Tag Archives: Financial crisis

Wallison: Leader of the Financial Wrecking Crew

Posted on January 28, 2011 by admin | 4 comments

The most theoclassical economists are often non-economists like Peter Wallison. His bio emphasizes the passion that has consumed his adult life.

From June 1981 to January 1985, he was general counsel of the United States Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry….

[He] is co-director of American Enterprise Institute’s (“AEI”) program on financial market deregulation.

Wallison is back in the media because the Republican Congressional leadership appointed him to the Financial Crisis Inquiry Commission. The Commission has four Republicans and six Democrats. Three of the Republicans were architects of the financial deregulation policies that made possible the current crisis. The fourth, Bill Thomas, was an ardent Congressional supporter of those policies that helped make those policies law. Unsurprisingly, none of the Republicans is willing to support the findings of the Commission’s staff’s investigations of the causes of the crisis because deregulation, desupervison, and de facto deregulation (the three “des”) played a decisive role in making the crisis possible. Each of the Republican members of the Commission is in the impossible position of being asked to investigate his own policies, which the Commission’s investigations have shown to have had disastrous consequences.

Even within the Republicans, however, Wallison stands out for the zeal of his efforts to blame everything on the government and working class Americans. He decided that his Republican colleagues had been too weak in condemning the staff’s findings and wrote a separate, lengthy dissent to make his case. Wallison’s actions were predictable. He was famous prior to his appointment for creating the narrative that the government’s desire to help working class Americans purchase homes twisted Fannie and Freddie into the Great Satans that caused the crisis. He believes in complete deregulation – banks deposits should not be insured by the public and banks should not be regulated.

I have critiqued Wallison’s claims about the current crisis and explained why I think he errs. I will return to this task in future columns now that he has written a lengthy dissent. In this column I will discuss a portion of a shorter, even more revealing article that he wrote that exemplifies what I will argue are the consistent defects introduced by his anti-regulatory dogma in each of his apologies for a series of financial deregulatory disasters over the last 30 years.

Wallison wrote an article in Spring 2007 (“Banking Regulation’s Illusive Quest”) criticizing a conservative law and economics scholar, Jonathan Macey, who had written an article about financial regulation. Wallison was disappointed that Macey, who typically opposes regulation, concluded that banking regulation was necessary. Wallison wrote the article to rebut Macey. I’ll discuss only the portion of Wallison’s article that seeks to defend S&L deregulation.

Wallison begins his critique of Macey by asserting:

If the business of banking is inherently unstable, it would long ago have been supplanted by a stable structure that performs the same functions without instability.

Why? That assumes that there are banking systems that are inherently stable and that the market will inherently establish such systems. There is nothing in logic or economic history that requires either conclusion. Economic theory predicts the opposite. Indeed, the paradox of stability producing instability was Hyman Minsky’s central finding.

Wallison does not support his assertion. The accuracy of the assertion is critical to Wallison’s embrace of financial deregulation. If banks are inherently stable, then financial regulation is unnecessary. He assumes that which is essential to his conclusion. His closest approach to reasoning is circular and unsupported.

In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits.

So, absent regulation and deposit insurance, bank instability cannot exist because instability would make banks unstable. Banks would want to be stable, so Wallison “expects” that they would hold “sufficient capital.” His “expectation” is his conclusion. One does not prove one’s conclusions by “expect[ing]” that they are true.

Wallison cited his (then) co-director of AEI’s deregulatory program, Charles Calomiris, who argued that early U.S. banks with broad branching authority had low failure rates. The study design could not prove Wallison’s argument about private market discipline. Mr. Calomiris’ attempt to employ his theories in the real world led to the failure in 2009 of the S&L he controlled. His brother, George, tried unsuccessfully to get Charles removed from his control of the S&L:

In 2004, after the company posted large losses, George Calomiris asked the board to replace Charles Calomiris and Amos with “qualified, experienced management,” he said in a letter to the board.

That request fell on deaf ears, George Calomiris said in an interview. “Since that time, I and everyone else who protested my brother’s total incapacity to do anything in the real world have seen the truth. … It’s been a total disaster.”

He said he has lost more than $1 million he invested in the bank. “This is not sour grapes. I’m not the only guy who has lost a fortune here.”

While calling his brother an esteemed professor, George Calomiris said “he hasn’t any idea how to run a bank.”

Several local banking experts and investors shared that sentiment, but declined to go on the record.

And that really is the central point of why Wallison, Calomiris, and AEI’s financial deregulatory efforts have caused so much harm to America. AEI’s financial deregulation efforts have been immensely influential even though they were run by individuals who had a “total incapacity to do anything” successful “in the real world.” Accounting and fraud happen in the real world and they turn these anti-regulatory dogmas into “a total disaster.” Indeed, they turn them into recurrent, intensifying disasters. That is why Tom Frank’s famous book title: “The Wrecking Crew” describes Wallison so well. He has led the financial wrecking crew. As his track record of failure has increased, so has his refusal to accept personal responsibility for those failures.

The dynamic Wallison relies upon, private market discipline, cannot be “expect[ed]” to be reliable. Even if we assumed that creditor and shareholders act in accordance with the rational actor model that Wallison implicitly relies upon (and economists and psychologists have proven that assumption is unreliable) it would not follow that private market discipline would be effective to make banks stable.

Private market discipline becomes harmful – not simply ineffective – in four common circumstances even if actors are purely rational. First, if creditors and shareholders believe they can rely on the bank having “sufficient capital” then control frauds will use accounting fraud to create fictional bank capital so that they can defraud the creditors and shareholders.

Second, given the risks of accounting control fraud to creditors and shareholders, creditors and shareholders will realize that reported net worth may be a lie. That uncertainty means that the creditors and shareholders may not be willing to lend to and invest in banks that are actually solvent. Indeed, the depositors may stage a run on a healthy bank. Capital does not save banks from serious runs.

Third, when the bank is an accounting control fraud its senior officers will use their ability to hire, fire, promote, and compensate to create perverse incentives that suborn its employees and internal and external controls (the appraisers, auditors, and credit rating agencies) and turn them into fraud allies. The perverse incentives create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace. This produces what white-collar criminologists refer to as “echo” epidemics of fraud.

Fourth, banks engaged in accounting control fraud can generate Gresham’s dynamics and produce “echo” epidemics of fraud in “upstream” providers of loans. Bank control frauds create pay systems for loan brokers, and loan products, i.e., “liar’s” loans, that produce such intensely perverse financial incentives that they are intensely criminogenic. This produced endemic fraud in liar’s loans obtained by loan brokers.

Note that these failures demonstrate that deposit insurance does not end private market discipline. Fraudulent CEOs systematically pervert market incentives and use their power as purchasers and their ability to massively inflate reported income and capital to exert discipline and produce perverse behavior. Indeed, they create an environment so perverse that it becomes criminogenic.

Famous economists, Akerlof & Romer 1993 (“Looting: the Economic Underworld of Bankruptcy for Profit), the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) 1993 (which investigated the causes of the S&L debacle) and many of the nation’s top white-collar criminologists, Calavita, Pontell & Tillman 1997 (Big Money Crime), and a number of my works had explained how accounting fraud worked many years before Wallison wrote this article.

Wallison relies on the same circularity when he turns explicitly to the S&L debacle.

Because they were backed by the government, the s&ls were not required to hold capital that was commensurate with the risk they were taking, and depositors and other creditors were not concerned about this risk for the same reason.

His first clause merely asserts that the S&Ls would have been required to hold more capital absent deposit insurance. His second clause is even weaker. Why do “other creditors” – uninsured creditors at risk of suffering severe losses upon the failure of the S&L – should have exercised effective market discipline against the S&Ls. They never did so. Many S&Ls had subordinated debt. Anti-regulatory proponents like Wallison assert that subordinated debt provides superb private market discipline against banks. The purchasers of sub debt are not insured, they are supposed to be financially sophisticated, and they often buy large amounts of sub debt – all factors that are supposed to optimize private market discipline. The problem is that they have consistently failed to do so in reality. Deeply insolvent S&Ls were able to issue sub debt.

Neither Macey nor Wallison address the consistent failure of uninsured S&L creditors and shareholders – a failure that destroys their underlying assumption that deposit insurance is the cause of market discipline failures. But recall that Macey and Wallison were writing well after the S&L debacle. They were writing after the failure of the Enron-era accounting control frauds – frauds at firms that had no deposit insurance. Market discipline becomes an oxymoron in the presence of accounting control fraud. As Akerlof & Romer (1993) stressed, fraud is a “sure thing.” Creditors rush to lend to uninsured non-financial firms that report record (albeit fictional) income. The control frauds loot the creditors and shareholders. Despite having seen “private market discipline” fund rather than discipline hundreds of huge frauds, Macey and Wallison simply assumed that private market discipline would succeed absent deposit insurance.

Macey writes, “Without government regulation to substitute for the market discipline typically supplied by contractual fixed claimants, disaster ensued.” True enough, but regulation was clearly the underlying cause of the problem.

Wallison’s description of S&L deregulation is remarkably selective and disingenuous.

The deregulation that occurred was an effort to compensate for the earlier regulatory mistakes, but it was too late. Many in the industry were already hopelessly insolvent.

Deregulation was an expedient that came too late to halt the slide of the s&l industry toward insolvency.

And allowing undercapitalized or insolvent s&ls to continue to function — attracting deposits through use of their government insurance — guaranteed a financial catastrophe.

Only the last assertion is sound, but Wallison misinterprets even it, for it was a product of the deregulation that his department (Treasury) imposed on the Federal Home Loan Bank Board. Relatively few S&L were “hopelessly insolvent” as a result of the interest rate increases of 1979-82. NCFIRRE’s estimate is that $25 billion (of the $150 billion in total, present value cost ($1993) of resolving the debacle) was caused by interest rate increases. Interest rates began to fall later in 1982 and generally continued to fall. The great bulk of S&L failures – and the overwhelming bulk of the cost of resolving those failures – was caused by credit losses. Accounting control fraud was a major cause of those costs.

Wallison, understandably, focuses on the most benign aspects of S&L deregulation. Federally chartered S&L were permitted to issue adjustable rate mortgages (ARMs) and S&Ls were permitted to pay depositors higher interest rates. (S&L regulators had long supported both of those changes. Congress was the problem.) I quoted above from Wallison’s bio to show his emphasis on his leadership role in framing the Reagan administration’s financial deregulation.

The deregulation, desupervision, and de facto decriminalization of the S&L industry that the Reagan administration initiated (including the “competition in laxity” that federal deregulation triggered at the State level) was far broader than Wallison discusses and was a dominant contributor to the cost of resolving the debacle. The “three des” created an exceptionally criminogenic environment. Absent reregulation, which we implemented over Wallison’s virulent opposition, it would have caused catastrophic losses. Here are only the most destructive of the “three des” that the administration initiated.

• Reducing the number of Federal Home Loan Bank Board examiners and froze hiring

• Sought to prevent the agency’s decision to double the number of examiners

• Perverting the accounting rules to hide losses and cover up the industry’s mass insolvency – which created fake capital and income that made it far harder to act against the frauds. Covering up the mass insolvency of the industry was at all time the Reagan administration’s dominant S&L industry priority.

• Reducing capital requirements

• Increasing the permissible loan-to-value (LTV) and loan-to-one-borrower (LTOB) ratios to the point where a single large, bad loan could render the S&L insolvent

• Allowed acquirers to create massive fictional assets – goodwill via mergers that made real losses disappear from accounting recognition and created large, fictional income from mergers of two insolvent S&Ls

• Allowed acquirers to have intense conflicts of interest

• Allowed single acquirers, overwhelmingly real estate developers, to take complete control of S&Ls

• Ceased placing insolvent S&Ls in receivership

• Created hundreds of new S&Ls (de novos), overwhelmingly controlled by real estate developers

• Attempted to appoint (on a recess basis without the Senate’s advice and consent) two members to run our federal agency selected by Charles Keating – the most infamous S&L control fraud. The agency was run by three members, so this would have given Charles Keating effective control of the agency.

• Testified before Congress and in a deposition taken in support of a lawsuit by the owners of an S&L challenging the Carter administration’s appointment of a receiver for the S&L based on its acknowledged insolvency. A senior Reagan administration Treasury official testified that insolvency

• The OMB threatened to file a criminal referral against the head of the agency, Ed Gray, who was reregulating the industry, on the purported grounds that he was closing too many failed S&Ls

• Treasury Secretary Baker met secretly with House Speaker James Wright and struck a deal under which the administration would not re-nominate Ed Gray,

The overall effect of the “three des” was that the S&L control frauds were originally able to loot with impunity. Roughly 300 fraudulent “high fliers” grew at an average rate of 50% in 1983. Gray began reregulating the industry in 1983, roughly six months after he became Chairman. The S&L frauds were able to hyper-inflate a regional real estate bubble in the Southwest. Reregulation contained the crisis by promptly and substantially reducing the growth of the fraudulent portion of the industry. Had deregulation continued an additional three years the costs of resolving the crisis would have risen to over $1 trillion. Note that Gray reregulated over the opposition of the Reagan administration (including Wallison), a majority of the members of the House, the Speaker of the House, the “Keating Five”, the industry trade association, and (at first) the media.

Wallison consistently refuses to even discuss the failures of private market discipline caused by accounting control fraud. His lengthy Financial Crisis Inquiry Commission rebuttal, for example, mentions the word fraud once. That reference ignores the evidence before the Commission on the endemic fraud by nonprime lenders and their agents that and mentions only fraud by borrowers. Accounting control fraud is the Achilles’ heel of private market discipline. Effective private market discipline is the sole pillar underlying Wallison’s anti-regulatory policies. He is one of the principal architects of the criminogenic environments that were principal causes of the second phase of the S&L debacle, the Enron-era frauds, and the current crisis. The recurrent, intensifying crises his policies generate have left him with a full time job as apologist-in-chief for his deregulatory disasters.

4 Comments

Posted in Regulation, Uncategorized, William K. Black

Tagged Control Fraud, deregulation, Financial crisis, fraud, regulation, William K. Black

Pressures on the Paradigm: The Fall of the New Monetary Consensus

Posted on January 10, 2011 by admin | 11 comments

By L. Randall Wray

The following is a paper given at the ASSA conference in Denver this past week for a panel organized by James Galbraith, titled Pressures on the Paradigm, sponsored by Economists for Peace & Security.

The Queen famously asked her economists why none had seen the global crisis coming. Obviously the answer is complex, but it must include the evolution of economic theory over the postwar period—from the “Age of Keynes”, through the Friedmanian era and the return of virulent Neoclassical economics, and finally on to the New Monetary Consensus with a New anti-Keynesian version of fine-tuning by an unaccountable (“independent”) central bank

We cannot leave out the parallel developments in finance theory—with its efficient markets hypothesis—and the subsequent deregulation and de-supervision that led to the financialization of everything.

But to make a long story short: if your theory says that a global collapse is impossible, you won’t see one coming. In truth, as Jamie has argued in his great book, the Predator State, no one outside Chicago and other institutes of the higher learning ever took the free market mantra seriously—outside the ivory towers it was nothing but a slogan, a justification for enrichment of the powerful few.

Like Jamie, I believe orthodox macroeconomics is finished—although not all the zombie practitioners of that dismal religion recognize they are dead. After the crisis hit, Jamie, Duncan Foley and I were invited to appear on panels at the University of Chicago along with a dozen or so of the Chicago boys.

Not surprisingly, none of them was budging from his dogma of free and efficient markets: the crisis was caused by too much government interference; the solution is more deregulation. Three years into this crisis those who never saw it coming proclaim signs of recovery everywhere they look.

And, still, it is only academia that is clueless. Everyone in financial markets saw it coming—indeed, they planned on it and worked fastidiously to create it. They would profit on the way up, and then profit more in the collapse whilst collecting on their credit default swap bets and stealing all the homes.

It is Bush’s ownership society and the goal all along was to transfer all ownership to the top through the creation of serial bubbles—what Michael Hudson calls Bubbleonia. The biggest land grab since the enclosure movement.

So, no, there is no recovery. The banks are more massively insolvent than they were 2 years ago. They are cooking their books so they can pay executive bonuses and reward the traders and the foreclosers who are successfully transferring all wealth to the elite.

But Jamie asked me to address the state of theory—not the economy.

I want to focus on one particular Zombie that needs a stake through its heart or a bullet through its head: the New Monetary Consensus. This is an updated New Keynesian version of the old Bastard ISLM model.

The idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust.

Every link in that sentence is a delicious illusion.

The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation.

But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy!

And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence.

Out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth.

Let us take the current experience as an example. We have moved on to QE2, an application of the NMC.

Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to create expectations of inflation—to counter the deflationary real world forces. And many wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation. Why?

Because those who might have pricing power—corporations and organized labor—cannot create inflation. Workers cannot increase their wages given massive global unemployment, and firms cannot increase prices in the face of competitive pressures. So no matter how strong is the will to believe, it has no purchase against the facts.

The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the power of the central bank to lower the price of reserves—the overnight rate–as close to zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there is a nonzero practical limit to that based on what Keynes called the square rule.

Quantitative easing supposedly pumps money into the economy to generate spending in order to create expectations of inflation. But all it really amounts to is substituting reserves for treasuries on bank balance sheets—lowering their interest earnings. QE won’t work because:

• (1) additional bank reserves do not enable or encourage greater bank lending;

• (2) the interest rate effects are small at best, and are swamped by private sector attempts to deleverage;

– The best estimate based on NYFed work: 18 basis points

• (3) purchases of Treasuries are simply an asset swap that reduce the maturity of private sector assets, but do not raise private sector incomes; and

• (4) given the reduced maturity of private sector portfolios, reduced interest income could actually be deflationary.

But we knew all that—Japan has been doing QE for 20 years, trying to create expectations of inflation in the face of deflationary headwinds, thus, it is interesting to compare Japanese and US experience (so far) by looking at a series of three graphs.

As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity would lead us to follow Japan’s path while expecting different results.

Let me finish my critique of the NMC with an observation of a Galbraith—John Kenneth this time:

To limit unemployment and recession in the US and the risk of inflation, the remedial entity is the Fed… For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman… The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Fed are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud.

Even if the early postwar “Keynesian” economics had little to do with Keynes at least it had some connection to the real world. What passed for macroeconomics on the precipice of the global collapse had nothing to do with reality—it is as relevant to our economy as flat earth theory is to natural science.

In short, expecting the Queen’s economists to foresee the crisis would be like putting flat- earthers in charge of navigation for NASA and expecting them to accurately predict points of re-entry and landing of the space shuttle. Of course, the economic advisors to Presidents Bush and Obama could do no better.

Referring to the work of the best known economists over the past thirty years, Lord Robert Skidelsky argues “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” Not only were they strange, but the ideas of the Larry Summers’, Bob Rubins, Mankiws, Marty Feldsteins, Bernankes and John Taylors of the world were, predictably, dangerous.

But one economist got it right, and did see it coming. And that is Hyman Minsky. His theory said it can happen again: market forces are destabilizing.

The economy emerged from WWII with a robust financial system—hardly any private debt and lots of safe and liquid government debt. Various New Deal and postwar reforms also made the economy stable: a safety net that stabilized consumption; strict financial regulation; minimum wage laws and support of unions; low cost mortgages and student loans, and so on. And memories of the Great Depression discouraged risky behavior.

Gradually all that changed—memories faded, self-regulation replaced financial regulations, unions lost power and government support, globalization brought low-wage competition, and the safety net was shredded. Further, profit-seeking firms and financial institutions took on greater risks with ever more precarious finance. Thus, fragility grew on trend. This made “it” possible again.

While most who invoke Minsky focus on the crash, he believed that the main instability is a tendency toward explosive euphoria. High aggregate demand and profits associated with high employment raise expectations and encourage increasingly risky ventures based on commitments of future revenues that will not be realized.

A snowball of defaults then leads to a debt deflation and high unemployment unless there are “circuit breakers” that intervene to stop the market forces. The main circuit breakers, are the Big Bank (central bank as lender of last resort) and Big Government (countercyclical budget deficits).

And, boy-oh-boy have we got a Big Bank and a Big Government! Together, the Benny and Timmy tag team have spent, lent, or guaranteed $25 trillion in the name of Uncle Sam. And that still is not enough. “It” is still happening.

The problem is that most of this was done by the Big Bank Fed, aimed at helping financial institutions—trying to prop up their worthless assets. In short, it was based on the theory that we need Money Manager capitalism and that the only hope is to generate another bubble.

It won’t work. Financialization is the problem, not a sustainable economic strategy. We need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing wages, consumption—especially public consumption, constrained and downsized finance, and greater equality. Monetary policy also has to be downsized, while fiscal policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to counter and guide and supplement the private purpose.

More importantly we’ve got to formulate theory applicable to the world in which we actually live—not one in which imaginary representative agents allocate resources along an optimal consumption path.

To that end, we stand on the shoulders of the giants like Minsky in the heterodox tradition.

11 Comments

Posted in Monetary policy, Uncategorized

Tagged Financial crisis, Hyman P. Minsky, Monetary policy

Randall Wray Interviewed on KPFK’s Daily Briefing

Posted on December 22, 2010 by admin | Comments Off

Randall Wray was interviewed recently on the economics and politics of the banking industry. The full program can be found here, with Professor Wray’s interview beginning at 39:00.

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Posted in L. Randall Wray, Uncategorized

Tagged Federal Reserve, Financial crisis, Financial system, fraud, L. Randall Wray

William Black interviewed on Portland’s KBOO Community Radio

Posted on November 3, 2010 by admin | 1 comment

William Black was recently interviewed on KBOO’s ‘Old Mole Variety Hour’ regarding corruption in the banking industry.

1 Comment

Posted in Uncategorized, William K. Black

Tagged Control Fraud, Financial crisis, fraud, William K. Black

William Black interviewed by GFS News

Posted on November 3, 2010 by admin | Comments Off

William Black was recently interview regarding the Obama administrations response to the financial collapse: “Obama has ignored the savings and loans crisis to this point. The position of the administration was that there were no lessons to be learned from the savings and loan crisis. I find that very bizarre.” See the full story.

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Posted in Uncategorized, William K. Black

Tagged Control Fraud, Financial crisis, William K. Black

FREDDIE MISHKIN DOES ICELAND: YOU’VE GOT TO TRUST THOSE CENTRAL BANKS

Posted on August 24, 2010 by admin | 9 comments

L. Randall Wray

Another one in the category of “you just can’t make this up”. Recall that Fred Mishkin was on the Fed’s Board of Governors when the global financial system bombed. Now watch this:

http://d.yimg.com/nl/movies/site/player.swf

For Mishkin’s report on Iceland, go here. For Tyler Durden’s commentary on the report and the video, go here.

If you are an academic, his performance makes you want to curl up under a table. If you are not in academics, it might make you want to take a baseball bat to the pointy-headed intellectuals at the nation’s “elite” universities. To be sure, what Columbia University’s Mishkin did to Iceland is no worse than what economics professors at Harvard—hey, Larry Summers, that includes you—have been doing to countries all over the world. The “research” they are paid to do is not research at all—it is marketing. In the case of Iceland, Freddie was paid by the Chamber of Commerce to do a fluff job—and he fluffed the heck out of Iceland. I wonder what the good people now suffering in Iceland would like to do with him.

One could give him a bit of slack—after all, why would anyone expect that Freddie knew anything at all about Iceland. His research method was to “talk to people” and to “trust the central bank”. That he didn’t see a financial collapse coming right around the corner isn’t, I guess, too surprising. Besides, if you are paid well to not see a crisis coming, you probably will not look too hard. Still, his squirming video takes the cake—even more fun than Geithner’s performances in front of Congress. Oh, right, his doctoring of his CV to change the title of his paper from “Stability” to “Instability” is a “typo”. And, right, he cannot remember how much he was paid as fluffer, but it is in the “public record”. Give us a break.

Actually, I had seen Mishkin squirm like that before. At the very beginning of the US financial crisis (April 2007)—when most still did not see it coming—Mishkin as member of the BOG gave a dinner speech. There was no indication in his speech that he “saw it coming”—he predicted moderate growth, emphasized some strong data in housing as well as low unemployment, and said the Fed would keep its interest rate target at 5.25. While it is hard to believe now, the Fed and most of the press was still worried about inflation at that time—even though anyone who was paying attention could see the economy was beginning to collapse into what would obviously be the worst crisis since the Great Depression. Still, commodities prices were being driven by a speculative boom coming mostly from pension funds—a story for another day. So Freddie was peppered with questions from the media present asking whether the Fed would be able to prevent an inflationary burst. Mishkin’s response was eerily similar to the response he gave in the video—you’ve got to trust the central bank. Do not worry, the Fed has ample ammunition to kill inflation.

When he returned to our table, we grilled him a bit more on that topic, and some of us also argued that the real danger facing the US was a financial crisis and deflation—not inflation. Let me interject that I liked Mishkin. He was a pleasant conversationalist, not at all arrogant, and even somewhat self-effacing. But when he gave his pat answer, “don’t worry, we are the Fed and we know what we are doing”, Jamie Galbraith pressed him for details: what are you going to do about inflation? And, if you raise interest rates now, when debt loads are so high, won’t that cause a wave of delinquencies on mortgages and consumer debt? That’s when we saw the same transformation you just witnessed in the video—from an easy, affable, confidence to sheer horror. Mishkin had been found out and was looking for the exits.

I must say that it was never clear exactly what that horror was. At the time I did not believe that Mishkin’s heart was in the inflation story. Surely he could not have believed, then, that the real danger was inflation. He’d been coached at the Fed about what he ought to say—and the Fed was riding the inflation story to divert attention away from the real danger. The Fed needed to keep the speculative bubbles going as long as possible—an election was around the corner and Republicans needed help. I was sure that he was actually afraid that we were right: the economy was going bust. And the Fed had nothing up its sleeve to prevent Armageddon.

Shortly thereafter, Mishkin left the Fed (August 2008—the second-shortest term ever served). That looked suspicious—and although I never tried to find out why, it fit with my interpretation that he knew what was coming, and so like Greenspan jumped the sinking ship before the Fed would be exposed as the impotent Wizard of Oz behind the curtain.

However, since then, Greenspan has publicly admitted that he had been clueless. His whole approach to economics was dangerously wrong. He never saw nothing coming. And after viewing this video, I am not so sure Mishkin had any clue, either.

Maybe his term at the Fed, like his research for Iceland, was nothing but marketing, too.
Columbia professor? Check.
NBER researcher? Check.
FDIC researcher? Check.
Highly paid consultant for international research? Check.
Vice President of NYFed? Check.
Former BOG member? Check.
Top selling money and banking textbook author? You betcha.

All he needed was a few months at the helm of the central bank, something he could add to the textbook blurb, to ramp up those sales.

9 Comments

Posted in L. Randall Wray, Uncategorized

Tagged Federal Reserve, Financial crisis, International Finance, L. Randall Wray

The Wingnuts go after Fannie and Freddie

Posted on August 19, 2010 by admin | 18 comments

By L. Randall Wray

In recent weeks the wingnut right wing ideologues have made a lot of headway in their goal of gutting Social Security. Well-funded by hedge fund manager Pete Peterson as well as right wing Washington think tanks, they have promoted the preposterous notion that our wealthy and productive economy cannot afford to take care of our elders. Now they have turned their sights on Fannie and Freddie. They argue that it is time to cut Uncle Sam out of the home mortgage market. Just as he has no role to play in providing decent pensions to our retired population, he should not help make homeownership affordable for most Americans. “Free markets” can do it all so much better than Uncle Sam can do.

Give me a break. These are the same bozos that are promoting home foreclosure and happily cheering the biggest transfer of wealth to Wall Street that the US has ever seen. Without Fannie and Freddie there would be no home financing or refinancing going on right now. Oh, right, free markets did such a good job with the subprime mortgage market, creating a global financial crisis that rivals the Great Crash of 1929. Hey, let’s reward them by getting government out of the mortgage markets so that Pete Peterson can run the whole shebang for the benefit of Wall Street. That, of course, is the real goal. Wall Street wants to get back to predatory lending as quickly as possible, and hates the competition from a newly missioned Fannie and Freddie—which have turned away from the practices that assisted rapacious private lenders from 2004 to 2008. Better close them down because Wall Street hates competition.

And, yes, let’s reduce Social Security benefits and raise payroll taxes, squeezing our seniors so that they have no choice but to let Pete Peterson charge them exorbitant fees to manage their miniscule life savings. Government is running out of keystrokes and won’t be able to afford to credit retiree bank accounts fifty years from now. Better slash Social Security now.

Ain’t it all just so convenient for the Pete Petersons of the world? Shift the blame, no matter how ridiculous the claims. Our current problems are caused by runaway Fannie and Freddie and Social Security—providing safety nets that our homeowners and seniors abused, taking advantage of poor little defenseless Goldmans and Morgans and Citibanks. That was the cause of the crisis! If we had just had more free market abuse of consumers, everything would have just been fine. Besides, government is broke. We’ve got to tighten the purse strings. Running out of cash, you know. No more keystrokes to credit bank accounts.

How about a reality check? Fannie and Freddie made no subprime loans. Indeed, they originated no loans at all. Yes, they offered insurance on privately originated mortgages, and yes, they lowered their standards. This has been carefully studied, and all analysts have reached the conclusion that Fannie and Freddie got into trouble because they catered to “free” market demands that they either insure the kinds of toxic mortgages markets wanted to provide or that they become irrelevant. The free markets wanted to do Liar loans and NINJA loans, making loans that borrowers could never service. The old fuddy duddies Fannie and Freddie would never have agreed to guarantee this trash, so they were partially privatized, with big gun, high paid CEOs hired. And just like magic, they started behaving like a Goldman or a Countrywide—maximizing CEO pay while damning the firms. Yes, that is the free market solution and my colleague Bill Black calls it control fraud. Fannie became a control fraud, just like all the big boy private financial institutions. Peterson’s solution? Promote control frauds by freeing markets.

The thing that the wingnuts cannot explain is why Fannie and Freddie—which had a history that goes back to the mid 1960s – did not encounter significant problems until they were directed by Congress to replicate a market-oriented strategy. And the wingnuts cannot explain why defaults on home mortgages were so rare until the “free markets” took over the mortgage sector. Heck, Fannie and Freddie even survived the savings and loan fiasco of the 1980s, when thrifts were “freed” to pursue free market maximization that resulted in suicide for the whole industry. It was only after 2004 when Fannie and Freddie were directed to cater to control frauds like Countrywide that they got into trouble.

Make no mistake. The wingnuts are likely to win these battles. President Obama will not put up a fight—he’s already bought the Peterson story, hook, line and sinker. Social Security is a done deal. It is going to be “reformed”. That is, it will be handed over to Pete Peterson, who will manage it right down the rat hole where all the private pensions are going. Wall Street will gamble away all the funds, whilst enriching itself with management fees. And Fannie and Freddie will be shut down so that Wall Street will have free reign in the housing market. Homeownership rates will plummet. Predatory mortgages will be the rule. Wealth will trickle up. Democratic Party coffers will be replenished. Obama will declare Social Security and Fannie and Freddie to be reformed—just like the healthcare system.

The only possible hope is that financial markets completely collapse in the next three to four months. That would discredit Pete Peterson and the wingnuts at his think tanks. It would make it possible to stop the right wing stampede and the collective amnesia about the last three years—that is, about the global financial crisis caused by free market wingnuts. Resumption of the crisis could discredit the crazy troglodyte thinking promoted at Chicago and Washington think tanks.

What is the free market path to homeownership? A subprime crisis.

What is the free market path to private pensions? Across the board collapse of commodities, real estate, and equities markets.

What is the free market alternative to Social Security? An impoverished elderly population.

What is the free market alternative to Medicare? High priced health insurance that most elderly people cannot afford.

Not to worry, all these reductions of government interference into the finely oiled free market machine will help to enrich Pete Peterson and the other funders of the wingnut think tanks.

Ok, how about a politically feasible alternative? We all know that Pete Peterson’s well-funded effort has convinced most policy makers that the federal government has run out of money, so cannot afford costly Social Security or government guarantees of mortgages. Any federal spending must be offset by tax hikes or spending cuts. Pete Peterson’s minions are fond of “infinite horizon” calculations that show that “government entitlements” will lead to shortfalls of tens of trillions of dollars. It is all nonsense, but it guides all policy making.

So here is a proposal consistent with such calculations. Let us raise Social Security benefits today to help seniors through the current depression. Let’s have a payroll tax holiday—stop collecting the taxes from employers and employees to put more pay into the hands of workers and to reduce the costs of employing them. Let us provide debt relief to homeowners so that they can keep their homes. Let us create a jobs program to put 12 million people back to work (the number of jobs created by New Deal programs).

To please the deficit hysteria crowd we will need to offset all of this spending. So let us propose that beginning in 2050 all seniors above age 65 will be ground to produce soylent green burgers, with a proviso that implementation can be postponed by majority vote of the population annually from 2050 on. For budgetary purposes, the future savings to Social Security and Medicare can be counted today, eliminating Peterson’s infinite horizon unfunded entitlements. Voters in 2050 and thereafter can decide whether they want those burgers—year-by-year so that infinite horizon forecasts will remain favorable. Each year voters will decide whether they want to eat seniors or feed them for one more year.

Personally, I don’t eat mammals, but I won’t be voting in 2050. Now, reptiles are an entirely different matter, and only discretion prevents me from naming a few that could be candidates for reptilian burgers. Bloodsucking vampire squid cakes, anyone?

Heck, no matter what we do today, it will be voters in 2050 that will decide the fate of seniors in 2050. That is what scares the Beetlejuice out of Pete Peterson—he’s afraid that American compassion and reason will triumph, hence the scaremongering to convince voters that retiring babyboomers expecting government to credit their bank accounts using keystrokes represents the biggest threat facing America today. And that is why the wingnuts think it is so important to start cutting benefits and raising payroll taxes today—to eliminate America’s most popular government program so that no one will have any alternative to Wall Street management of pensions. Yes it is unimaginatively silly—the agenda of simpletons who have no understanding of balance sheets or of sovereign currencies or of anything else that is important to the issues of Social Security or government guarantees of home mortgages. Unfortunately, these are the most dangerous kind of simpleton—with billions of dollars to throw around to get their way.

Remember Thatcher’s motto: TINA = there is no alternative to free markets. The wingnuts have learned these lessons well. Remove any alternative to Wall Street’s complete control over all aspects of life. Then TINA will be true.

I do not want to be accused of being unfair to wingnuts. There is certainly room for debate on the necessity of reforming Social Security and government guarantees of mortgages (and student loans, and small business loans, and farm loans, and veteran’s loans). One can coherently—even if repugnantly—argue that government should play no role in helping to provide seniors with a decent living standard. Declaring that any senior who is not sufficiently lucky, industrious, and foresighted to provide for her own retirement ought to live out a miserable old age is an opinion that deserves to be debated. But declaring that government simply cannot afford current law Social Security benefits it just plain ignorant—it is a position that deserves no attention. Siding with Wall Street against government protection of homeowners might be an unpopular position but it is, again, worthy of debate. Yet claiming that Fannie and Freddie as originally constituted would have contributed in an important way to the global financial crisis does not merit consideration. It is not even worthy of Fox News. It is beyond stupid. It is an outright misrepresentation of the facts.

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Posted in L. Randall Wray, Policy and Reform, Uncategorized

Tagged Financial crisis, L. Randall Wray, New financial structure, Policy and Reform, The Financial Bailout

Investment Banking by Blood Sucking Vampire Squids

Posted on August 10, 2010 by admin | 13 comments

By L. Randall Wray

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson www.nytimes.com/2010/08/06/business/06denver.html)

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman’s Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

13 Comments

Posted in L. Randall Wray, Regulation, Uncategorized

Tagged Financial crisis, Financial innovation, Financial system, L. Randall Wray, regulation, The Financial Bailout

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

Posted on July 29, 2010 by admin | 14 comments

By Eric Tymoigne

The Congressional Budget Office (CBO) has just released an 8-page brief titled “Federal Debt and the Risk of a Fiscal Crisis.” In it you will find all the traditional arguments regarding government deficits and debt: “unsustainability,” “crowding out”, bond rates rising to “unaffordable” levels because of fears that the Treasury would default or “monetize the debt,” the need to raise taxes to pay for interest servicing and government spending, the need “to restore investor’s confidence” by cutting government spending and raising taxes. This gives us an opportunity to go over those issues one more time.

“growing budget deficits will cause debt to rise to unsupportable levels”

A government with a sovereign currency (i.e. one that creates its own currency by fiat, only issues securities denominated in its own currency and does not promise to convert its currency into a foreign currency under any condition) does not face any liquidity or solvency constraints. All spending and debt servicing is done by crediting the accounts of the bond holders (be they foreign or domestic) and a monetarily-sovereign government can do that at will by simply pushing a computer button to mark up the size of the bond holder’s account (see Bernanke attesting to this here).

In the US, financial market participants (forget about the hopelessly misguided international “credit ratings”) recognize this implicitly by not rating Treasuries and related government-entities bonds like Fannie and Freddie. They know that the US government will always pay because it faces no operational constraint when it comes to making payments denominated in a sovereign currency. It can, quite literally, afford to buy anything for sale in its own unit of account.

This, of course, as many of us have already stated, does not mean that the government should spend without restraint. It only means that it is incorrect to state that government will “run of out money” or “burden our grandchildren” with debt (which, after all, allows us to earn interest on a very safe security), arguments that are commonly used by those who wish to reduce government services. These arguments are not wholly without merit. That is, there may well be things that the government is currently doing that the private economy could or should be doing. But that is not the case being made by the CBO, the pundits or the politicians. They are focused on questions of “affordability” and “sustainability,” which have no place in the debate over the proper size and role for government (a debate we would prefer to have). So let us get to that debate by recognizing that there is no operational constraint – ever – for a monetarily sovereign government. Any financial commitments, be they for Social Security, Medicare, the war effort, etc., that come due today and into the infinite future can be made on time and in full. Of course, this means that there is no need for a lock box, a trust fund or any of other accounting gimmick, to help the government make payments in the future. We can simply recognize that every government payment is made through the general budget. Once this is understood, issues like Social Security, Medicare and other important problems can be analyzed properly: it is not a financial problem; it is a productivity/growth problem. Such an understanding would lead to very different policies than the one currently proposed by the CBO (see Randy’s post here).

“A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers.”

First, this sentence seems to imply that government activities are unproductive (given that, following their logic, Treasury issuances “finance” government spending), which is simply wrong, just look around you in the street and your eyes will cross dozens of essential government services.

Second, the internal logic gets confusing for two reasons. One, if people are so afraid of a growing fiscal crisis, why would they buy more treasuries with their precious savings? Why not use their savings to buy bonds to fund “productive capital goods”? Using the CBO’s own logic, higher rates on government bonds would not help given that a “fiscal crisis” is expected and given that participants are supposed to allocate funds efficiently toward the most productive economic activity (and so not the government according to them). Second, we are told that “it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.” I will get back to what the government can do in that case, but you cannot get it both ways; either financial market participants buy more government securities or they don’t.

Third, this argument drives home the crowding-out effect. I am not going to go back to the old debates between Keynes and others on this, but the bottom line is that promoting thriftiness (increasing the propensity to save out of monetary income) depresses economic activity (because monetary profits and incomes go down) and so decreases willingness to invest (i.e. to increase production capacities). In addition, by spending, the government releases funds in the private sector that can be used to fund private economic activity; there is a crowding-in, not a crowding-out. This is not theory, this is what happens in practice, higher government spending injects reserves and cash in the system, which immediately places downward pressure on short-term rates unless the Fed compensates for it by selling securities and draining reserves (which is what the Fed does on a daily basis).

“if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output.”

No, as noted many times here, all spending and servicing is done by crediting creditor’s account not by taxing (or issuing bonds). Taxes are not a funding source for monetarily-sovereign governments, they serve to reduce the purchasing power of the private sector so that more real resources can be allocated to the government without leading to inflation (again all this does not mean that the government should raise taxes and takeover the entire economy; it is just a plain statement of the effects of taxation). All interest payments on domestically-denominated government securities (we are talking about a monetarily-sovereign government) can be paid, and have been met, at all times, whatever the amount, whatever their size in the government budget.

“a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.”

If the US Treasury cannot issue bonds at the rate it likes there is a very simple solution: do not issue them. This does not alter in any way its spending capacity given that the US federal government is a monetarily-sovereign government so bond issuances are not a source of funds for the government. Think of the Federal Reserve: does it need to borrow its own Federal Reserve notes to be able to spend? No, all spending is done by issuing more notes (or, more accurately, crediting more accounts) and if the Fed ever decided borrow its own notes by issuing Fed bonds to holders of Federal Reserve notes (a pretty weird idea), a failure of the auction would not alter its spending power. The Treasury uses the Fed as an accountant (or fiscal agent) for its own economic operations; the “independence” of the Fed in making monetary policy does not alter this fact.

“It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis.”

It is always possible that anything can happen, but what is the record? The record is that there is no relationship between the fiscal position of the US government and T-bond rates. Massive deficits in WWII went pari passu with record low interest rates on the whole Treasury yield curve. With the help of the central bank, the government made a point of keeping long-term rates on treasuries at about 2% for the entire war and beyond, despite massive deficits. There is a repetition of this story playing out right now, and Japan has been doing the same for more than a decade. Despite its mounting government debt, the yield on 10-year government bonds is not more than 2% as of July 2010. In the end, market rates tend to follow whatever the central bank does in terms of short-term rates, not what the fiscal position of the government is.

As we already stated on this blog before, a simple observation of how government finance operates shows that government spending injects reserves into the banking system (pressing down short-term interest rate), while the payment of taxes reduces/destroys reserves (pushing short-term rates up). The Fed has institutions that allow it to coordinate on a daily basis with the Treasury (they call each other every day) to make sure that all these government operations do not push the interest rate outside the Fed’s target range.

“If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.”

That’s a repeat of the first question but with a bit of elaboration. The US government cannot default on its securities for financial reasons, it is perfectly solvent and liquid. (Sovereign governments can, as we have conceded on this blog, refuse to pay – e.g. Japan after the war – but that is because it was unwilling to repay, not because it was unable to pay.) Thus, despite Reinhart and Rogoff’s warnings, the credit history of the US government (and any monetarily-sovereign government) remains perfect. No government with a non-convertible, sovereign currency has ever bounced a check trying to make payment in its own unit of account.

The US government always pays by crediting the account of someone (i.e. “monetary creation”). If the creditor is a bank, this leads to higher reserves, if it is a non-bank institution it leads also to an increase in the money supply. It has been like this from day one of Treasury activities. It is not a choice the government can make (between increasing the money supply, taxing or issuing bonds); any spending must lead to a monetary creation; there is no alternative. Again taxes and bonds are not funding sources for the US federal government; however they have important functions. Taxes help to keep inflation in check (in addition to maintaining demand for the government’s monetary instruments). Bond sales allow the government to deficit spend without creating excessive volatility in the federal funds market. If financial market participants want more bonds, the Treasury issues more to keep bond rates high enough for its tastes; if financial market participants do not want more treasury bonds, the government does not issue to avoid raising rates. The US Treasury (and any monetarily sovereign government as long as they understand it) has total control over the rate it pays on its debts; whether the government understands this or not is another question. A monetarily sovereign government does not have to pay “market rates” in order to convince markets to hold its bonds. Indeed, it does not even have to issue securities if it does not want to. In the US, it is usually the financial institutions that beg the Treasury to issue more securities.

The recent episode of the “Supplementary Financing Program” is a very good illustration of that point. Financial market participants were crying for more Treasuries and the Fed could not keep pace. As a consequence the Treasury agreed to issue more Treasuries than expected to meet the demand and help the Fed drain reserves and thereby hit their interest rate target. According to the Federal Reserve Bank of New York (DOMESTIC OPEN MARKET OPERATIONS DURING 2008, page 28): “To help manage the balance sheet impact of the Federal Reserve’s liquidity initiatives, the Treasury announced the establishment of a temporary Supplementary Financing Program (SFP) on September 17. The program consists of a series of Treasury bills issued by Treasury, the proceeds of which are deposited in an account at the Federal Reserve, draining reserve balances from the banking sector.”

Now look how this was deformed by the Treasury (quite a few journalists and bloggers followed): “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.” No, Mr. Treasury, this was not done for funding purpose; it was done to drain reserves from the banking system. The Fed does not need any cash from the Treasury. The Fed is the monopoly supplier of cash.

A final point regarding inflation. Inflation is a potential issue, as we have always maintained. But, there is no automatic causation from the money supply to inflation (a point Paul Krugman appears to have forgotten). Inflationary pressures depend on the state of the economy (supply and demand-side factors). Most importantly, perhaps, it depends on people’s desire to hoard vs. spend cash. Even the massive deficits during WWII, when resources were fully employed, did not lead to a spiraling out of control of inflation. Finally, it is quite possible that causation actually runs the other way around – i.e. from inflation to the money supply – given the endogeneity of the money supply, but that’s a story for another day…

14 Comments

Posted in Eric Tymoigne, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, Uncategorized, Unemployment

Tagged Eric Tymoigne, Financial crisis, Fiscal Policy, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, unemployment

Troubles in the Eurozone: Is a Conflict with the U.S. Far Behind?

Posted on April 19, 2010 by admin | 7 comments

By Marshall Auerback

At its most basic, our economy can be divided up into 3 sectors: there is a private sector that includes both households and firms; there is a government sector that includes both the federal government as well as all levels of state and local governments; and there is a foreign sector that includes imports and exports. As my friend Randy Wray notes (.pdf): “At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income). This applies to households, businesses, net saving nations vs. net “dis-saving” nations, and the government sector.”

How does this work in practice? If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output are likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse. Which is why any particular nation in these circumstances must either run an external surplus on its current account, or experience a rising government deficit or some combination of the two.

Of course, given the prevailing levels of government deficit hysteria in the US right now, one can see the political appeal of focusing on export led growth, along Asian lines, since a sufficiently large trade surplus will facilitate the government’s ability to cut spending and run public sector surpluses. The problem of course comes from the fact that it is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. There has to be another nation willing to become a net importer. For nations running external deficits (the majority), public surpluses have to be associated with private domestic deficits, which is inherently constraining in a way that government deficits are not.

Historically the US private sector has spent less than its income—that is, it has run a surplus, whereas the government has run deficits. From a straight national accounts identity, then, the paradox of private sector thrift is that it is facilitated by public sector profligacy. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector.

Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus—meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth. By extension, a country which runs a large trade deficit (as the US has persistently done for the past quarter century), needs an even greater degree of government fiscal expenditure to offset the potential “deficit” spending by the private sector.

Clearly, this financial balances approach is not well understood by most voters. Indeed, a recent poll by Douglas Schoen and Patrick Caddell suggests that the swing voters, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs. But the latter two goals are generally incompatible, especially during major recessions. In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as “stimulus packages”) the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country’s aversion to increased government deficit spending. The German government’s reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here). Following the inexorable logic of the financial balances approach sketched above, then, I am now more convinced than ever that there is a “Lehman” style event waiting to happen in the euro zone. Last week’s Greek “rescue” is, as we suggested earlier, Europe’s “Bear Stearns event”. The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America’s external deficit. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other “PIIGS” countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country’s industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany’s industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro’s weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of ‘inflation’ flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the ECB may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It’s all getting very ugly as it all threatens the value of the euro. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The ‘support’ scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary ‘race to the bottom’ of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone’s external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America’s external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either “virtuously” (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America’s trade deficit.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus, but this becomes virtually impossible if the euro zone’s problems continue, as we suspect that they will.

President Obama, however, has long decried our “out of control” government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we’ve sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages – just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always “afford” to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today’s budget deficit “Chicken Littles”, we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That’s the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided–the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses. In the 220 year experience of the United States there have only been a few years when we’ve not had deficits and each time the surpluses were immediately followed by a depression or a recession. So the historical evidence here, indicates that we can run nearly permanent deficits and that when we do, it’s better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.