Bad Cop; Crazed Cop – the IMF and the ECB

By William K. Black

Greetings again from Ireland. One of the many mysteries about the current crisis is why anyone listens to the IMF or anyone that supported its anti-regulatory policies. Prior to the crisis, even the IMF had begun to confess that its austerity programs made poor nations’ financial crises worse. In the lead up to the crisis the IMF was blind to the developing crises. It even praised nations like Ireland during the run up to the crisis, missing the largest bubble (relative to GDP) of any nation, an epidemic of banking control fraud, and the destruction of any pretense to effective Irish banking regulation.

Crises reveal many deficiencies and one of the most glaring was the European Central Bank (ECB). The ECB was set up, unlike the Federal Reserve, to have only one mission and one function – securing price stability through monetary policy. The Fed has three missions and three primary functions. The missions are systemic financial stability, price stability, and full employment. The functions are conducting monetary policy, serving as the lender of last resort, and acting as a financial supervisor. The crisis revealed that both dominant forms of central banking could attain their most fervent goal – near total “independence” in determining and conducting monetary policy – and fail abjectly.

The crisis revealed that the ECB’s narrow mission and function left the EU helpless to deal with a severe economic crisis. The ECB could not save Europe. Only the Fed could, and did, save Europe through currency swaps, serving as a lender of last resort (often on the basis of chimerical collateral) to major European banks, and providing liquidity backstops to myriad financial markets.

What Happens When the Government Tightens its Belt?

By Stephanie Kelton

Imagine two people sitting on opposite ends of a 15-foot teeter-totter. The laws of physics dictate that the seesaw will balance if the product of the first mass (w1) and its distance (d1) from the fulcrum (i.e. the balancing point) is equal to the product of the other mass (w2) and its distance (d2) from the fulcrum. Thus, the physicist can show that the teeter-totter will be in balance when the fulcrum is placed 6 feet from the end holding a 150lb person and 9 feet from the end holding a 100lb person. Moreover, the laws of physics ensure that an imbalance will arise if the mass or the relative position of one of the people is changed.

The laws of accounting allow us to demonstrate that similarly powerful concepts apply to the science of economics. Beginning with the simple identity for GDP in a closed economy, we have:

[1]   Y = C + I + G, where:

Y = GDP = National Income
C = Aggregate Consumption Expenditure
I = Aggregate Investment Expenditure
G = Aggregate Government Expenditure

For economists, this is as obvious as stating that a linear foot is the sum of 12 sequential inches. It simply recognizes that the total amount of money spent buying newly produced goods and services will yield an equivalent income to the sellers of these products. Thus, it demonstrates that expenditures are a source of income.

Once earned, income can be allocated in one of three ways. At the end of the day, all income (Y) will be spent (C), saved (S) or used in payment of taxes (T):

[2]   Y = C + S + T

Since they are equivalent expressions for Y, we can set equation [1] equal to equation [2], giving us:

C + I + G = C + S + T

Or, after canceling (C) from both sides and moving terms around:

[3]   (S – I) = (G – T)

Equation [3] shows that there is a direct relationship between what’s happening in the private sector (S – I) and what’s happening in the public sector (G – T). But it is not the one that Pete Peterson, Erskin Bowles, or President Obama would have you believe. And I want you to understand why they are wrong.

Breakup of the euro? Is Iceland’s rejection of financial bullying a model for Greece and Ireland?

By Michael Hudson

Last month Iceland voted against submitting to British and Dutch demands that it compensate their national bank insurance agencies for bailing out their own domestic Icesave depositors. This was the second vote against settlement (by a ratio of 3:2), and Icelandic support for membership in the Eurozone has fallen to just 30 percent. The feeling is that European politics are being run for the benefit of bankers, not the social democracy that Iceland imagined was the guiding philosophy – as indeed it was when the European Economic Community (Common Market) was formed in 1957.

By permitting Britain and the Netherlands to blackball Iceland to pay for the mistakes of Gordon Brown and his Dutch counterparts, Europe has made Icelandic membership conditional upon imposing financial austerity and poverty on the population – all to pay money that legally it does not owe. The problem is to find an honest court willing to enforce Europe’s own banking laws placing responsibility where it legally lies.

The reason why the EU has fought so hard to make Iceland’s government take responsibility for Icesave debts is what creditors call “contagion.” Ireland and Greece are faced with much larger debts. Europe’s creditor “troika” – the European Central Bank (ECB), European Commission and the IMF – view debt write-downs and progressive taxation to protect their domestic economies as a communicable disease.

Like Greece, Ireland asked for debt relief so that its government would not be forced to slash spending in the face of deepening recession. “The Irish press reported that EU officials ‘hit the roof’ when Irish negotiators talked of broader burden-sharing. The European Central Bank is afraid that any such move would cause instant contagion through the debt markets of southern Europe,” wrote one journalist, warning that the cost of taking reckless public debt onto the national balance sheet threatened to bankrupt the economy [1]. Europe – in effect, German and Dutch banks – refused to let the government scale back the debts it had taken on (except to smaller and less politically influential depositors). “The comments came just as the EU authorities were ruling out investor ‘haircuts’ in Ireland, making this a condition for the country’s €85bn (£72bn) loan package. Dublin has imposed 80 percent haircuts on the junior debt of Anglo Irish Bank but has not extended this to senior debt, viewed as sacrosanct.”

To Save the Euro, Germany Has To Quit the Eurozone

By Marshall Auerback

When the euro was launched, leading German politicians used to argue, with evident relish (and much to the chagrin of the British in particular), that monetary union would eventually require political union. The Greek crisis was precisely the sort of event that was expected to force the pace. But, faced with a defining crisis, Ms Merkel’s government is avoiding airy talk of political union – preferring instead to force harsh economic medicine down the throats of the reluctant Greeks, Irish, Portuguese and Spanish electorates. This is becoming both economically and politically unsustainable. If the objective is to save the currency union, perhaps policy makers are looking at this the wrong way around. In the end, paradoxically, to save the European Monetary Union, the least disruptive way forward would be for the Germans, not the periphery countries, to leave.

One major reason why political, and social, unification is so important is that it provides conditions under which the adjustment mechanism, to being uncompetitive, is facilitated. Labour mobility is much greater within, than between, countries. Cross-regional fiscal transfers help to smooth the adjustment process. Social and national unity makes break-away policies almost unthinkable and hence provides the cement to keep the discipline of adjustment in place.

None of the above are, as yet, strongly anchored in the euro-zone. Nor are they likely to be in the current context in which any moves toward a broader supranational fiscal structure continue to be resisted by the Germans, who perceive this as a backdoor mechanism for yet more bailouts of their “profligate” Mediterranean European “partners”.

And yet some sort of broader fiscal expansion is becoming increasingly necessary if the euro project is to be sustained.

In Praise of Sorkin’s Praise of Lowenstein’s Praise of Financial CEOs

By William K. Black

Roger Lowenstein has just taken the brave step of praising the failure to prosecute elite financial managers for fraud as a demonstration of the greatness of America. Lowenstein declares (1) that Blankfein was right – Goldman really was doing “God’s work,” (2) virtually no financial elites committed crimes, (3) any crimes they may have committed were trivial and played no material role in causing the crisis, (4) those that wish to hold fraudulent elites accountable for their crimes are (a) financially illiterate, (b) paranoid conspiracy theorists equivalent to those claiming the U.S. attacked the twin towers on 9/11, (c) a threat to our democracy and constitutional rights, and (d) engaged in “punishing profit,” (5) the prosecutors who refuse to bring criminal charges where they find elite frauds are the heroes safeguarding our democracy and constitutional rights, (6) the FBI is conducting a “serious” investigation of the elite financial frauds (despite points one through four above), and (7) the crisis was caused by “society” – because we’re all guilty no one should be held accountable – except those paranoids who want to destroy America’s greatness by prosecuting financial CEOs on fraud charges.

Wall Street: Not Guilty (May 12, 2011)

Lowenstein’s former colleague at the New York Times, Andrew Ross Sorkin, twittered that Lowenstein was “courageous” and “probably right.”

I join Lowenstein and Sorkin in denouncing the demagogues that denounce America’s financial CEOs for fraud and corruption and those that denounce our economic system for cronyism. My research has detected the ravings of two of the worst examples of this form of parasite. Two of the nation’s leading financial commentators have filled their books and columns with demagogic attacks on the productive class. Here are some of one's vicious assaults on America’s CEOs and capitalist system.

Mitch Daniels Uses Benefit-Cost Analysis to Teach his Daughter Ethics

By William K. Black

(Cross-posted with Benzinga.com)

This is the fourth and final article in a series of pieces discussing the claim by a Cato scholar at CIFA’s recent meeting in Monaco that formal benefit-cost tests by economists were essential to prevent regulatory excess. The second column focused on a speech in 2001 by Mitch Daniels, then President Bush’s Office of Management and Budget (OMB) director to the Competitive Enterprise Institute (CEI).

Mitchell E. Daniels, Jr., Competitive Enterprise Institute Speech, 05/22/2002

Daniels is the nation’s leading proponent of benefit-cost tests, and the purpose of his speech was to advance arguments in favor of OMB economists’ use of benefit-cost tests to block the adoption of regulations. The column discussed Daniel’s use of a “mistress metaphor” to explain why economists’ formal benefit-cost tests are vital.

Daniels warmed up his global warming denial audience (pun intended) with this joke, which he said he often shared with his daughter. Many of us who are parents look for these opportunities to mix family meals and an opportunity for moral instruction. This is how Daniels relates his efforts at teaching moral reasoning:

'If James Carville and Geraldo Rivera were both drowning, and you could only save one [laughter], would you read the paper, or eat lunch [laughter and applause]?'

Altruism is, as Ayn Rand stressed, a grave error. To be a Good Samaritan, particularly to save the life of someone who disagrees with you, is not a mitzvah but an unpardonable sin. It follows that one should teach their children that the correct response to learning that a person is drowning and only they can save a life – is to let them drown – while noshing. The death of those who disagree with us is a cause for celebration [“laughter and applause”].

Mitch Daniels Fails to use Benefit-Cost Tests when they demonstrate an Inconvenient Truth

By William K. Black

(Cross-posted with Benzinga.com)

This is the third article in a series of pieces discussing the claim by a Cato scholar at CIFA’s recent meeting in Monaco that formal benefit-cost tests by economists were essential to prevent regulatory excess. The second column focused on a portion of a speech in 2002 by Mitch Daniels, then President Bush’s Office of Management and Budget (OMB) director to the Competitive Enterprise Institute (CEI). Daniels is the nation’s leading proponent of benefit-cost tests, and the purpose of his speech was to advance arguments in favor of OMB economists’ use of benefit-cost tests to block the adoption of regulations. The second column discussed Daniel’s use of a “mistress metaphor” to explain why economists’ formal benefit-cost tests are vital. This column focuses on Daniels’ dismissal of benefit-cost analysis when it demonstrates an inconvenient truth.

A word about Daniels’ host is in order to understand the raucous laughter his misogynist memes about how wives should not object to their husbands taking a mistress produced among his audience. The CEI is a group funded by the usual anti-regulatory firms. CEI’s mission is to oppose regulation. I wrote in my first column of the embarrassing spectacle of theoclassical economists (with a track record of getting economics disastrously wrong) trying to become amateur climatologists denying global climate change. CEI, largely funded by Exxon, and acting through a non-scientist (much less a climatologist) exemplifies this embarrassment. What’s particularly humorous is that CEI decries “junk science.” What I didn’t learn until researching the context of Daniels’ speech to CEI is that he too is an amateur climatologist.

Daniels relies primarily on Michael Crichton, a deceased science fiction writer who was not a climatologist or related scientist, as his authority for the assertion that global climate change is a fiction, or unrelated to human activity, or desirable, or whatever is the next desperate dodge of science. On May 30, 2009, Governor Daniels gave the commencement address at Rose-Hulman, a superb school emphasizing math and science in Indiana. The address contains the usual, and in the case of Rose-Hulman, fully justified odes to the need for scientists to bring their expertise to bear on scientific problems that “our politicians” do not understand. The address even has an ode to benefit-cost studies – just before a politician (Daniels) who lacks any scientific expertise and does not “understand” complex scientific issues declares that it takes “courage” for him to deny global climate change even though he lacks any scientific basis for his denial. And he wants the grads to know that he is really, really upset that people criticize him for his theocratic, non-scientific rejection of climatologists’ research findings. He asserts that the scientists, writing in their area of expertise, are from “Hollywood” and are “Ayatollah[s].” Well no, actually, but then Daniels had just warned his audience that politicians do not understand scientific issues and are want, in the inimitable words of Senator Kyl to make claims about their opponents that are “not intended to be a factual statement.” Or, as Daniels put it in his address: “When I say these things, that's just one more politician spouting off.”

Mitch Daniels’ ode to learning to treasure your husband’s mistress

By William K. Black

Cead mile failte romhat – one hundred thousand greetings to you from Dublin. My UMKC economics department colleague and I are presenting ideas on how Ireland could respond to its banking, budget, and financial crises.

This is the second part of my series of articles on benefit-cost analysis, prompted by a discussion at CIFA’s recent ninth annual meeting in Monaco. This part focuses on the logic employed by the nation’s leading advocate of requiring benefit-cost tests before allowing any regulatory actions. Governor Daniels (R. Indiana) previously served as President Bush’s Director of the Office of Management and Budget (OMB). In 2002, OMB Director Daniels explained to a Competitive Enterprise Institute (CEI) audience why formal benefit-cost analyses by OMB mirrored “everyday life.”

“We need to remind people, that cost benefit analysis is part of everyday life. Perhaps you've heard of the couple out dining one evening, when a lovely, much younger lady passed by the table and visibly winked at the husband. His wife, not missing a thing, said, "Who was that?" After some hemming and hawing, he finally confesses: it's his mistress. She said, "That's it! I always feared and suspected. It's over, I want a divorce." "Now dear, not so fast. You [do] realize if that happens, no more diamonds on your birthday, fewer of those shopping trips to New York, what about the country club charge account?" About that time, another couple passed by and she said, "Isn't that your friend Jim from the office?" He said, "Yes." "Well who's that young woman with him?" "Well, that's Jim's mistress." She says, "Aha! Ours is prettier." [laughter]”

http://www.whitehouse.gov/omb/speeches_cei_regulatory052202
Mitchell E. Daniels, Jr., Competitive Enterprise Institute Speech, 05/22/2002

Again, one cannot compete with unintentional self-parody. Daniels chose a metaphor to defend benefit-cost tests that lays bare many of the worst aspects of formal benefit-cost tests by economists. Daniels delights in his tale of how an unfaithful, rich, powerful, and older man cheats on his wife, humiliates her in public, and essentially prostitutes his wife and his mistress. Perhaps the worst aspect – and here Daniels is simultaneously acute and clueless – is the wife’s use of the word “ours.” When elites use their dominant power to exploit and corrupt less powerful people they also seek to impose a false construct on their victims that makes them appear to be beneficiaries rather than victims. The macho male meme is that his domineering control of his wife’s life and decisions constitutes “protecting” his wife. She is supposed to perceive and express a debt of gratitude rather than resentment to her oppressor.

Should Irish Voters Follow the Example Set by Icelandic Voters?

By L. Randall Wray

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

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

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

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

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

William Black interviewed on Le Show

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

Benefit-Cost Analyses of Governmental Programs: Elusive Illusions of Science

By William K. Black

(cross-posted with Benzinga.com)

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

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

Theoclassical Economists Despise Government Programs, particularly Successful Regulation

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

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

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

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

Failed economic dogma leads to failed amateur climatology

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

The only thing more pathetic, arrogant, and dangerous than theoclassical economists purporting to be superior, objective judges of the net benefits of programs in which they lack relevant scientific expertise and experience is the theoclassical economists trying to play amateur climatologists.