December 22, 2009 by | 1 comment

UMKC’s Professor Bill Black joined Spitzer in calling for release of information on AIG’s operations and bail-out.

Many economists showing support by signing on to letter.

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Some Things to Consider Before Reappointing Bernanke

Posted on December 21, 2009 by | 4 comments

By Eric Tymoigne

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

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

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

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

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

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

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

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

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The Lost Science of Classical Political Economy

Posted on December 21, 2009 by | 4 comments

By Michael Hudson

There is a seeming riddle in the recent evolution of economic thought. It has become more otherworldly and abstract, more detached from the reality of how economies are running deeper into debt to a financial oligarchy. The global economy itself is polarizing between creditor and debtor nations, financial core and periphery (even as the United States manages to play both sides of this street). Yet academic orthodoxy treats this as anomalous, side-stepping the two key features of today’s economic crisis: the “magic of compound interest” multiplying debts owed by the bottom 90 percent of the population to savers among the top 10 percent, while industrial capitalism is turned into a “tollbooth economy” by privatizing rent-extracting privileges on what used to be the public domain.

Academic rationalizers of today’s economic policy use models that deny that such as failure could exist in the first place. Yet mathematically inclined economists claim that their discipline has become a science. It may seem natural enough for the hallmark of science to be mathematics, but the real issue should not be universals but rather how nations are diverging economically and how this is a result of policy, not the presumably automatic workings of “free markets.” The mathematical boys confuse social sciences grounded in history and jockeying for political power with the universals of physics. We should be glad that they finally have dropped equilibrium theorizing, but game theory and chaos mathematics still do not address the key causal dynamics at work.

Pseudo-science wielded on behalf of special interests turns mathematical abstraction into a vehicle to strip away what used to be the major concern of classical political economy, and indeed economic reform, over the past two centuries. The aim of classical value and price theory was to isolate land rent, monopoly rent, and financial interest and fees (and “capital” gains) as a free lunch accruing to privilege.
Chicago School practitioners of free-market mathematics crow that “there is no such thing as a free lunch,” distracting attention from economic reality by dropping the history of economic thought and economic history itself from the curriculum. The very idea that there is such a thing as a free lunch is deemed heretical. This idea now governs academic departments and monopolizes the most prestigious economic journals, without publication in which it is difficult for junior faculty ever to rise to tenured positions in their universities. The aim is to censor the perception that today’s economy is all about getting a free lunch by obtaining legal privileges, as exemplified by the recent U.S. health care HMOs, the bailouts over banks deemed “too big to fail” and other beneficiaries of government largesse.

Most wealth through the ages has come from privatizing the public domain. Europe’s landed aristocracy descended from the Viking invaders who seized the Commons and levied groundrent. What is not taken physically from the public domain is taken by legal rights: HMO privileges, banking privileges, the rezoning of land, monopoly rights, patent rights everything that falls under the character of economic rent accruing to special privilege, most recently notorious in the post-Soviet kleptocracies, and earlier in the regions of the world colonized by Europe. (The word “privilege” derives from the Latin, meaning “private law,” legis.) These bodies of privilege are what make national economies different from each other.

Classical economists, the original “liberals”, were reformers with a political agenda. The “scientific” mathematizers seek to strip away their agenda, above all by exiling the analysis of rent extraction and special privilege to the academic sub-basement of institutionalism, claiming that a sphere of study that is not mathematized cannot claim the mantel of scientific method. The problem with this reactionary stance is that attempts to base economics on the “real” economy focusing on technology and universals are so materialistic as to be non-historical and lacking in the political element of property and finance. By the 1970s, for example, economic observers were talking about the convergence of the Soviet Union and America on the ground that each used virtually the same technology, along with Japan and Western Europe. For that matter, as early as the Bronze Age (3200-1200 BC) the economies of Mesopotamia (Sumer and Babylonia), Egypt, the Indus Valley and other regions all shared a similar technology, but each had entirely different economic and social systems. A “real” economic analysis focusing on their common denominators would miss the distinct ways in which each accumulated wealth in the hands of (or under the management of) a ruling elite different modes of property and finance, and hence with what the classical economists came to classify as “unearned income.”

Mathematizing economics and its claims to become a science overlooks these institutional differences, including the land rent and other revenue that John Stuart Mill said landlords made “in their sleep.” What this approach leaves out of account is the social policy wrapping for technology. If we lived back in 1945 and were told of all the marvelous technological breakthroughs of the past half-century, we would imagine that societies would now be living a life of leisure. Why has this not occurred? The reason is largely to be found in the predatory behavior that has enriched the finance, insurance and real estate (FIRE) sectors.

For classical and Progressive Era economists, the word “reform” meant taxing economic rent or minimizing it. Today it means giving away public enterprise to kleptocrats and political insiders, or simply for indebted governments to conduct a pre-bankruptcy sale of the public domain to buyers (who in turn buy on credit, subtracting their interest payments from their taxable income). The global economy is being “financialized,” not industrialized in the way that most economic futurists anticipated would be the case a century ago.
One would think that this should be the focus of economic theory and the mathematics it uses backed by appropriate statistical categories so that the mathematics would have something empirically quantitative as their subject matter, not merely Greek letters. That this has not occurred should throw the whole mathematical fad in question as being fundamentally dishonest and captured by the special interests. And this political use of mathematics merely as a rhetorical ploy should not be welcomed as science. It is simply deception.

The problem is not mathematics as such, but the junk economics and junk statistics used by the mathematicians who have captured the discipline of economics. For contrast, one need only turn to the 19th century’s rich toolbox of economic concepts developed to analyze today’s most pressing problems. What could be more relevant, for example, than the question of whether the exorbitant salaries and bonuses that bankers pay themselves are unfair, and how much they should fairly charge for their services? To answer this question the 13th-century Schoolmen developed the theory of Just Price. For the next six centuries down through the late 19th century, economists refined the distinction between technologically necessary costs of production and “free lunch” exploitation, using the labor theory of value to define intrinsic costs (reducible to labor, including that embodied in the capital goods and other materials used up in production) and the complementary concept of economic rent (unearned income above these costs, that is, market price less cost value).

To what extent does our burdensome and intrusive debt overhead grow faster than the economy¹s ability to pay, and what is the best policy to deal with excessive debts? Already in 1776, Rev. Richard Price dealt with the “magic of compound interest”, its tendency to grow exponentially (“geometrically”) while the economy grew at only simple (“arithmetic”) rates. This idea survives only in the form that Malthus borrowed in his 1798 population theory.

The overburden of public debt prompted Adam Smith to comment that year that no government ever had repaid its debts, and to propose means to keep it in check by freeing the American colonies that were a major source of conflict with France, for instance, and most of all, by paying for wars out of current taxation so that populations would feel their immediate cost rather than running into debt to international bankers such as the Dutch. Interest on Britain’s public debt absorbed three-quarters of its fiscal budget after the Napoleonic Wars. Writers such as Malachy Postlethwayt analyzed how this debt service added to the cost of living and doing business. His logic along these lines is part of the lost science of classical political economy.

The early 19th-century French reformer St. Simon proposed that banks shift from making straight interest-bearing loans to “equity” loans, taking payment in dividends rather than stipulated interest charges so that debt service would be kept within the means to pay. (Islamic law already had banned interest.) This became the inspiration for the industrial banking policies developed in continental Europe later in the century. St. Simon influenced Marx, whose manuscript notes for what became Vol. III of Capital and Theories of Surplus Value collected what he read from Martin Luther to Richard Price on how debts multiplied by purely mathematical laws independently of the “real” economy¹s ability to produce a surplus. The classical concept of productive credit was to provide borrowers with the means to pay. Unproductive debts had to be paid out of revenue obtained elsewhere.

This distinction threatened the financial sector’s option of making unproductive loans. More congenial were the Austrian School and marginal utility theorists who depicted debt as a voluntary trade-off of present consumer utility (“pleasure,” not need) for future income that presumably would rise, thanks to the prosperity brought in the train of technological progress. Interest paid by consumers was treated as a psychological choice, while industrial profit was treated as a return for the widening time it presumably took to produce capital-intensive goods and services. The ideas of “time preference” and the “roundabout” cycle of production were substituted for the simpler idea of charging a price for credit without any out-of-pocket cost or real risk undertaken by bankers. The world in which economic theorists operated was becoming increasingly speculative and hypothetical.

Financial analysis turned away from viewing interest as a form of economic rent income achieved without a cost of production. After the Napoleonic wars ended in 1815, Britain’s leading bank spokesman, David Ricardo, applied the concept of economic rent to the land in the process of arguing against the agricultural tariffs (the protectionist Corn Laws) in his 1817 Principles of Political Economy and Taxation. His treatment deftly sidestepped what had been the “original” discussion of rentier income squeezed out by the financial sector.

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