Tag Archives: Fiscal Policy

It Takes Two to Tango: Look At The Numerator and Denominator

Posted on March 5, 2010 by admin | 4 comments

A new book by Kenneth Rogoff and Carmen Reinhart, “This Time It’s Different: Eight Centuries of Financial Follies“, has occasioned much comment in the press and blogosphere (see here and here).

The book purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically.

But that’s too simplistic: Debt to GDP is a ratio and the ratio value is a function of both the numerator and denominator. The ratio can rise as a function of either an increase in debt or a decrease in GDP. So to blindly take a number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent work, is unduly simplistic. It appears that they looked at the ratio, assumed that its rise was due to an increase in debt, and then looked at GDP growth from that period forward assuming that weakness was caused by debt instead of that the rise in the ratio was caused by economic weakness. In other words, they have the causation backwards: Deficits go up as growth slows due to the automatic counter cyclical stabilizers.They don’t cause the slow down, etc.

As Randy Wray and Yeva Nersisyan have noted in a yet unpublished work, after the Second World War, the debt ratio came down rather rapidly-mostly not due to budget surpluses and debt retirement but rather due to rapid growth that raised the denominator of the debt ratio. By contrast, slower economic growth post 1973, accompanied by budget deficits, led to slow growth of the debt ratio until the Clinton boom (that saw growth return nearly to golden age rates) and budget surpluses lowered the ratio.

From 1991 through 2001 the growth of government debt had been falling and since then rising most recently at a faster pace. The raw data comes courtesy of the St. Louis Fed: http://research.stlouisfed.org/fred2/
(and attached spreadsheet).

The Ratio of the rates of change of Debt / GDP is rising faster than the change in Debt indicating that both the increase in Debt and the fall in GDP are contributing to a rising Debt / GDP ratio. For policy makers who obsess about a rising Debt / GDP ratio, they fail to understand that austerity measures that cut GDP growth will cause a rise in the Debt to GDP ratio. Basically, it boils down to this simple observation: it is foolish, dangerous, and thoroughly counterproductive to treat fiscal balances in isolation. In particular, setting a fiscal deficit to GDP target equal to expected long run real GDP growth in order to hold public debt/GDP ratios at a completely arbitrary (indeed, literally pulled out of thin air) public debt to GDP ratio without for a moment considering what the means for the feasible range of current account and domestic private sector financial balance is utterly nonsensensical.

It is crucial that investors and policy makers recognize and learn to think coherently about the connectedness of the financial balances before they demand what is being currently called fiscal sustainability. As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. To put it bluntly, if the private sector continues to pursue a high net saving/financial surplus position while fiscal retrenchment is attempted, unless some other bloc of nations becomes large net importers (and the BRICs are surely not there yet), nominal GDP will fall in the fiscally “sound” nations, the designated fiscal deficit targets WILL NEVER BE ACHIEVED (there can also be a paradox of public thrift), and private debt distress will simply escalate.

In fact, if austerity measures are based on measures of debt relative to economic growth there is a very real risk of a downward spiral where economic growth declines at a faster pace than government debt and the rising Debt / GDP ratio leads to ever greater austerity measures. At a minimum, focusing only on the debt side of the equation risks increasing the Debt / GDP ratio that is the object of purported concern is likely to lead to policy incoherence and HIGHER levels of debt as GDP plunges. The solution is to recognize that the increase in the ratio is in some fair measure the result of declining economic growth and that only by increasing economic growth will the ratio be brought down. This may cause an initial rise in the ratio because of debt financing of fiscal stimulus but if positive economic growth is achieved the problem should be temporary. The alternative is to risk a debt deflationary spiral that will be much more difficult (and costly) to reverse.

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Posted in Marshall Auerback, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Fiscal Policy, Marshall Auerback, The Federal Government Deficit, The National Debt

Will the Quest for Fiscal Sustainability Destabilize Private Debt?

Posted on March 2, 2010 by admin | 5 comments

By Robert Parenteau, CFA*

The question of fiscal sustainability looms large at the moment – not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt to GDP ratios, and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.

However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities (see here and here). Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere – unless an offsetting increase in current account balances can be accomplished in tandem.

To make the interconnectedness of sector financial balances clearer, proposed fiscal trajectories need to be considered in the context of what we call the financial balances map. Only then can tradeoffs between fiscal sustainability efforts and the issue of financial stability for the economy as a whole be made visible. Absent consideration of the interrelated nature of sector financial balances, unnecessarily damaging choices may soon be made to the detriment of citizens and firms in many nations.

Navigating the Financial Balances Map

For the economy as a whole, in any accounting period, total income must equal total expenditures. There are, after all, two sides to every transaction: a spender of money and a receiver of money income. Similarly, total saving out of income flows must equal total investment in tangible capital during any accounting period.

For individual sectors of the economy, these equalities need not hold. The financial balance of any one sector can be in surplus, in balance, or in deficit. The only requirement is, regardless of how many sectors we choose to divide the whole economy into, the sum of the sectoral financial balances must equal zero.

For example, if we divide the economy into three sectors – the domestic private (households and firms), government, and foreign sectors, the following identity must hold true:

Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0

Note that it is impossible for all three sectors to net save – that is, to run a financial surplus – at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time – some sector has to be issuing liabilities.

Since foreigners earn a surplus by selling more exports to their trading partners than they buy in imports, the last term can be replaced by the inverse of the trade or current account balance. This reveals the cunning core of the Asian neo-mercantilist strategy. If a current account surplus can be sustained, then both the private sector and the government can maintain a financial surplus as well. Domestic debt burdens, be they public or private, need not build up over time on household, business, or government balance sheets.

Domestic Private Sector Financial Balance + Fiscal Balance – Current Account Balance = 0
Again, keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong. To make these relationships between sectors even clearer, we can visually represent this accounting identity in the following financial balances map as displayed below.

On the vertical axis we track the fiscal balance, and on the horizontal axis we track the current account balance. If we rearrange the financial balance identity as follows, we can also introduce the domestic private sector financial balance to the map:

Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance

That means at every point on this map where the current account balance is equal to the fiscal balance, we know the domestic private sector financial balance must equal zero. In other words, the income of households and businesses just matches their expenditures (or alternatively, if you prefer, the saving out of income flows by the domestic private sector just matches the investment expenditures of the sector). The dotted line that passes through the origin at a 45 degree angle marks off the range of possible combinations where the domestic private sector is neither net issuing financial liabilities to other sectors, nor is it net accumulating financial assets from other sectors.

Once we mark this range of combinations where the domestic private sector is in financial balance, we also have determined two distinct zones in the financial balance map. To the left of the dotted line, the current account balance is less than the fiscal balance: the domestic private sector is deficit spending. To the right of the dotted line, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus or net saving position.

This follows from the recognition that a current account surplus presents a net inflow to the domestic private sector (as export income for the domestic private sector exceeds their import spending), while a fiscal surplus presents a net outflow for the domestic private sector (as tax payments by the private sector exceed the government spending they receive).

Accordingly, the further we move up and to the left of the origin (toward the northwest corner of the map), the larger the deficit spending of households and firms as a share of GDP, and the faster the domestic private sector is either increasing its debt to income ratio, or reducing its net worth to income ratio (absent an asset bubble). Moving to the southeast corner from the origin takes us into larger domestic private surpluses.

The financial balance map forces us to recognize that changes in one sector’s financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode.

When sustained over time, this negative cash flow position for the domestic private sector will eventually increase the financial fragility of the economy, if not insure the proliferation of household and business bankruptcies. Mimicking the military planner logic of “we must bomb the village in order to save the village”, the blind pursuit of fiscal sustainability may simply induce more financial instability in the private sector.

Leading the PIIGS to an (as yet) Unrecognized Slaughter

The rules of the eurozone are designed to reduce the room for policy maneuver of any one member country, and thereby force private markets to act as the primary adjustment mechanism. Each country is subject to a single monetary policy set by the European Central Bank (ECB). One policy rate must fit the needs of all the member nations in the Eurozone. Each country has relinquished its own currency in favor of the euro. One exchange rate must fit the needs of all member nations in the Eurozone. The fiscal balance of member countries is also, under the provisions of the Stability and Growth Path, supposed to be limited to a deficit of 3% of GDP. The principle here is one of stabilizing or reducing government debt to GDP ratios. Assuming economies in the Eurozone have the potential to grow at 3% of GDP in nominal terms, only fiscal deficits greater than 3% of GDP will increase the public debt ratio.

In other words, to join the European Monetary Union, nations have substantially diluted their policy autonomy. Markets mechanisms must achieve more of the necessary adjustments – policy measures are circumscribed. Policy responses are constrained by design, and experience suggests relative price adjustments in the marketplace have a difficult time at best of automatically inducing private investment levels consistent with desired private saving at a level of full employment income.

Now let’s layer on top of this structure three complicating developments of late. First, current account balances in a number of the peripheral nations have fallen, in part due to the prior strength in the euro. Second, fiscal shenanigans along with a very sharp global recession have led to very large fiscal deficits in a number of peripheral nations. Third, following the Dubai World debt restructuring, global investors have become increasingly alarmed about the sustainability of fiscal trajectories, and there is mounting pressure for governments to commit to tangible plans to reduce fiscal deficits over the next three years, with Ireland and Greece facing the first wave of demands for fiscal retrenchment.

We can apply the financial balances approach to make the current predicament plain. If, for example, Spain is expected to reduce it’s fiscal deficit from roughly 10% of GDP to 3% of GDP in three years time, then the foreign and private domestic sectors must be together willing and able to reduce their financial balances by 7% of GDP. Spain is estimated to be running a 4.5% of GDP current account deficit this year. If Spain cannot improve its current account balance (in part because it relinquished its control over its nominal exchange rate the day it joined EMU), the arithmetic of sector financial balances is clear. Spain’s households and businesses would, accordingly, need to reduce their current net saving position by 7% of GDP over the next three years. Since they are currently estimated to be net saving 5.5% of GDP, Spain’s domestic private sector would move to a 1.5% of GDP deficit, and thereby enter a path of increasing leverage.

Spain already is running one of the higher private debt to GDP ratios in the region. In addition, Spain had one of the more dramatic housing busts in the region, which Spanish banks are still trying to dig themselves out from (mostly, it is alleged, by issuing new loans to keep the prior bad loans serviced, in what appears to be a Ponzi scheme fashion). It is highly unlikely Spanish businesses and households will voluntarily raise their indebtedness in an environment of 20% plus unemployment rates, combined with the prospect of rising tax rates and reduced government expenditures as fiscal retrenchment is pursued.

Alternatively, if we assume Spain’s private sector will attempt to preserve its estimated 5.5% of GDP financial balance, or perhaps even attempt to run a larger net saving or surplus position so it can reduce its private debt faster, Spain’s trade balance will need to improve by more than 7% of GDP over the next three years. Barring a major surge in tradable goods demand in the rest of the world, or a rogue wave of rapid product innovation from Spanish entrepreneurs, there is an additional way for Spain to accomplish such a significant reversal in its current account balance.

Prices and wages in Spain’s tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the Eurozone members). Arguably, the slack resulting from the fiscal retrenchment is just what the doctor might order to raise the odds of accomplishing such a large wage and price deflation in Spain. But how, we must wonder, will Spain’s private debt continue to be serviced during the transition as Spanish household wages and business revenues are falling under higher taxes or lower government spending?

Part II Spain Ensnared in the EMU Trap

As evident from the financial balances map, there are a whole range of possible combinations of current account and domestic private sector financial balances which could be consistent with the 7% of GDP reduction in Spain’s fiscal deficit. But the simple yet still widely unrecognized reality is as follows: both the public sector and the domestic private sector cannot deleverage at the same time unless Spain produces a nearly unimaginable trade surplus – unimaginable especially since Spain will not be the only country in Europe trying to pull this transition off.

As an admittedly rough exercise, we can assume each of the peripheral nations will be constrained to achieving a fiscal deficit that does not exceed 3% of GDP in three years time. In addition, we will assume each nation finds some way to improve its current account imbalances by 2% of GDP over the same interval. What, then, are the upper limits implied for domestic private sector financial balances as a share of GDP for each nation?

Greece and Portugal appear most at risk of facing deeper private sector deficit spending under the above scenario, while Spain comes very close to joining them. But that obscures another point which is worth emphasizing. With the exception of Italy, this scenario implies declines in private sector balances as a share of GDP ranging from 3% in Portugal to nearly 9% in Ireland.

Private sectors agents only tend to voluntarily target lower financial balances in the midst of asset bubbles, when, for example home prices boom and gross personal saving rates fall. Alternatively, during profit booms, firms issue debt and reinvest well in excess of their retained earnings in order take advantage of an unusually large gap between the cost of capital and the expected return on capital. We have no compelling reasons to believe either of these conditions is immediately on the horizon.

The above conclusion regarding the need for a substantial trade balance swing flows in a straightforward fashion from the financial balance approach, and yet it is obviously being widely ignored, because the issue of fiscal retrenchment is being discussed as if it had no influence on the other sector financial balances. This is unmitigated nonsense. It is even more retrograde than primitive tales of “twin deficits” (fiscal deficits are nearly guaranteed to produce offsetting current account deficits) or Ricardian Equivalence stories (fiscal deficits are nearly guaranteed to produce offsetting domestic private sector surpluses) mainstream economists have been force feeing us for the past three decades. Both of these stories reveal an incomplete understanding of the financial balance framework – or at best, one requiring highly restrictive (and therefore highly unrealistic) assumptions.

The EMU Triangle

This observation is especially relevant in the Eurozone, as the combination of the policy constraints that were designed into the EMU, plus the weak trade positions many peripheral nations have managed to achieve, have literally backed these countries into a corner. To illustrate the nature of their conundrum, consider the following application of the financial balances map.

First, a constraint on fiscal deficits to 3% of GDP can be represented as a line running parallel to and below the horizontal axis. Under Stability and Growth Pact rules, we must define all combinations of sector financial balance in the region below this line as inadmissible. Second, since current account deficits as a share of GDP in the peripheral nations are running anywhere from near 2% in Ireland to over 10% in Portugal, and changes in nominal exchange rates are ruled out by virtue of the currency union, we can provisionally assume a return to current account surpluses in these nations is at best a bit of a stretch. This eliminates the financial balance combinations available in the right hand half of the map.

If peripheral European nations wish to avoid higher private sector deficit spending – and realistically, for most of the peripheral countries, the question is whether private sectors can be induced to take on more debt anytime soon, and whether banks and other creditors will be willing to lend more to the private sector following a rash of burst housing bubbles, and a severe recession that is not quite over – then there is a very small triangle that captures the range of feasible solutions for these nations on the financial balance map.

It is the height of folly to expect peripheral Eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative), the peripheral nations in the Eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will run up their debt to income ratios.

Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.

As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. European economic growth will prove extremely difficult to achieve if the current fiscal “sustainability” plans are carried out. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability.

Summary and Conclusions

These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path – the very outcome policy makers were frantically attempting to prevent but a year ago.

There may be ways to thread the needle – Domingo Cavallo’s recent proposal to pursue a “fiscal devaluation” by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation. Cavallo’s claims to the contrary, however, it was not the IMF that tripped him up. Fiscal cuts begat lower domestic income flows, which led to tax shortfalls, missed fiscal balance targets, and another round of fiscal retrenchment, in a vicious spiral fashion. But more innovative solutions than these, where financial stability, not just fiscal sustainability, is the primary objective, will not even be brought to light unless policy makers and investors begin to think coherently about how financial balances interact.

Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher’s paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue.

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. We remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s tradable products, but it is also said that necessity is the mother of all invention (and desperation, its father?). Pray there is life on Mars that consumes olives, red wine, and Guinness beer.

Rob Parenteau, CFA
MacroStrategy Edge
February 22, 2010
* This article originally appeared on NakedCapitalism here and here.

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Posted in Uncategorized

Tagged Fiscal Policy, International Finance

Warren Mosler’s Proposals for the Treasury, the Federal Reserve, the FDIC, and the Banking System

Posted on February 15, 2010 by admin | 18 comments

By Warren Mosler

The purpose of this paper is to present proposals for the Treasury, the Fed, and the banking system. Government begins with an assumption that it exists for public purpose, and I use that as the guiding assumption of my proposals. I begin with my proposals for the banking system, as banking operations influence both Fed and Treasury operations.

Proposals for the Banking System

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. Hence most of the world’s banking systems include some form of government deposit insurance, as well as a central bank standing by to loan to its member banks.

Under a gold standard or other fixed exchange rate regime, bank funding can’t be credibly guaranteed. In fact, fixed exchange rate regimes by design operate with an ongoing constraint on the supply side of the convertible currency. Banks are required to hold reserves of convertible currency, to be able to meet depositor’s demands for withdrawals. Confidence is critical for banks working under a gold standard. No bank can operate with 100% reserves. They depend on depositors not panicking and trying to cash in their deposits for convertible currency. The U.S. experienced a series of severe depressions in the late 1800’s, with the ‘panic’ of 1907 disturbing enough to result in the creation of the Federal Reserve in 1913. The Fed was to be the lender of last resort to insure the nation would never again go through another 1907. Unfortunately, that strategy failed. The depression of 1930 was even worse than the panic of 1907. The gold standard regime kept the Fed from being able to lend its banks the convertible currency they needed to meet withdrawal demands. After thousands of catastrophic bank failures, a bank holiday was declared and the remaining banks were closed by the government while the banking system was reorganized. When the banking system reopened in 1934, convertibility of the currency into gold was permanently suspended (domestically), and bank deposits were covered by federal deposit insurance. The Federal Reserve wasn’t able to stop depressions. It was going off the gold standard that did the trick.

It has been 80 years since the great depression. It would now take exceptionally poor policy responses for even the current severe recession to deteriorate into a depression, though misguided and overly tight fiscal policies have unfortunately prolonged the restoration of output and employment.

The hard lesson of banking history is that the liability side of banking is not the place for market discipline. Therefore, with banks funded without limit by government insured deposits and loans from the central bank, discipline is entirely on the asset side. This includes being limited to assets deemed ‘legal’ by the regulators and minimum capital requirements also set by the regulators.

Given that the public purpose of banking is to provide for a payments system and to fund loans based on credit analysis, additional proposals and restrictions are in order:

1. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well. For that reason (no public purpose and geometrically growing regulatory
burdens with severe social costs in the case of regulatory and supervisory lapses), banks should be prohibited from engaging in any secondary market activity. The argument that these areas might be profitable for the banks is not a reason to extend government sponsored enterprises into those areas.

2. US banks should not be allowed to contract in LIBOR. LIBOR is an interest rate set in a foreign country (the UK) with a large, subjective component that is out of the hands of the US government. Part of the current crisis was the Federal Reserve’s inability to bring down the LIBOR settings to its target interest rate, as it tried to assist millions of US homeowners and other borrowers who had contacted with US banks to pay interest based on LIBOR settings. Desperate to bring $US interest rates down for domestic borrowers, the Federal Reserve resorted to a very high risk policy of advancing unlimited, functionally unsecured, $US lines of credit called ‘swap lines’ to several foreign central banks. These loans were advanced at the Fed’s low target rate, with the hope that the foreign central banks would lend these funds to their member banks at the low rates, and thereby bring down the LIBOR settings and the cost of borrowing $US for US households and businesses. The loans to the foreign central banks peaked at about $600 billion and did eventually work to bring down the LIBOR settings. But the risks were substantial. There is no way for the Fed to collect a loan from a foreign central bank that elects not to pay it back. If, instead of contracting based on LIBOR settings, US banks had been linking their loan rates and lines of credit to the US fed funds rate, this problem
would have been avoided. The rates paid by US borrowers, including homeowners and businesses, would have come down as the Fed intended when it cut the fed funds rate.

3. Banks should not be allowed to have subsidiaries of any kind. No public purpose is served by allowing bank to hold any assets ‘off balance sheet.’

4. Banks should not be allowed to accept financial assets as collateral for loans. No public purpose is served by financial leverage.

5. US Banks should not be allowed to lend off shore. No public purpose is served by allowing US banks to lend for foreign purposes.

6. Banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks. If a bank instead relies on credit default insurance it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system.

7. Banks should not be allowed to engage in proprietary trading or any profit making ventures beyond basic lending. If the public sector wants to venture out of banking for some presumed public purpose it can be done through other outlets.

8. My last proposal for the banks in this draft is to utilize FDIC approved credit models for evaluation of bank assets. I would not allow mark to market of bank assets. In fact, if there is a valid argument to marking a particular bank asset to market prices, that likely means that asset should not be a permissible bank asset in the first place. The public purpose of banking is to facilitate loans based on credit analysis rather, than market valuation. And the accompanying provision of government insured funding allows those loans to be held to maturity without liquidity issues, in support of that same public purpose. Therefore, marking to market rather
than evaluation by credit analysis both serves no further public purpose and subverts the existing public purpose of providing a stable platform for lending.

Proposals for the FDIC (Federal Deposit Insurance Corporation)

I have three proposals for the FDIC. The first is to remove the $250,000 cap on deposit insurance. The public purpose behind the cap is to help small banks attract deposits, under the theory that if there were no cap large depositors would gravitate towards the larger banks. However, once the Fed is directed to trade in the fed funds markets with all member banks, in unlimited size, the issue of available funding is moot.
The second is to not tax banks in order to recover funds lost on bank failures. The FDIC should be entirely funded by the US Treasury. Taxes on solvent banks should not be on the basis of the funding needs of the FDIC. Taxes on banks have ramifications that can either serve or conflict with the larger public purposes presumably served by government participation in the banking system. These include sustaining the payments system and lending based on credit analysis. Any tax on banks should be judged entirely by how that tax
serves or doesn’t serve public purpose.

My third proposal for the FDIC is to do its job without any assistance by Treasury (apart from funding any FDIC expenditures). The FDIC is charged with taking over any bank it deems insolvent, and then either selling that bank, selling the bank’s assets, reorganizing the bank, or any other similar action that serves the public purpose government participation in the banking system. The TARP program was at least partially established to allow the US Treasury to buy equity in specific banks to keep them from being declared insolvent by the FDIC, and to allow them to continue to have sufficient capital to continue to lend. What the
TARP did, however, was reveal the total failure of both the Bush and Obama administrations to comprehend the essence of the workings of the banking system. Once a bank incurs losses in excess of its private capital, further losses are covered by the FDIC, an arm of the US government. If the Treasury ‘injects capital’ into a bank, all that happens is that once losses exceed the same amount of private capital, the US Treasury, also an arm of the US government is next in line for any losses to the extent of its capital contribution, with the FDIC covering any losses beyond that. So what is changed by Treasury purchases of bank equity? After the private capital is lost, the losses are taken by the US Treasury instead of the FDIC, which also gets its funding from the US Treasury. It makes no difference for the US government and the ‘taxpayers’ whether the Treasury covers the loss indirectly when funding the FDIC, or directly after ‘injecting capital’ into a bank. All that was needed to accomplish the same end as the TARP program- to allow banks to continue to function and acquire FDIC insured deposits- was for the FDIC to directly reduce the private capital requirements. Instead, and as direct evidence of a costly ignorance of the dynamics of the banking model, both the Obama and Bush administrations burned through substantial quantities of political capital to get the legislative authority to allow the Treasury to buy equity positions in dozens of private banks. And, to make matters worse, it was all accounted for as additional federal deficit spending. While this would not matter if Congress and the administrations understood the monetary system, the fact is they don’t, and so the TARP has therefore restricted their inclination to make further fiscal adjustments to restore employment and output. Ironically, the overly tight fiscal policy continues to contribute to the rising delinquency and default rate for
bank loans, which continues to impede the desired growth of bank capital.

Proposals for the Federal Reserve

1. The fed should lend unsecured to member banks, and in unlimited quantities at its target fed funds rate, by simply trading in the fed funds market. There is no reason to do other wise. Currently the Fed will only loan to its banks on a fully collateralized basis. However, this is both redundant and disruptive. The Fed demanding collateral when it lends is redundant because all bank assets are already fully regulated by Federal regulators. It is the job of the regulators to make sure that all FDIC insured deposits are ‘safe’ and ‘taxpayer money’ is not at risk from losses that exceed the available private capital. Therefore, the FDIC has already determined that funds loaned by the Fed to a bank can only be invested in ‘legal’ assets and that the bank is adequately capitalized as required by law. There is no room for funding from the Fed to be ‘misused’ as banks already can obtain virtually unlimited funding by FDIC insured deposits. The only difference between banks funding with FDIC insured deposits and funding directly from the Fed might be the interest rate the bank may have to pay, however it’s the further purpose of the Fed’s monetary policy to target the fed funds rate. The Fed also tends to set quantity limits when it lends to its member banks, when there is every reason to instead lend in unlimited quantities. Bank lending is not reserve constrained, so constraining lending to the banks by quantity does not alter lending. What constraining reserves does is alter the fed funds rate, which is the rate banks pay for reserves as well as the Fed’s target rate. So the only way the Fed can fully stabilize the fed funds rate at its target rate is to simple offer to provide unlimited funds at that rate as well as offer to accept fed funds deposits at that same target rate. And with no monetary risk or adverse economic consequences for lending unlimited quantities at its target rate there is no reason not to do this. Another benefit of this policy would be to entirely eliminate the inter bank fed funds market. There is no public purpose served by banks trading fed funds with each other when they can do it with the Fed, and transactions costs are reduced as well. And to eliminate the inter bank markets entirely the Fed has the further option to provide funding with an entire term structure of rates to its banks to both target those rates and also eliminate the need for any inter bank trading.

2. I would limit the Fed to using banks as agents for monetary policy. I would not pursue the policy of attempting to establish additional public/private partnerships for the purpose of buying various financial assets. Instead, if I agreed with the need to purchase those assets, I would enable the banking system to do this along the same lines proposed for the new public/private partnerships. That might take the form of allowing banks to put these ‘qualifying assets’ in a segregated account, where losses to bank capital would be limited to, for example, 10% of the investment in those accounts. This would have the same result as the recently proposed public/private partnerships but within the existing highly regulated and supervised banking system. Banks are the appropriate instrument of monetary policy for targeting the risk adjusted term structure of interest rates. Why go to the expense and risk of creating new public/private partnerships when there are already approximately 8,000 member banks already set up for that purpose?

3. I would make the current zero interest rate policy permanent. This minimizes cost pressures on output, including investment, and thereby helps to stabilize prices. It also minimizes rentier incomes, thereby encouraging higher labor force participation and increased real output. Additionally, because the non government sectors are net savers of financial assets, this policy hurts savers more than it aids borrowers, so a fiscal adjustment such as a tax cut or spending increase would be appropriate to sustain output and employment.

4. I would instruct the Fed to offer credit default insurance on all Treasury securities through its banking system to any buyer. There is no default risk in US Treasury securities, but, if market participants do want to buy such credit default insurance, I would make it available through the Fed. This would keep the premiums and the perception of risk down to a level determined by the Fed. I would suggest they offer it freely at 5 basis points for any maturity.

Proposals for the Treasury

1. I would cease all issuance of Treasury securities. Instead any deficit spending would accumulate as excess reserve balances at the Fed. No public purpose is served by the issuance of Treasury securities with a non convertible currency and floating exchange rate policy. Issuing Treasury securities only serves to support the term structure of interest rates at higher levels than would be the case. And, as longer term rates are the realm of investment, higher term rates only serve to adversely distort the price structure of all goods and services.

2. I would not allow the Treasury to purchase financial assets. This should be done only by the Fed as has traditionally been the case. When the Treasury buys financial assets instead of the Fed all that changes is the reaction of the President, the Congress, the economists, and the media, as they misread the Treasury purchases of financial assets as federal ‘deficit spending’ that limits other fiscal options.

Conclusion

I conclude with my proposals to support aggregate demand and restore output and employment.

1. A full payroll tax holiday where the Treasury makes all the contributions for employees and employers. This immediately restores the purchasing power of those still working and enables them to make their mortgage payments which also stabilizes the banking system.

2. I would distribute $150 billion of revenue sharing to the State governments on a per capita basis. This would stabilize State governments currently cutting back on public services due to revenue short falls caused by the recession. Distribution on per capita basis makes it ‘fair’ and does not ‘reward bad behavior.

3. I would have the Federal government fund $8/hr full time jobs for anyone willing and able to work, that includes health care benefits. This provides an employed labor buffer stock that’s a superior price anchor to our current unemployed buffer stock. This helps support an expansion in private sector employment as the economy improves. It’s been demonstrated that the private sector prefers to hire those already working rather than those who are unemployed. These three proposals, along with above proposals for the Fed, the Treasury, the FDIC, and banking system, will quickly restore the US economy to positive growth, full employment, and establish a banking system that will promote the intended public purpose and require less regulation while substantially reducing the systemic risk inherent in our current institutional arrangements.

Warren Mosler
October 11, 2009
President, Valance Co.
www.moslereconomics.com
www.mosler2012.com

18 Comments

Posted in Monetary policy, Policy and Reform, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Federal Reserve, Fiscal Policy, Monetary policy, Policy and Reform, The Federal Government Deficit, The National Debt

The President Remains Trapped In the Talons of Deficit Hawks

Posted on February 1, 2010 by admin | 8 comments

By Marshall Auerback

Last Friday Mr. Obama and the GOP staged the equivalent of a British Parliamentary Question Period in front of the TV cameras. It showed the quick-thinking, articulate President at his best. Unfortunately, the subsequent Saturday morning national radio address showed him at his worst. Obama reiterated the need for job creation, even as he decried government deficits, which allegedly imperil our long term economic prosperity. It’s like calling for an open house policy, whilst simultaneously putting explosives on the door knobs.

“As we work to create jobs, it is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now”.

Give Obama credit. He packs a veritable trifecta of innocent, but deadly, frauds into one sentence – government debt is bad, markets determine interest rates, deficits represent a form of “intergenerational theft”– and then adds several new ones to boot.

Unfortunately, he’s got it backwards. The deficits he decries actually help to sustain demand, and create jobs, thereby supporting the economy – not destroying it. And he reflects a commonly held belief that growing government debt represents a burden on our children and grandchildren, implicitly suggesting that future generations will have to reduce consumption in order to pay the taxes required to pay off the outstanding debt. Related to this is the fallacy that too much bond issuance will create a “debtors’ revolt”, whereby “the markets” will force the country to pay higher interest rates in order to “fund” its spending.

Where to begin? Since the days of George Washington’s administration, national budget deficits and increased public debt have been the rule on all but about six very short occasions. And the US has generally prospered. Why? Far from being a burden, the deficits, and the corresponding government bonds, constitute the foundation of private financial wealth in any nation that creates its own sovereign currency for use by its citizens. Debt owed by the government yields net income to the private sector, unlike all purely private debts, which merely transfer income from one part of the private sector to another. In basic national accounting terms, government deficits equal non-government savings surpluses.

Another important other angle that is often overlooked is that private holdings of government bonds also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the Government retires debt it reduces private incomes, just as when it runs budget surpluses, it constrains private sector demand directly by reducing private income and access to adequate currency. Just ask any pensioner if he/she is happy when their income stream from annuities has declined.

Take away that debt, and you take away income. It is no coincidence that the budget surpluses of the Clinton years (wrongly trumpeted as a great fiscal triumph by President Obama) subsequently led to recessions: government budget surpluses ultimately restrict private sector demand and income growth and force greater reliance on PRIVATE debt. Does anybody think it is a coincidence that two of the longest and largest periods of budget surpluses in America history – the periods of 1997-2000 and 1927-1930 – were followed by calamitous economic collapses?

There are ample analyses which explain how government surpluses drain aggregate demand (here, and here). Suffice to say, a government budget surplus has two negative effects for the private sector: the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and private disposable income also falls as tax demands exceed income. And, as Stephanie Kelton has noted, the case of Japan illustrates that despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either.

Furthermore, now that we’re off the gold standard, Chinese and other Treasury buyers do not “fund” anything for us, contrary to the completely false and misguided scare stories that deficit hawks and, and now Obama, implicitly endorse. (See here for an explanation). Legions of economists, investment advisors, Wall Street practitioners and policy makers continue to peddle such gold-standard thinking to their citizens nationwide. To paraphrase Churchill, “It is as though a vast Gold Standard curtain has descended across the entire body of public thinking.”

Let’s consider a real world example to demonstrate the President’s conceptual confusion on government deficits. We’re in a recession. Our American citizen who was working in a pie shop has lost his job even though his productivity was just as high during the boom years. The problem is that as the recession intensified, pie demand fell as did consumer demand in general. For a variety of reasons, households perceive their wealth holdings are not going to appreciate as quickly as they did in prior periods, so they are saving more money out of their income flows.

The pie guy wants to exercise his freedom to work hard for money. So too do 152 million other people. But there are jobs available for only 138 million of them given current business perceptions of money profit prospects from production now and in the future. The pie guy is stuck with over 15 million other people who would like to exercise their freedom to work hard for money. Over 6 million of those people have been trying to exercise that freedom for over half a year, with no luck. They are dumpster diving for leftover pie scraps.

In desperation, the pie guy has gone back to the pie shop to offer his services for a lower money wage, but unit pie demand is still down, even though the owner has cut pie prices. However, the pie owner, facing lower prices per pie, decides to hire the pie guy back at a lower wage and fires one of his other workers to scratch his way to a little higher profit. Are we all any better off? I suppose pies are cheaper, but then so too are incomes earned by pie makers lower.

In that situation, someone else has to take up the spending slack. Fortunately, we live in an economic system in which a government can freely spend and fill the gap left by the private sector. It has the unique capacity to spend without the constraint of a private firm on productive job creation, thereby increasing output, not just redistributing it. Just giving the pie firm a payroll tax cut on new hires is not going to generate more jobs. Rather giving it to all employees will lead to more pie sales. And the government can do that. Rather than decrying the government deficits, then, the President should be celebrating them as a form of economic salvation.

The problem obviously isn’t about money which a government can always create. The ultimate irony is that in order to somehow ‘save’ public funds for the future, as the President appears to be advocating, what we do is cut back on expenditures today, which does nothing but set our economy back and cause the growth of output and employment to decline. Worse yet, the great irony is that the first thing governments generally cut back on is education- the one thing the mainstream agrees should be done that actually helps our children 50 years down the road. Education cutbacks – as any Californian can tell you – are something that does hurt us, as well as harming our children AND our grandchildren down the road. This is the true “intergenerational theft”, not “runway” government spending.

Like many other people who embrace the nostrums of the Concord Coalition, the President continues to view government spending through a failed household budget analogy:

“There are certain core principles our families and businesses follow when they sit down to do their own budgets. They accept that they can’t get everything they want and focus on what they really need. They make tough decisions and sacrifice for their kids. They don’t spend what they don’t have, and they make do with what they’ve got.”

Yes, it’s true: If households spend more than their income now, they have to borrow. To pay the loan back they have to ensure that they can dedicate adequate income in the future, either by increasing incomes somehow or diverting existing income from consumption. If a household borrows too much, it will face major corrections in its balance of income and expenditure and consequently may have to seriously forgo spending later.

That is the logic that the users of the currency have to consider every day. They have to finance every $ they spend and so planning is required to ensure they don’t blow out their personal balance sheets. If all 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 private sector incomes and real output will decline absent an increase in government spending.

But it’s not the same for a government, as the President wrongly suggests, as the government is the creator of a currency. They can spend now. They can also spend later as well as service and pay back the debt without compromising anything. And a government, unlike a household or a private business, can choose to exact greater tax revenues by imposing new taxes or raising tax rates.

Notwithstanding the obvious reality that sovereign governments have no solvency risk because they create their own currency, most financial commentators (and the President’s own advisors) still waste their time talking about sovereign default risks and the President implicitly legitimizes this sort of talk when he talks about the need for government to embrace budgeting like a household does. This is what we presume he has in mind when he discusses the long term dangers of government deficits. Firms, households, and even state and local governments require income or borrowings in order to spend. But the federal government’s spending is not constrained by revenues or borrowing. It is constrained only by what our population chooses as national goals.

Suffice to say, we would all rather live in a world where profit prospects are so abundant that business investment spending is high enough to insure full employment given household preferences to save out of income flows. But historical and current experience suggests that is a rare configuration indeed. Ideally, that would be the business sector investing more than it retains in earnings. But in recent decades, such appears to only be the case during asset bubbles, and we know how that story ends. Alternatively, the foreign sector could deficit spend – the US could run a trade surplus. But the reality is US firms have chosen to reinvest in low cost production centers abroad (or would prefer to use free cash flow to engage in short run shareholder value maximization through various financial engineering efforts, including M&A) so the US based production structure no longer matches foreign demand very well. Ironically that leaves government fiscal deficit spending as the sole remaining mechanism to insure the freedom of its citizens to work hard for money.

The President, unfortunately, has yet to put the pieces of the puzzle together. He also fails to understand the idea that a government like the United States – i.e. one that issues a non-convertible sovereign currency (i.e. one the government doesn’t promise to convert into gold or other currencies at a fixed price) – can meet any and all outstanding financial obligations, provided the debts are denominated in its national currency. In this regard, the size of the national debt is irrelevant. This myth, and this myth alone, underpins arguments by orthodox economists against government activism in macroeconomic policy. The President does his Administration and the country no service by continuing to jump on this mythical bandwagon. Myth may constitute good grounds for literature, but is a horrible foundation for sound economic policy.

8 Comments

Posted in Marshall Auerback, The Federal Government Deficit, Uncategorized

Tagged Fiscal Policy, Government's IOU, Marshall Auerback, The Federal Government Deficit

Can we spend our way out of the recession? Is the fiscal deficit unsustainable? And is it time to cut government spending?

Posted on January 28, 2010 by admin | 3 comments

By Eric Tymoigne

If the reader is familiar with history, she or he will note a close similarity between the current policy debates and those of the 1930s; the latest similarity is the proposed spending freeze by the Obama Administration. In the early 1930s, President Roosevelt first criticized President Hoover for engaging in deficit spending and driving the country down the road to ruin, and then proceeded to implement policies that further increased the fiscal deficit of the federal government to about 5% of GDP (a historical record at that time). These policies greatly helped the economy to get out of the Great Depression, but were the subject of ferocious attacks on the ground that the “massive” deficits would lead to the insolvency of the country, uncontrollable inflation, wasteful spending, the taking over of the economy by the government, and, ultimately, the rise of Communism. A cartoon in the Chicago Tribune says it all. Those criticisms were so ferocious and effective at frightening the population that Roosevelt decided to return to a balance budget during the election year of 1936, just like President Obama wants to do.

Did any of those problems actually materialize? As the saying goes “the proof is in the pudding.” There was no government takeover, no rise of Communism, and no insolvency. In fact, Roosevelt proceeded to increase government deficit over 20% of GDP during WWII without any of those problems arising. The non-sense about insolvency and government takeover of the economy have been explained elsewhere on this blog (here and here) and on Bill Mitchell’s blog and no additional time needs to be devoted to that subject. Instead, let us see what the actual consequences of rising federal government deficit (current government outlays minus current government receipts) and rising public debt (the sum of all past and current federal government deficits and surpluses) were.

Staying in the pre-WWII period, unemployment went down steeply to about 10% of the economy, once one removes people employed by government programs from the unemployment data. Even if one just follows the official BLS data (the gray line in Figure 1), unemployment rate was down to 15%. Far from great but much better than 25%. Unemployment would have declined much further if Roosevelt had let the government spending grow. However, political pressures pushed him to limit government spending and government deficit and to actually reduce them massively. This generated a recession in 1937, followed by rising unemployment.

Figure 1. Annual Unemployment Rate in the U.S.: 1890-2009.

The main argument used for counting people employed by the CCC, WPA and other government programs as unemployed, is that those jobs were makeshift jobs not driven by the needs of the private sector. They were wasteful employment not justified by the profit motive. However, while they probably were not profitable, they were extremely beneficial for the welfare of the US population and provided the foundation for the long period of stability after WWII. Here are some of the achievements through June 1940, 3 years before most employment programs ended (NRPB is the National Resources Planning Board’s Security Work and Relief Policy):

Work Projects Adminitration (WPA)
“Through December 31, 1940, some of the tangible accomplishments of WPA projects were as follows: over 560,000 miles of highways, roads and streets constructed or improved; almost 5,000 schools built and 30,000 improved; 143 new hospitals provided and almost 1,700 improved; over 2,000 stadiums, grandstands, and bleachers built; 1,490 parks, 2,700 playgrounds, and more than 700 swimming pools constructed; 19,700 miles of new storm and sanitary sewers laid; over 2,000,000 sanitary privies built. Conservation work included the planting of more than 100,000,000 trees, and the construction or improvement of over 6,000 miles of fire and forest trails. The work in airport and airway facilities included some 500 landing fields and over 1,800 runways. During January 1941, 1,000,000 adults and 37,000 children were enrolled in classes and nursery schools; over 280,000 persons received music instruction and over 67,000 art instruction; and attendance at concerts reached almost 3,000,000 people. Participant hours in various recreational activities totaled almost 14,000,000. Since the beginning of the WPA, welfare activities have included a total of 312,045,000 garments completed by sewing projects and of 85,270,000 other articles, while more than 57,000,000 quarts of food have been canned and almost 600,000,000 school lunches were served.” (NRPB 1942: 342, n.4)

National Youth Administration (NYA)
“Through June 30, 1940, the accomplishments of youth workers on the out-of-school program had included the following: New construction or additions to more than 6,000 public buildings, such as schools, libraries, gymnasiums, and hospitals, and addition to or repair or improvement of about 18,300 others; construction of almost 4,000 recreational structures, such as stadiums, bandstands, and park shelters, and repair or improvement of nearly 6,000 others; construction of 350 swimming or wading pools and 3,500 tennis courts. About 1,500 miles of roads had been constructed and 7,000 repaired or improved; nearly 2,000 bridges had been built. Seven landing fields had been constructed at airports. 188 miles of sewer and water lines had been laid, and 6,200 sanitary privies built. Over 6.5 million articles of clothing had been produced or renovated, nearly 2 million articles of furniture constructed or repaired, and 350,000 tools or other mechanical equipment constructed or repaired. 77.5 million school lunches had been served by NYA youth; nearly 4 million pounds of foodstuffs had been produced and nearly 7 million pounds canned or preserved. Conservation activities had included the construction or repair of 127 miles of levees and retaining walls and 15,700 check and storage dams.” (NRPB 1942: 342, n.5)

Civilian Conservation Corps (CCC)
“Through June 30, 1940, the accomplishments on these [CCC] projects included: The construction of 37,203 vehicle bridges, 21,684,898 rods of fence, and 79,538 mileage of telephone lines; the development of almost 21,000 springs waterhole, and small reservoirs; the building of more than 5 million permanent and temporary check dams in connection with treating gullies for erosion control; as well as the planting, seeding, or sodding of 114 million square yards of terraces for protection against erosion; the planting or seeding of almost 2,000,000 acres of forest land with an average of 1,000 trees to the acre; 5,741,000 man-days spent in fighting forest fires and 5,392,000 man-days in fire presuppression and prevention work; forest-stand improvement on 3,694,930 acres; development of about 55,000 acres of public camp and picnic grounds; stocking lakes, ponds, and streams with 9.3 million fish.” (NRPB 1942: 343, n.8)

The overall cost of running those programs was extremely small, less than 1% of GDP. Despite their limited scope, they helped millions of people to make a living, helped to avoid waste of resources (if they had been left idle), and promoted the growth of U.S. infrastructures. In addition, the large deficit spending flooded the private sector with cash; thereby, restoring profitability and willingness to employ. War deficit spending reinforced this trend by flushing banks and private businesses with money and by creating a long period of financial stability. All this without any sign of insolvency of the federal government.

A final complaint is usually that government deficit always creates huge inflation and even hyperinflation. There is here a ton of data going against this argument. One just needs to look at Japan over the past 20 years: massive debt, very low interest rate, deflation or stable prices. But we do not have to go that far. Here is the United States, the “massive” deficits of the 1930s and 1940s did not generate high inflation.

Figure 2. Annual CPI Growth in the US.

In the 1930s, inflation stayed moderate at about 3%, after WWII inflation did spike to 15% for one year but that was it. And this spike is explained by the disturbances in the production system induced by WWII. After the production capacities were reoriented toward meeting the demands of a peaceful economy, inflation declined tremendously even though public debt was still very high relative to GDP. Today for the first time since 1955, the US economy experienced deflation despite rapidly rising deficits. Thus, there is no automatic relationship between government spending and inflation. It all depends on the state of the economy. If the economy is at full employment, any type of spending (private domestic consumption, private domestic investment, exports, and government spending) leads to inflation. If production capacities are underemployed, as they are today, companies can meet all the additional private or public demand without increasing their prices.

So can we spend our way out of a recession? Yes we can; provided that spending is high enough. Will a sovereign government go bankrupt by doing so? No, it will not. Does government spending lead to inflation? No, it does not. Does bigger government spending mean that the government will take over the economy? No, it does not. Does it mean that all types of spending are equally beneficial? Definitely not. Government spending can be wasteful if there is no improvement in the welfare of society through infrastructure spending, better social programs, and other government spending, preferably employment-enhancing, that improve the standard of living of the population. That is the major critique that one can make about the Obama administration under the guidance of Geithner and Summers. Far too much money was spent on wasteful financial rescues and far too few dollars were used for the benefits of the overall population. The clear example of this is that, while unemployment as leveled off it has not declined significantly. Even more telling is what has happened to the employment-population ratio. The latter has been dropping so much that all the gains of the past 25 years have been eliminated.

Figure 3. Employment-Population Ratio

We need a second “stimulus.” Even better, we need a permanent employment policy that provides a buffer against unemployment through employment-government programs. Those who promote small government do so on the basis of a value system, not on the basis of sound economic arguments or historical data. Unfortunately, this value system is highly dangerous for the well-being of the U.S. population. The alternative is not government takeover but rather using the government in a productive fashion to improve economic well being. Make your voice heard, not just by hanging passively signs in the streets and going to vote, but through massive organized protests and, if necessary, strikes. This is how a healthy democracy works. This is what happens all the time in other democratic countries and this is what this country did in the 1930s with the Bonus Marchers, industrial strikes, and the peasant movements. Want a few ideas to fight for? What about increasing healthcare benefits, eliminating the payroll tax, engaging in massive green infrastructure programs, providing free education in the fields in need (definitely not finance)? Those were the sort of commitments made during the 1930s and they have been hugely popular among the U.S. population, have contributed to the rise of US economic power, and have not affected at all the solvency of the United States. Again the proof is in the pudding: just look at the popularity of Medicare, Social Security, the air transportation system, the highway system and many other achievements of the New Deal and post-WWII policies.

3 Comments

Posted in Eric Tymoigne, Uncategorized, Unemployment

Tagged Eric Tymoigne, Fiscal Policy, unemployment

A Plea to the President: Tear Up That Speech

Posted on January 27, 2010 by admin | 1 comment

By Stephanie Kelton

My colleague and fellow blogger, Randy Wray, has just argued that President Obama should scrap the speech he’s planning to deliver tonight and surprise the American people with something entirely different. I couldn’t agree more. And while I agree that job creation must be JOB ONE in the months (and years) ahead, I would encourage the President to make massive tax relief the cornerstone of tonight’s speech.

Specifically, the President should call on Congress to support a full and immediate payroll tax holiday. Right now, the government takes away about 15% of our incomes in the form of payroll taxes. With a full payroll tax holiday, a married couple earning $60,000 a year would see their take-home pay increase by about $750 each month. In the aggregate, this will help millions of Americans pay their mortgages, student loans, credit card bills, and so on, while at the same time reducing business expenses (remember that employers contribute to the payroll tax too). All told, a full payroll tax holiday would allow Americans to keep about $1 trillion this year.

So stand before us, Mr. President, and tell us that you want to stop taking this income away from us until we, as a nation, have clawed back every job that has been lost since the start of the recession. Tell us that you intend to take bold steps to protect jobs, keep families intact and provide relief for millions of American businesses. Tell us that you have done all you intend to do to help the banks and the automakers and that you will not accept a jobless recovery — that an increase in economic activity is meaningless without rising employment in good jobs.

And, most importantly, tell us that you refuse to adopt a timeline for cutting the deficit. Tell us that you will not take one dime of payroll taxes away from us until your Administration can declare “Mission Accomplished” on the job front.

Finally, tell the American people that anyone who opposes a payroll tax holiday wants to keep taking hundreds, perhaps thousands, of dollars from them every month. Then watch what happens in 2012.

1 Comment

Posted in Policy and Reform, Stephanie Kelton, Taxes, The Federal Government Deficit, Uncategorized, Unemployment

Tagged Fiscal Policy, Hyman P. Minsky, Policy and Reform, Stephanie Kelton, Subprime mortgage crisis, Taxes, The Federal Government Deficit, unemployment

Helicopter Drops Are FISCAL Operations

Posted on January 7, 2010 by Scott Fullwiler | 24 comments

By Scott Fullwiler

Given all the chatter in the blogosphere about “Helicopter Ben” Bernanke, it’s probably time to look more carefully at the actual accounting behind so-called “helicopter drops of money,” made famous years ago by Milton Friedman. As most everyone knows, the idea behind a hypothetical helicopter drop is that the central bank would essentially drop currency from a helicopter in an effort to stimulate aggregate spending. One could modernize the story and presume that the central bank credits X number of dollars to the bank (deposit) accounts of all (or even some) individuals. And while traditionally it’s been presumed that it would be the Fed that would be dropping money from the helicopter(s), it could just as easily be action taken by the Treasury – e.g. by requiring the Treasury to take an overdraft on its account at the central bank via mandate from Congress and the President.

Continue reading →

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Posted in Scott Fullwiler

Tagged Federal Reserve, Fiscal Policy, Monetary policy, Scott Fullwiler

“Fixing the Economy”

Posted on December 31, 2009 by admin | 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

7 Comments

Posted in Monetary policy, Policy and Reform, Uncategorized

Tagged Fiscal Policy, Monetary policy, Policy and Reform

Is It Time to Reduce the Ease to Prevent Inflation and Possible National Insolvency?

Posted on December 16, 2009 by admin | 7 comments

By L. Randall Wray

The growing consensus view is that the worst is behind us. The Fed’s massive intervention finally quelled the liquidity crisis. The fiscal stimulus package has done its work, saving jobs and boosting retail sales. The latest data show that net exports are booming. While residential real estate remains moribund, there are occasional reports that sales are picking up and that prices are firming. Recovery is just around the corner.

Hence, many have started to call on the Fed to think about reversing its “quantitative ease”—that is, to remove some of the reserves it has injected into the banking system. Further, most commentators reject any discussion of additional fiscal stimulus on the argument that it is no longer needed and would likely increase inflation pressures. Thus, the ARRA’s stimulus package should be allowed to expire and Congress ought to begin thinking about raising taxes to close the budget deficit.

Still, there remain three worries: unemployment is high and while job losses have slowed all plausible projections are for continued slack labor markets for months and even years to come; state and local government finances are a mess; and continued monetary and fiscal ease threaten to bring on inflation and perhaps even national insolvency.

Me thinks that reported sightings of economic recovery are premature. Still, let us suppose that policy has indeed produced a resurrection. What should we do about unemployment, state and local government shortfalls, and federal budget deficits? I will be brief on the first two topics but will provide a detailed rebuttal to the belief that continued monetary ease as well as federal government deficits might spark inflation and national insolvency.

1. Unemployment

Despite the slight improvement in the jobs picture (meaning only that things did not get worse), we need 12 million new jobs just to deal with workers who have lost their jobs since the crisis began, plus those who would have entered the labor force (such as graduating students) if conditions had been better. At least another 12 million more jobs would be needed on top of that to get to full employment—or, 24 million total. Even at a rapid pace of job creation equal to an average of 300,000 net jobs created monthly it would take more than six years to provide work to all who now want to work (and, of course, the labor force would continue to grow over that period). There is no chance that the private sector will sustain such a pace of job creation. As discussed many times on this blog, the only hope is a direct job creation program funded by the federal government. This goes by the name of the job guarantee, employer of last resort, or public service employment proposal. (see here, here, and here)

2. State and Local Government Finance

Revenues of state and local governments are collapsing, forcing them to cut services, lay-off employees, and raise fees and taxes. Problems will get worse in coming months. Most property taxes are infrequently adjusted, and many governments will be recognizing depressed property values for the first time since the crisis began. Lower assessed values will mean much lower property tax revenues next year, compounding fiscal distress. Ratings agencies have begun to downgrade state and local government bonds—triggering a vicious downward spiral because interest rates rise (and in some cases, downgrades trigger penalties that must be paid by governments—to those same financial institutions that caused the crisis). Note that contractual obligations, such as debt service, must be met first. Hence, state and local governments have to cut noncontractual spending like that for schools, fire departments, and law enforcement so that they can use scarce tax revenue to pay interest and fees to fat cat bankers. As government employees lose their jobs, local communities not only suffer from diminished services but also from reduced retail sales and higher mortgage delinquencies—again pushing a vicious cycle that collapses tax revenue.

The solution, again, must come from the federal government, which is the only entity that can spend countercyclically without regard to its tax revenue. As discussed on this blog in several posts (here and here), one of the best ways to provide funding would be in the form of federal block grants to states on a per capita basis—perhaps $400 billion next year. A payroll tax holiday would also help—increasing take-home pay of employees and reducing employer costs on all employees covered by Social Security.

3. Federal Budget Deficit, Insolvency, and Inflation

Resolving the unemployment and state and local budget problems will require help from the federal government. Yet that conflicts with the claimed necessity of tightening fiscal and monetary policy in order to preempt inflation and solvency problems. Two former Fed Chairmen have weighed in on US fiscal and monetary policy ease and the dangers posed. On NBC’s Meet the Press, Alan Greenspan argued:

“I think the Fed has done an extraordinary job and it’s done a huge amount (to bolster employment). There’s just so much monetary policy and the central bank can do. And I think they’ve gone to their limits, at this particular stage. You cannot ask a central bank to do more than it is capable of without very dire consequences,”

He went on, claiming that the US faces inflation unless the Fed begins to pull back “all the stimulus it put into the economy.”

In an interview (with SPIEGEL ONLINE – News – International) former Chairman Paul Volcker said the deficit will need to be cut:

Volcker: You’ve got to deal with the deficit and you’ve got to deal with it in a timely way. Right now, with the unemployment rate still very high, excess capacity is still evident, and the economy is dependent on government money as we said. We are not going to successfully attack the deficit right now but we have got to prepare for attacking it.

SPIEGEL: Should Americans prepare themselves for a tax increase?

Volcker: Not at the moment, but I think we would have to think about it. The present tax system historically has transferred about 18 to 19 percent of the GNP to the government. And we are going to come out of all this with an expenditure relationship to GNP very substantially above that. We either have to cut expenditures and that means reducing entitlements and certainly defense expenditures by an amount that may not be possible. If you can do it, fine. If we can’t do it, then we have to think about taxes.

Both the Fed and the Treasury are said to be “pumping” too much money into the economy, sowing the seeds of future inflation. There are two kinds of cases made for the argument that monetary and fiscal policy are too lax. The first is based loosely on the old Monetarist view that too much money causes inflation., while the second is more Keynesian, pointing toward the money provided through the Treasury’s spending. The evidence can be found in the huge expansion of the Fed’s balance sheet to two trillion dollars of liabilities and in the Treasury’s budget deficit that has grown toward a trillion and a half dollars. Chairman Greenspan, a committed Monetarist, points to the first of these, recognizing that most of these Fed liabilities take the form of reserves held by banks—which will eventually start lending their excess reserves. Chairman Volcker points to the second—federal government spending that will create income that will be spent. Hence, those trillions of extra dollars provided by the Treasury and Fed surely will fuel more lending and spending, leading to inflation or even to a hyperinflation of Zimbabwean proportions.

Some have made a related argument: all those excess reserves in the banking system will be lent to speculators, fueling yet another asset price bubble. The consequence could be rising commodities prices (such as oil prices) feeding through to inflation of consumer and producer prices. Or, the speculative bubble would give way to yet another financial crisis. Worse, either inflation or a bursting bubble could generate a run out of the dollar, collapsing the currency—and off we go again toward Zimbabwean ruin.

Finally, over the past two decades the Fed—accompanied by New Consensus macroeconomists—has managed to create a widespread belief that inflation is caused by expected inflation. In other words, if everyone believes there will be inflation, then inflation will result because wages and prices will be hiked on the expectation that costs will rise. For this reason, monetary policy has long been directed toward managing inflation expectations, with the Fed convincing markets that it is diligently fighting inflation pressures even before they arise. Now, however, the Fed is in danger of losing the battle because all of those extra reserves in the banking system will create the expectation of inflation—which will itself cause inflation. For this reason, the Fed needs to begin raising interest rates and (or, by?) removing reserves from the banking system. That would prevent expected inflation from generating Zimbabwean hyperinflation.

Unfortunately, all these arguments misunderstand the situation. Here is why:

You cannot tell much of anything by looking at current bank reserve positions. As and when banks decide they do not need to hold so many reserves, they will begin to unwind them, repaying loans to the Fed (destroying reserves) and buying Treasuries (the Fed will accommodate by selling assets in order to keep the overnight fed funds rate on target—if it did not, excess reserves would drive the fed funds rate to zero).There are no direct inflationary pressures that result from such operations. Indeed, all else equal, the reserves will be reduced with no new bank lending or deposit creation.

Banks normally buy financial assets (including loan IOUs) by issuing liabilities (including deposits). As the economy recovers, banks will want to resume such activities. If there is a general demand to buy output or financial assets, coming from borrowers perceived to be creditworthy, banks normally accommodate by making loans. This does not require ex ante reserves (or even capital if regulators do not enforce capital requirements or if banks can move assets off balance sheet). Yes, such a process can generate rising asset prices and banks broadly defined might accommodate this as they seek profits through lending to speculators. In this respect you could argue that expected inflation of asset prices fuels actual inflation of asset prices since that can fuel a speculative run up. Yet, this can occur with or without any excess reserves–indeed even if banks were already short required reserves they could expand lending then go to Fed to get the reserves. In other words, banks do not lend reserves nor is their lending constrained by reserves. Thus, while it is true that banks can finance a speculative bubble in asset prices, they can do this no matter what their reserve position is.

Nor will bank lending for asset purchases necessarily generate inflation of output prices. Any implications of renewed bank lending for CPI or PPI inflation are contingent on pass through from commodities to output prices. If the speculative binge in, say, futures prices of commodities feeds through to commodities spot prices, and if this then pressures output price inflation (as measured by the CPI and PPI), there can be an effect on measured inflation. There are lots of caveats–due to the way these indexes are calculated, to the possibility of consumer and producer substitutions, and to offsetting price deflation pressures (Chinese production and all of that). In any case, if there is a real danger that the current commodities price boom could accelerate to the point that it might create a crash or output price inflation, the best course of action would be to constrain the speculation directly. This can be done through direct credit controls placed on lenders as well as regulation of speculators.

It is true that the Fed has operated on the belief that by controlling inflation expectations it prevents inflation. Low inflation, in turn, is supposed to generate robust economic growth and high employment. This has been exposed by the current crisis as an unwarranted belief. The Wizard of Oz behind the curtain was exposed as an impotent fraud—while Bernanke remained focused on controlling inflation expectations for far too long, the whole economy collapsed around him. It was only when he finally abandoned expectations management in favor of bold action—lending without limit to institutions that needed reserves—that he helped to quell the liquidity crisis. All of his subsequent actions have had no impact on the economy—“quantitative easing” is nothing but a slogan, meaning that the Fed accommodates the demand for reserves (which it has always done, and necessarily must do so long as it has an interest rate target and wants par clearing).

It is sheer folly to believe that inflation expectations lead to inflation and that by controlling the expectations one controls inflation. In the modern capitalist economy, prices of output are mostly administered, with the caveat that competitive pressures from low cost producers in China and India put downward pressure on prices that may force domestic sellers to cut prices. Hence, US inflation has remained low in recent years because there has been little cost pressure; and note that most countries around the world have also experienced low inflation over the same period even though they did not enjoy the supposed benefits of a Wizard in charge of monetary policy. In the current environment of a global financial and economic calamity, the real danger is price deflation. The bit of inflation we do experience is due almost entirely to energy price blips—which could be prevented if we would just prohibit pension funds from speculating in commodities.

Still, there remains one path to Zimbabwean hyperinflation: a collapse of the currency due to insolvency and default by our federal government on its debts. Yet, as many have discussed on this blog (see here, here, here, here, and here), the US government is the sovereign issuer of our dollar currency. It cannot be forced into bankruptcy because it services its dollar debt by crediting bank accounts. It can never run out of these credits, since they are merely electronic entries on balance sheets, created at the stroke of a computer key. It can, and will, make all payments as they come due. In short, federal government insolvency is not possible.

To be sure, as we have emphasized many times, too much government spending can be inflationary. But the measure of “too much” cannot be found by looking at the size of the deficit (or, equivalently, at the shortfall of tax revenue), or at the ratio of government spending to GDP, or at the outstanding debt stock. Rather, government spending will approach an inflation barrier as the economy approaches full employment of resources, including labor resources. Yet, we are no where near to full employment. Any fear that current levels of spending, or even much larger amounts of federal spending, might be inflationary are premature. With 12 to 25 million jobless workers remaining, inflation is not a legitimate worry.

You can be sure that no matter how misguided President Obama’s policies might be, he is not taking us down the path to a Zimbabwean hyperinflation. This is not the place for a detailed analysis of the probable course of the dollar. In coming months it might decline a bit, or rise a bit (I’d bet on the latter if I were a gambler)—but there will be no global run out of the dollar. For one thing, runners must run to something—and as recent reports suggest, Euroland’s prospects look dire. That leaves smallish nations (Japan, the UK—both with their own problems) or big nations (China, India) that are too risky for foreigners. The best place to park savings will remain the US dollar.

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Posted in L. Randall Wray, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Fiscal Policy, Government's IOU, inflation, L. Randall Wray, The Federal Government Deficit, The National Debt

What If the Government Just Prints Money?

Posted on November 22, 2009 by Scott Fullwiler | 46 comments

By Scott Fullwiler

As Congress gets set in the near future to consider raising the debt ceiling yet again, my fellow blogger L. Randall Wray creatively suggests not raising the debt ceiling but instead having the Treasury continue spending as it always does: by simply crediting bank accounts. As he puts it:

The anti-deficit mania in Washington is getting crazier by the day. So here is what I propose: let’s support Senator Bayh’s proposal to “just say no” to raising the debt ceiling. Once the federal debt reaches $12.1 trillion, the Treasury would be prohibited from selling any more bonds. Treasury would continue to spend by crediting bank accounts of recipients, and reserve accounts of their banks. Banks would offer excess reserves in overnight markets, but would find no takers—hence would have to be content holding reserves and earning whatever rate the Fed wants to pay. But as Chairman Bernanke told Congress, this is no problem because the Fed spends simply by crediting bank accounts.

This would allow Senator Bayh and other deficit warriors to stop worrying about Treasury debt and move on to something important like the loss of millions of jobs.

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