Mark Halperin Was Right

By Marshall Auerback

It may not have been the most felicitous choice of phrase, but Mark Halperin’s characterization of Barack Obama was not far off the mark, even if he did get suspended for it.  The President is a dick, at least as far as his understanding of basic economics goes.  Obama’s perverse fixation with deficit reduction uber alles takes him to areas where even George W. Bush and Ronald Reagan dared not to venture.  Medicare and Social Security are now on the table.  In fact entitlements of all kinds (excluding the myriad of subsidies still present to Wall Street) are all deemed fair game.

To what end?  Deficit control and deficit reduction, despite the fact that at present, the US has massive excess capacity including millions of unemployed and underemployed, a negative contribution from net exports, and a stagnant private spending growth horizon.  Yet the President marches on, oblivious to the harm his policies would introduce to an already bleeding economy, using the tired analogy between a household and a sovereign government to support his tired arguments. It may have been impolitic, but  “dick” is what immediately sprang to mind as one listened incredulously to the President’s press conference, which went from the sublime to the ridiculous.

Discussion of government budget deficits often begins with an analogy to a household’s budget, and the President continues that horrible pattern of misinformation. Obama challenged the view that the government might side-step the debt ceiling constraint by just paying “interest on the debt” and said:

This is the equivalent of me saying, you know what, I will choose to pay my mortgage, but I’m not going to pay my car note. Or I’m going to pay my car note but I’m not going to pay my student loan. Now, a lot of people in really tough situations are having to make those tough decisions. But for the U.S. government to start picking and choosing like that is not going to inspire a lot of confidence. 

Let’s state it again: households do not have the power to levy taxes, to issue the currency we use, and to demand that those taxes are paid in the currency it issues. Rather, households are users of the currency issued by the sovereign government. Here the same distinction applies to private businesses, which are also users of the currency.  There’s a big difference, as all us on this blog have repeatedly stressed:  Users of a currency do face an external constraint in a way that a sovereign issuer of its currency does not.

This key point, which is persistently obscured in these discussions, is that if a government issues a currency that is not backed by any metal or pegged to another currency, then there is no reason why it should be constrained in its ability to “finance” its spending by issuing currency.  Unfortunately, this elementary concept seems to have eluded the President and, presumably, the countless members of Congress involved in the debt ceiling negotiations.  Typical is this statement from the President:

I do think that the steps that I talked about to deal with job growth and economic growth right now are vitally important to deficit reduction. Just as deficit reduction is important to grow the economy and to create jobs — well, creating jobs and growing the economy also helps reduce the deficit. If we just increased the growth rate by one percentage point, that would drastically bring down the long-term projections of the deficit, because people are paying more into the coffers and fewer people are drawing unemployment insurance. It makes a huge difference.

The President has the causation here totally backward.  A growing economy, characterized by rising employment, rising incomes and rising capacity utilization causes the deficit to shrink, not the other way around.  Rising prosperity means rising tax revenues and reduced social welfare payments, whereas there is an overwhelming body of evidence to support the opposite – cutting budget deficits when there is slack private spending growth and external deficits will erode growth and destroy net jobs. Even the IMF (in its October 2010 World Economic Outlook)  recognized that fiscal consolidations, even though they tend to be accompanied by lower interest rates and lower exchange rates, are more frequently associated with economic contractions.  Amazing to think that we’d ever see the day where the President outflanks the IMF.

Expansionary fiscal consolidations are virtually impossible – the initial conditions, as well as the structure of the economy in question, must be right to support a stronger trade improvement, or a more aggressive spending path by domestic firms and households, which largely OFFSETS the impact of decreased government spending.  Again, the key is looking at the impact of government spending reductions within the context of what the other two major sectors of the economy – private households and firms , and the external account (exports and imports) – are doing.  In fact, if we had a balanced foreign sector (i.e. no trade deficit), there would be no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Yes, one individual can spend less than her income, but another would have to spend more than his income. It all has to balance in the end, as any accountant can tell you.

To be fair to the President, most of his Republican counterparts are also “dicks.”   Consider the comments of Senate Minority Leader, Mitch McConnell:

What Republicans want is simple: We want to cut spending now, we want to cap runaway spending in the future and we want to save our entitlements and our country from bankruptcy by requiring the nation to balance its budget. We want to finally get our economy growing again at a pace that will lead to significant job growth.

Like the President, McConnell evidently also feels that the US government can run out of dollars or, at the very least, computer keyboards to mark up or down the numbers in our national accounts.  This is the only way one could make sense of his nonsensical bankruptcy comments.  This perverse inability to distinguish between issuers and users of currencies is a disease which  afflicts members of both parties and largely explains the willingness to hack away at what’s left of the American social welfare net (the President unilaterally disarming his party on Medicare before securing a single concession from the GOP).  Change you can believe in!  And the President wonders why his base is totally dispirited!

Let’s be clear: the government creates 'money' whenever it spends; it destroys 'money' whenever it taxes.  The issue, which the President should be out and front explaining, is whether or not its spending too much or taxing too little.  With a rising unemployment rate, and a huge reserve of underemployed and disadvantaged workers, it is the height of insanity to cut spending overall which is what the US President is claiming is an important and urgent policy goal when there is so much idle productive capacity.  Yet both the President and his Republican negotiators on the other side of this issue take it as a given that public debt per se is an unalloyed evil that should be eliminated as a long term policy goal. That is only possible if the external surplus is large enough. Otherwise, if you attempt to achieve that stage via fiscal cutbacks the policy strategy will undermine employment and growth. The upshot is that the budget deficit is likely to rise because of the slowing economy will undermine tax revenue.

Yes, it’s true that government deficits are not always good, or that the bigger the deficit, the better. The point the President and his equally misinformed economic advisors continue to ignore is that we have to recognize the macro relations among the sectors, much as a surgeon has to consider the impact of removing an organ from the patient in the overall context of how it will affect the rest of the body’s functioning.  Blaming the deficit for our economic woes is akin to blaming the thermometer when it records a temperature from a patient suffering from the flu.  They are both forms of quackery.  To believe otherwise is to be, well, a “dick.”  There’s no other word to describe it.

THE MODERN MONEY APPROACH TO SECTORAL BALANCES AND CAUSATION: MMP Blog #4 Responses

There were a large number of relevant comments and questions. I have done some cut and paste here and will deal with them in order.

Question: Is there any material difference between the sectoral balances in a currency and the sectoral balances issued in the national accounts for GDP purposes?

Answer: Here is my understanding: for the US there would be no (significant) difference as we use dollars in our stocks and our flows. Even if we buy foreign made output, we provide dollars that are exchanged for foreign currency. In other countries there could well be a significant portion of the economy that is denominated in a foreign (dollar) currency. Much of that could go unrecorded, of course. In that case the official accounts would be in domestic currency but if it were feasible we could also keep some accounts in dollars. All the macroidentities for this country would still apply for transactions that take place in dollars.

Q: Several comments were made about this statement: "No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend."

1. So do you consider inventory run up to be in the category of 'willing'?
2. I'm thinking optimist makes perishable goods that in the end nobody wants to buy having somehow managed to persuade a bank to create the necessary money (possibly by having large valuable real thing to offer as collateral).
3. I also find it very confusing. A desire to accumulate wealth is very easy to realize - do not spend your income. Whenever anybody gets a paycheck technically the whole amount is saved. So saving or accumulation is realized by definition while spending requires action.

A: If a firm is producing “widgets” it does so to “realize” them in the form of money things—it wants to sell them to get a credit to its bank account If it cannot sell them, they are added to inventory and count in the GDP accounts (technically NIPA) as investment. There will be an offsetting flow which is saving. Within the private sector, the increase to investment equals the increase to saving—this activity has no impact on the overall private sector’s balance. But let us imagine that foreigners order those widgets; in that case, the firm gets to sell them (receiving a credit to its bank account); there will be no increase to domestic investment. Instead, exports have increased—there is a positive entry to the current account balance. Ignoring all other entries, the US domestic private sector gets a surplus on its balance (saving) while the foreign sector “deficit spends”.

I know this will not answer all possible questions that follow on from this. After we look at the “circuit approach” later in the MMP we will see how the firm financed its production of widgets and what the implication is for the firm if it fails to “realize” them in the form of sales for money things. You can think of the “saving” of the household sector as the counterpart to the undesired inventory accumulation by the widget manufacturer. The manufacture of the widget produces household income that can be consumed or saved; of course the firms hope workers never save—because that means lost potential sales. If households do save, widgets go to inventory as investment. The firm can then be in trouble—not able to cover its costs. But foreigners or the government can step in to fill the demand gap.


Q: I wonder about "a) Individual spending is mostly determined by income." Is this important/necessary/useful for you exposition?

A: Of course, it is true that wealthier people can fairly easily spend even if their flow of income is zero—they can sell off assets or borrow against them. But for many households, it is “mostly” true that income determines spending. And it is common sense to most people. My bigger point, however, is that at the aggregate level we need to think about reversing the causation. My household’s income is mostly determined by my employer’s decision to spend on my wages and salaries. So household consumption really depends to a great extent on its income (so consumption is called “induced spending) but its income in turn comes from somewhere—largely spending by firms and governments on wages, profits, and interest. At that spending by firms is undertaken on the expectation of sales (expenditures by households or other firms). We then also have government and investment and exports that are at least to some extent “autonomous” to income (don’t depend on today’s income). Yes these are important issues both for explanation and for projections of economic performance. There is also a logical angle: a society can decide to spend more but it cannot decide to have more income (unless it spends more). Spending is thus logically prior.

Q: When somebody hands you a five dollar bill, you can't spend (create an outflow) out of that instantaneous inflow. You can only spend out of your stock -- whether it's a Swiss bank account or the buck and a quarter you have in your pocket. Flows are strings of instantaneous events; stocks have existence and duration. You can only spend out of wealth, not out of income. Obvious, but a point of confusion out there in the world.

A: When my boss pays me my $5 wages, that is indeed an income flow—ie: $5 per hour, per week, per month, or per year. Flows occur over time (even if the time is short). I can accumulate my income (wages) flow in the form of green paper dollar notes—the flows accumulate to a stock of dollar bills. (Stocks are measured at a point in time. Now!, for example.) If instead I spend the wages as I receive them, that is a consumption flow financed out of wages flow. But if I save all my wages as accumulated stacks of dollar bills for a period of a year, and then at the end of the year I choose to run down my wealth by splurging on a new BMW, then I am dissaving (reducing stock of wealth) to finance consumption.

Note that if I accumulated BMWs as my wealth (rather than dollar notes) then I would first have to sell the BMWs before I could finance consumption. That is of course the advantage of accumulating “cash”—I don’t have to sell it before spending. So my exposition was not confused. You could say that it is rather arbitrary whether to count hoarding of $5 notes as a saving flow into my stock of wealth, that I then run down to finance consumption versus spending the $5 income flow to finance consumption. That is to say, as we collapse the time period toward an “instant” then the distinction between flows and stocks disappears. That seems to be what you are saying. An instantaneous flow reduces to a stock as time approaches zero. And that of course is correct, too.

Note that income can be received as a flow of claims (rather than green paper). I work all month long, accumulating wage claims on my employer. (Legally enforceable in court.) Then I finally get my paycheck and deposit it in my bank account. Now I spend down my deposit until my next paycheck. If we want to be technically wonky we would say you are receiving an income flow every day of the month that finances a consumption flow every day of the month. But as you say, the “payment” of the wage actually takes place on a single day as a credit to your bank account (increasing your stock of wealth). (Technically, the claim on your employer is converted to a bank deposit—usually a debit to your employer’s account and a credit to yours.) You could not “really” spend your wages (claims on your employer) until you got your paycheck—except by borrowing against the claims.

Q: My understanding of domestic government budget surpluses is that they merely destroy the dollars that earlier spending created. Isn't it meaningless to suggest that a sovereign government "saves" its own fiat currency?

A: In practical terms, yes. In the US during the Clinton boom there was a projection that all outstanding US Treasury debt would be retired. This led to a mad rush at the Fed to figure out how the federal government could continue to run surpluses if there were no government IOUs out there to “destroy”. If we ever did get to that point, the only way the private sector could continue to run deficits against the government would be to surrender assets (not government IOUs) in payment. You’d have to turn over your car, house, bank account, and children to the government to pay taxes!! That is the logical result of a government surplus carried to infinity—government would accumulate infinite claims on you. And yes you are correct that sovereign government does not—cannot—“save” its own currency!

Q: "It is impossible for every individual in the private domestic sector to net save at the same time if that sector's aggregate balance is zero" Sure, but the logic is not the one you and this post claim. It is savers who force deficit spending and not the other way. This is the reason why.

A: Takes two to tango, of course. I think I made that clear. But carrying on from above, at the aggregate level (at least) it makes more sense to say that spending “causes” income which in turn “causes” saving. Here is why. If I am credit worthy I can always decide to spend more (the bank takes my IOU, gives me its IOU, and I deficit spend). I cannot (easily) decide to have more income. I need income to save more. Still, it takes two to tango. Yes, if I have income I can decide to consume less and save more. That will have an implication on someone else’s income flow (since I am not buying her widgets). And that means undesired deficit spending (and perhaps inventory accumulation—as above).

Q: Could you provide an algebraic description of MMT and its prescriptions as part of the MMP?

A: I did.

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

That is pretty much all the math(s) you need to become a good macroeconomist! If you understand that, you are way ahead of most Nobel winners. (More seriously, where math helps, we will use it.)

State Opposition to the MLK Holiday: Which State Opposing Marriage Equality Wants to Reprise the Role of Arizona?

By William K. Black

New York’s adoption of marriage equality is the end of the beginning of the struggle on behalf of marriage equality.  Ultimate success is never certain, but it is now highly likely though it will take over a decade to attain.  The opposition to marriage equality has four crippling legal, social, and policy problems that I will briefly review.  This article emphasizes an economic problem for the States barring marriage equality that will become intense given New York’s adoption of marriage equality and near certainty that California will soon do so.

The four legal, social, and policy problems that increasingly confront opponents of marriage equality include:

1. The brilliant strategy of “coming out.”  Instead of the sinister unknown, over a hundred million Americans realized that they knew homosexuals who were exceedingly, boringly normal.
2. Much of the history of the West since the Enlightenment has been the recurrent broadening of the concept of “us.”  We continue to transfer members of the hated and feared “other” into the category of “us” to whom we owe respect and care.  Increasingly, those who grew up in a Western culture include homosexuals as “us.”
3. The opponents of marriage equality have lost the young.  Overwhelmingly young conservatives are embarrassed and amazed at their older counterparts’ homophobia.  Strong majorities of younger people support marriage equality.  The present is already untenable for the opponents of marriage equality in many blue states – the future is terrifying. 

Red Families v. Blue Families, Naomi Cahn & June Carbone (Oxford University Press 2010). 

4. The opponents of marriage equality have no arguments that will convince the unconvinced.  Worse, their inability to come up with any convincing argument as to why marriage equality would harm society has led them to base their policy arguments on their prejudices – exposing and focusing attention on those prejudices.  This is why, when writing to friendly audiences, opponents of marriage equality have emphasized the vital need to avoid any trial at which they would have to make and defend a claim that marriage equality harms society.  They describe the effort to defend such a claim in Hawaii as a “disaster.”  Instead of the sin that dares not speak its name, we have the indefensible prejudice that dares not be tested in any court.  Here is the link to my prior column explaining this point.  

In that article I also quote Gerard Bradley with regard to the economic dynamic that is the focus of this column.

“What then is to be done? Conservatives must hold the defensive lines -- in state courts, in legislatures, in corporate America -- as best they can. These efforts will come to naught, however, if the [Supreme] Court stays its course.”

The problem with Bradley’s strategy is “corporate America.”  Corporate America will provide the impetus for ending state opposition to marriage equality.  Recent articles have explained the strong role that business elites played in achieving the passage of New York’s marriage equality law.  The CEOs who helped produce the passage were not motivated by economics.  Their motivation arose from the four legal, social, and policy factors that I discussed.  They had homosexual family members and understood the demonization that their kin faced and the pain of denying them the right to marry the life partner they loved.  They believed that the denial of marriage equality was inhumane, unethical, and intolerable. 

The rise of CEOs who are strongly motivated to be politically active in defense of marriage equality was a critical development in New York.  It is likely to be replicated in some of the bluest states, particularly California.  Even if the decision overturning California’s Proposition 8 is reversed there will be a prompt introduction of a proposition to overturn Proposition 8.  Opinion in California has continued to swing to towards greater majority support for marriage equality since the Passage of Proposition 8.  The role of pro-marriage equality CEOs in countering the LDS’ funding of the anti-marriage equality effort is likely to provide an extra margin of victory at the polls.

The political attraction of demonizing homosexuals will continue for years.  Opponents of marriage equality will continue to introduce laws attacking it in the hopes of raising the saliency of the issue in order to increase the turnout by voters who are most strongly opposed to equality.   There will be a series of legislative mixed legislative wins and losses on marriage equality.  Losses will likely dominate for several years.  But here is where the second aspect of economics and corporate America will prove decisive.

The bluest states have enormous populations and their economies are disproportionately large.  They are home to tens of thousands of multinational and multistate businesses that have sophisticated pension and benefit provisions.  The states that bar marriage equality will become increasingly unattractive places for many of these businesses.  Regardless of the nature of their laws, states that deny marriage equality will become nightmares for these businesses if the states attempt to deny full faith and credit to the bluest states’ marriage equality laws.  Executives and professionals who are homosexuals will either refuse to relocate to hostile states (damaging both the business and states denying marriage equality) or they will relocate and (often) live out and proud.  That will lead to recurrent national publicity about intolerance.  Their employers will either back them or fail to do so.  Either response will only increase business pressure on the states refusing to respect marriage equality.  Businesses and professional firms located in the diminishing pool of states that prohibit marriage equality will find it more difficult to recruit and will increasingly view their location as a competitive disadvantage. 

Religious opponents of marriage equality consider it deeply unfair that most supporters of marriage equality view their opposition as bigoted, but that is the reality.  Supporters of marriage equality will be repeatedly energized by each act of intolerance against same sex couples who end up living in states barring marriage equality.  They will demand that businesses make a choice and they will demand that associations refuse to meet in states that are hostile to equality.  As the number of states adopting marriage equality grows – and it will – the third economic pressure on businesses, and by businesses, in favor of equality will grow. 

Arizona’s refusal to honor the Martin Luther King holiday offers an example of how acute this third economic pressure can become as the ranks of states barring marriage equality diminish.  Arizona rescinded recognition of the holiday after it elected an ultra conservative Governor.  Arizona voted to refuse to reinstate recognition of the holiday in 1990.  That action led the NFL to move the Super Bowl from Arizona to the Rose Bowl in Pasadena, California.  Arizona became a national embarrassment because its refusal was widely perceived as the product of bigotry.  Arizona businesses demanded that the State stop this insanity.  Prominent Arizona politicians like Senator McCain flipped their position and demanded that the state recognize the holiday.  The question we will face, though it may take two decades, is which State wishes to reprise Arizona’s starring role as the symbol of intolerance?  The time has come to start the betting pool to predict which State will be the last to abandon laws forbidding marriage equality.      

Cato is Shocked that the Three “de’s” Produce a Criminogenic Environment

By William K. Black

(Cross-posted with Benzinga.com)

James Bovard of Cato wrote an article entitled “The Food-Stamp Crime Wave” on June 23, 2011 for the Wall Street Journal.

http://online.wsj.com/article/SB10001424052702304657804576401412033504294.html?mod=WSJ_hps_sections_opinion

Bovard shows no awareness of criminology, but what he described was the creation of a criminogenic environment. A criminogenic environment has such perverse incentives that it produces widespread crime in a particular field of activity. Non-criminologists frequently have difficulty believing that fraud can become common. They often believe that fraud can only arise among “a few rotten apples.” This view is naïve and crimionological research falsified the claim over a half century ago. Bovard is correct, therefore, that fraud can become common in an industry. This is particularly true if fraud produces a “Gresham’s dynamic.” George Akerlof explained this point over 40 years ago in his famous article on a market for “lemons” (1970).

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”

Bovard purports to be a libertarian, yet he ascribes the creation of the criminogenic environment in food stamps to the three “de’s” – deregulation, desupervision, and de facto decriminalization. He is also upset that the federal government, in the context of food stamps, has failed to sufficiently distort consumer decision making. I address his substantive position on food stamps in another column.

MMT, SECTORAL BALANCES AND BEHAVIOR

In Blog #2 we introduced the basics of macro accounting, and in Blog #3 we took a break from accounting to take a look at the rise and fall of the Goldilocks economy in the US. Thus, we applied our sectoral balance identity to the case of the US. In today’s blog we will go a bit deeper into the accounting, looking at the relation between flows (deficits) and stocks (debts). To avoid making mistakes we need to make sure that we have “consistency” between our flows and our stocks. We want to make sure that all spending and saving comes from somewhere and goes somewhere. And we must make sure that one sector’s surplus is offset by a deficit in another sector. This is a lot like keeping track of the scores in a baseball game, and in fact most financial “scores” really are electronic entries in the modern world.

We will also try to say something about causation. It is not sufficient to say that at the aggregate level, the private balance plus the government balance plus the foreign balance equals zero. We would like to be able to understand why the private sector balance was negative during the Clinton Goldilocks years while the government balance was positive—how did we get to that point, and what sorts of processes did it induce. Obviously that is necessary before we can really analyse the situation and formulate policy. Unlike the macro accounting identity (which must be true), it is not possible to say with certainty what causes a particular sector’s balance. It is quite easy to say that if the government runs a surplus and if the foreign balance is positive (foreign sector spends less than its income) then the domestic private sector must by accounting identity be negative (running a deficit). It all must sum to zero.

Explaining why the private sector had a deficit during the Goldilocks years is harder; it is even harder to project if and for how long that deficit would continue. I already made clear in Blog 3 that I got the timing wrong—private sector deficits continued for about 4 years longer than I expected. Projections are darned hard to get right—if they were easy, MMTers would all make lots of money placing bets on outcomes. Another way of stating this is to say that a good understanding of MMT does not give one any monopoly on explanations of causation. We must not be overly confident. As the late and great Wynne Godley used to put it, he did not make forecasts, rather, he made contingent projections.

For example, carrying on with the work of Godley, the Levy Economics Institute (www.levy.org) makes such projections. Typically it begins with CBO (Congressional Budget Office) projections of the path of government deficits and of economic growth over the next few years. CBO projections are largely determined by current law (ie: laws determining government spending and taxing, as well as mandates over deficit reduction). However, the CBO’s projections are not stock-flow consistent and do not adopt the three sector balances approach (this used to drive Godley crazy). In other words, they are incoherent. But given projections over the government balance and GDP growth as well as empirical estimates of various economic parameters (propensity to consume and import, for example), one can produce a stock-flow consistent model that produces the implied sectoral balances as well as path of debt. The Levy Institute often finds that economic growth rates (for example) plus government deficit projections used in CBO forecasts imply highly implausible balances in the other two sectors (domestic private and foreign) as well as private debt ratios. To do that kind of analysis, you must go beyond the simple accounting identities.

Deficits -> savings and debts -> wealth. We have established in our previous blogs that the deficits of one sector must equal the surpluses of (at least) one of the other sectors. We have also established that the debts of one sector must equal the financial wealth of (at least) one of the other sectors. So far, this all follows from the principles of macro accounting. However, the economist wishes to say more than this, for like all scientists, economists are interested in causation. Economics is a social science, that is, the science of extraordinarily complex social systems in which causation is never simple because economic phenomena are subject to interdependence, hysteresis, cumulative causation, and so on. Still, we can say something about causal relationships among the flows and stocks that we have been discussing in the previous blogs. Some readers will note that the causal connections adopted here follow from Keynesian theory.

a) Individual spending is mostly determined by income. Our starting point will be the private sector decision to spend. For the individual, it seems plausible to argue that income largely determines spending because one with no income is certainly going to be severely constrained when deciding to purchase goods and services. However, on reflection it is apparent that even at the individual level, the link between income and spending is loose—one can spend less than one’s income, accumulating net financial assets, or one can spend more than one’s income by issuing financial liabilities and thereby becoming indebted. Still, at the level of the individual household or firm, the direction of causation largely runs from income to spending even if the correspondence between the two flows is not perfect. There is little reason to believe that one’s own spending significantly determines one’s own income.

b) Deficits create financial wealth. We can also say something about the direction of causation regarding accumulation of financial wealth at the level of the individual. If a household or firm decides to spend more than its income (running a budget deficit), it can issue liabilities to finance purchases. These liabilities will be accumulated as net financial wealth by another household, firm, or government that is saving (running a budget surplus). Of course, for this net financial wealth accumulation to take place, we must have one household or firm willing to deficit spend, and another household, firm, or government willing to accumulate wealth in the form of the liabilities of that deficit spender. We can say that “it takes two to tango”. However, it is the decision to deficit spend that is the initiating cause of the creation of net financial wealth. No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend.

Still, it is true that the household or firm will not be able to deficit spend unless it can sell accumulated assets or find someone willing to hold its liabilities. We can suppose there is a propensity (or desire) to accumulate net financial wealth. This does not mean that every individual firm or household will be able to issue debt so that it can deficit spend, but it does ensure that many firms and households will find willing holders of their debt. And in the case of a sovereign government, there is a special power—the ability to tax--that virtually guarantees that households and firms will want to accumulate the government’s debt. (That is a topic we pursue later.) We conclude that while causation is complex, and while “it takes two to tango”, causation tends to run from individual deficit spending to accumulation of financial wealth, and from debt to financial wealth. Since accumulation of a stock of financial wealth results from a budget surplus, that is, from a flow of saving, we can also conclude that causation tends to run from deficit spending to saving.

c) Aggregate spending creates aggregate income. At the aggregate level, taking the economy as a whole, causation is more clear-cut. A society cannot decide to have more income, but it can decide to spend more. Further, all spending must be received by someone, somewhere, as income. Finally, as discussed earlier, spending is not necessarily constrained by income because it is possible for households, firms, or government to spend more than income. Indeed, as we discussed, any of the three main sectors can run a deficit with at least one of the others running a surplus. However, it is not possible for spending at the aggregate level to be different from aggregate income since the sum of the sectoral balances must be zero. For all of these reasons, we must reverse causation between spending and income when we turn to the aggregate: while at the individual level, income causes spending, at the aggregate level, spending causes income.

d) Deficits in one sector create the surpluses of another. Earlier we showed that the deficits of one sector are by identity equal to the sum of the surplus balances of the other sector(s). If we divide the economy into three sectors (domestic private sector, domestic government sector, and foreign sector), then if one sector runs a deficit at least one other must run a surplus. Just as in the case of our analysis of individual balances, it “takes two to tango” in the sense that one sector cannot run a deficit if no other sector will run a surplus. Equivalently, we can say that one sector cannot issue debt if no other sector is willing to accumulate the debt instruments.

Of course, much of the debt issued within a sector will be held by others in the same sector. For example, if we look at the finances of the private domestic sector we will find that most business debt is held by domestic firms and households. In the terminology we introduced earlier, this is “inside debt” of those firms and households that run budget deficits, held as “inside wealth” by those households and firms that run budget surpluses. However, if the domestic private sector taken as a whole spends more than its income, it must issue “outside debt” held as “outside wealth” by at least one of the other two sectors (domestic government sector and foreign sector). Because the initiating cause of a budget deficit is a desire to spend more than income, the causation mostly goes from deficits to surpluses and from debt to net financial wealth. While we recognize that no sector can run a deficit unless another wants to run a surplus, this is not usually a problem because there is a propensity to net save financial assets. That is to say, there is a desire to accumulate financial wealth—which by definition is somebody’s liability.

Conclusion. Before moving on it is necessary to emphasize that everything in this blog (as well as Blog #2) applies to the macro accounting of any country. While examples used the dollar, all of the results apply no matter what currency is used. Our fundamental macro balance equation,

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

will strictly apply to the accounting of balances of any currency. Within a country there can also be flows (accumulating to stocks) in a foreign currency, and there will be a macro balance equation in that currency, too.

Note that nothing changes if we expand our model to include a number of different countries, each of which issues its own currency. There will be a macro balance equation for each of these countries and for each of the currencies. Individual firms or households (or, for that matter, governments) can accumulate net financial assets denominated in several different currencies; vice versa, individual firms or households (or governments) can issue net debt denominated in several different currencies. It can even become more complicated, with an individual running a deficit in one currency and a surplus in another (issuing debt in one currency and accumulating wealth in another). Still, for every country and for every currency there will be a macro balance equation.

OK that is enough for this week. Can I remind commentators and questioners that this is a Primer. We will collect questions and comments until Wednesday and then post a response. We appreciate comments and questions directly related to this blog. We really do not want comments from those who have already examined and rejected MMT.

Can Greece Survive?

By L. Randall Wray

(Cross-posted with Benzinga.com)

It was obvious to those who understand Modern Money Theory that the set-up of the European Monetary Union was fatally flawed. We knew that the first serious financial and economic crisis would threaten its very existence. In a sense, it was from the beginning much like the US in 1929, on the eve of the Great Depression—with excessive lender fraud, household and business debt, and a boom that had run on too long. Anything could have set off the crisis that followed—just as discovery that Greece had been cooking its books sealed Euroland’s fate. And like the US post-1929, Euroland has struggled to understand and to deal with the crisis. Meanwhile, it is slipping into another great depression.

Many economists and policy-makers—even fairly mainstream ones—have come to recognize that the barrier to resolution is the inability to mount an effective fiscal policy response. And that is because there is no Euro-wide fiscal authority. Hence, the half-measures undertaken by the ECB and other authorities to put band-aids on the debt problem.

To be sure there is a conflict among authorities over the solution—given absence of a fiscal authority. Many want to impose austerity—equivalent to medieval blood-letting. These argue that the real problem is the lack of self-discipline in the periphery countries. Note that this view is shared by the elites in those countries! Many of them would be happy to throw their countries into deep depressions that wipe out all resistance to wage-cutting and slashing of all social programs that benefit working people. That is always the preferred solution of unenlightened elites. Through this method, wage costs in the periphery nations can be cut, making production more competitive.

This of course is also the position of the most powerful member of the EU. Prudent Germany had held wages in check over the past decade while ramping up productivity. As a result, it became the low cost producer in Europe and can even go toe-to-toe and win against Asia. Mind you, not in the production of cheap labor intensive output, but where it really counts in the high value added export sector.

And this view is also common among working classes in the central countries—that share the view of periphery populations as lazy and over-rewarded. While untrue, what is most shocking about this attitude is that if the blood-letting and crushing of wages in the periphery actually does work, the factories will be moved out of Germany seeking lower cost workers. In other words, success in the periphery would shift the burden back to Germany’s workers, who would have to accept lower wages to compete. That will be fueled by job losses if Germany cannot find sales outside the EU that will be lost as the periphery nations fall farther into depression. The result will be a nice little rush to the bottom, benefiting Europe’s elite. How nice.

To be sure, I do not think there is a snowball’s chance in hell that the EU will squeeze sufficient blood out of the Greeks (and Spanish and Italians and Irish and Portuguese) for this to work. What actually makes far more sense is to raise German wages—to achieve competitiveness within the EU by leveling up. But that snowball does not have a chance, either, because Germany is looking far outside the borders of Europe—and mostly in an eastern direction. As a result, it will remain focused on cutting its own labor costs—so the periphery nations will never catch Germany on the way down.

That leaves two alternative approaches.

Bill Gross advocates for a Job Guarantee Program

Bill Gross, co-founder of Pacific Investment Management, recently advocated for an employer of last
resort program:

In the end, I hearken back to revered economist Hyman Minsky – a modern-day economic godfather who predicted the subprime crisis. “Big Government,” he wrote, should become the “employer of last resort” in a crisis, offering a job to anyone who wants one – for health care, street cleaning, or slum renovation. FDR had a program for it – the CCC, Civilian Conservation Corps, and Barack Obama can do the same. Economist David Rosenberg of Gluskin Sheff sums up my feelings rather well. “I’d have a shovel in the hands of the long-term unemployed from 8am to noon, and from 1pm to 5pm I’d have them studying algebra, physics, and geometry.” Deficits are important, but their immediate reduction can wait for a stronger economy and lower unemployment. Jobs are today’s and tomorrow’s immediate problem.

Click here for the full post.

Whither Greece? Without a national referendum Iceland-style, EU dictates cannot be binding

By Michael Hudson

The fight for Europe’s future is being waged in Athens and other Greek cities to resist financial demands that are the 21st century’s version of an outright military attack. The threat of bank overlordship is not the kind of economy-killing policy that affords opportunities for heroism in armed battle, to be sure. Destructive financial policies are more like an exercise in the banality of evil – in this case, the pro-creditor assumptions of the European Central Bank (ECB), EU and IMF (egged on by the U.S. Treasury).

As Vladimir Putin pointed out some years ago, the neoliberal reforms put in Boris Yeltsin’s hands by the Harvard Boys in the 1990s caused Russia to suffer lower birth rates, shortening life spans and emigration – the greatest loss in population growth since World War II. Capital flight is another consequence of financial austerity. The ECB’s proposed “solution” to Greece’s debt problem is thus self-defeating. It only buys time for the ECB to take on yet more Greek government debt, leaving all EU taxpayers to get the bill. It is to avoid this shift of bank losses onto taxpayers that Angela Merkel in Germany has insisted that private bondholders must absorb some of the loss resulting from their bad investments.

The bankers are trying to get a windfall by using the debt hammer to achieve what warfare did in times past. They are demanding privatization of public assets (on credit, with tax deductibility for interest so as to leave more cash flow to pay the bankers). This transfer of land, public utilities and interest as financial booty and tribute to creditor economies is what makes financial austerity like war in its effect.

Socrates said that ignorance must be the root of all evil, because no one deliberately sets out to be bad. But the economic “medicine” of driving debtors into poverty and forcing the selloff of their public domain has become socially accepted wisdom taught in today’s business schools.

MMP BLOG # 3 RESPONSES

Thank you for comments and questions. Let me divide the responses into several different issues.

1. “Sustainability Conditions” for Government Deficits

I said: “If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Private Balance (+2) + Government Balance (-5) + Foreign Balance (+3) = 0.

And so we are back to the concept of zero!”

Now I want to be clear, I said nothing to imply these particular sectoral balances would continue on through infinity to the sweet hereafter. What I gave was a contingent statement (what the balances would look like AFTER recovery and if we return to LONG-RUN AVERAGES—that is to say, average stances over the past 30 years or so, taking into account trends—essentially just eye-balling the 3 sectors graph provided in the blog). I have made no projection that we actually WILL recover, and it is certainly possible that even after recovery our private sector balance will remain in high surplus. Let us say it remains at 6% (which would be higher than average but consistent with an attempt to delever debt—that is, to keep consumption low in order to pay down debt). In that case, and again assuming the foreign balance remains a positive 3% (that is, our current account deficit is 3%) then the government will remain in deficit of 9% (more or less where it is now). I will not place probabilities on these two outcomes—I think the original statement is more likely—because my main point is simply that taking balances of each of the 3 sectors, the overall balance must be 0.

For those who would like to balance the government budget, the burden is on them to tell me what the implied outcome for the private and foreign sectors will be. If we are not going to return to the disastrous “Goldilocks” outcome with the private sector running deficits, then a huge adjustment will be necessary in the foreign balance in order to have a balanced government budget with a private sector surplus. Virtually none of the deficit hawks consider this. But, again, I would like to hear their explanation for how we will get the current account into surplus.

On to the sustainability conditions. It has become trendy among economist wonks to look at government budget stances to determine whether they could continue forever. Many objections could be raised to such purely mental exercises. An obvious one is that no government has ever lasted forever—and so any such exercise is a waste of time. Ok that one is not something we want to contemplate. Economist Herb Stein quipped that unsustainable processes will not be sustained. Something will change. That gets us somewhat closer to the problem with such approaches. And finally, if we are dealing with sovereign budget deficits we must first understand WHAT is not sustainable, and what is. That requires that we need to do sensible exercises. The one that the deficit hysterians propose is not sensible.

Let us first look at a somewhat simpler unsustainable process. Suppose that some guy—we’ll use the name Ramanan—decides to replicate the “Supersize me” experiment (based on the 2004 documentary by Morgan Spurlock). His caloric intake is 5000 calories a day, and he burns 2000 daily. The excess 3000 calories lets him gain one pound of body weight each day. If he weighed 200 pounds on January 1, by the end of the year he weighs 565 pounds. After 100 years he’s up to 36,700 pounds—a bit on the pudgy side. But we don’t stop there. After 100,000 years he weighs 36,700,000 pounds, and after a few million years, he’s heavy enough to affect the earth’s spin on its axis and its revolutions about the sun. But, according to our policy wonks, that still is not a long enough period—we’ve got to carry this out to infinity, at which point, Ramanan is infinite sized, like the universe, and if he is growing faster than the expansion of the universe, the entire rest of the universe will eventually be infinitesimally smaller than Ramanan. I guess he’s become the black hole of the universe (but I’m no physicist or biologist). So, yes this is unsustainable. Aren’t we all clever?

But would the process actually work that way? Of course not. First, Ramanan is not going to live an infinite number of years; second, he’s either going to blow up (literally) or go on a diet; and third, and most important, his body is going to adjust. As his body mass increases, he will burn more than 2000 calories a day—perhaps he’ll get up to a 5000 calorie a day burn-rate—and his body will use the food in a less efficient manner. So he will stop gaining weight long before he becomes the universe’s black hole. Herb Stein was right.

Our little mental exercise was fundamentally flawed. It assumed a fixed caloric input (flow) and a fixed caloric burn-rate (consumption flow) with the difference between the two accumulating as a stock (weight gain) at a fixed rate (essentially, “savings”). No adjustments to behavior or metabolism are allowed. And then the whole absurd set-up is carried to the ultimate absurdity by the use of infinite horizon projections. Anything carried to a logical absurdity is unsustainable. As you will see, this is the rigged game used by deficit warriors to “prove” the US Federal budget deficit is unsustainable.

The trick used by deficit warriors is similar but with the inputs and outputs reversed. Rather than caloric inputs, we have GDP growth as the input; rather than burning calories, we pay interest; and rather than weight gain as the output we have budget deficits accumulating to government debt outstanding. To rig the little model to ensure it is not sustainable, we have the interest rate higher than the growth rate—just as we had Ramanan’s caloric input at 5000 calories and his burn rate at only 2000—and this will ensure that the debt ratio grows (just as we ensured that Ramanan’s waistline grew without limit). Let us see how this works.

We will start with a simple example similar to the one used in our blog and response last week. Let us have two sectors, government and private. Our government follows the Goldilocks model, spending less than its income (tax revenue); the private sector by identity runs a deficit (spends more than its income). We know this means the private sector is running up debt, held by the government as its asset (surpluses are realized in the form of private sector IOUs). The private sector must service the debt by paying interest; that of course adds to its deficit (interest is additional spending it must make out of its income). In comparison to our Supersizing Ramanan, the sustainability conditions will be determined by the interest rate paid, the growth rate of income (or GDP), and the deficit of the private sector.

Jamie Galbraith laid out the typical model used to evaluate sustainability of deficit spending as follows:

The key formula is:

Δd = –s + d * [(r – g)/(1 + g)]

Here, d is the starting ratio of debt to GDP, s is the “primary surplus” or budget surplus after deducting net interest payments (as shares of GDP), r is the real interest rate, and g is the real rate of GDP growth. (http://www.levyinstitute.org/publications/?docid=1379)

Now, this is wonky but the key idea is that (given a relation between the primary surplus and starting debt--both as ratios to GDP) so long as the interest rate (r) is above the growth rate (g) the debt ratio is going to grow. (Jamie has put these key terms in “real”—that is inflation adjusted—terms but that really does not matter; we can keep it all in nominal terms since “deflation” by the inflation rate merely reduces all terms by the inflation rate). Note that the starting debt ratio (d) as well as the primary surplus (what the private sector’s budget would be if it did not have to pay interest) also play a role. (Galbraith proves that the starting debt ratio does not matter much—just as Ramanan’s initial weight will not matter since in any case he will grow to an infinite size.) But we do not need to get too hung up in math to see that all things equal if the interest rate is above the growth rate, we get a rising debt ratio. If we carry this through eternity, that ratio gets big. Really big. Ok that sounds bad. And it is. Remember, that is a big part of the reason that the GFC hit—overindebted private sector. The GFC is the equivalent to an explosion of Ramanan that would prevent him from growing to an infinite size. (A debt diet would have been far preferable, but Greenspan and Bernanke opposed “interfering” with Wall Street lender fraud.)

Now let us change all this around. Let us say that the government runs a continuous budget deficit while the private sector runs a surplus. We can obtain the same equation. It appears that a continuous government budget deficit implies a continuously rising debt to GDP ratio and surely that is unsustainable. (See the appendix below for more complex math.)

But wait a minute. Is such a mental exercise sensible? We already saw that our supersizing Ramanan is going to adjust: he will diet, explode, increase his metabolism, and reduce the efficiency of his absorption of calories. If he does not explode, he will reach some “equilibrium” in which his intake of calories will equal his burn-rate so that his waistline will stop growing. What about our supersizing government? Here are the possible consequences of a persistent deficit that implies rising interest payments and debt ratios:

1. Inflation: this tends to increase tax revenues so that they grow faster than government spending, thus lowering deficits. (Many, including Galbraith, would point to the tendency to generate “negative” interest rates.) In other words the growth rate will rise above the interest rate, and reverse the dynamics so that the debt ratio stops growing. (That is equivalent to an increase of Ramanan’s caloric burn rate—so he stops growing.)
2. Austerity: government can try to adjust its fiscal stance (increasing taxes and reducing spending to lower its defict). Of course, it takes “two to tango”—raising tax rates might not change the government’s balance. It could lower growth rates, and thereby actually increase the rate of growth of the debt ratio.
3. The private sector will adjust its flows (spending and saving) in response to the government’s stance. If government continually spends more than its income, it will be adding net wealth to the private sector; and its interest payments will add to private sector income. It is not plausible to believe that as the government’s debt ratio goes toward infinity (which means that the private sector’s net wealth ratio goes to infinity) there is no induced spending in the private sector. That is usually called the “wealth effect”. In other words, government debt is private wealth and as private wealth grows without limit this will eventually cause spending to rise relative to private sector income—reducing government deficits. In addition, private sector income includes government interest payments, so rising government interest payments on its debt could induce consumption. When all is said and done, the private sector will not be happy consuming less than its income flow—given its rising wealth—and will adjust its saving behavior. If the private sector tries to reduce its surpluses, this can be done only by reducing the government sector’s deficits. It takes two to tango and the likely result is that tax revenues and consumption will rise, the government’s deficit will fall, and the private sector’s surplus will fall.
4. Government deficit spending and interest payments could increase the growth rate; it can be pushed above the interest rate. This changes the dynamics and can stop the growth of the debt ratio.
5. The interest rate is a policy variable (as will be discussed in subsequent weeks). Ignoring all the dynamics discussed in the previous points, to avoid an exploding debt ratio, all the government needs to do is to lower the interest rate below the economic growth rate. End of story, sustainability achieved.

Finally, and this is the most contentious point. Suppose none of the dynamics just discussed come into play, so the government’s debt ratio rises on trend. Will a sovereign government be forced to miss an interest payment—no matter how big that becomes? The answer is a simple “no”. It will take weeks of explication of MMT to explain why. But let us put this in the simple terms that Chairman Bernanke used to explain all the Fed spending to bail-out Wall Street: government spends using keystrokes, or, electronic entries on balance sheets. There is no technical or operational limit to its ability to do that. So long as there are keyboard keys to stroke, government can stroke them to produce interest payments credited to balance sheets.

And that finally gets us to the difference between perpetual private sector deficit spending versus perpetual government sector deficits: the first really is unsustainable while the second is not. Now, I want to be clear. We have argued that persistent government budget deficits that increase government debt ratios and thus private wealth ratios will lead to behavioral changes. They could lead to inflation. They could lead to policy changes. Hence, they are not likely to last “forever”. So when I say they are “sustainable” I merely mean in the sense that sovereign government can continue to make all payments as they come due—including interest payments—no matter how big those payments become. It might choose not to make those payments. And the mere act of making those payments will likely cause changes in growth rates and budget deficits and growth of debt rations.

2. “Sustainability” of Current Account ratios:

In the quote at the top of this response there was also a contingent statement about US current account deficits. To be more clear (and thus to respond to comments), the current account includes the balance of trade (and, more broadly, the balance between exports and imports) plus some other items including “factor payments” (interest and profits paid and received). For the US, we obviously run a trade deficit (and exports are less than imports), but the factor payments are in our favor (we receive more in profits and interest from abroad than we pay to foreign creditors and owners). In any event, our negative current account balance is offset by a positive capital account balance. To put it simply—there is a “flow” of dollars abroad due to the current account deficit that is matched by the “flow” of dollars back to the US due to our capital account surplus. This is often (misleadingly) presented as US “borrowing” of dollars to “pay for” our trade deficit. We could just as well put it this way: the US imports more than it exports because the rest of the world wants to accumulate savings in dollar-denominated assets. I do not want to go into that in detail since it is the subject of later blogs.

But here’s the question. Is a continuous current account deficit possible? A simple answer is yes, so long as “two want to tango”: if the rest of the world wants dollar assets and Americans want rest of world exports (imported to the US), this will continue. But, hold it, say the worriers. As the rest of the world accumulates dollar claims on the US, they also receive interest payments. That is a factor payment that increases our current account deficit. You can see the relation to the point above about government deficits and interest payments. The world will be flooded with dollars twice over: once from our excessive propensity to import and once from our interest payments on debt.

But here is the interesting point: even though the US is the “biggest debtor on earth”, those factor payments flow in our favor. We pay extremely low interest rates and profit rates to foreigners, and earn much higher interest rates and profits on our holdings of foreign investments and debt. Why is that? Because the US is the safest investment on earth. Anytime there is a financial crisis anywhere in the world, where do international investors run? To the US dollar. Ironically, that happens even when the crisis begins in the US! Why? The US has a sovereign government with a sovereign currency. Its interest rate is set by the Fed, which can always set the rate below the US growth rate (and, indeed, as Galbraith points out, the inflation-adjusted interest rate is often below the “real” growth rate). In spite of the deficit hysteria whipped up by hedge fund billionaire Pete Peterson, no investor in her right mind believes there is any default risk on US Treasury debt. So when global fears rise, investors run to the dollar. This could change, but not in your lifetime.

In short, I make no projection about continued US current account deficits but I believe they will continue far longer than anyone imagines. They are sustainable. They will be sustained until the rest of the world decides not to accumulate more dollars and Americans decide they really do not want the cheap junk and environment-destroying oil produced by the rest of the world. When that will happen, I do not know. It is nothing to lose sleep over. Yes we can calculate “sustainability conditions” but it would just be an exercise in mental masturbation. We’ve already done enough of that. I suppose it is titillating but ultimately unsatisfying.

3. Briefly there were several other points raised.

There were some about maldistribution of income as a contributing cause of the private sector deficit. Agreed. There were some questions about stocks and relations to flows. Some of that is treated above but much more will come in the next series of blogs. There were points made about need to regulate Wall Street. Yes! There were questions about QE and the difference between helicopter drops and fiscal policy. Put it this way: Treasury SPENDS money things into existence, the Fed LENDS money things into existence. The first adds income and net wealth, the second only transforms balance sheets. This will be explained in more detail later.

Appendix:

Government debt outstanding (D) follows the following law of motion:

That is, every year, assuming the debt never matures, the outstanding debt increases by the size of the deficit. The deficit is the difference between government spending (G), taxes (T) plus interest payments on outstanding debt (iD)

Let us assume to simplify that G = T so: therefore

The gross domestic product (Y) grows at a rate g and so follows the following law of motion:

Let us find the limit of this ratio:

Following the same logic for Y we get (noting d the debt to gdp ratio)

It is pretty clear that if i > g then the ratio tends toward infinity when n tends toward infinity; and toward zero otherwise. If g = i then dt = d0 for all t.

The complication of the deficit to GDP ratio at 5% would mean:

Without going too far into the implications we have:

Therefore by doing a recursive calculation we get:

As n tends toward infinity dt also does. Note that a given deficit to gdp ratio means that deficit has to explode as gdp increases.

Thanks: to James Galbraith and Eric Tymoigne.

Dawn of the Gargoyles: Romney Proves He’s Learned Nothing from the Crisis

By William K. Black

Mitt Romney chose to unveil the economic plank of his campaign for the Republican nomination with a speech in Aurora, Colorado decrying banking regulation.  He could not have picked a more symbolic location to make this argument, for Aurora is the home and name of one of the massive financial frauds that caused the Great Recession.  Lehman Brothers’ collapse made the crisis acute and Lehman’s subsidiary, Aurora, doomed Lehman Brothers.  Lehman acquired Aurora to be its liar’s loan specialist.  The senior officers that Lehman put in charge of Aurora, which was inherently in the business of buying and selling fraudulent loans, set its ethical plane at subterranean levels.

Aurora sealed Lehman’s fate by serving as a “vector” that spread an epidemic of mortgage fraud throughout the financial system and caused catastrophic losses far greater than Lehman’s entire purported capital.  Aurora epitomizes what happens when we demonize the regulators and create regulatory “black holes.”  Romney literally demonized banking regulators as “gargoyles” and claimed that banking regulations and regulators were the cause of the economy’s weak recovery.

On April 20, 2010, I testified before the Committee on Financial Services of the United States House of Representatives regarding Lehman’s failure.  I was the witness chosen by the (then) Republican minority because they wished to have testimony from an experienced and successful financial regulator who would pull no punches in critiquing the failures of the Federal Reserve Bank of New York (FRBNY), the Board of Governors of the Federal Reserve (the Fed), and the Securities and Exchange Commission (SEC) with regard to Lehman.  The Republicans’ target was the former President of the FRBNY, Timothy Geithner. 

My House testimony explained why Aurora was the key to understanding Lehman’s failure and the causes of the financial crisis. 

Lehman was a “control fraud.”  That is a criminology term that refers to situation in which the persons controlling a seemingly legitimate entity use it as a “weapon” (Wheeler & Rothman 1982) of fraud (Black 2005).   Financial control frauds’ “weapon of choice” for looting is accounting.

Lehman’s nominal corporate governance structure was a sham.  Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.”  Lehman did not “manage” the risk of making liar’s loans.  It engaged in massive, fraudulent transactions that were “sure things” (Akerlof & Romer 1993).  The Valukas Report … provides further evidence of the accuracy of George Akerlof and Paul Romer’s famous article – “Looting: Bankruptcy for Profit.”  The “looting” that Akerlof & Romer identified is a “sure thing” in both directions – firms that loot through accounting scams will report superb (fictional) income in the short-term and catastrophic losses in the long-term. 

The value of Lehman's Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.[1]

     

This roughly $9 billion loss, in 2008, was an important factor in destroying Lehman, but it represents only losses on liar’s loans still held in portfolio.  Aurora specialized in making liar’s loans and Aurora’s loans caused massive losses because they were pervasively fraudulent.    Lehman sold tens of billions of dollars of liar’s loans through Aurora and a subsidiary (BNC Mortgage) that specialized in making subprime loans – roughly half of which were liar’s loans by 2006.  The purchasers of these fraudulent loans had the legal right and economic incentive to require Lehman to repurchase the loans, which would have far exceeded Lehman’s reported capital.  Making and selling fraudulent liar’s loans doomed Lehman.  Lehman was one of the largest vectors that spread fraudulent mortgage paper throughout much of Europe and the United States.

Lehman had become the only vertically integrated player in the industry, doing everything from making loans to securitizing them for sale to investors.

***

Lehman was a dominant player on all sides of the business. Through its subsidiaries – Aurora, BNC Mortgage LLC and Finance America – it was one of the 10 largest mortgage lenders in the U.S. The subsidiaries fed nearly all their loans to Lehman, making it one of the largest issuers of mortgage-backed securities. In 2007, Lehman securitized more than $100-billion worth of residential mortgages.

These demands posed a much larger problem: contagion. Because these CDOs were thinly traded, many of them did not yet reflect the loss in value implied by their crumbling mortgage holdings. If Bear Stearns or its lenders began auctioning these CDOs off, and nobody wanted to buy them, prices would plummet, requiring all banks with mortgage exposure to begin adjusting their books with massive writedowns.

Lehman, despite its huge mortgage exposure, appeared less scathed than some. Mr. Fuld was awarded $35-million in total compensation at the end of the year.

The volume of liar’s loans and subprime loans was everything – as long as Lehman could sell the liar’s loans to other parties.  Volume created immense real losses, but it also maximized Dick Fuld’s compensation.  Nonprime loans drove Lehman’s (fictional) gains in income and capital under Fuld.

Marshall Auerback Interviewed on Squeeze Play

NEP Blogger Marshall Auerback was interviewed yesterday on Greece and the Eurozone on BNN's Squeeze Play.  Click here to watch.

Can Sesame Street Help Europe’s Finance Ministers Understand the Debt Crisis? (Members of Congress Take Note)

By Stephanie Kelton

You might expect the head of the group of countries that use the euro to understand the common currency better than anyone. You would be wrong.

Jean-Claude Juncker, head of the Eurozone’s group of finance ministers, can’t figure out why financial markets are so anxious about Europe’s ability to service its debt and so unconcerned about debt levels in other parts of the world. He’s convinced that Europe’s fundamentals are better than ours, so he can’t figure out why investors are gobbling up Treasuries despite the “disastrous” debt level here in this United States. To him, financial markets appear to be getting it badly wrong. He said:

"The real problem is that no one can explain well why the euro zone is in the epicenter of a global financial challenge at a moment, at which the fundamental indicators of the euro zone are substantially better than those of the U.S. or Japanese economy."

Well, Mr. Junker, not only have we – the scholars of MMT – explained why the debt crisis hit members of the Eurozone, we also predicted that the design of the euro system would lead, precisely, to this outcome. Even before the launching of the euro, people like Charles Goodhart, Wynne Godley, Jan Kregel and Warren Mosler were sounding the alarms, warning that the Maastricht Treaty contained a dangerous design flaw that would strip member nations of their power to safely expand their deficits in times of economic crises. And so while mainstream economists like Willem Buiter were busy arguing over the appropriateness of the 3% deficit-to-GDP and 60% debt-to-GDP limits established under the Stability and Growth Pact (SGP), those of us working in the MMT tradition were busy pointing out that bond markets, not the SGP, would impose the relevant constraint under the new monetary system. I wrote in 2003:

“[B]y forsaking their monetary independence and agreeing to the terms set out in Article 104 of the Maastricht Treaty …. obligations issued by EUR-11 governments begin to resemble those issued by state and local governments in the United States ….. Since markets will perceive some members of the EUR-11 as more creditworthy than others, financial markets will not view bonds issued by different nations as perfect substitutes. Therefore, high-debt countries may be unable to secure funding on the same terms as their low-debt competitors. ….. if interest payments are becoming a significant portion of a member state’s total outlays, it may be difficult to convince financial markets to accept new issues in order to service the growing debt.”

As a group, we warned that without a fiscal analogue to the ECB, the euro was essentially an accident waiting to happen – a sort of ticking bomb, ready to ignite the periphery at the slightest strain on public budgets. We wrote pamphlets, articles, chapters and books, travelled the Eurozone, met with elected officials, appeared on television, radio, and in print media.

It Became Necessary to Destroy the Periphery in Order to Save the Core’s Banks

By William K. Black

* Cross-posted with Benziga

Gary O’Callaghan, a former IMF economist has written about his distress over what he views as the European Central Bank’s (ECB’s) destructive policies toward the periphery. 

The ECB, EU, and the IMF are the troika that contributed to the periphery’s crises and have responded in such a destructive manner to the crises.  O’Callaghan’s column urges the European finance ministers to focus on “three simple questions about the [troika’s] Irish, Greek and Portuguese” loan programs.  My column focuses on the reasoning underlying his third question.

“Third, how important is it that the programs succeed?  Obviously it is crucial.  The success of the programs is key to the survival of the euro and should, therefore, take precedence over any other European agenda.” 

O’Callaghan, unintentionally, has disclosed the core irrationality that underlies the euro.  It is not “obvious” that “the survival of the euro” is critical, much less a goal of such transcendent importance that it should “take precedence over any other European agenda.”  The euro is simply instrumental to some substantive purpose such as economic security, employment, or at least increased efficiency.  The economic welfare of the people of the EU should be the EU’s transcendent economic goal.    

Recent USA Sectoral Balances: Goldilocks, the Global Crash, and the Perfect Fiscal Storm

In the previous blog, we did some heavy lifting. Unless you are an economics or accounting nerd, you found it quite boring. This week we will take a little break from pure accounting, and apply what we’ve learned to a real world example. By now, long-time readers are quite familiar with the NEP’s approach to the GFC (global financial crisis). Let us revisit the Clintonian Goldilocks economy to find the seeds of the GFC, using our sectoral balance approach.

To be clear, what follows uses our sectoral balances identity plus some real world data to provide an interpretation of the causes of the crash. As always, interpretations are subject to disagreement. The identity as well as the data are not. (You can of course always begin analysis with other identities and other data.) Next week we return to a bit more accounting.

Back in 2002 I wrote a paper announcing that forces were aligned to produce the perfect fiscal storm. (I note that in recent days a few analysts—including Nouriel Roubini—have picked up that terminology.) What I was talking about was a budget crisis at the state and local government levels. I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996. As we now know, I called it too soon—the private sector continued to spend more than its income until 2006. The economy then crashed—a casualty of the excesses. What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath.

Still, it is worthwhile to return to the so-called “Goldilocks” period (mid to late 1990s, said to be “just right”, with growth sufficiently strong to keep unemployment low, but not so swift that it caused inflation) to see why economists and policymakers still get it wrong. As I noted in that earlier paper,

It is ironic that on June 29, 1999 the Wall Street Journal ran two long articles, one boasting that government surpluses would wipe out the national debt and add to national saving—and the other scratching its head wondering why private saving had gone negative. The caption to a graph showing personal saving and government deficits/surpluses proclaimed “As the government saves, people spend”. (The Wall Street Journal front page is reproduced below.) Almost no one at the time (or since!) recognized the necessary relation between these two that is implied by aggregate balance sheets. Since the economic slowdown that began at the end of 2000, the government balance sheet has reversed toward a deficit that reached 3.5% of GDP last quarter, while the private sector’s financial balance improved to a deficit of 1% of GDP. So long as the balance of payments deficit remains in the four-to-five percent of GDP range, a private sector surplus cannot be achieved until the federal budget’s deficit rises beyond 5% of GDP (as we’ll see in a moment, state and local government will continue to run aggregate surpluses, increasing the size of the necessary federal deficit). [I]n recession the private sector normally runs a surplus of at least 3% of GDP; given our trade deficit, this implies the federal budget deficit will rise to 7% or more if a deep recession is in store. At that point, the Wall Street Journal will no doubt chastise: “As the people save, the government spends”, calling for a tighter fiscal stance to increase national saving!

Turning to the international sphere, it should be noted that US Goldilocks growth was not unique in its character. [P]ublic sector balances in most of the OECD nations tightened considerably in the past decade--at least in part due to attempts to tighten budgets in line with the Washington Consensus (and for Euroland, in line with the dictates of Maastricht criteria). (Japan, of course, stands out as the glaring exception—it ran large budget surpluses at the end of the 1980s before collapsing into a prolonged recession that wiped out government revenue and resulted in a government deficit of nearly 9% of GDP.) Tighter public balances implied deterioration of private sector balances. Except for the case of nations that could run trade surpluses, the tighter fiscal stances around the world necessarily implied more fragile private sector balances. Indeed, Canada, the UK and Australia all achieved private sector deficits at some point near the beginning of the new millennium. (Source: L. Randall Wray, “The Perfect Fiscal Storm” 2002, available at http://www.epicoalition.org/docs/perfect_fiscal_storm.htm)

Let us revisit “Goldilocks” and see what lessons we can learn from “her” that help us to understand the Global Financial Collapse that began in 2007. As we now know, my short-term projections predicting the demise of Goldilocks into a recession were not too bad, but the medium-term projections were off. The Bush deficit did grow to 5% of GDP, helping the economy to recover. But then the private sector moved right back to huge deficits as lender fraud fuelled a real estate boom as well as a consumption boom (financed by home equity loans). See the chart below (thanks to Scott Fullwiler). Note that we have divided each sectoral balance by GDP (since we are dividing each balance by the same number—GDP—this does not change the relationships; it only “scales” the balances). This is a convenient scaling that we will use often in the MMP. Since most macroeconomic data tends to grow over time, dividing by GDP makes it easier to plot (and rather than dealing with trillions of dollars—so many zeroes!—we express everything as a percent of total spending).

This chart shows the “mirror image”: a government deficit from 1980 through to the Goldilocks years is the mirror image of the domestic private sector’s surplus plus our current account deficit (shown as a positive number because it reflects a positive capital account balance—the rest of the world runs a positive financial balance against us). (Note: the chart confirms what we learned from Blog #2: the sum of deficits and surpluses across the three sectors must equal zero.) During the Clinton years as the government budget moved to surplus, it was the private sector’s deficit that was the mirror image to the budget surplus plus the current account deficit.

This mirror image is what the Wall Street Journal had failed to recognize—and what almost no one except those following the Modern Money approach as well as the Levy Economic Institute’s researchers who used Wynne Godley’s sectoral balance approach understand. After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell.

Unfortunately, just as policymakers learned the wrong lessons from the Clinton administration budget surpluses—thinking that the federal budget surpluses were great while they actually were just the flip side to the private sector’s deficit spending—they are now learning the wrong lessons from the global crash after 2007. They’ve managed to convince themselves that it is all caused by government sector profligacy. This, in turn has led to calls for spending cuts (and, more rarely, tax increases) to reduce budget deficits in many countries around the world (notably, in the US and UK).

The reality is different: Wall Street’s excesses led to too much private sector debt that crashed the economy and reduced government tax revenues. This caused a tremendous increase of federal government deficits. {As a sovereign currency-issuer, the federal government faces no solvency constraints (readers will have to take that claim at face value for now—it is the topic for upcoming MMP blogs).} However, the downturn hurt state and local government revenue. Hence, they responded by cutting spending, laying-off workers, and searching for revenue.

The fiscal storm that killed state budgets is the same fiscal storm that created the federal budget deficits shown in the chart above. An economy cannot lose about 8% of GDP (due to spending cuts by households, firms and local and state governments) and over 8 million jobs without negatively impacting government budgets. Tax revenue has collapsed at an historic pace. Federal, state, and local government deficits will not fall until robust recovery returns—ending the perfect fiscal storm.

Robust recovery will reduce the overall government sector’s budget deficit as the private sector reduces its budget surplus. It is probable that our current account deficit will grow a bit when we recover. If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Private Balance (+2) + Government Balance (-5) + Foreign Balance (+3) = 0.

And so we are back to the concept of zero!