Control Frauds Continue to Maim and Kill

By William K Black

The financial scandal and the Great Recession that it caused have understandably captured the bulk of our attention, but we must not lose sight of the fact that “control frauds” continue to maim and kill enormous numbers of people and damage the environment and society throughout the world.  Several examples of these frauds have led to recent press reports.  I write to point out that control fraud is the common feature of these scandals.  I address four recent manifestations of control fraud:  the French manufacturer of defective silicone breast implants, the death of many Fillipinoes in floods made lethal by illegal deforestation, the deaths and devastation caused by illegal seizure and exploitation of mines in the Congo, and the scrap metal dealers who put the profit in the theft of metals in the UK.  This first column explains the French breast implant fraud.

President Obama Negotiates our Formal Surrender to Crony Capitalism – and the Nation Yawns

By William K. Black

On December 13, 2011, the Wall Street Journal published an article entitled “Banks in Push for Pact.” It was an obscure article buried in the real estate section.  The article contained this clause:  “Under the proposal, banks would be released from legal claims tied to servicing delinquent mortgages as well as certain mortgage-origination practices….”  Opponents of this proposed amnesty for mortgage-origination fraud have charged repeatedly that the federal government and Tom Miller, the Attorney General of Iowa, who is leading the settlement negotiations, support the amnesty.  Previously, Miller’s key lieutenant, but not the Obama administration, angrily denounced the charge. 

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part Six

By Dan Kervick

I will conclude by proposing six social tasks for the rising generation – six challenging tasks whose successful pursuit will help us achieve a more just, equal and democratic society.   It is my view that the resulting society will not only be fairer and more decent.   It will also be more economically productive, and will better promote human happiness and flourishing by more effectively distributing the goods and services we produce.    Most of us will be happier in such a society as well, because the practices of democratic equality do a better job satisfying the human desires for cooperation, solidarity, trust, stability and fellowship that are the foundation of the social life for which human beings are naturally framed.

Fannie and Freddie Fantasies

By William K. Black

(Cross-posted from Benzinga)

An important but fundamentally flawed debate about Fannie and Freddie’s role in the ongoing crisis has raged since the SEC sued the former senior managers of both entities for securities fraud.  The Wall Street Journal and Peter Wallison (in the WSJ) have claimed that the suit vindicates their positions and discredits the Federal Crisis Inquiry Commission (FCIC).  Joe Nocera, in his New York Times column, has thundered at the SEC and then Wallison, accusing him of “The Big Lie.”  Nocera’s column is also interesting because it (implicitly) argues that the thesis of Reckless Endangerment is incorrect.  His colleague Gretchen Morgenson and Joshua Rosner co-authored that book.  I write to provide yet another view, distinct from each of the sources. 

There are two primary issues about Fannie and Freddie and the crisis discussed in the debate.  First, why did Fannie and Freddie, relatively suddenly, change their business practices radically and begin purchasing large amounts of nonprime mortgages?  Second, what role did declining mortgage credit quality that did not descend to the level of loans that the industry described as “subprime” play in the Fannie and Freddie crisis?  The first issue is vastly more important and this article focuses on it.  (The short answer to the second question is:  “The first issue, for everyone except the SEC, comes down to this question: did Fannie and Freddie’s controlling officers (eventually) cause them to buy large amounts of nonprime loans for the same reason their counterparts running Lehman, Bear Stearns and Merrill Lynch did (the higher nominal short-term yield maximized their current compensation) or because “the government” made them buy the loans?)  (Lehman, Bear Stearns, and Merrill Lynch were not subject to any governmental requirements to purchase any category of nonprime loans.)

Did OFHEO Fix Fannie and Freddie’s Compensation Systems after discovering their Frauds?

By William K. Black

I have been chastised by a friend and former colleague for writing:

“Here is the crazy thing – the SEC, OFHEO, and Department of Justice all failed to demand that Fannie and Freddie end their perverse executive compensation system that made the executives wealthy through fraud and put the entities and the government at risk.”

My friend notes that Fannie, under pressure from OFHEO and with its prior approval, changed its compensation system after the initial accounting fraud.  

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part Five

By Dan Kervick

Where We Can Go from Here

I have asked the reader to follow me through a lengthy series of reflections and thought experiments on the nature and role of money in modern economies.   Some might ask why this issue is so important.  How can these ruminations on the nature of modern monetary systems help guide our thinking on the task of building a more fair and decent society of democratic equals?   How can they help us create a society in which democratic solidarity trumps self-regarding and avaricious greed, and in which broad and shared prosperity replaces the concentrated economic privilege and supremacy of the few?

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part Four

By Dan Kervick

Is The United States a Monetary Sovereign?

I have set out a simplified model of a monetarily sovereign government.   But near the end of the previous section, I began to suggest that the United States government is indeed a monetary sovereign by this kind.   The reader might now suspect that I have yielded my rational mind over to a simplistic fiction of my own creation.   And by this point, the reader is probably thinking that however interesting it might be to imagine this fictional entity, the so-called monetary sovereign, such fictions have nothing to do with the complexities of the real world, because actual governments maintain accounts that are indeed constrained by the amount of money in those accounts and by the external sources of funding to which they have access.   After all, can’t a government default on its debt?  What about the recent debt ceiling debate in the US?  What about what is happening in Europe with the sovereign debt crisis?   Also, if a government like the United States government was a monetary sovereign of the kind I have described, the consequences would seem to be enormous.  Surely if a democratic government possessed this kind of power, we would make much more use of it than we do.   In short, monetary sovereignty as described seems both too simple to be real and too good to be true.

What if the SEC investigated Banks the way it is investigating Mutual Funds?

By William K. Black 

The Wall Street Journal ran a story today (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.”

“Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.

The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won't say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the "aberrational performance initiative."” The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds). 

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part Three

By Dan Kervick

Consequences of Monetary Sovereignty

Now so far, I have described the operations of the monetary sovereign as though money were the only thing in the world.   But this is clearly not the case.   The model of the monetary sovereign I have developed is intended to be a model of a government.   And while governments might have nearly unlimited and very easily deployed power in the creation and destruction of money, a government also participates in the exchange of real goods and services.   And these goods and services are clearly finite.    So there is something very special about money which is yet to be considered.

Let’s remember that government spending – insertions of money - can come in different varieties: there are purchases, in which money is inserted into a private sector account in exchange for some good or service delivered to the sovereign; and there are straight transfers, in which some money is inserted into a private sector account without condition, with the government receiving nothing in return.    Similarly, we need to recall that government receipts – removals of money -  can come also in different varieties: there are sales, in which money is removed from a private sector account in exchange for some good or service delivered by the government to the owner of that account – as when someone buys a carton from the postal service, for example - and there are taxes, in which some money is removed from a private sector account without condition, with the owner of that account receiving nothing in return.

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part Two

By Dan Kervick

Reflections on Modern Money

Before considering what it would mean to make our monetary system more democratic, let’s begin by calling to mind a few familiar features of money and modern monetary systems in general, features we all intuitively understand as users of money in a modern monetary economy.

First, money obviously comes in very different forms.   Not only are there different currency systems – the dollar system, the euro system, the renminbi system, etc. – but even within a single system, money can take significantly different forms.   There is all of that familiar paper and metal currency, consisting of tangible objects that can be physically transported from one hand to another, and that are denominated with different face values.  But money might also exist simply as “points” electronically credited to someone’s digital monetary scorecard at a bank.  These points are debited from and credited to various accounts, and need never be exchanged for physical currency.   We can already see a near future in which the traditional material currency of metal coins and paper notes will no longer be used.   In thinking about our modern monetary system, then, it is useful to think of it as a network of such monetary scorecards.   And we can think of the exchange of physical paper and metal currency as just one among several ways of adding and subtracting points from the monetary scorecards of those who exchange the money.   Each individual possess such a scorecard, but so do businesses, governments and other organizations.

MMP Blog #29: What about a country that adopts a foreign currency? Part Two

By L. Randall Wray

Yet another rescue plan for the EMU is making its way through central Europe—with the ECB acting as lender of last resort to Euro-banks. It is trying the tried-and-failed Fed method of rescue. As we now know the Fed lent and spent over $29 TRILLION trying to rescue (mostly) US banks. It did not work. The biggest banks are still insolvent, and have continued their massive frauds trying to cover up their insolvencies. You cannot paper-over insolvency through massive lending by the central bank. And the Euroland problems are compounded by the insolvencies of virtually all their member states.

To be sure, we also have probable insolvencies of some of our US states—but we’ve got a sovereign government that will eventually do the right thing (as Mr. Churchill famously said, Americans get around to that, after trying everything else first). But the Euro states do not have any sovereign backing them up. And note that the ECB remains unwilling to do the job. A disastrous financial collapse and possible Great Depression 2.0 remains the most likely scenario.

How Did Euroland Get Into Such A Mess? Part One: Private Debt

We all know the favourite story told: profligate-spending Mediterranean governments blew up their budgets, causing the crisis. If only they had followed the example of Germany—as they were supposed to do once they joined the Euro—the EMU would have worked just fine.

While the story of fiscal excess is a stretch even in the case of the Greeks, it doesn’t easily apply to Ireland and Iceland—or even to Spain—all of which had low budget deficits (or even surpluses) until the crisis hit. In truth, there were two problems.

First, like most Western countries, private sector debts blew up in many Euroland countries after the financial system was de-regulated and de-supervised. To label this a sovereign debt problem is quite misleading. The dynamics are surely complex but it is clear that there is something that is driving debt growth in the developed world that cannot be reduced to runaway government budget deficits. Nor does it make sense to point fingers at Mediterraneans since it is (largely) the English-speaking world of the US, UK, Canada and Australia that has seen some of the biggest increases of household debt—the total US debt ratio reached 500%, of which household debt alone is 100%, and financial institution debt is another 125% of GDP.

Take a look at this graph, which shows the debt-to-GDP ratios for the private and government sectors:

Clearly, up to 2007 the really big debt ratios were in the private sector. The story is very similar to that of the US. But note that the problem tends to be worse in those countries with smaller government debts—there is an inverse relation between private debt ratios and government debt ratios. Now why is that?

And as we know from previous MMP sections, the sectoral balance identity shows the domestic private balance equals the sum of the domestic government balance less the external balance. To put it succinctly, if a nation (say, the US) runs a current account deficit, then its domestic private balance (households plus firms) equals its government balance less that current account deficit. To make this concrete, when the US runs a current account deficit of 5% of GDP and a budget deficit of 10% of GDP its domestic sector has a surplus of 5%; or if its current account deficit is 8% of GDP and its budget deficit is 3% then the private sector must have a deficit of 5%--running up its debt.

{An aside: A big reason why much of the developed world has had a growth of its outstanding private and public sector debts relative to GDP is because we have witnessed the rise of BRIC (and others—especially in Asia) current account surpluses—matched by current account deficits in the developed Western nations taken as a whole. Hence, developed country budget deficits have widened even as their private sector debts have grown. By itself, this is neither good nor bad. But over time, the debt ratios and hence debt service commitments of Western domestic private sectors got too large. This was a major contributing factor to the GFC.}

Our Austerians see the solution in belt-tightening, especially by Western governments. But that tends to slow growth, increase unemployment, and hence increase the burden of private sector debt. The idea is that this will reduce government debt and deficit ratios but in practice that does not work due to impacts on the domestic private sector. Tightening the fiscal stance can occur in conjunction with reduction of private sector debts and deficits only if somehow this reduces current account deficits. Yet many nations around the world rely on current account surpluses to fuel domestic growth and to keep domestic government and private sector balance sheets strong. They therefor react to fiscal tightening by trading partners—either by depreciating their exchange rates or by lowering their costs. In the end, this sets off a sort of modern Mercantilist dynamic that leads to race to the bottom policies that few Western nations can win.

Germany, however has specialized in such dynamics and has played its cards well. It has held the line on nominal wages while greatly increasing productivity. As a result, in spite of reasonably high living standards it has become a low cost producer in Europe. Given productivity advantages it can go toe-to-toe against non-Euro countries in spite of what looks like an overvalued currency. For Germany however, the euro is significantly undervalued—even though most euro nations find it overvalued. The result is that Germany has operated with a current account surplus that allowed its domestic private sector and government to run deficits that were relatively small. Germany’s overall debt ratio is at 200% of GDP, approximately 50% of GDP lower than the Euro zone average.

Not surprisingly, the sectoral balances identity hit the periphery nations particularly hard as they suffer from what is for them an overvalued euro, and lower productivity than Germany enjoys. With current accounts biased toward deficits it is not a surprise to find that the Mediterraneans have bigger government and private sector debt loads.

Now, if Europe’s center understood balance sheets, it would be obvious that Germany’s relatively “better” balances rely on the periphery’s relatively “worse” balances. If each had separate currencies, the solution would be to adjust exchange rates so that our debtors would have depreciation and Germany would have an appreciating currency. Since within the euro this is not possible, the only price adjustment that can work would be either rising wages and prices in Germany or falling wages and prices on the periphery. But ECB, Bundesbank and EU policy more generally will not allow significant wage and price inflation in the center. Hence the only solution is persistent deflationary pressures on the periphery. Those dynamics lead to slow growth and hence compound the debt burden problems.

How Did Euroland Get Into Such A Mess? Part Two: Government Debt

To be sure, the private debt problem—related to the internal European dynamics of a strong mercantilist Germany in the center—would be very hard to resolve. But Euroland has an even more fatal problem: the Euro, itself. So let us turn to that second problem.

The fundamental fault with the set-up of the EMU was the separation of nations from their currencies. It was a system designed to fail. It would be like a USA with no Washington—with each state fully responsible not only for state spending, but also for social security, health care, natural disasters, and bail-outs of financial institutions within its borders.  In the US, all of those responsibilities fall under the purview of the issuers of the national currency—the Fed and the Treasury. In truth, the Fed must play a subsidiary role because like the ECB it is prohibited from directly buying Treasury debt. It can only lend to financial institutions, and purchase government debt in the open market. It can help to stabilize the financial system, but can only lend, not spend, dollars into existence. The Treasury spends them into existence. When Congress is not preoccupied with Kindergarten-level spats over debt ceilings that arrangement works almost tolerably well—a hurricane in the Gulf leads to Treasury spending to relieve the pain. A national economic disaster generates a Federal budget deficit of 5 or 10 percent of GDP to relieve pain.

That cannot happen in Euroland, where the Euro Parliament’s budget is less than one percent of GDP. The first serious Euro-wide financial crisis would expose the flaws. And it did.

Member states became much like US states, but with two key differences. First, while US states can and do rely on fiscal transfers from Washington—which controls a budget equal to more than a fifth of US GDP—EMU member states got an underfunded European Parliament with a total budget of less than 1% of Europe’s GDP. (To make it even worse, the Parliament’s funding comes from the member states!)

This meant that member states were responsible for dealing not only with the routine expenditures on social welfare (health care, retirement, poverty relief) but also had to rise to the challenge of economic and financial crises.

The second difference is that Maastricht criteria were far too lax—permitting outrageously high budget deficits and government debt ratios.  Most of the critics had always (wrongly) argued that the Maastricht criteria were too tight—prohibiting member states from adding enough aggregate demand to keep their economies humming along at full employment. It is true that government spending was chronically too low across Europe as evidenced by chronically high unemployment and rotten growth in most places. But since these states were essentially spending and borrowing a foreign currency—the Euro—the Maastricht criteria permitted deficits and debts that were inappropriate.

Let us take a look at US states. All but two have balanced budget requirements—written into state constitutions—and all of them are disciplined by markets to submit balanced budgets. When a state finishes the year with a deficit, it faces a credit downgrade by our good friends the credit ratings agencies. (Yes, the same folks who thought that bundles of trash mortgages ought to be rated AAA—but that is not the topic today.) That would cause interest rates paid by states on their bonds to rise, raising budget deficits and fueling a vicious cycle of downgrades, rate hikes and burgeoning deficits. So a mixture of austerity, default on debt, and Federal government fiscal transfers keeps US state budget deficits low.

(Yes, I know that right now many states are facing Armageddon—especially California—as the global crisis has crashed revenues and caused deficits to explode. This is not an exception but rather demonstrates my argument.)

The following table shows the debt ratios of a selection of US states. Note that none of them even reaches 20% of GDP, less than a third of the Maastricht criteria.

Alaska	15.7	Montana	12.2
Connecticut	12.1	New Hampshire	13.0
Hawaii	12.2	New York	10.5
Maine	11.0	Rhode Island	16.9
Massachusetts	16.5	Vermont	12.6

By contrast, Euro states had much higher debt ratios—with only Ireland coming close to the low ratios we find among US states (the red line is drawn at the Maastricht criterion of 60%).

To be clear, none of these debt ratios would be too high for a sovereign government that issues its own currency. Remember that Japan’s government debt ratio is 200%--and its interest rate has been close to zero for two decades. But they are too high for nonsovereign nations that use a foreign currency.

Those who follow Modern Money Theory believed that market “discipline” would eventually impose debt and deficit limits far below Maastricht criteria—to ratios closer to those imposed on US states. And with no fiscal authority in the center to match the US Treasury, the first serious economic or financial crisis would expose the flaws of the design of the euro. Because the crisis would cause member state deficits and debts to grow. At the same time markets would begin to realize that these member states are much like US states but without the backstop of a European Treasury.

And that is precisely what has happened.

To be sure markets have not reacted simultaneously against all member states. If you think about it, this makes sense. There is a desire to hold euro-denominated debt—the euro is a strong currency and much of the world wants to buy European exports. So markets run out of Greece and Ireland and now Italy but need to get into other euro debt. Since Germany is the strongest member and by far the biggest exporter, it benefits the most from a run against the periphery.

Yet as Germany is a net exporter with a relatively small budget deficit, it is hard to get German debt. The biggest issuer of debt was Italy, and there was a strong belief in markets that because Italy’s debt is so large, it is like a Bank of America—too big to fail. And ditto for France and Spain. So spreads widened for Greece and Ireland and Portugal, but have only recently increased for Spain and Italy.

But after the agreement to accept a “voluntary” haircut of 50% on Greek debt, no prudent investor can any longer pretend that Italy, Spain or even France and Germany is a safe bet. Faith based investing in Euro debt is over. And note that if the stronger nations really do bail-out a Spain or an Italy, our friendly credit rating agencies will quickly downgrade the strong nations (they are now threatening France) for contributing funds to rescue their neighbors. Even Germany will not be safe if it participates in a bailout of Italy by committing funds.

There is thus a damned-if-you-do and damned-if-you-don’t dilemma. A bail-out by member states threatens the EMU by burdening and eventually bringing down the strong states; and allowing too-big-to-fail Italy to default would prove to markets that no member state is safe.

And this is why it does not matter how much the ECB lends to Eurobanks—the banks would be crazy to buy up government debt. And it is hard to believe that any US money managers can make a case that it is still prudent to invest in euro debt.

Many critics of the EMU have long blamed the ECB for sluggish growth, especially on the periphery. The argument is that it kept interest rates too high for full employment to be achieved. I have always thought that was wrong—not because I do not agree that lower interest rates are desirable, but because even with the best-run central bank, the real problem in the set-up was fiscal policy constraints. Indeed, several years ago, Claudio Sardoni and I demonstrated that the ECB’s policy was not significantly tighter than the Fed’s—but US economic performance was consistently better. The difference was fiscal policy—with Washington commanding a budget that was more than 20% of GDP, and usually running a budget deficit of several percent of GDP. By contrast, the EU Parliament’s budget could never run deficits like that. Individual nations tried to fill the gap with deficits by their own governments, these created the problems we see today—as the chickens came home to roost, so to speak.

Is There Any Solution?

Once the EMU weakness is understood, it is not hard to see the solutions. These include ramping up fiscal policy space of the EU parliament—say, increasing its budget to 15% of GDP with a capacity to issue debt. Whether the spending decisions should be centralized is a political matter—funds could simply be transferred to individual states on a per capita basis.

It can also be done by the ECB: change the rules so that the ECB can buy, say, an amount equal to 6% of Euroland GDP each year in the form of government debt issued by EMU members. As buyer it can set the interest rate—might be best to mandate that at the ECB’s overnight interest rate target or some mark-up above that. Again, the allocation would be on a percapita basis across the members. Note that this is similar to the blue bond, red bond proposal discussed above. Individual members could continue to also issue bonds to markets, so they could exceed the debt issue that is bought by the ECB—much as US states do issue bonds.

One can conceive of variations on this theme, such as creation of some EMU-wide funding authority backed by the ECB that issues debt to buy government debt from individual nations—again, along the lines of the blue bond proposal. What is essential, however, is that the backing comes from the center—the ECB or the EU stands behind the debt.

No amount of faith in the European integration is going to hide the flaws any longer. A comprehensive rescue by the ECB—which must stand ready to buy ALL member state debt at a price to ensure debt service costs below 3%--plus the creation of a central fiscal mechanism of a size appropriate to the needs of the European Union is the only way out. If these actions are not taken—and soon—the only option left is to dissolve the Union.

So, finally, returning to the “one nation-one currency” rule would allow each nation to recapture domestic policy space by returning to its own currency. There was never a strong argument for adopting the Euro, and the weaknesses have been exposed. Currency union without fiscal union was a mistake.

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy - Part One

By Dan Kervick

A new year is upon us.  And even before its first hour has been rung in, 2012 is already taking shape before us as a pivotal year in global politics.  We can all feel the awakening under way.   A revived longing for equality, shared prosperity and democratic solidarity is inspiring a vibrant new politics around the world.   This new activist spirit is quickened by the keen apprehension of young people on every continent that something is very, very wrong with the present economic and political order.   The rising generation, heirs to sick and damaged societies that have been unbalanced by decades of plutocratic rule and antisocial cupidity, have now begun to rouse themselves - and in the process they have rallied the moral outrage of their fellow citizens.

Government Spending with Self-Imposed Constraints: Responses to MMP #28

By L. Randall Wray

Comments are thankfully few and I already dealt with some of them. I doubt there will be many readers this week, but here we go:

Q1: Is it possible to show these transactions simply from a nominal perspective?

A: Look if you buy a stick of gum we need to show the "real"--you exchange a demand deposit for gum, your store gets the demand deposit and you get the gum. We can stick to purely "nominal" only if it is a financial transaction only. But you do pay "money" (the gum you buy was denominated in dollars) so it is valued in nominal terms: $1.45. If you did not think it was worth that you would not buy it. So that is the nominal value we put on it. Kenneth Boulding had a very nice way of looking at it. You exchange your liquid savings (deposit) for illiquid assets (gum); then you dissave over time as you consume them. As Boulding said, consumption is destruction of your assets--you chew your assets away. He said you get no satisfaction from consumption=destruction of assets. Tires on your car are a clearer example. You "consume" them over 5 years as you wear them out. You’d rather that they do not wear out, but they will. That is destruction of assets. It is a stock-flow consistent model. Boulding was among the most clever and greatest of economists.

AQ2 by WH: You wrote in Blog #24, referring to foreigner's accumulation of reserves, such as China's:
"Neither of these activities will force the hand of the issuing government—there is no pressure on it to offer higher interest rates to try to find buyers of its bonds...  Government can always “afford” larger  keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and thereby let markets  accumulate reserves instead." In world with self-imposed constraints like the US's, it doesn't have the option to stop selling bonds if it wants to deficit spend.  However, like you mention, bonds are an interest-earning alternative to reserves.  So: 1) If bonds are an interest-earning alternative to reserves, is there an economic reason why the ultimate holder of reserves (whether it's China or whoever China sells dollars to) would not place their reserves into US debt and at an interest rate consistent with the future path of FFRs?  In other words, it's generally understood interest rates on US debt follow the expected future path of FFRs.  Why would this change if foreigners hold the debt (even a majority portion of the debt)? 2) Let's assume foreigners arbitrarily abstain from buying the debt.  Could the US and its holding of reserves as well as credit creation abilities still fund the US debt at rates consistent with the path of expected FFRs?

A: First, sovereign government can target any interest rate it wants—overnight, short-term, long-term. It can refuse to offer long-term debt and instead stay at short end of market. Thus it can offer Chinese 0.50% on 30 days, or 0% on overnight. Period. They’ll take the 30 days, but if they decide not to, so what? And in any case, all the monetary ops undertaken to let the Treasury spend have nothing to do with Chinese—it is the special banks in the US.

AQ3: wh10 1 comment collapsed Collapse Expand It seems if we take foreigners out of the picture, then there is a smaller amount of reser Q ves/treasury debt with which to buy/rollover into new debt.  However, in sort of a reversal from my alien scenario, why couldn't the US just hold smaller but more frequent auctions to overcome any 'funding' issues?

A: It is not a funding issue and yes, the US can do whatever it wants. The foreigners are never in the “funding” part—it is special domestic banks.

AQ4: Paul Krueger 1 comment collapsed Collapse Expand Thanks, this is a nice exposition of the (at least partial) equivalence of different views of the process. To really prove a complete functional equivalence it seems to me that you would need to show that the interest rate paid on government bonds was the same in any of the cases. Is that a correct assumption or does that not matter for some reason?

Q5: wh10 1 comment collapsed Collapse Expand I believe at the end of Fullwiler’s paper, he also comments that bank primary dealers can take on the govt’s tsys in a manner similar to your case 3 (as opposed to non-bank primary dealers having to engage in repos to obtain the deposits to purchase the tsy).  Is there a practical difference between these two types of primary dealers?  Can bank primary dealers handle a greater
govt debt load or do it more easily?  What is the ratio of these bank primary dealers to non-bank primary dealers? Secondly, Fullwiler has commented to me that it is possible that a tsy auction could fail if the govt conducted a tsy auction, say, 2-3x the size of what it normally does (or some conceivable size).  This is because investors do have to secure financing to participate in the auction, and they might not be able to do it readily enough with such a large issuance.  Although, he says, the next time around, they’d likely have no problem getting things together.  Though this doesn’t present an issue to a
govt normally, I think it does underscore a real difference between a govt being able to simply spend first whatever it pleases (e.g. if it had overdraftsfrom the Fed) and a govt needing to tax/sell debt to the private sector in order to spend.  That is, the private does have to secure financing for a govt debt auction to succeed.  So just because the final balance sheet position is the same, the path to get there may be more obstructive in the real world.  Usually, it is not an issue at all, but it seems it could conceivably be.  I just think these types of qualifiers are worth mentioning when teaching MMT to others who may be skeptical about ‘govt spends first,’ since it paints a more accurate picture
and clarifies why the real world doesn’t operate exactly like the general case of a consolidated Fed/Tsy. 

Q6: ANeil Wilson 1 comment collapsed Collapse Expand S is there any benefit from all those extra transactions? Or is this, like allegedly private pensions that 'invest'  in Treasuries, simply a Job Guarantee scheme for financial sector workers?

LRWray Answers: 

Paul: A treasury that understands what bonds are would only sell bills and so would have no impact on interest rates; that said, there might be an impact if treasury tries to sell too many long term bonds into mkts. Solution: don’t sell long term bonds.

WH: Scott is the expert and I won't disagree. And aliens might explode a supernova at some distant place in the universe precidely when the treasury tries to auction, causing a temporary hiccup. We cannot possibly deal with every unlikely event. Treas and Fed converse every morning to go over plans. They aren't going to try to auction of 3x what the mkt can handle. In any case, the primary dealers are “banks” so not sure what you are getting at. While the path could be more difficult in practice it is not. Except when Congress refuses to raise debt limit!

And that leads to Neil: NO, obviously all the intermediate transactions just introduce the possibility that something could possibly go wrong. You can be a much better boxer if you do not tie your hands behind your back and your shoes together. These constraints arise because Congress doesn’t understand monetary operations.

Solvency Starts with the ECB

President Obama’s view of fraud “from 40,000 feet” (without an oxygen mask)

By William K. Black
(Cross-posted from Benzinga)


Sixty Minutes’ December 11, 2011 interview of President Obama included the following gem:

KROFT: One of the things that surprised me the most about this poll is that 42%, when asked who your policies favor the most, 42% said Wall Street. Only 35% said average Americans. My suspicion is some of that may have to do with the fact that there's not been any prosecutions, criminal prosecutions, of people on Wall Street. And that the civil charges that have been brought have often resulted in what many people think have been slap on the wrists, fines. "Cost of doing business," I think you called it in the Kansas speech. Are you disappointed by that?

PRESIDENT OBAMA: Well, I think you're absolutely right in your interpretation. And, you know, I can't, as President of the United States, comment on the decisions about particular prosecutions. That's the job of the Justice Department. And we keep those things separate, so that there's no political influence on decisions made by professional prosecutors. I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn't illegal.

That's exactly why we had to change the laws. And that's why we put in place the toughest financial reform package since F.D.R. and the Great Depression. And that law is not yet fully implemented, but already what we're doing is we've said to banks, "You know what? You can't take wild risks with other people's money. You can't expect a taxpayer bailout.

Hallucinations occur at high altitude when you become oxygen deprived.  Let’s review the bidding on the Bush/Obama record in prosecuting the elite control frauds that drove the ongoing crisis.  There are no convictions of the Wall Street elites that made, purchased, packaged, and sold millions of fraudulent liar’s loans.  There are no federal prosecutions of the major banks that committed over 100,000 fraudulent foreclosures.  There are a few settlements that sound like large dollar amounts, but are merely what even Obama concedes to be the (deeply inadequate) “cost of doing (fraudulent) business.”  Fraud pays – it pays enormously and our elites now commit it with impunity as a means of becoming wealthy.  We have just witnessed the travesty of Wachovia admitting to criminal conduct in their (grotesquely weak) settlement with the Department of Justice (which has a policy of no longer prosecuting large corporations that commit crimes) – and having the SEC refuse to require Wachovia to make similar admissions in its settlement.  All this, the President implicitly or even explicitly concedes.

But the President asserts:  “I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn't illegal.”  Kroft, sadly, did not follow up on this incredible and, if true, extraordinarily important assertion.  Obama’s statements about fraud and ethics are inaccurate on multiple levels. 
Obama’s factual assertions about the failure to prosecute fraud are unresponsive to the question, false, and logically inconsistent.  Note the artful manner in which Obama evaded answering Kroft’s question.  Kroft asks why there are no prosecutions of the Wall Street frauds that drove the crisis.  Obama answers that “some” unethical Wall Street actions were not illegal.  Obama’s answer implicitly admitted that most Wall Street actions that caused the crisis were criminal.  He simply argues that some highly unethical behavior by Wall Street that was not illegal contributed to that crisis.  As David Cay Johnston emphasized in his column about Obama’s response to Kroft’s question, Obama’s answer is a non-answer.  Why has he failed to prosecute any of the criminal conduct by Wall Street that drove the financial crisis?  The (alleged) fact that “some” destructive Wall Street conduct was highly unethical, but not illegal, obviously provides no basis for not prosecuting what Obama concedes was primarily criminal conduct.   

MMP Blog #28: Government Spending with Self-Imposed Constraints

By L. Randall Wray

               

In the Primer we discussed the general case of government spending, taxing, and bond sales. To briefly summarize, we saw that when a government spends, there is a simultaneous credit to someone’s bank deposit and to the bank’s reserve deposit at the central bank; taxes are simply the reverse of that operation: a debit to a bank account and to bank reserves. Bond sales are accomplished by debiting a bank’s reserves. For the purposes of the simplest explication, it is convenient to consolidate the treasury and central bank accounts into a “government account”.

To be sure, the real world is more complicated: there is a central bank and a treasury, and there are specific operational procedures adopted. In addition there are constraints imposed on those operations. Two common and important constraints are a) the treasury keeps a deposit account at the central bank, and must draw upon that in order to spend, and b) the central bank is prohibited from buying bonds directly from the treasury and from lending to the treasury (which would directly increase the treasury’s deposit at the central bank). The US is an example of a country that has both of these constraints. In this blog we will go through the complex operating procedures used by the Fed and US Treasury. Scott Fullwiler is perhaps the most knowledgeable economist on these matters, and this discussion draws very heavily on his paper. Readers who want even more detail should go to his paper, which uses a stock-flow consistent approach to explicitly show results.

First, however, let us do the simple case, beginning with a consolidated government (central bank plus treasury) and look at the consequences of its spending. Then we will look at the real world example of the US today. Readers have asked for some balance sheet examples, so I am using some simple T-accounts here. It might take some readers a bit of patience to work through this if they have not seen T-accounts before. (Note: these are partial balance sheets—I am only entering the minimum number of entries to show what is going on.)

Let us assume government buys a bomb and imposes a tax liability. This is shown as Case 1a:

The government gets the bomb, the private seller gets a demand deposit. Note that the tax liability reduces the seller’s net worth and increases the government’s (after all, that is the purpose of taxes—to move resources to the government). The private bank gets a reserve deposit at the government.

Now the tax is paid by debiting the taxpayer’s deposit and the bank’s reserves:

 And so the final position is:

The implication of “balanced budget” spending and taxing by the government is to move the bomb to the government sector—reducing the private sector’s net worth. Government uses the monetary system to accomplish the “public purpose”: to get resources such as bombs.

Now let us see what happens when government deficit spends. (Don’t get confused—we are not arguing that taxes are not needed; remember “taxes drive money” so there is a tax system in place but government decides that this week it will buy a bomb without imposing an additional tax).

Here, the bomb is moved to the government, but the deficit spending allows net financial assets to be created in the private sector (the seller has a demand deposit equal to the government’s financial liability—reserves). However, the bank is holding more reserves than desired. It would like to earn more interest, so government responds by selling a bond (remember: bonds are sold as part of monetary policy, to allow the government to hit its overnight interest rate target):

And the end result is:

The net financial asset remains, but in the form of a treasury rather than reserves. Compared with Case 1a, the private sector is much happier! It’s total wealth is not changed, but the wealth was converted from a real asset (bomb) to a financial asset (claim on government).

Ah, but that was too easy. Government decides to tie its hands behind its back by requiring it sell the bond before it deficit spends. Here’s the first balance sheet, with the bank buying the bond and crediting the government’s deposit account:

Now government writes a check on its deposit account, to buy the bomb:

The bank debits the government’s deposit and credits the seller’s. The final position is as follows:

Note it is exactly the same as case 1b: selling the bond before deficit spending has no impact on the result, so long as the private bank is able to buy the bond and the government can write a check on its deposit account.

That, too, is too simple. Let’s tie the government’s shoes together: it can only write checks on its account at the central bank. So in the first step it sells a bond to get a deposit at a private bank.

Next it will move the deposit to the central bank, so that it can write a check.

We have assumed the bank had no extra reserves to be debited when the Treasury moved its deposit, hence, the central bank had to lend reserves to the private bank (temporarily, as we will see). Now the treasury has its deposit at the central bank, on which it can write a check to buy the bomb.

When the treasury spends, the private bank receives a credit of reserves, allowing it to retire its short term borrowing from the central bank (looking to the private bank’s balance sheet, we could show a credit of reserves to its asset side, and then that is debited simultaneously with its borrowed reserves; I left out the intermediate step to keep the balance sheet simpler). The private bank credits the bomb seller’s account. The final position is as follows:

What do you know, it is exactly the same as Case 2 and Case 1b! Even if the government ties its hands behind its back and its shoes together, it makes no difference.

OK, admittedly these are still overly simple thought experiments. Let’s see how it is really done in the US—where the Treasury really does hold accounts in both private banks and the Fed, but can write checks only on its account at the Fed. Further, the Fed is prohibited from buying Treasuries directly from the Treasury (and is not supposed to allow overdrafts on the Treasury’s account). The deposits in private banks come (mostly) from tax receipts, but Treasury cannot write checks on those deposits. So the Treasury needs to move those deposits from private banks and/or sell bonds to obtain deposits when tax receipts are too low. So let us go through the actual steps taken. Warning: it gets wonky.

*The following discussion is adapted from Treasury Debt Operations—An Analysis Integrating Social Fabric Matrix and Social Accounting Matrix Methodologies, by Scott T. Fullwiler, September 2010 (edited April 2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1874795

The Federal Reserve Act now specifies that the Fed can only purchase Treasury debt in “the open market,” though this has not always been the case.  This necessitates that the Treasury have a positive balance in its account at the Fed (which, as set in the Federal Reserve Act, is the fiscal agent for the Treasury and holds the Treasury’s balances as a liability on its balance sheet).  Therefore, prior to spending, the Treasury must replenish its own account at the Fed either via balances collected from tax (and other) revenues or debt issuance to “the open market”. 

Given that the Treasury’s deposit account is a liability for the Fed, flows to/from this account affect the quantity of reserve balances. For example, Treasury spending will increase bank reserve balances while tax receipts will lower reserve balances. Normally, increases or decreases to banking system reserves impact overnight interest rates. Consequently, the Treasury’s debt operations are inseparable from the Fed’s monetary policy operations related to setting and maintaining its target rate.  Flows to/from the Treasury’s account must be offset by other changes to the Fed’s balance sheet if they are not consistent with the quantity of reserve balances required for the Fed to achieve its target rate on a given day.  As such, the Treasury uses transfers to and from thousands of private bank deposit (both demand and time) accounts—usually called tax and loan accounts—for this purpose.  Prior to fall 2008, the Treasury would attempt to maintain its end-of-day account balance at the Fed at $5 around billion on most days, achieving this through “calls” from tax and loan accounts to its account at the Fed (if the latter’s balance were below $5 billion) or “adds” to the tax and loan accounts from the account at the Fed (if the latter were above $5 billion). (The global financial crisis and the Fed’s response, especially “quantitative easing” has led to some rather abnormal situations that we will mostly ignore here.)

In other words, timeliness in the Treasury’s debt operations requires consistency with both the Treasury’s management of its own spending/revenue time sequences and the time sequences related to the Fed’s management of its interest rate target.  As such, under normal, “pre-global financial crisis” conditions for the Fed’s operations in which its target rate was set above the rate paid on banks’ reserve balances (which had been set at zero prior to October 2008, but is now set above zero as the Fed pays interest on reserves), there were six financial transactions required for the Treasury to engage in deficit spending.  Since it is clear that current conditions for the Fed’s operations (in which the target rate is set equal to the remuneration rate) are intended to be temporary and at some point there is presumably a desire (by Fed policy makers) to return to the more “normal” “pre-crisis” conditions, these six transactions are the base case analyzed here (though the “post-crisis” operating procedures do not significantly impact conclusions reached). 

The six transactions for Treasury debt operations for the purpose of deficit spending in the base case conditions are the following:

1. The Fed undertakes repurchase agreement operations with primary dealers (in which the Fed purchases Treasury securities from primary dealers with a promise to buy them back on a specific date) to ensure sufficient reserve balances are circulating for settlement of the Treasury’s auction (which will debit reserve balances in bank accounts as the Treasury’s account is credited) while also achieving the Fed’s target rate.  It is well-known that settlement of Treasury auctions are “high payment flow days” that necessitate a larger quantity of reserve balances circulating than other days, and the Fed accommodates the demand.


2. The Treasury’s auction settles as Treasury securities are exchanged for reserve balances, so bank reserve accounts are debited to credit the Treasury’s account, and dealer accounts at banks are debited. 


3. The Treasury adds balances credited to its account from the auction settlement to tax and loan accounts.  This credits the reserve accounts of the banks holding the credited tax and loan accounts.


4. (Transactions D and E are interchangeable; that is, in practice, transaction E might occur before transaction D.)  The Fed’s repurchase agreement is reversed, as the second leg of the repurchase agreement occurs in which a primary dealer purchases Treasury securities back from the Fed.  Transactions in A above are reversed.


5. Prior to spending, the Treasury calls in balances from its tax and loan accounts at banks.  This reverses the transactions in C.
6. The Treasury deficit spends by debiting its account at the Fed, resulting in a credit to bank reserve accounts at the Fed and the bank accounts of spending recipients.

Again, it is important to recall that all of the transactions listed above settle via Fedwire (T2).  Also, the analysis is much the same in the case of a deficit created by a tax cut instead of an increase in spending.  That is, with a tax cut the Treasury’s spending is greater than revenues just as it is with pro-active deficit spending.

Note, also that the end result is exactly as stated above using the example of a consolidated government (treasury and central bank): government deficit spending leads to a credit to someone’s bank account and a credit of reserves to a bank which are then exchanged for a treasury to extinguish the excess reserves. However, with the procedures actually adopted, the transactions are more complex and the sequencing is different. But the final balance sheet position is the same: the government has the bomb, and the private sector has a treasury.

Watch William K. Black's Latest Appearance on The Dylan Ratigan Show

Visit msnbc.com for breaking news, world news, and news about the economy

Dante’s Divine Comedy: Banksters Edition

By William K. Black
(Cross-posted from Benzinga)

Sixty Minutes’ December 11, 2011 interview of President Obama included a claim by Obama that, unfortunately, did not lead the interviewer to ask the obvious, essential follow-up questions.

“I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn't illegal.”

Obama did not explain what Wall Street behavior he found least ethical or what unethical Wall Street actions he believed was not illegal. It would have done the world (and Obama) a great service had he been asked these questions. He would not have given a coherent answer because his thinking on these issues has never been coherent. If he had to explain his position he, and the public, would recognize it was indefensible. I offer the following scale of unethical banker behavior related to fraudulent mortgages and mortgage paper (principally collateralized debt obligations (CDOs)) that is illegal and deserved punishment. I write to prompt the rigorous analytical discussion that is essential to expose and end Obama and Bush’s “Presidential Amnesty for Contributors” (PAC) doctrine. The financial industry is the leading campaign contributor to both parties and those contributions come overwhelmingly from the wealthiest officers – the one-tenth of one percent that thrives by being parasites on the 99 percent.

I have explained at length in my blogs and articles why:

• Only fraudulent home lenders made liar’s loans 
• Liar’s loans were endemically fraudulent 
• Lenders and their agents put the lies in liar’s loans 
• Appraisal fraud was endemic and led by lenders and their agents 
• Liar’s loans could only be sold through fraudulent reps and warranties 
• CDOs “backed” by liar’s loans were inherently fraudulent 
• CDOs backed by liar’s loans could only be sold through fraudulent reps and warranties 
• Liar’s loans hyper-inflated the bubble 
• Liar’s loans became roughly one-third of mortgage originations by 2006

Each of these frauds is a conventional fraud that could be prosecuted under existing laws. Hundreds of lenders and over a hundred thousand loan brokers were “accounting control frauds” specializing largely in making fraudulent liar’s loans. My prior work explains control fraud, why accounting is the “weapon on choice” for fraudulent financial firms, and why liar’s loans were superior “ammunition” for committing massive accounting fraud. These accounting control frauds caused greater direct financial losses than any other crime epidemic in history. They also drove the financial crisis that produced the Great Recession and cost millions of Americans their jobs.