New Economic Perspectives

Banks Weren’t Meant to Be Like This. What Will their Future Be – and What is the Government’s Proper Financial Role?

2012-01-27T09:21:00.002-06:00

By Michael Hudson
This article first appeared at FAZ

The inherently symbioticrelationship between banks and governments recently has been reversed. Inmedieval times, wealthy bankers lent to kings and princes as their majorcustomers. But now it is the banks that are needy, relying on governments forfunding – capped by the post-2008 bailouts to save them from going bankruptfrom their bad private-sector loans and gambles.

Yetthe banks now browbeat governments – not by having ready cash but bythreatening to go bust and drag the economy down with them if they are notgiven control of public tax policy, spending and planning. The process has gonefurthest in the United States. Joseph Stiglitz characterizes the Obamaadministration’s vast transfer of money and pubic debt to the banks as a “privatizingof gains and the socializing of losses. It is a ‘partnership’ in which onepartner robs the other.”[1]Prof. Bill Black describes banks as becoming criminogenic and innovating“control fraud.”[2]High finance has corrupted regulatory agencies, falsified account-keeping by“mark to model” trickery, and financed the campaigns of its supporters todisable public oversight. The effect is to leave banks in control of how theeconomy’s allocates its credit and resources.

If there is any silver lining totoday’s debt crisis, it is that the present situation and trends cannotcontinue. So this is not only an opportunity to restructure banking; we havelittle choice. The urgent issue is who will control the economy: governments,or the financial sector and monopolies with which it has made an alliance.

Fortunately, it is not necessary tore-invent the wheel. Already a century ago the outlines of a productiveindustrial banking system were well understood. But recent bank lobbying hasbeen remarkably successful in distracting attention away from classicalanalyses of how to shape the financial and tax system to best promote economicgrowth – by public checks on bank privileges.

How banks broke the social compact,promoting their own special interests

People used to know what banks did.Bankers took deposits and lent them out, paying short-term depositors less thanthey charged for risky or less liquid loans. The risk was borne by bankers, notdepositors or the government. But today, bank loans are made increasingly tospeculators in recklessly large amounts for quick in-and-out trading. Financialcrashes have become deeper and affect a wider swath of the population as debtpyramiding has soared and credit quality plunged into the toxic category of“liars’ loans.”

Thefirst step toward today’s mutual interdependence between high finance andgovernment was for central banks to act as lenders of last resort to mitigatethe liquidity crises that periodically resulted from the banks’ privilege ofcredit creation. In due course governments also provided public depositinsurance, recognizing the need to mobilize and recycle savings into capitalinvestment as the Industrial Revolution gained momentum. In exchange for thissupport, they regulated banks as public utilities.

Over time, banks have sought todisable this regulatory oversight, even to the point of decriminalizing fraud.Sponsoring an ideological attack on government, they accuse publicbureaucracies of “distorting” free markets (by which they mean markets free forpredatory behavior). The financial sector is now making its move to concentrateplanning in its own hands.

The problem is that the financialtime frame is notoriously short-term and often self-destructive. And inasmuchas the banking system’s product is debt, its business plan tends to beextractive and predatory, leaving economies high-cost. This is why checks andbalances are needed, along with regulatory oversight to ensure fair dealing.Dismantling public attempts to steer banking to promote economic growth (ratherthan merely to make bankers rich) has permitted banks to turn into somethingnobody anticipated. Their major customers are other financial institutions,insurance and real estate – the FIRE sector, not industrial firms. Debtleveraging by real estate and monopolies, arbitrage speculators, hedge funds andcorporate raiders inflates asset prices on credit. The effect of creating“balance sheet wealth” in this way is to load down the “real”production-and-consumption economy with debt and related rentier charges, adding more to the cost of living and doingbusiness than rising productivity reduces production costs.

Since 2008, public bailouts havetaken bad loans off the banks’ balance sheet at enormous taxpayer expense –some $13 trillion in the United States, and proportionally higher in Irelandand other economies now being subjected to austerity to pay for “free market” deregulation.Bankers are holding economies hostage, threatening a monetary crash if they donot get more bailouts and nearly free central bank credit, and more mortgageand other loan guarantees for their casino-like game. The resulting “too big tofail” policy means making governments too weak to fight back.

The process that began with centralbank support thus has turned into broad government guarantees against bankinsolvency. The largest banks have made so many reckless loans that they havebecome wards of the state. Yet they have become powerful enough to capturelawmakers to act as their facilitators. The popular media and even academiceconomic theorists have been mobilized to pose as experts in an attempt toconvince the public that financial policy is best left to technocrats – of thebanks’ own choosing, as if there is no alternative policy but for governmentsto subsidize a financial free lunch and crown bankers as society’s rulers.

The Bubble Economy and its austerityaftermath could not have occurred without the banking sector’s success inweakening public regulation, capturing national treasuries and even disablinglaw enforcement. Must governments surrender to this power grab? If not, whoshould bear the losses run up by a financial system that has becomedysfunctional? If taxpayers have to pay, their economy will become high-costand uncompetitive – and a financial oligarchy will rule.

The present debt quandary

The endgame in times past was towrite down bad debts. That meant losses for banks and investors. But today’sdebt overhead is being kept in place – shifting bad loans off bank balancesheets to become public debts owed by taxpayers to save banks and theircreditors from loss. Governments have given banks newly minted bonds or centralbank credit in exchange for junk mortgages and bad gambles – withoutre-structuring the financial system to create a more stable, less debt-riddeneconomy. The pretense is that these bailouts will enable banks to lend enoughto revive the economy by enough to pay its debts.

Seeing the handwriting on the wall,bankers are taking as much bailout money as they can get, and running, usingthe money to buy as much tangible property and ownership rights as they canwhile their lobbyists keep the public subsidy faucet running.

The pretense is that debt-strappedeconomies can resume business-as-usual growth by borrowing their way out ofdebt. But a quarter of U.S. real estate already is in negative equity – worthless than the mortgages attached to it – and the property market is stillshrinking, so banks are not lending except with public Federal HousingAdministration guarantees to cover whatever losses they may suffer. In anyevent, it already is mathematically impossible to carry today’s debt overheadwithout imposing austerity, debt deflation and depression.

This is not how banking was supposedto evolve. If governments are to underwrite bank loans, they may as well bedoing the lending in the first place – and receiving the gains. Indeed, since2008 the over-indebted economy’s crash led governments to become the majorshareholders of the largest and most troubled banks – Citibank in the UnitedStates, Anglo-Irish Bank in Ireland, and Britain’s Royal Bank of Scotland. Yetrather than taking this opportunity to run these banks as public utilities andlower their charges for credit-card services – or most important of all, tostop their lending to speculators and gamblers – governments left these banksoperating as part of the “casino capitalism” that has become their businessplan.

There is no natural reason formatters to be like this. Relations between banks and government used to be thereverse. In 1307, France’s Philip IV (“The Fair”) set the tone by seizing theKnights Templars’ wealth, arresting them and putting many to death – not onfinancial charges, but on the accusation of devil-worshipping and satanicsexual practices. In 1344 the Peruzzi bank went broke, followed by the Bardi bymaking unsecured loans to Edward III of England and other monarchs who died ordefaulted. Many subsequent banks had to suffer losses on loans gone bad to realestate or financial speculators.

By contrast, now the U.S., British,Irish and Latvian governments have taken bad bank loans onto their nationalbalance sheets, imposing a heavy burden on taxpayers – while letting bankerscash out with immense wealth. These “cash for trash” swaps have turned themortgage crisis and general debt collapse into a fiscal problem. Shifting thenew public bailout debts onto the non-financial economy threaten to increasethe cost of living and doing business. This is the result of the economy’sfailure to distinguish productive from unproductive loans and debts. It helpsexplain why nations now are facing financial austerity and debt peonage insteadof the leisure economy promised so eagerly by technological optimists a centuryago.

So we are brought back to thequestion of what the proper role of banks should be. This issue was discussedexhaustively prior to World War I. It is even more urgent today.

How classical economists hoped to modernizebanks as agents of industrial capitalism

Britain was the home of theIndustrial Revolution, but there was little long-term lending to financeinvestment in factories or other means of production. British and Dutchmerchant banking was to extend short-term credit on the basis of collateralsuch as real property or sales contracts for merchandise shipped(“receivables”). Buoyed by this trade financing, merchant bankers weresuccessful enough to maintain long-established short-term funding practices.This meant that James Watt and other innovators were obliged to raiseinvestment money from their families and friends rather than from banks.

It was the French and Germans whomoved banking into the industrial stage to help their nations catch up. InFrance, the Saint-Simonians described the need to create an industrial creditsystem aimed at funding means of production. In effect, the Saint-Simoniansproposed to restructure banks along lines akin to a mutual fund. A start wasmade with the Crédit Mobilier, founded by the Péreire Brothers in 1852. Theiraim was to shift the banking and financial system away from debt financing atinterest toward equity lending, taking returns in the form of dividends thatwould rise or decline in keeping with the debtor’s business fortunes. By givingbusinesses leeway to cut back dividends when sales and profits decline,profit-sharing agreements avoid the problem that interest must be paidwilly-nilly. If an interest payment is missed, the debtor may be forced intobankruptcy and creditors can foreclose. It was to avoid this favoritism forcreditors regardless of the debtor’s ability to pay that prompted Mohammed toban interest under Islamic law.

Attracting reformers ranging fromsocialists to investment bankers, the Saint-Simonians won government backingfor their policies under France’s Third Empire. Their approach inspired Marx aswell as industrialists in Germany and protectionists in the United States andEngland. The common denominator of this broad spectrum was recognition that anefficient banking system was needed to finance the industry on which a strongnational state and military power depended.

Germany develops an industrial bankingsystem

Itwas above all in Germany that long-term financing found its expression in theReichsbank and other large industrial banks as part of the “holy trinity” ofbanking, industry and government planning under Bismarck’s “state socialism.”German banks made a virtue of necessity. British banks “derived the greaterpart of their funds from the depositors,” and steered these savings andbusiness deposits into mercantile trade financing. This forced domestic firmsto finance most new investment out of their own earnings. By contrast, Germany’s“lack of capital … forced industry to turn to the banks for assistance,” notedthe financial historian George Edwards. “A considerable proportion of the fundsof the German banks came not from the deposits of customers but from thecapital subscribed by the proprietors themselves.[3]As a result, German banks “stressed investment operations and were formed notso much for receiving deposits and granting loans but rather for supplying theinvestment requirements of industry.”

Whenthe Great War broke out in 1914, Germany’s rapid victories were widely viewedas reflecting the superior efficiency of its financial system. To someobservers the war appeared as a struggle between rival forms of financialorganization. At issue was not only who would rule Europe, but whether thecontinent would have laissez faire or a more state-socialist economy.

In1915, shortly after fighting broke out, the Christian Socialistpriest-politician Friedrich Naumann published Mitteleuropa, describing how Germany recognized more than any othernation that industrial technology needed long‑term financing and governmentsupport. His book inspired Prof. H. S. Foxwell in England to draw on hisarguments in two remarkable essays published in the Economic Journal in September and December 1917: “The Nature of theIndustrial Struggle,” and “The Financing of Industry and Trade.” He endorsedNaumann’s contention that “the old individualistic capitalism, of what he callsthe English type, is giving way to the new, more impersonal, group form; to thedisciplined scientific capitalism he claims as German.”

Thiswas necessarily a group undertaking, with the emerging tripartite integrationof industry, banking and government, with finance being “undoubtedly the maincause of the success of modern German enterprise,” Foxwell concluded (p. 514).German bank staffs included industrial experts who were forging industrialpolicy into a science. And in America, Thorstein Veblen’s The Engineers and the Price System (1921) voiced the new industrialphilosophy calling for bankers and government planners to become engineers inshaping credit markets.

Foxwellwarned that British steel, automotive, capital equipment and other heavyindustry was becoming obsolete largely because its bankers failed to perceivethe need to promote equity investment and extend long‑term credit. They basedtheir loan decisions not on the new production and revenue their lending mightcreate, but simply on what collateral they could liquidate in the event ofdefault: inventories of unsold goods, real estate, and money due on bills forgoods sold and awaiting payment from customers. And rather than investing inthe shares of the companies that their loans supposedly were building up, theypaid out most of their earnings as dividends – and urged companies to do thesame. This short time horizon forced business to remain liquid rather thanhaving leeway to pursue long‑term strategy.

Germanbanks, by contrast, paid out dividends (and expected such dividends from theirclients) at only half the rate of British banks, choosing to retain earnings ascapital reserves and invest them largely in the stocks of their industrialclients. Viewing these companies as allies rather than merely as customers fromwhom to make as large a profit as quickly as possible, German bank officialssat on their boards, and helped expand their business by extending loans toforeign governments on condition that their clients be named the chiefsuppliers in major public investments. Germany viewed the laws of history asfavoring national planning to organize the financing of heavy industry, andgave its bankers a voice in formulating international diplomacy, making them“the principal instrument in the extension of her foreign trade and politicalpower.”

A similarcontrast existed in the stock market. British brokers were no more up to thetask of financing manufacturing in its early stages than were its banks. Thenation had taken an early lead by forming Crown corporations such as the EastIndia Company, the Bank of England and even the South Sea Company. Despite thecollapse of the South Sea Bubble in 1720, the run-up of share prices from 1715to 1720 in these joint-stock monopolies established London’s stock market as apopular investment vehicle, for Dutch and other foreigners as well as forBritish investors. But the market was dominated by railroads, canals and largepublic utilities. Industrial firms were not major issuers of stock.

In anycase, after earning their commissions on one issue, British stockbrokers werenotorious for moving on to the next without much concern for what happened tothe investors who had bought the earlier securities. “As soon as he hascontrived to get his issue quoted at a premium and his underwriters haveunloaded at a profit,” complained Foxwell, “his enterprise ceases. ‘To him,’ asthe Times says, ‘a successful flotation is of more importance than a soundventure.’”

Much thesame was true in the United States. Its merchant heroes were individualistictraders and political insiders often operating on the edge of the law to gaintheir fortunes by stock-market manipulation, railroad politicking for landgiveaways, and insurance companies, mining and natural resource extraction.America’s wealth-seeking spirit found its epitome in Thomas Edison’shit-or-miss method of invention, coupled with a high degree of litigiousness toobtain patent and monopoly rights.

In sum, neither British nor Americanbanking or stock markets planned for the future. Their time frame was short, andthey preferred rent-extracting projects to industrial innovation. Most banksfavored large real estate borrowers, railroads and public utilities whoseincome streams easily could be forecast. Only after manufacturing companiesgrew fairly large did they obtain significant bank and stock market credit.

What isremarkable is that this is the tradition of banking and high finance that hasemerged victorious throughout the world. The explanation is primarily themilitary victory of the United States, Britain and their Allies in the GreatWar and a generation later, in World War II.

The regression toward burdensomeunproductive debts after World War I

The development of industrial creditled economists to distinguish between productive and unproductive lending. Aproductive loan provides borrowers with resources to trade or invest at aprofit sufficient to pay back the loan and its interest charge. An unproductiveloan must be paid out of income earned elsewhere. Governments must pay warloans out of tax revenues. Consumers must pay loans out of income they earn ata job – or by selling assets. These debt payments divert revenue away frombeing spent on consumption and investment, so the economy shrinks. Thistraditionally has led to crises that wipe out debts, above all those that areunproductive.

In the aftermath of World War I theeconomies of Europe’s victorious and defeated nations alike were dominated bypostwar arms and reparations debts. These inter-governmental debts were to payfor weapons (by the Allies when the United States unexpectedly demanded thatthey pay for the arms they had bought before America’s entry into the war), andfor the destruction of property (by the Central Powers), not new means of production. Yetto the extent that they were inter-governmental, these debts were moreintractable than debts to private bankers and bondholders. Despite the factthat governments in principle are sovereign and hence can annul debts owed toprivate creditors, the defeated Central Power governments were in no position to dothis.

And among the Allies, Britain ledthe capitulation to U.S. arms billing, captive to the creditor ideology that “adebt is a debt” and must be paid regardless of what this entails in practice oreven whether the debt in fact can be paid. Confronted with America’s demand forpayment, the Allies turned to Germany to make them whole. After taking itsliquid assets and major natural resources, they insisted that it squeeze outpayments by taxing its economy. No attempt was made to calculate just howGermany was to do this – or most important, how it was to convert this domesticrevenue (the “budgetary problem”) into hard currency or gold. Despite the factthat banking had focused on international credit and currency transfers sincethe 12^th century, there was a broad denial of what John MaynardKeynes identified as a foreign exchange transferproblem.

Never before had there been anobligation of such enormous magnitude. Nevertheless, all of Germany’s politicalparties and government agencies sought to devise ways to tax the economy toraise the sums being demanded. Taxes, however, are levied in a nation’s owncurrency. The only way to pay the Allies was for the Reichsbank to take thisfiscal revenue and throw it onto the foreign exchange markets to obtain thesterling and other hard currency to pay. Britain, France and the otherrecipients then paid this money on their Inter-Ally debts to the United States.

AdamSmith pointed out that no government ever had paid down its public debt. Butcreditors always have been reluctant to acknowledge that debtors are unable topay. Ever since David Ricardo’s lobbying for their perspective in Britain’sBullion debates, creditors have found it their self-interest to promote adoctrinaire blind spot, insisting that debts of any magnitude could be paid.They resist acknowledging a distinction between raising funds domestically (byrunning a budget surplus) and obtaining the foreign exchange to payforeign-currency debt. Furthermore, despite the evident fact that austeritycutbacks on consumption and investment can only be extractive,creditor-oriented economists refused to recognize that debts cannot be paid byshrinking the economy.[4]Or that foreign debts and other international payments cannot be paid indomestic currency without lowering the exchange rate.

The more domestic currency Germanysought to convert, the further its exchange rate was driven down against thedollar and other gold-based currencies. This obliged Germans to pay much morefor imports. The collapse of the exchange rate was the source ofhyperinflation, not an increase in domestic money creation as today’screditor-sponsored monetarist economists insist. In vain Keynes pointed to thespecific structure of Germany’s balance of payments and asked creditors tospecify just how many German exports they were willing to take, and to explainhow domestic currency could be converted into foreign exchange withoutcollapsing the exchange rate and causing price inflation.

Tragically, Ricardian tunnel visionwon Allied government backing. Bertil Ohlin and Jacques Rueff claimed thateconomies receiving German payments would recycle their inflows to Germany andother debt-paying countries by buying their imports. If income adjustments didnot keep exchange rates and prices stable, then Germany’s falling exchange ratewould make its exports sufficiently more attractive to enable it to earn therevenue to pay.

Thisis the logic that the International Monetary Fund followed half a century laterin insisting that Third World countries remit foreign earnings and even permitflight capital as well as pay their foreign debts. It is the neoliberal stancenow demanding austerity for Greece, Ireland, Italy and other Eurozoneeconomies.

Banklobbyists claim that the European Central Bank will risk spurring domestic wageand price inflation of it does what central banks were founded to do: financebudget deficits. Europe’s financial institutions are given a monopoly right toperform this electronic task – and to receive interest for what a real centralbank could create on its own computer keyboard.

But why it is less inflationary forcommercial banks to finance budget deficits than for central banks to do this?The bank lending that has inflated a global financial bubble since the 1980shas left as its legacy a debt overhead that can no more be supported today thanGermany was able to carry its reparations debt in the 1920s. Would governmentcredit have so recklessly inflated asset prices?

How debt creation has fueled asset-priceinflation since the 1980s

Banking in recent decades has notfollowed the productive lines that early economic futurists expected. As notedabove, instead of financing tangible investment to expand production andinnovation, most loans are made against collateral, with interest to be paidout of what borrowers can make elsewhere. Despite being unproductive in theclassical sense, it was remunerative for debtors from 1980 until 2008 – not byinvesting the loan proceeds to expand economic activity, but by riding the waveof asset-price inflation. Mortgage credit enabled borrowers to bid up propertyprices, drawing speculators and new customers into the market in theexpectation that prices would continue to rise. But hothouse credit infusionsmeant additional debt service, which ended up shrinking the market for goodsand services.

Under normal conditions the effectwould have been for rents to decline, with property prices following suit,leading to mortgage defaults. But banks postponed the collapse into negativeequity by lowering their lending standards, providing enough new credit to keepon inflating prices. This averted a collapse of their speculative mortgage andstock market lending. It was inflationary – but it was inflating asset prices,not commodity prices or wages. Two decades of asset price inflation enabledspeculators, homeowners and commercial investors to borrow the interest fallingdue and still make a capital gain.

This hope for a price gain madewinning bidders willing to pay lenders all the current income – making banksthe ultimate and major rentier incomerecipients. The process of inflating asset prices by easing credit terms andlowering the interest rate was self-feeding. But it also was self-terminating,because raising the multiple by which a given real estate rent or businessincome can be “capitalized” into bank loans increased the economy’s debtoverhead.

Securities markets became part ofthis problem. Rising stock and bond prices made pension funds pay more topurchase a retirement income – so “pension fund capitalism” was coming undone.So was the industrial economy itself. Instead of raising new equity financingfor companies, the stock market became a vehicle for corporate buyouts. Raidersborrowed to buy out stockholders, loading down companies with debt. The mostsuccessful looters left them bankrupt shells. And when creditors turned theireconomic gains from this process into political power to shift the tax burdenonto wage earners and industry, this raised the cost of living and doingbusiness – by more than technology was able to lower prices.

The EU rejects central bank money creation,leaving deficit financing to the banks

So the plan has backfired. When“hard money” policy makers limited central bank power, they assumed that publicdebts would be risk-free. Obliging budget deficits to be financed by privatecreditors seemed to offer a bonanza: being able to collect interest forcreating electronic credit that governments can create themselves. But now,European governments need credit to balance their budget or face default. Sobanks now want a central bank to create the money to bail them out for the badloans they have made.

For starters, the ECB’s €489 billionin three-year loans at 1% interest gives banks a free lunch arbitrageopportunity (the “carry trade”) to buy Greek and Spanish bonds yielding ahigher rate. The policy of buying government bonds in the open market – afterbanks first have bought them at a lower issue price – gives the banks a quickand easy trading gain.

How are these giveaways lessinflationary than for central banks to directly finance budget deficits androll over government debts? Is the aim of giving banks easy gains simply toprovide them with resources to resume the Bubble Economy lending that led totoday’s debt overhead in the first place?

Conclusion

Governmentscan create new credit electronically on their own computer keyboards as easilyas commercial banks can. And unlike banks, their spending is expected to servea broad social purpose, to be determined democratically. When commercial banksgain policy control over governments and central banks, they tend to supporttheir own remunerative policy of creating asset-inflationary credit – leavingthe clean-up costs to be solved by a post-bubble austerity. This makes the debtoverhead even harder to pay – indeed, impossible.

So we are brought back to the policyissue of how public money creation to finance budget deficits differs from issuinggovernment bonds for banks to buy. Is not the latter option a convoluted way tofinance such deficits – at a needless interest charge? When governmentsmonetize their budget deficits, they do not have to pay bondholders.

I have heard bankers argue thatgovernments need an honest broker to decide whether a loan or public spendingpolicy is responsible. To date their advice has not promoted productive credit.Yet they now are attempting to compensate for the financial crisis by tellingdebtor governments to sell off property in their public domain. This “solution”relies on the myth that privatization is more efficient and will lower the costof basic infrastructure services. Yet it involves paying interest to the buyersof rent-extraction rights, higher executive salaries, stock options and otherfinancial fees.

Most cost savings are achieved byshifting to non-unionized labor, and typically end up being paid to theprivatizers, their bankers and bondholders, not passed on to the public. Andbankers back price deregulation, enabling privatizers to raise access charges.This makes the economy higher cost and hence less competitive – just theopposite of what is promised.

Banking has moved so far away fromfunding industrial growth and economic development that it now benefitsprimarily at the economy’s expense in a predator and extractive way, not bymaking productive loans. This is now the great problem confronting our time.Banks now lend mainly to other financial institutions, hedge funds, corporateraiders, insurance companies and real estate, and engage in their ownspeculation in foreign currency, interest-rate arbitrage, and computer-driventrading programs. Industrial firms bypass the banking system by financing newcapital investment out of their own retained earnings, and meet their liquidityneeds by issuing their own commercial paper directly. Yet to keep the bankcasino winning, global bankers now want governments not only to bail them outbut to enable them to renew their failed business plan – and to keep thepresent debts in place so that creditors will not have to take a loss.

This wish means that society shouldlose, and even suffer depression. We are dealing here not only with greed, butwith outright antisocial behavior and hostility.

Europe thus has reached a criticalpoint in having to decide whose interest to put first: that of banks, or the“real” economy. History provides a wealth of examples illustrating the dangersof capitulating to bankers, and also for how to restructure banking along moreproductive lines. The underlying questions are clear enough:

Have banks outlived their historical role, or can they be restructured tofinance productive capital investment rather than simply inflate asset prices?
Would a public option provide less costly and better directed credit?
Why not promote economic recovery by writing down debts to reflect the abilityto pay, rather than relinquishing more wealth to an increasingly aggressivecreditor class?

Solving the Eurozone’s financialproblem can be made much easier by the tax reforms that classical economistsadvocated to complement their financial reforms. To free consumers andemployers from taxation, they proposed to levy the burden on the “unearnedincrement” of land and natural resource rent, monopoly rent and financialprivilege. The guiding principle was that property rights in the earth,monopolies and other ownership privileges have no direct cost of production,and hence can be taxed without reducing their supply or raising their price,which is set in the market. Removing the tax deductibility for interest is theother key reform that is needed.

A rent tax holds down housing pricesand those of basic infrastructure services, whose untaxed revenue tends to becapitalized into bank loans and paid out in the form of interest charges.Additionally, land and natural resource rents – along with interest – are theeasiest to tax, because they are highly visible and their value is easy toassess.

Pressure to narrow existing budgetdeficits offers a timely opportunity to rationalize the tax systems of Greeceand other PIIGS countries in which the wealthy avoid paying their fair share oftaxes. The political problem blocking this classical fiscal policy is that it“interferes” with the rent-extracting free lunches that banks seek to lendagainst. So they act as lobbyists for untaxing real estate and monopolies (andthemselves as well). Despite the financial sector’s desire to see governmentsremain sufficiently solvent to pay bondholders, it has subsidized an enormouspublic relations apparatus and academic junk economics to oppose the taxpolicies that can close the fiscal gap in the fairest way.

Itis too early to forecast whether banks or governments will emerge victoriousfrom today’s crisis. As economies polarize between debtors and creditors,planning is shifting out of public hands into those of bankers. The easiest wayfor them to keep this power is to block a true central bank or strong publicsector from interfering with their monopoly of credit creation. The counter isfor central banks and governments to act as they were intended to, by providinga public option for credit creation.

[1] Joseph E. Stiglitz,“Obama’s Ersatz Capitalism,” The New YorkTimes, April 1, 2009
http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html.

[2] http://neweconomicperspectives.blogspot.com,and The Best Way to Rob a Bank is to OwnOne (2005).

[3] George W. Edwards, The Evolution of Finance Capitalism (NewYork: 1938):68.

[4] I review the literaturefrom the 1920s, its Ricardian pedigree and subsequent revival by the IMF andother creditor institutions in Trade,Development and Foreign Debt: A History of Theories of Polarization v.Convergence in the World Economy (1992; new ed. ISLET 2010). I provide thepolitical background in SuperImperialism: The Economic Strategy of American Empire (New York: Holt,Rinehart and Winston, 1972; 2^nd ed., London: Pluto Press, 2002),

Response to Comments on Blog #33: MMT and Inequality

2012-01-25T21:29:00.000-06:00

By L. Randall Wray

OK there really were only two themes inthe comments: first a question about sovereign vs nonsovereignissuers of IOUs and second questions about the MMT position oninequality.

The first has been dealt with all alongin the MM Primer. The sovereign chooses the unit of account, taxes inthat unit and issues IOUs in that unit that can be used to payobligations to the sovereign. Q. E. D.

On the second: MMTers reject the notionthat sovereign government uses taxes to “redistribute” income.No, taxes destroy income. If we want poor people to have income, wegive them jobs and keystroke their bank accounts. If we think richpeople are too rich we can reverse keystroke their bank accounts.

Here’s the problem. I suppose all ofyou looked at Mitt Romney’s (who on earth would name their kidafter a leather implement used in a baseball game?) tax return.Q.E.D. Forget taxes. Ain’t going to reduce wealth of the rich. Intruth, Romney pays way too much in taxes for someone in his incomeclass—remember, he knew he would run for president and so avoidedall questionable evasions. In spite of what the news is nowreporting, most really rich people do not pay taxes. Don’t take myword for it. Bartlett and Steele (two reporters in Philly) got famousfor going through the thousands of pages of the tax code andidentifying thousands of exemptions for well-connected rich folksthat exempted them from paying taxes. They actually figured outexactly who these people were. There were thousands more they couldnot identify—but the exemptions were so specific that it wasobvious they were meant for some favored individual.

Anyway, suppose someone’s income is$20 million a year like Mitt’s (a piker by Bill Gates standards),what tax rate would we need to levy to significantly reduceinequality? Not 30%. Not 70%. 90%? Ain’t never going to happen. Youwill not pass a tax law imposing a rate of 90% much less actuallymake it stick.

So here is what I wrote:

MMTers have written lots on poverty,inequality and the recent massive concentration of wealth income atthe top, so I have no idea where you get the idea that we avoid thesetopics. Indeed, Kelton and I did a detailed study contrasting the Waron Poverty (which did not reduce poverty at all) with the JG/ELRproposal which would have wiped out two-thirds of all poverty even ifthe wage was set at the minimum wage. I have no idea why you belive JG/ELR would lead to massive underemployment--it leads to fullemployment. So far as I can tell, the complaint is that we have notput them in the Primer? That does not mean we have ignored theissued. For those who want to read our study, go here:

“Public Policy Brief No. 78 | June2004

The War on Poverty after 40 Years: AMinskyan Assessment

Twenty to 25 years ago, a debate wasunder way in academe and in the popular press over the War onPoverty. One group of scholars argued that the war, initiated byPresidents Kennedy and Johnson, had been lost, owing to the inherentineffectiveness of government welfare programs. Charles Murray andother scholars argued that welfare programs only encouragedshiftlessness and burdened federal and state budgets.In recent years,despite the fact that the extent of poverty has not significantlydiminished since the early 1970s, the debate over poverty hasseemingly ended. In a country in which middle-class citizens struggleto afford health insurance and other necessities, the problems of theworst-off Americans seem to many remote and less than pressing.Moreover, the welfare reform bill of 1996 has deflected much of thecriticism of the welfare state by ending the individual-levelentitlement to Aid to Families with Dependent Children benefits (nowknown as Temporary Assistance to Needy Families) and putting timelimits on welfare recipiency, among other measures.” Download:Public Policy Brief No. 78, 2004 at www.levy.org.And while you are there browsing the Levy pices you will see I wrotemany other pieces on related topics.

So: to reduce inequality, first youstart at the bottom: give jobs. That eliminates 2/3 of all poverty.Then you gradually raise wages over time, by increasing the JG/ELRbasic wage.

And yes, you tackle income at the top.And as some comments indicated, most of the increase of inequality inrecent years is due to the outrageous rewards in the FIRE sector(finance, insurance, real estate). So you must reduce the rewards inthat sector. There is nothing “natural” about such high rewards.They are due largely to government policy. That is not the topichere, but it begins with the fraudsters and then changescompensations, incentives, and rewards. This is not difficultstuff—American management’s rewards are totally out of linecompared with compensation around the globe. And financialinstitutions—where the biggest rewards are—are inherentlypublic-private partnerships.

On progressive taxes, yes I propose acubic-foot-of-dwelling space tax. It is also environmentally sound.

However, we need to understandpolitical economy as well as MMT. First we do not need to"redistribute" from rich to poor. We can give the poor anyincome we want (hint: "keystrokes") and any income we takefrom the rich goes no where (hint: reverse those keystrokes). So thatis a bogeyman. We can take BMWs away from the rich and give them tothe poor, if you like. But don't confuse that with taxes—which areimposed in monetary form. Taking BMWs away is confiscation.

Finally, Americans oppose high taxeson the rich. We may not agree with them but it is the truth. In theUS taxes have never "redistributed" income--the rich justavoid and evade taxes and if that doesn't work they hire Congress togive them loopholes. Forget it, it will not work in America.

Best to confrontthe problem head-on: jobs for the poor, better wages at the bottom,support for unions, and constraints at the top.

The World Needs 600 Million New Jobs

2012-01-23T17:01:00.000-06:00

By Stephanie Kelton

The International Labor Office (ILO) has just released asobering report on the growing crisis in worldlabor markets. We began the year with 1.1billion people – one out of every three people in the global laborforce – either unemployed or among the 900 million working poor whoearn less than US$2 a day. On top of the existing glut of 200 millionunemployed, global labor markets will see an average of 40 million new entrantseach year. That means that an additional400 million jobs will need to be created over the next decade in order toprevent a further increase in unemployment. To employ everyone who wants to work, the world needs 600 million newjobs.

The concern, however, is that global growth is decelerating,which means it will be difficult for global labor markets to keep up with thegrowth of the labor force, much less make up any lost ground. In 2011, global growth slowed from 5.1percent to just 4 percent, and the IMF is warning of a further deceleration in2012. The ILO report warns that even amodest slowdown in 2012, say 0.2 percent points, would mean an additional 1.7million unemployed by 2013. The report alsohighlights the impact that overly tight fiscal policies have had on growth andemployment, beginning with the job-killing austerity programs that have becomeespecially common within the Eurozone. Elsewhere, in nations with ample policy space, governments have losttheir appetite for fiscal stimulus, even as heightened insecurity and depressedconsumer confidence keep private sector demand weak.

Analytically, the report begins on a high note, with an analysisthat employs the sectoral balance approach that is central to the MMT framework. Here, the report draws out the (negative)implications of declining public budgets on private net savings. Unfortunately, the authors of the report failto grasp enough MMT to develop a cogent analysis throughout, particularly whenit comes to distinguishing between currency issuers and currency users. As aresult, the report concludes with a weak-kneed policy prescription to address“the urgent challenge of creating 600 million productive jobs over the nextdecade.”

Below are some excerpts (my emphasis) to give you a sense of the study’smain conclusions:

Even though only a few countriesare facing serious and long-term economic and fiscal challenges, the global economy has weakened rapidlyas uncertainty spread beyond advanced economies. As a result, the world economy has moved evenfurther away from the pre-crisis trend path and, at the current juncture, evena double dip remains a distinct possibility.

There is growing evidence of anegative feedback loop between the labour market and the macro-economy, particularlyin developed economies: highunemployment and low wage growth are reducing demand for goods andservices, which further damages business confidence and leaves firms hesitantto invest and hire. Breaking thisnegative loop will be essential if a sustainable recovery is to take root. In much of the developing world, suchsustainable increases in productivity will require accelerated structuraltransformation – shifting to higher value added activities while movingaway from subsistence agriculture as a main source of employment and reducingreliance on volatile commodity markets for export earnings.

Further gains in education andskills development, adequate social protection schemes that ensure a basicstandard of living for the most vulnerable, and strengthened dialogue betweenworkers, employers and governments are needed to ensure broad-based developmentbuilt on a fair and just distribution ofeconomic gains.

Housing and other asset price bubbles prior to the crisis createdsubstantial sectoral misalignments that need to be fixed and which will requirelengthy and costly job shifts, both across the economy and across countries.

To address the protracted labourmarket recession and put the world economy on a more sustainable recovery path,several policy changes are necessary.

First, global policies needto be coordinated more firmly. Deficit-financed public spending andmonetary easing simultaneously implemented by many advanced and emergingeconomies at the beginning of the crisis is no longer a feasible option for allof them. Indeed, the large increase inpublic debt and ensuing concerns about the sustainability of public finances insome countries have forced those most exposed to rising sovereign debt riskpremiums to implement strict belt-tightening. However, cross-country spillover effects from fiscalspending and liquidity creation can be substantial and – if used in acoordinated way – could allow countries that still have room for maneuverto support both their own economies as well as the global economy. It is suchcoordinated public finance measures that are now necessary to support globalaggregate demand and stimulate job creation going forward.

Second, more substantial repairand regulation of the financial system would restore credibility and confidence…

Third, what is most needed now is to target the real economy tosupport job growth. The ILO’s particularconcern is that despite large stimulus packages, these measures have not managedto roll back the 27 million increase in unemployed since the initial impact ofthe crisis. Clearly, the policy measureshave not been well targeted and need reassessment in terms of their effectiveness. … policies that have proven very effective instimulating job creation and supporting incomes include: the extension ofunemployment benefits and work sharing programmes, there-evaluation of minimum wages and wage subsidies as well as enhancing publicemployment services, public worksprogrammes and entrepreneurship incentives – show impacts onemployment and incomes.

Fourth, additional public support measures alone will not be sufficientto foster a sustainable jobs recovery. Policy-makers must act decisively and ina coordinated fashion to reduce the fear and uncertainty that is hinderingprivate investment so that the private sector can restart the main engine ofglobal job creation. Incentives to businesses to invest in plantand equipment and to expand their payrolls will be essential to stimulate astrong and sustainable recovery in employment.

Fifth, to be effective, additionalstimulus packages must not put the sustainability of public finances at risk byfurther raising public debt. In thisrespect, public spending fully matched by revenue increases can still provide astimulus to the real economy, thanks to the balanced budget multiplier. Intimes of faltering demand, expanding the role of government in aggregate demandhelps stabilize the economy and sets forth a new stimulus, even if the spendingincrease is fully matched by simultaneous rises in tax revenues. As argued inthis report, balanced-budget multipliers can be large, especially in thecurrent environment of massively underutilized capacities and high unemploymentrates. At the same time, balancing spending with higher revenues ensures thatbudgetary risk is kept low enough to satisfy capital markets.

The report concludes with the following sentence:

At the same time, balancingspending with higher revenues ensures that budgetary risk is kept low tosatisfy capital markets. Interest rates will therefore remain unaffected bysuch a policy choice, allowing the stimulus to develop its full effect on theeconomy.

And this is my biggest problem with the report: there is noattempt to distinguish countries that must satisfy capital markets from thosethat need not. As MMT makes clear,governments that issue “modern money” (i.e. non-convertible fiat currencies)can help restore growth by permitting their deficits to expand to the point wherethe private sector is satisfied with its net saving position. Only governments that that operate with fixedexchange rates or other incarnations of a gold standard must cow-tow to capitalmarkets. A far bolder jobs program could be advanced if people understood the importance of monetary sovereignty.

The New York Times’ Ode to Foxconn and Anti-Employee Control Fraud

2012-01-23T10:44:00.001-06:00

By William K. Black

I wrote recently about Apple’s release ofinformation from its “audits” of its major suppliers. Apple constructed the release to deny thepublic information on the identity of the suppliers that defrauded andendangered the lives and health of their workers. I explained that criminologists classifythese as “anti-employee control frauds.” Control frauds occur when the persons who control a seemingly legitimateentity use it as a “weapon” to defraud. Anti-employee control frauds defraud the workers. Apple’s audit, and I explained why it was farfrom vigorous, showed endemic anti-employee control fraud by itssuppliers. Apple overwhelminglypurchases components from Asian suppliers that are criminal enterprises. The control frauds operate in fraud-friendlynations with non-Western managers selected for their willingness to cheat theworkers.

Apple creates a criminogenic environment in itssupplier selection process that leads it to, pervasively, hire criminalsuppliers. Honest manufacturers cannotcompete with firms that force their workers to work more than the maximum 60hour work week and fraudulently refuse to pay them for the extra time theywork. Firms that provide minimal safetyprotections also find it difficult to compete with fraudulent rivals. This is known as a “Gresham’s dynamic” inwhich bad ethics drives good ethics out of the workplace. The perverse dynamic is not limited toApple’s suppliers. Any honest Westernfirm that seeks to compete with Apple’s suppliers will be driven to slash itsworkers’ wages, benefits, working conditions, and pensions while increasingtheir workload. I call this the “Road toBangladesh” strategy.

I explained that the fact that Apple’s supplierskeep records proving that they are cheating their workers, even though theyknow that Apple will audit those records and their governments could do sodemonstrates that they have no fear that their frauds will be sanctioned. Apple obviously does not stop dealing withsuppliers it knows to be criminal enterprises that cheat their workers. I urge reporters to ask Apple how manycriminal and regulatory referrals it has made to the relevant governments aboutthe endemic anti-employee fraud it has documented among its suppliers. I am willing to bet that the number iscurrently zero.

Jon Stewart has shown pictures of one of the mostinfamous Apple suppliers’ workplace – Foxconn. The most unusual feature is the nets strung between the dormitorieswhere the workers live. The nets arethere to reduce the suicides among the workers. Foxconn is so dehumanizing a place to work that suicide is a leadingcause of deaths among the workers and workers protest the inhumane conditionsby threatening to engage in mass suicide.

It was certain that there would be push back onApple’s suppliers, but it is revealing that it came in the New York Times on January 21, 2012 in an article entitled “How U.S.Lost Out on iPhone Work.”

I address one the article’s weaknesses, itsdiscussion of Foxconn. The article isover 4,500 words, so its failure to discuss Foxconn’s anti-employee actions wasnot compelled by space constraints. Indeed, Foxconn’s anti-employee practices are of central importance tothe issue that the article purports to discuss – why Apple rarely employs U.S.suppliers based in the U.S. Instead, thearticle alludes to an illegal act by Foxconn, in tones of amazed praise, withno discussion of the illegality.

“Apple executives say that going overseas, at this point, is their only option. One former executive described how the company relied upon a Chinese factory to revamp iPhone manufacturing just weeks before the device was due on shelves. Apple had redesigned the iPhone’s screen at the last minute, forcing an assembly line overhaul. New screens began arriving at the plant near midnight.

A foreman immediately roused 8,000 workers inside the company’s dormitories, according to the executive. Each employee was given a biscuit and a cup of tea, guided to a workstation and within half an hour started a 12-hour shift fitting glass screens into beveled frames. Within 96 hours, the plant was producing over 10,000 iPhones a day.

“The speed and flexibility is breathtaking,” the executive said. “There’s no American plant that can match that.””

Ah yes, what “speed” and “flexibility.” Indeed, it could not be matched in the U.S. –or any other nation that enforced its laws. What the authors are describing was unlawful under Chinese law. The article eventually gets back to Foxconn.

To Apple executives, Foxconn City was furtherevidence that China could deliver workers — and diligence — that outpaced theirAmerican counterparts.

“That’s because nothing like Foxconn City exists in the United States.

The facility has 230,000 employees, many working six days a week, often spending up to 12 hours a day at the plant. Over a quarter of Foxconn’s work force lives in company barracks and many workers earn less than $17 a day. When one Apple executive arrived during a shift change, his car was stuck in a river of employees streaming past. “The scale is unimaginable,” he said.

Foxconn employs nearly 300 guards to direct foot traffic so workers are not crushed in doorway bottlenecks. The facility’s central kitchen cooks an average of three tons of pork and 13 tons of rice a day. While factories are spotless, the air inside nearby teahouses is hazy with the smoke and stench of cigarettes.

“They could hire 3,000 people overnight,” said Jennifer Rigoni, who was Apple’s worldwide supply demand manager until 2010, but declined to discuss specifics of her work. “What U.S. plant can find 3,000 people overnight and convince them to live in dorms?””

Yes, “convince” them to live them in dorms complete with anti-suicide netting at no extra charge. Foxconn truly is convincing. It’s probably the pork and rice. Alternatively, it could be the fact that rural China is still extremely poor, the rule of law is a fiction in China, and it is a crime to start a real labor union. It could also be that the “300 guards” have broader duties than guiding traffic flow.

So, the workers had already generally worked a 12 hour shift and were then woken up at midnight to be ordered (unlawfully) to work another 12 hour shift. In case this is not obvious, some of the workers’ tasks are dangerous and exhaustion endangers their health and lives. Indeed, the facts are likely far worse than what I have just related. Apple’s refusal to identify the suppliers that violated the maximum work week rules and the suppliers that stole their workers’ overtime pay makes it impossible to say for sure how bad things are at Foxconn. Apple’s audits found that both forms of anti-employee control fraud were common among its suppliers. Given Foxconn’s problem with suicide one is entitled to demand that Apple identify what violations its audits found at Foxconn.

The article later comes back to the Foxconn tale fora third time to add this passage.

“Foxconn, in statements, declined to speak about specific clients.

“Any worker recruited by our firm is covered by a clear contract outlining terms and conditions and by Chinese government law that protects their rights,” the company wrote. Foxconn “takes our responsibility to our employees very seriously and we work hard to give our more than one million employees a safe and positive environment.”

The company disputed some details of the former Apple executive’s account, and wrote that a midnight shift, such as the one described, was impossible “because we have strict regulations regarding the working hours of our employees based on their designated shifts, and every employee has computerized timecards that would bar them from working at any facility at a time outside of their approved shift.” The company said that all shifts began at either 7 a.m. or 7 p.m., and that employees receive at least 12 hours’ notice of any schedule changes.

Foxconn employees, in interviews, have challenged those assertions.”

I doubt that the average reader could tell from thedisjointed article that the actions that Apple’s officers ascribe to Foxconnwere unlawful, but Foxconn obviously understood that such actions would beunlawful and fraudulent. Apple’s auditfound that over 60% of its suppliers violated its policy limiting the workweekto 60 hours. That means that thesuppliers kept records that on their face demonstrated that they had violated(a) their contracts with their workers, (b) their contracts with Apple, and (c)Chinese law. If Foxconn keeps“computerized timecards” that prove that the unlawful and fraudulent actionsthat both Apple and its employees say it committed that would not make theaction “impossible” – it would make it the norm for Apple’s suppliers. The fact, demonstrated by Apple’s audit, thatmost Apple suppliers maintain a papertrail proving that they engage in anti-employee control fraud proves that theyknow that can defraud their employees with impunity. Neither their governments nor Apple hasestablished even such a minimal threat of sanctioning their violations that ithas become cost-effective for the suppliers to hide their frauds.

Consider another fact that the NYT article ignores. TheApple officers were describing an action by Foxconn that violated Apple’sstandards, which it had imposed on Foxconn by contract. Apple’s corporate response – and the responseof the Apple officials that the authors interviewed about the incident – was togush with enthusiasm about Foxconn’s violation of Apple’s standards. What conclusion would Foxconn draw fromApple’s reaction as to the importance of not defrauding the workers or havingthem work in inhumane and exceptionally dangerous conditions?

The NYT ombudsmanhas heaped derision on the concept, formerly known as journalism, that itsreporters should inform the reader that they have strong reason to doubt theveracity of a source’s statement. Thismay explain why the reporters felt there was no need to inform the reader thatthe quoted claim that Foxconn “takes our responsibility to our employees very seriously and we workhard to give our more than one million employees a safe and positiveenvironment” is demonstrated most graphically by its provision of anti-suicidenetting in its dormitory complex.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

MMP #33: Functional Finance and Long Term Growth

2012-01-22T21:08:00.000-06:00

By L. Randall Wray

Last weekwe examined Milton Friedman’s version of Functional Finance, which we found tobe remarkably similar to Abba Lerner’s. If the economy is operating below fullemployment, government ought to run a budget deficit; if beyond full employmentit should run a surplus. He also advocated that all government spendingshould be financed by “printing money” and taxes would destroy money. That, aswe know, is an accurate description of sovereign government spending—exceptthat it is keystrokes, not money printing. Deficits mean net money creation, throughnet keystrokes. The only problem with Friedman’s analysis is that he did notaccount for the external sector: he wanted a balanced budget at fullemployment, but if a country tends to run a trade deficit at full employment,then it must have a government budget deficit to allow the private sector torun a balanced budget—which is the minimum we should normally expect.

Somehow allthis understanding was lost over the course of the postwar period, replaced by“sound finance” which is anything but sound. It was based on an inappropriateextension of the household “budget constraint” to government. This is obviouslyinappropriate—households are users of the currency, while government is theissuer. It doesn’t face anything like a household budget constraint. How couldeconomics have become so confused? Let us see what Paul Samuelson said, andthen turn to proper policy to promote long term growth.

Functional Finance versus Superstition. The functional finance approach ofFriedman and Lerner was mostly forgotten by the 1970s. Indeed, it was replacedin academia with something known as the “government budget constraint”. Theidea is simple: a government’s spending is constrained by its tax revenue, itsability to borrow (sell bonds) and “printing money”. In this view, governmentreally spends its tax revenue and borrows money from markets in order tofinance a shortfall of tax revenue. If all else fails, it can run the printingpresses, but most economists abhor this activity because it is believed to behighly inflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’sexperience, or in modern times, Zimbabwe—asa cautionary tale against “financing” spending through printing money.

Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes usinggovernment’s own IOUs; banks use government’s own IOUs to buy bonds fromgovernment.

Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in the US—is far moreconfused. For example, President Obama frequently asserted throughout 2010 thatthe USgovernment was “running out of money”—like a household that had spent all themoney it had saved in a cookie jar.

So how didwe get to this point? How could we have forgotten what Lerner and Friedmanclearly understood?

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:

"I think there is an elementof truth in the view that the superstition that the budget must be balanced atall times [is necessary]. Once it is debunked [that] takes away one of thebulwarks that every society must have against expenditure out of control. Theremust be discipline in the allocation of resources or you will have anarchisticchaos and inefficiency. And one of the functions of old fashioned religion wasto scare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he would say "uh, oh what youhave done" and James Buchanan argues in those terms. I have to say that Isee merit in that view."

The beliefthat the government must balance its budget over some timeframe is likened to a“religion”, a “superstition” that is necessary to scare the population intobehaving in a desired manner. Otherwise, voters might demand that their electedofficials spend too much, causing inflation. Thus, the view that balancedbudgets are desirable has nothing to do with “affordability” and the analogiesbetween a household budget and a government budget are not correct. Rather, itis necessary to constrain government spending with the “myth” precisely becauseit does not really face a budget constraint.

The US (and manyother nations) really did face inflationary pressures from the late 1960s untilthe 1990s (at least periodically). Those who believed the inflation resultedfrom too much government spending helped to fuel the creation of the balancedbudget “religion” to fight the inflation. The problem is that what started assomething recognized by economists and policymakers to be a “myth” came to bebelieved as the truth. An incorrect understanding was developed. Originally themyth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation. But like many useful myths,this one eventually became a harmful myth—an example of what John KennethGalbraith called an “innocent fraud”, an unwarranted belief that preventsproper behaviour. Sovereign governments began to believe that the really couldnot “afford” to undertake desired policy, on the belief they might becomeinsolvent. Ironically, in the midst of the worst economic crisis since theGreat Depression of the 1930s, President Obama repeatedly claimed that the US governmenthad “run out of money”—that it could not afford to undertake policy that mostbelieved to be desired. As unemployment rose to nearly 10%, the government wasparalysed—it could not adopt the policy that both Lerner and Friedmanadvocated: spend enough to return the economy toward full employment.

Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional $600billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.

Thatindicates just how dysfunctional the myth has become.

A Budget Stance to Promote Long Term Growth. The lesson that can be learned fromthat three decade experience of the US is that in the context of a privatesector desire to run a budget surplus (to accumulate savings) plus a propensityto run current account deficits, the government budget must be biased to run adeficit even at full employment. Thisis a situation that had not been foreseen by Friedman (not surprising since theUSwas running a current account surplus in the first two decades after WWII). Theother lesson to be learned is that a budget surplus (like the one PresidentClinton presided over) is not something to be celebrated as anaccomplishment—it falls out of an identity, and is indicative of a privatesector deficit (ignoring the current account). Unlike the sovereign issuer ofthe currency, the private sector is a user of the currency. It really does facea budget constraint. And as we now know, that decade of deficit spending by theUSprivate sector left it with a mountain of debt that it could not service. Thatis part of the explanation for the global financial crisis that began in the US.

To be sure,the causal relations are complex. We should not conclude that the cause of the private deficit was the Clinton budget surplus; and we should not conclude thatthe global crisis should be attributed solely to US household deficit spending. Butwe can conclude that accounting identities do hold: with a current accountbalance of zero, a private domestic deficit equals a government surplus. And ifthe current account balance is in deficit, then the private sector can run asurplus (“save”) only if the budget deficit of the government is larger thanthe current account deficit.

Finally,the conclusion we should reach from our understanding of currency sovereigntyis that a government deficit is more sustainable than a private sector deficit—thegovernment is the issuer, the household or the firm is the user of thecurrency. Unless a nation can run a continuous current account surplus, thegovernment’s budget will need to be biased to run deficits on a sustained basisto promote long term growth.

However, weknow from our previous discussion that fiscal policy space depends on theexchange rate regime—the topic of the next blog.

Further, wewant to be clear: the appropriate budget stance depends on the balance of theother two sectors. A nation that tends to run a current account surplus can runtighter fiscal policy; it might even be able to run a sustained governmentbudget surplus (this is the case in Singapore—which pegs its exchangerate, and runs a budget surplus because it runs a current account surplus whileit accumulates foreign exchange). A government budget surplus is alsoappropriate when the domestic private sector runs a deficit (given a currentaccount balance of zero, this must be true by identity). However, for thereasons discussed above, that is not ultimately sustainable because the privatesector is a user, not an issuer, of the currency.

Finally, we must note that it is not possible for all nations to runcurrent account surpluses—Asian net exporters, for example, rely heavily onsales to the US, which runs a current account deficit to provide the Dollarassets the exporters want to accumulate. We conclude that at least somegovernments will have to run persistent deficits to provide the net financialassets desired by the world’s savers. It makes sense for the government of thenation that provides the international reserve currency to fill that role. Forthe time being, that is the US government.

Response to blog #32: Friedman's Functional Finance Approach

2012-01-18T23:38:00.000-06:00

By L. Randall Wray

Thanks for comments and questions. As I had alreadyintervened, I addressed the main points related to this week’s blog already.Let me pick up a few loose ends, and reformat my earlier response.

Q1: When you said US Debt/GDP reached 500% was that allprivate debt? And how can the private sector get out of debt?

A: No. Here’s the data break-down. You can see that it iscertainly private debt that has exploded, however. This ends in 2008, and afterthe GFC hit and the US slowed down, government debt started growing rapidly andprivate debt came down a bit as a percent of GDP so it would look a bitdifferent today.

How does the private sector get out of debt? If GDP andincome grow, households can service more debt all else equal, and the ratiowill decline. They can pay off debt. And yes they can default. Note how sharplythe debt ratio came down after the Great Depression—as all 3 of those thingshappened. The most important was economic growth fueled by government spending(and record govt deficits of 25% of GDP during WWII). It can also go down as theeconomy uses export-led growth but for the US that is not likely. The best waywould be to ramp up government spending today.

Q2: Several questions on US current account deficits,foreign accumulation of US Dollar assets, and so on. Also on the Bretton WoodsSystem.

A: I have discussed that a bit previously and we’ll do a lotmore of it in coming weeks—so let’s hold off. With respect to BW: it was amistake. Failed. Worked in the beginning because ROW needed US exports afterWWII and US lent dollars so they could buy them (Marshall Plan). More coming inthe MMP on exchange rate regimes. But briefly, both the BW system and theSterling system (pre WWI) failed. Such international pegged systems do notwork—they always generate crises and then collapse.

Q3: Didn’t Clinton announce he would retire the debt? Did hebelieve it?

A: Yes Clinton appeared on TV and announced all govt debtwould be retired. Who knows or cares what he believed? I think it was Rubin whopushed the idea. But what matters is that all Democrats after him think thatwas the right thing to do, and claim Bush Jr blew it by not continuing with thesurpluses. And so they want to bring back the good old Clinton-Rubin policy assoon as they can get through this crisis! They learned no lessons from thedeath of Goldilocks. Clinton’s tight fiscal policy killed her deader thanElvis.

Q4: Didn’t budget deficits of big-spending Democrats in the1960s cause high inflation?

A: Deficits of the 60s were miniscule. Don't take my word for it. You can checkit out. Until Obama, no Democratic administration ran big deficits after WWII.Again, check it out. Yes there was some inflation in the late 60s. Big warsusually do generate some—but the war against Viet Nam plus the wimpy and failed“War on Poverty” did not create big deficits because the economy grew fastenough to generate tax revenue. Republicans have always had the biggestdeficits—not necessarily due to big spending, but due to their rotteneconomies that do not grow. Coincidence? Me thinks not.

Q5: Don’t you accept the dollar because you can convert itto gold?

A: Hah: I’ve never done so and would never consider it. Goldis a fool’s gamut. We all accept Dollars because there is a tax system thatrequires them.

Q6: Later Friedman said inflation results from excessivemoney supply.

A: Yes, and he was wrong then and he’s still wrong. Hisfunctional finance paper is probably the only thing he ever got right. Andnobody reads it!

Anti-employee Control Fraud

2012-01-17T00:00:00.000-06:00

By William K. Black

Apple has released a report on working conditions inits suppliers’ factories. It highlightsa form of control fraud that criminology has identified but rarelydiscussed. I write overwhelmingly aboutaccounting control fraud because it drives our recurrent, intensifyingfinancial crises. The primary intendedvictims of accounting control frauds are the shareholders and thecreditors. Other private sector controlfrauds target customers (e.g., George Akerlof’s 1970 article on “lemons”), andthe public (e.g., the unlawful disposal of toxic waste, illegal logging, andtax fraud).

Anti-employee control frauds most commonly fall infour broad, but not mutually exclusive, categories – illegal work conditionsdue to violation of safety rules, violation of child labor laws, failure to payemployees’ wages and benefits, and frauds based on goods and loans provided bythe employer to the employee that lock the employee into quasi-slavery. Apple has just released a report on itssuppliers that shows that anti-employeecontrol fraud is the norm. Remember,fraud is hidden and is often not discovered and Apple did not have an incentiveto make an exhaustive investigation. Apple calls its inquiries “audits” and it is apparent that most of itsinformation comes from reviewing written and electronic records at itssuppliers. That is exceptionallyrevealing. The suppliers know that theycan defraud their employees with such impunity that they don’t even bother toget rid of records that prove their frauds. Apple has resisted making public its suppliers and the report refused toidentify which suppliers committed which violations – often for years despiterepeated, false promises to end their anti-employee control frauds. Two other facts are evident (but notreported). First, Apple rarelyterminates suppliers for defrauding their employees – even when the fraudsendanger the lives and health of the workers and the community – and even whereApple knows that the supplier repeatedly lies to Apple about these fraudulentand lethal practices. Second, it appearsunlikely in the extreme that Apple makes criminal referrals on its supplierseven when they commit anti-employee control frauds as a routine practice, evenwhen the frauds endanger the worker’s and the public’s health, and even whenthe supplier repeatedly lies to Apple about the frauds. Apple’s report, therefore, understatessubstantially the actual incidence of fraud by the 156 suppliers (accountingfor 97% of its payments to suppliers).

“The company said audits revealed that93 supplier facilities had records indicating that more than half of theirworkers exceed a 60-hour weekly working limit. Apple said 108 facilities didnot pay proper overtime as required by law. In 15 facilities, Apple foundforeign contract workers who had paid excessive recruitment fees to laboragencies.

And though Apple said it mandatedchanges at those suppliers, and some facilities showed improvements, inaggregate, many types of lapses remained at levels that have persisted foryears.”

http://www.nytimes.com/2012/01/14/technology/apple-releases-list-of-its-suppliers-for-the-first-time.html?hp

The New YorkTimes, Wall Street Journal, and theWashington Post articles on the Apple report are all lengthy, but none ofthem has any input from a criminologist and each of the articles misses most ofthe significance of the report. I havealready brought out several of these deficiencies. The most fundamental flaws, however, have todo with why anti-employee control fraud is the norm at Apple’s suppliers andwhy the suppliers typically don’t even take the inexpensive efforts necessaryto avoid holding a paper trail that makes the frauds obvious even to a notterribly vigorous audit that they know is coming.

If there is one single thing that drives uswhite-collar criminologists around the bend it is the implicit assumption thatfraud cannot be common. There is, ofcourse, no logical (or experiential) reason for this belief. Nevertheless, it is a common belief and amongeconomists it is a virtually universal dogma. Economists have a tribal taboo against even using the word “fraud” todescribe individual frauds. The surestway to be considered an un-serious economist is to use the “f” word to describefrauds by elite economic actors. Economists’ taboo is particularly bizarre because it is economic theory,developed by a Nobel Laureate that explains why fraud can become endemic. George Akerlof, in his famous article onmarkets for “lemons” (largely describing anti-customer control fraud),explained the perverse “Gresham’s” dynamic in 1970.

“[D]ishonest dealingstend 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; thecost also must include the loss incurred from driving legitimate business outof existence.”

Anti-employee control fraud creates real economicprofits for the firm and can massively increase the controlling officers’wealth. Honest firm normally cannotcompete with anti-employee control frauds, so bad ethics drives good ethics outof the markets. Companies like Apple andits counterparts create this criminogenic environment by selecting least-cost –criminal – suppliers who offer components at prices that honest firms cannotmatch. Effectively, they hang out a sign– only the fraudulent need apply to be suppliers. But the sign is, of course, invisible andcannot be introduced in court so Apple and its peers also get deniability. They are shocked, shocked that its suppliersare frauds that cheat their employees and put them and the public’s health atrisk in order to make a few extra yuan ordong for the senior officers.

Fraudulent suppliers, therefore, have compellingincentives to locate in nations and regions in which they can commit fraud withimpunity. The best way to evaluate thefraudulent CEOs’ view as to the risk of prosecution for their frauds is toobserve whether they take cheap means of hiding their frauds. When the CEOs do not even bother to avoidcreating a paper trail documenting their frauds one knows that they view therisk of prosecution as trivial. Nationsthat are corrupt, have weak rule of law, weak or non-existent unions, poorprotections for workers, a reserve army of the impoverished, and have fewresources devoted to prosecuting elite white-collar crime provide an idealcriminogenic environment for firms engaged in anti-employee control fraud. The ubiquitous nature of anti-employeecontrol fraud (and tax fraud) in many nations explains why U.S. industries havebeen so eager to “outsource” U.S. jobs to fraud-friendly nations. Companies like Apple also discovered long agothat Americans often made poor senior managers in these nations because theyobjected to defrauding workers. Not aproblem – there are plenty of managers from other nations that have no suchethical restraints. Foreign suppliersrun by Asian managers are increasingly dominant.

The endemic nature of anti-employee control fraudalso demonstrates an important technical point. The wages reported in the most fraud-friendly nations are substantiallyoverstated because workers work far longer hours without receiving thecompensation to which they are entitled. Their hourly rate is much lower than reported, which means that the wagegap between U.S. and the most fraud-friendly nations is significantly greaterthan reported. U.S. firms that haveforeign suppliers in these nations are well aware of this data bias and maketheir outsourcing decisions based on the real (much larger) wage gap.

TheHarm to Employee and Consumer Health is Grave

The NYT article notes that it was badpublicity in the U.S. that finally forced Apple to make greater disclosuresabout its suppliers’ frauds.

“The calls for Apple to disclosesuppliers became particularly acute after a series of deaths and accidents inrecent years. In the last two years at firms supplying services to Apple, 137employees were seriously injured after cleaning iPad screens with n-hexane, atoxic chemical that can cause nerve damage and paralysis; over a dozen workershave committed suicide or fell or jumped from buildings in a manner thatsuggests a suicide attempt; and in two separate blasts caused by dust frompolishing iPad cases, four were killed and 77 injured.”

The Washington Post article noted:

“Apple found that 62 percent of the 229 facilitiesit inspected were not in compliance with the company’s maximum 60-hour workpolicy; 13 percent did not have adequate protections for juvenile workers; and32 percent had problems with the management of hazardous waste.

One supplier was caught dumping wastewater at anearby farm. Another had a total lack of safety measures, creating “unsafeworking conditions,” the report found. Five facilities employed underageworkers.

The company in the past had refused to divulge itsfull supplier list even as it became standard practice for multinationalcorporations to do so after the public outcry in the 1990s over labor problemsat Nike factories in developing countries.

Apple’s change of heart follows a highly publicizedstring of factory worker suicides in 2010 and deadly explosions in two Chinesefactories in 2011.”

The WSJ emphasized this chillingfinding:

“The report also found 24 facilities conducted pregnancytests and 56 didn't have procedures to prevent discrimination against pregnantworkers. Apple said that at its direction, the suppliers have stoppeddiscriminatory screenings for medical conditions or pregnancy.”

The article does not make this point explicitly, but these firms conductthese tests in order to unlawfully coerce their pregnant employees to haveundesired abortions in order to obtain and keep their jobs.

ForeignAnti-employee Control Fraud harms U.S. Workers

These frauds take place abroad, but they harm employees in the U.S. Mitt Romney explains that Bain had to slashwages and pensions to save firms located in the U.S. who had to meetcompetition from foreign anti-employee control frauds. The damage from foreign anti-employee controlfrauds drives the domestic attack on U.S. manufacturing wages. Bad ethics increasingly drive good ethics outof the markets and manufacturing jobs out of the U.S. and into morefraud-friendly nations.

A final caution is in order because each of the major articles on the Applereport failed to mention it. CEOs whoare willing to routinely defraud their workers and expose them to grave threatsto their health are exceptionally likely to commit other forms of controlfraud.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

MMP BLOG #32: MILTON FRIEDMAN’S VERSION OF FUNCTIONAL FINANCE: A PROPOSAL FOR INTEGRATION OF FISCAL AND MONETARY POLICY

2012-01-15T22:18:00.003-06:00

By L. Randall Wray

In thecontext of today’s conventional wisdom about the dangers of budget deficits,Lerner’s views (examined last week) appear somewhat radical. What is surprisingis that they were not all that radical at the time. As everyone knows, MiltonFriedman was a conservative economist and a vocal critic of “big government”and of Keynesian economics. No one has more solid credentials on the topic ofconstraining both fiscal and monetary policy than Friedman. Yet, in 1948 hemade a proposal that was almost identical to Lerner’s functional finance views.On one hand, this demonstrates how far today’s debate has moved away from aclear understanding of the policy space available to a sovereign government,but also that Lerner’s ideas must have been “in the air”, so to speak, widelyshared by economists across the political spectrum. At the end of thissubsection we will also visit Paul Samuelson’s comment on this topic—whichprovides a cogent explanation for today’s confusion about fiscal and monetarypolicy. As Samuelson hints, the confusion was purposely created in order tomystify the subject.

Briefly,Milton Friedman's 1948 article, "AMonetary and Fiscal Framework for Economic Stability" put forward aproposal according to which the government would run a balanced budget only atfull employment, with deficits in recession and surpluses in economic booms.There is little doubt that most economists in the early postwar period sharedFriedman’s views on that. But Friedman went further, almost all the way toLerner’s functional finance approach: all government spending would be paid forby issuing government money (currency and bank reserves); when taxes were paid,this money would be “destroyed” (just as you tear up your own IOU when it isreturned to you). Thus, budget deficits lead to net money creation. Surpluseswould lead to net reduction of money.

He thusproposed to combine monetary policy and fiscal policy, using the budget tocontrol monetary emission in a countercyclical manner. (He also would haveeliminated private money creation by banks through a 100% reserverequirement--an idea he had picked up from Irving Fisher and Herbert Simons inthe early 1930s--hence, there would be no "net" money creation byprivate banks. They would expand the supply of bank money only as theyaccumulated reserves of government-issued money. We will not address this partof the proposal.) This stands in stark contrast to later conventional views(such as those associated with the ISLM model taught in textbooks) that“dichotomized monetary and fiscal policy. Friedman, too, later argued that thecentral bank ought to control the money supply, delinking in his later work theconnection between fiscal policy and monetary policy. But at least in this 1948paper he clearly tied the two in a manner consistent with Lerner’s approach.

Friedmanbelieved his proposal results in strong counter-cyclical forces to helpstabilize the economy as monetary and fiscal policy operate with combinedforce: deficits and net money creation when unemployment exists; surpluses andnet money destruction when at full employment. Further, his plan forcountercyclical stimulus is rules-based, not based on discretionary policy—itwould operate automatically, quickly, and always at just the right level. As iswell known, he later became famous for his distrust of discretionary policy,arguing for “rules” rather than “authorities”. This 1948 paper provides a neatway of tying policy to rules that automatically stabilize output and employmentnear full employment.

We see thatFriedman’s “proposal” is actually quite close to a description of the waythings work in a sovereign nation. When government spends, it does so bycreating "high powered money" (HPM)--that is, by crediting bankreserves. When it taxes, it destroys HPM, debiting bank reserves. A deficitnecessarily leads to a net injection of reserves, that is, to what Friedmancalled money creation. Most have come to believe that government finances itsspending through taxes, and that deficits force the government to borrow backits own money so that it can spend. However, any close analysis of the balancesheet effects of fiscal operations shows that Friedman (and Lerner) had itabout right.

But if thatis so, why do we fail to maintain full employment? The problem is that theautomatic stabilizers are not sufficiently strong to offset fluctuations ofprivate demand. Below we will examine why that is the case.

Note thatFriedman would have had government deficits and, thus, net money emission solong as the economy operated below full employment. Again, that is quite closeto Lerner's functional finance view, and as discussed above it was a commonview of economists in the early postwar period. But almost no respectableeconomist or politician will today go along with that on the belief it would beinflationary and/or would bust the budget. Such is the sorry state of economicseducation today. How did we get to this point? In last week’s blog, Samuelsonexplained that the belief that the government must balance its budget over sometimeframe a “religion”, a “superstition” that is necessary to scare thepopulation into behaving in a desired manner. Otherwise, voters might demandthat their elected officials spend too much, causing inflation. Thus, the viewthat balanced budgets are desirable has nothing to do with “affordability” andthe analogies between a household budget and a government budget are notcorrect. Rather, it is necessary to constrain government spending with the“myth” precisely because it does not really face a budget constraint.

A Budget Stance for Economic Stability. In Friedman's proposal, the sizeof government would be determined by what the population wanted government toprovide. Tax rates would then be set in such a way so as to balance the budgetonly at full employment. Obviously that is consistent with Lerner’s approach—ifunemployment exists, government needs to spend more, without worrying aboutwhether that generates a budget deficit. Essentially, Friedman’s proposal is tohave the budget move countercyclically so that it will operate as an automaticstabilizer. And, indeed, that is how modern government budgets do operate:deficits increase in recessions and shrink in expansions. In robust expansions,budgets even move to surpluses (this happened in the US during theadministration of President Clinton). Yet, we usually observe that these swingsto deficits are not sufficiently large to keep the economy at full employment.The recommendations of Friedman and Lerner to operate the budget in a mannerthat maintains full employment are not followed. Why not? Because the automaticstabilizers are not sufficiently strong.

To build in sufficient countercyclical swingsto move the economy back to full employment requires two conditions. First,government spending and tax revenues must be strongly cyclical--spending needsto be countercyclical (increasing in a downturn), and taxes pro-cyclical(falling in a downturn). One way to make spending automatically countercyclicalis to have a generous social safety net so that transfer spending (onunemployment compensation and social assistance) increases sharply in adownturn. Alternatively, or additionally, tax revenues also need to be tied toeconomic performance--progressive income or sales taxes that movecountercyclically.

Second,government needs to be relatively large. Hyman Minsky (1986) used to say thatgovernment needs to be about the same size as overall investment spending--orat least, swings of the government’s budget have got to be as big as investmentswings, moving in the opposite direction. (This is based on the belief thatinvestment is the most volatile component of GDP. This includes residentialreal estate investment, which is an important driver of the business cycle inthe US. The idea is that government spending needs to swing sufficiently and inthe opposite direction to investment in order to keep national income andoutput relatively stable; that, in turn will keep consumption relativelystable.) According to Minsky, government was far too small in the 1930s tostabilize the economy--even during the height of the New Deal, the federalgovernment was only 10% of GDP. Today, all major OECD nations probably have agovernment that is big enough, although some developing countries probably havea government that is too small by this measure. Based on current realities, itlooks like the national government should range from the US low of less than20% of GDP to a high of 50% in France. The countries at the low end of therange need more automatic fluctuation built into the budget than those with abigger government.

Looking tothe decade of the 1960s in the US, one sees that it was more-or-less consistentwith Friedman's proposal and with Lerner’s functional finance approach. Federalgovernment spending averaged around 18-20% of GDP, and deficits averaged $4 or$5 billion a year, except for 1968 when they temporarily increased to $25billion--but for the decade, deficits ran well under 1% of GDP on average. Wecould quibble about whether the US was at full employment in the 1960s, but itwas certainly closer to full employment during that decade than it was afterthe early 1970s. From the early 1970s until the boom of the 1990s during thepresidency of Bill Clinton, the budget was too tight relative to therecommendations of Friedman and Lerner. How do we know? Because unemploymentwas chronically too high—even in expansions it never got down to 1960s levels.

Note thatthis was not because government spending fell much, or because taxes wereraised. Indeed, the deficit tended to be much higher after the early 1970s (thehigh unemployment period) than it was during the 1960s (the low unemploymentperiod).

What went wrong? Briefly, the problem could be attributed tothe evolution of the international position of the US that led to a chroniccurrent account deficit. The US emerged from WWII in a dominant position—notonly was the dollar in high demand, but so were US exports—needed bywar-ravaged Europe and Japan. The US had a trade surplus, and lent Dollars tothe rest of the world to buy its output. That added to US demand and—from ouraccounting identities—kept our budget deficits small and let our private sectorrun surpluses (save).

Recall thatthe international monetary system (Bretton Woods) was based on a dollar-goldstandard, with exchange rates fixed to the Dollar and the Dollar convertible togold. By the early 1970s, the US was running a trade deficit and foreignholders were exchanging excess dollars for gold. To make a long story short,the US abandoned gold, the Bretton Woods system collapsed, and most developedcountries floated. The dollar fell in value (helping to generate inflationpressures in the US as imports, especially oil, got more expensive), and the USfound it harder to compete in international markets (Japan and Europe hadlargely recovered and were producing for their own markets—and even for the USconsumer). The current account deficit turned negative—more or lesspermanently--during the administration of President Reagan. As we know from ourmacro identities, that deficit would have to be offset by a growing budgetdeficit—which had to be large enough to offset both the current account as wellas the US domestic sector surplus (saving of households and firms). By the endof the 1980s, Congress and the new president (George Bush) agreed to try toreign-in deficit spending. Hence, an already too-small budget deficit (giventhe current account deficit and the desire of the domestic private sector torun surpluses, demand was too low to eliminate unemployment) was constrainedfurther by the Gramm-Rudman Amendment that promised to work toward a budgetbalance.

The economysuffered from weak growth and relatively high unemployment over most of thisperiod. Then, suddenly, economic growth picked up speed during the Clintonadministration; indeed it grew so fast that it produced a budget surplus (astax revenues boomed) that lasted for nearly three years (the first sustainedsurplus since 1929!). President Clinton actually predicted at the time that thebudget surplus would continue for at least 15 more years, and that alloutstanding Federal government debt would be retired (for the first time since1837).

Note thatthis was not accomplished by reversing the current account deficit—whichactually grew. How could the US run a current account deficit and a government budget surplus? Only byrunning a sustained private sector deficit. Indeed, from 1996 until 2007 the USprivate sector ran a budget deficit every year except during the recession ofthe early 2000s. At times, the domestic private sector deficit reached 6% ofGDP (meaning that for every Dollar of US national income, the private sectorspent $1.06. With such a large “flow” deficit, the stock of private sector debt grewrapidly—both in nominal terms and as a ratio to GDP. By 2007, total US debtreached five times GDP (versus three times GDP in 1929 on the verge of theGreat Depression). This huge debt implied a big debt burden—the portion ofincome that had to be devoted to servicing debt. When the economy collapsed in2007, a private sector surplus finally returned (the turn-around from private deficitsto private surpluses amounted to 8% of GDP—a huge reversal that removedapproximately $1 trillion of spending from the economy)—and the governmentbudget deficit grew rapidly to 10% of GDP. Even as the private sector cut downits spending, it was forced to default on debts run up since the Clintonperiod. A wave of bankruptcies and home foreclosures resulted that drove theeconomy into a deep recession and financial crisis that spread around theworld.

Next week: a budget stance to promote growth.

Bill Black Chats with Dylan Ratigan: Firedoglake Book Salon This Afternoon

2012-01-14T19:47:00.001-06:00

Don't miss William K. Black on today's Firedoglake book salon. Professor Black will be chatting with Dylan Ratigan about his new book, Greedy Bastards: How We Can Stop Corporate Communists, Banksters, and Other Vampires from Sucking America Dry. The chat begins at 5:00 p.m. (EST). Click here to watch the chat.

In the meantime, you can read Professor Black's review of Dylan's book below.

Dylan Ratigan is well positioned to author a book,designed to be an enjoyable and informative read by normal humans, on theongoing financial crisis. He is the wunderkind who became Global Managing Editor for Corporate Finance ofBloomberg, the premier news service that specializes in finance, at anexceptionally young age. He was at CNBCwhile that network was hyping the housing bubble as a non-bubble offeringfantastic investment opportunities.

Now an anchor forMSNBC, Ratigan is a fierce critic of prominent politicians in both parties forwhat he views as their destructive policies and slavish efforts to aid thewealthiest and most politically powerful at the expense of the best interestsof America and its people. He ispassionate about these subjects and far less predictable than many of his peersbecause he is not a political partisan.

In finance, the most important question is why wesuffer recurrent, intensifying financial crises. That question is really two questions. Answering it requires that we determine whatcauses our crises and why we fail to learn from these crises, but instead makethe incentive structure ever more perverse after each crisis. Anyone from a finance background is likely toconclude that perverse incentives cause financial crises, so I was surprised byRatigan’s choice of book title (“Greedy Bastards”). I think that greed is unlikelyto have changed greatly over the last quarter century in which the U.S. hassuffered three recurrent, intensifying financial crises.

Idon’t call people bastards, even the self-made ones, because my mother reactedpoorly to Speaker Wright referring to me as the “red-headed SOB.” Ratigan’s view on these points turns out to be similar to mine. He arguesthat the issue is not greed, but perverse incentives. When CEOs haveincentives adverse to the public and their customers they tend to act on thoseincentives and harm the public and their customers. This observation isone of those essential points so often overlooked by writers about this crisis. A CEOs’ principal function is creating, monitoring, and adjusting thecorporation’s incentive structures. There is a massive businessliterature on this function and CEOs uniformly believe that incentivestructures for officers and employees are critical in shaping their behavior.

There is only one (disingenuous)exception to this rule – when officers and employees act criminally because theCEO has created perverse incentive structures. Suddenly, the CEO isshocked that his officers and employees acted criminally in response to theCEO’s incentive structures that encourage criminal conduct. Ratiganfocuses on precisely this exception. Anyone that has had the misfortuneto listen to compulsory business ethics training by his or her employer willhave learned that the key is the “tone at the top” set by the CEO. True,but that always ends the discussion. No employee is going to be trainedby his employer as to what to do when the tone at the top set by the CEO ispro-fraud.

As Ratigan demonstrates,our most elite financial CEOs typically created and maintained grotesquelyperverse incentive structures that encouraged their officers and employees aswell as “independent” professionals to act criminally in a manner that harmedcustomers, the public, and shareholders – but made the controlling officerswealthy. Is there any CEO of a lender incapable of understanding that whenthe loan officers and brokers’ compensation depends on volume and yield – notquality – the result will be catastrophic? Is there any CEO of a lenderincapable of understanding that if the loan brokers’ fees depend as well on thereported debt-to-income and loan-to-value ratios and the broker ispermitted to make liar’s loans the result will be that the brokers will engagein endemic, severe inflation of the borrowers’ incomes and their homes’appraised values? Is there any reader that doubts that the CEOs intendedto produce precisely what their perverse incentives were certain toproduce? A CEO cannot send a memo to 50,000 loan brokers instructing themto inflate appraisals and use liar’s loans to inflate the borrowers incomes’but he can, and does, send the same message through his compensationsystem. Each of these perverse incentives produces precisely the resultthat the CEOs expected and desired.

Ratigan gets right twoof the essentials to understanding why we suffer recurrent, intensifyingfinancial crises. First, cheating has become the dominant strategy infinance. Second, cheating is dominant because finance CEOs create suchintensely perverse incentives that fraud becomes endemic. The BusinessRoundtable (the largest100 U.S. corporations), had to react to the Enron erafrauds. It chose as its spokesperson a CEO who embodied the best ofAmerican big business. This was the response he gave to Business Week whentheir reporter asked why so many top corporations engaged in accounting controlfraud:

“Don't just say: "If you hit this revenuenumber, your bonus is going to be this." It sets up an incentive that'soverwhelming. You wave enough money in front of people, and good people will dobad things.”

How did the CEO knowabout the “overwhelming” effect of creating incentives so perverse that theywould routinely cause “good people [to] do bad things”? He knew becausehe directed and administered such a perverse compensation system. An SECcomplaint would soon identify that compensation system as driving accountingcontrol fraud at his firm. His name was Franklin Raines, CEO of FannieMae.

What Ratigan does in this book that differs soimportantly, and accurately, from nearly every other account of the crisis by aprominent writer is to say in plain English that our most elite financialinstitutions caused the crisis, that they did so because their controllingofficers caused them to cheat, and that the senior officers cheated their ownshareholders for the purpose of becoming wealthy.

Ratigan shows that theself-described “productive class” is actually a group dominated by “greedybastards” who win by cheating. As GeorgeAkerlof and Paul Romer said in their famous 1993 article (“Looting: theEconomic Underworld of Bankruptcy for Profit”), accounting fraud is a “surething.” Ratigan shows that while lootingbegins with accounting fraud it ends with tax fraud, political domination andscandal by the wealthy frauds, and crony capitalism. Indeed, Ratigan shows how far we have fallensince 1993. Fraudulent CEOs who controlsystemically dangerous institutions (SDIs) can now become wealthy by looting,cause the SDI to become insolvent, get bailed out by their political lackeys,resume looting, pay virtually no federal income tax, and do so with nearlycomplete immunity from prosecution. Heshows that rather than being “productive”, the greedy bastards are destroyingAmerica’s middle and working classes, hollowing out our economy, and destroyingwealth and employment.

2012-01-14T19:30:00.000-06:00

Marshall Auerback discusses the Euro on the Lang and O'Leary Exchange. Watch it here.

Bill Moyers Essay: Occupying a Cause

2012-01-14T19:18:00.002-06:00

The first episode of Bill Moyers' new TV, Moyers & Company, features our own William K. Black and the Occupy Wall Street movement. Click here for local listings.

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A Federally-Funded Jobs Program? Lessons from the WPA

2012-01-12T12:56:00.000-06:00

By John Henry

In the current debates surrounding various jobguarantee programs (in association with the Chartalistor Modern Money perspectives), it might prove helpful to review some aspects ofthe Works Progress Administration (renamed in 1939 as Work ProjectsAdministration). While the WPA was not a“job guarantee” program, it nevertheless points to a number of issues that areunder current discussion, including those of the nature of the projectsundertaken, impact on the larger economy, concerns surrounding bureaucraticimpediments, etc. Let’s begin with an introductory statement pertainingto the political and economic orientation of Franklin Delano Roosevelt (and hisAdministration).

Roosevelt was nota progressive. He ran on a balanced budget platform, and initially attempted tofulfill his campaign promise of reducing the federal budget by slashingmilitary spending from $752 million in 1932 to $531 million in 1934, includinga 40% reduction in spending for veteran’s benefits which eliminated thepensions of half-a-million veterans and widows and reduced the benefits forthose remaining on the rolls. As well, federal spending on research andeducation was slashed and salaries of federal employees were reduced. Suchprograms were reversed after 1935. And one might recall that Rooseveltattempted to return to a balanced budget program in 1937, just as the economyappeared to be slowly recovering. The result was a renewed depression thatbegan in the fall of that year and ran through 1938.

Thus, the Roosevelt Administration was forced into progressive activism becauseof massive—and organized—popular discontent based mainly in working class andsmall farmer organizations. The union movement was rejuvenated through theformation of the CIO, farmers organized to prevent the forced sales of theirproperties (and this often included the threat of armed action), rent strikeswere rampant, etc. Chicago, New York, other cities saw massive demonstrations.“Riots” shook the Kentucky coal fields. One must remember that the communistparty was large (as these parties go), active, and popular. The specter ofrevolution was in the air and some politicians responded. HamiltonFish Jr. instructed his fellow Congressmen, “(i)f we don’tgive (security) under the existing system, the people will change the system.Make no mistake about that.”

The WPA was one of several programs developed torespond to this supposed threat. Initially,the Roosevelt Administration authorized the Federal Emergency Administration ofPublic Works in 1933 (renamed in 1939 as the Public Works Administration). The PWA allocated over $6 billion to privatefirms that actually undertook the large scale projects ordered by government.Dams, including Grand Coulee, hospitals, bridges (the Triborough Bridge andLincoln Tunnel in New York City), etc.

Inthe same year, the Civilian Conservation Corps (ostensibly Roosevelt’s favoritesuch program) was organized. Exceptionally active in erosion control,reforestation, the creation of public parks, etc., the CCC hired 2 millionyoung men over the course of its history. The fundamental difference between the CCC andthe PWA was that workers on CCC projects were hired directly by the government.And this funding relationship served as the model for the WPA.

TheWPA was under the direction of Harry Hopkins, a notable figure in his day. While the program was officially terminated in1943, U.S. entry into WWII effectively ended its existence. On average through1941, the WPA employed about 3 million people each month. If we includeemployees in the CCC and the National Youth Administration (a separate programunder the WPA), total employment in government contracted work came to roughly4.3 million per month. This represented 8-9% of the U.S. labor force. Originally,the WPA was an extension of the Federal Emergency Relief Administration—thefirst federally-funded welfare program in the U.S. One rationale for the WPA was that it wasbetter to put people to work performing useful tasks rather than merelyreceiving assistance: off the dole and on the job.

Amaximum work week was set at 30 hours, and pay was set at “the prevailingwage.” This latter standard raised some unintended humorous criticism. Senator Richard Russell of Georgia complained that: “Inthe State of Tennessee the man who is working with a pick and shovel at 18cents an hour is limited to $26 a month, and he must work 144 hours to earn$26. Whereas the man who is working in Pennsylvania has to work only 30 hoursto earn $94, out of funds which are being paid out of the common Treasury ofthe United States” (In Couch, 2008).

The WPA was not intended as a“full employment” program. Only one household member could be employed underthe program (it was usually males), though one does find female heads ofhouseholds so employed. It should alsobe noted that state and local governments were required to contribute 10-30% ofthe costs of the various projects undertaken. Over its life, total spending on WPA projectsamounted to about $13.4 billion, roughly 2% of GDP over those years.

And what were those projects? Was this simply a “make work” program thatmade little difference in the long run? Or, was the WPA integral to the largereconomy and its contributions socially useful? A truncated tally follows. (See below for a slideshow of projects under the WPA)

560,000 milesof roads built or improved
20,000 milesof water mains, sewers constructed
417 dams built
325 firehousesbuilt; 2384 renovated
5,000 schoolsconstructed or renovated
143 newhospitals, 1,700 improved
2,000stadiums, grandstands built
500 landing fields; 1,800 runways (includingparticipation in the construction of LaGuardia Airport, NYC)
State and municipal parks, including the foundation ofthe extensive California state park system.
100 milliontrees planted
6,000 miles offire and forest trails created
Education: Through 1941, 1 million enrolled in adulteducation courses, 37,000 children in classes and nursery schools;280,000 received music instruction, 67,000 art instruction.
Libraries werebuilt. These were especially directed toward poor and rural communities.
Zoo buildingsconstructed

In addition to the above, oneshould note the WPA’s contribution to the cultural life of the country. Underthe direction of Hallie Flanagan, the Federal Theatre Project mounted 1,200productions including 300 new plays. Audiences were estimated at 25 million inforty states, many of whom had never before seen a play. As well, WPA programsincluded Federal Music, Federal Arts, and Federal Writers’ Projects. Thislatter program produced the most notable “Slave Narrative Collection,”consisting of 10,000 pages of interviews with former slaves, a continuingtreasure-trove for researchers. Last, let us not forget the famous murals thatwere produced by artists hired by the WPA. These dot the country from post offices(though these were mainly funded by the Treasury Department through a grantfrom the government) to college buildings, to government buildings. Included inthis array were those painted by Diego Rivera for the City College of SanFrancisco, Anton Refregier in the Rincon Annex Post Office, San Francisco, andThomas Hart Benton in the Missouri State Capitol rotunda.

Let us now turn to some numbers and tell somethingof a story about some of the macro effects of the jobs programs.

YEAR	FEDERAL GOVERNMENT SPENDING (BILLIONS $)	GROSS DOMESTIC PRODUCT (BILLLIONS $)	INF RATE	FEDERAL DEFICIT (BILLIONS $)	UNEMPLOYMENT RATE (ESTIMATED)	ADJUSTED	WAGE RATE MANUFACTURING (1923-25=100)
1930	4.0	91.2	-2.7	-0.9	8.7	8.9	92
1931	4.1	76.5	-8.9	0.1	15.9	15.7	78
1932	4.3	58.7	-10.3	1.6	23.6	22.9	66
1933	5.1	56.4	-5.1	1.8	24.6	21	73
1934	5.9	66.0	+3.5	2.1	21.7	16.2	86
1935	7.6	73.3	+2.6	3.0	20.1	14.4	91
1936	9.2	83.8	+1.0	4.0	16.9	10	99
1937	8.8	91.9	+3.7	2.6	14.3	9.2	109
1938	8.4	86.1	-2.0	1.2	19.0	12.5	91
1939	9.3	92.2	-1.3	2.1	17.2	11.3	100
1940	10.1	101.4	+0.7	3.1	14.6	9.5	108
1941	14.2	126.7	+5.1	4.7	9.9	6.0	-----
1942	35.5	161.9	+11	19.5	3.9	3.1	-----

Source: Historical Statistics of the United States

The first matter to note is the unemployment rate.Official estimates did not count WPA (or CCC) workers as employed. Rather, theyremained on the unemployed lists as they were not working in private sectorjobs. The adjusted rate includes these workers as working—as they were. Thisresults in a roughly 6% differential and paints a much rosier picture of theeffects of the WPA and other programs in reducing unemployment.

The second issue is that of the relation betweengovernment deficit spending and inflation. Observe that in the 1930-32 period,when private sector spending fell precipitously and government spending wasflat, the economy suffered deflation and tumbling GDP—the worst possible developmentin a capitalist economy as the specter of a declining price level and GDP generatespessimistic “animal spirits” (à la Keynes). The growing federal governmentdeficits of 1932-33 were not the result of increased spending, but decliningtax revenues that resulted from declining incomes and spending in the privatesectors. With increased government spending and accompanying deficits, GDPbegan to increase as did prices. But observe that in the heyday of the WPA, theCPI rose to a mere 3.7% rate: this is in the normal range for a capitalisteconomy and clearly does not represent “real” inflation, but merely risingprices which is necessary to induce more optimistic animal spirits. Indeed,though this is not shown, private investment was rising during this period. Aswell, with rising investment and rising employment (private as well as public),real wages also rose, reaching their 1923-25 level by 1936. (Here, I use wagesin manufacturing as a proxy for economy-wide real wages, as most commentatorsfocus on manufacturing, then a much larger portion of the economy, as a keyindicator of economic health.)

We also observe that when the RooseveltAdministration returned to its balanced budget program in 1937, thingsdeteriorated: GDP fell, unemployment rose, real wages fell, private investmentfell (though not shown here), and deflation once again reared its ugly head. And,as is well known, with U.S. entry into WWII, government spending and deficitssoared, but the economy finally recovered. Had the federal government spent asmuch in the 1930’s to generate useful, constructive activities, rather thandestructive activities associated with war, it can be argued that thedepression would have been over within a year, even with the financial debacleof the late 1920’s.

Last, let’s consider two standard complaints aboutgovernment bureaucracies: they are too large, unwieldy, thus inefficient; andthey are prone to “capture” by private interests, thus do not serve the “publicgood.” Dealing with the second issue first, I have no doubt that this is aproblem in the present period at a minimum. If one puts industry pimps in chargeof the various bureaus, if one perpetrates a campaign denigrating publicservice, if one treats “public servants” as slaves, then government bureaus areripe for such capture. Indeed, an argument can be made that over the last 30years that has been the objective of various administrations—Democrat as wellas Republican. The public servants of the 1930’s seem to fit a different mold,at least in the main. If one reads about the self-sacrificing work of a HarryHopkins, of a Hallie Flanagan, of the government employees in the trenches, a quitealtered picture emerges. These people were, again, in the main,public-spirited, rather selfless, quite competent, and hard-working. We shouldnot hypothesize about the behavior and character of people of different erasusing the rather depraved standard of the current period. (See Quinn, 2008 forsome insight into the character of WPA personalities.)

The other issue is that of the size of suchbureaucracies. The WPA had a central administrative personnel of around 2,000people (depending on month and year). Most of WPA employees were at the stateand district offices where the projects were actually undertaken and the hiringof project employees took place. Again, depending on month and year, thisnumber ranged from 15 to 35 thousand. The ratio of government employees toproject workers—a more telling figure—ranged from 11 to 21 per 1,000 projectworkers, with the average running about 13/1,000 (Final Report of the WPA Program, p. 10). That is, less that 2% ofthe total number of workers in the WPA program consisted of administrativepersonnel. How would that ratio compare with, say, General Motors?

An examination of previous government programs suchas the WPA assists in developing a clearer understanding of various versions ofa job guarantee program, in both its positive and negative features. Obviously,the WPA was not such a program, but it points in that direction. Taking accountof the differences in the eras of the 1930’s and the 21^st century,what lessons can be drawn from previous experiments—and the WPA was anexperiment—and what can current imaginations produce in the present period. AsKeynes stated at the beginning of the Great Depression: “As soon as we have anew atmosphere of doing things, instead of one of smothering negation,everybody’s brains will get busy, and there will be masses of claimants forattention, the precise character of which it would be impossible to specifybeforehand” (Keynes [1929] 1972, 99).

References:

Couch,Jim. "Works Progress Administration". EH.Net Encyclopedia, edited byRobert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/article/couch.works.progress.administration

FederalWorks Agency. Final Report on the WPA Program, 1935-43. Washington, D.C.: U.S.

GovernmentPrinting Office. 1947

Keynes. J. M. [1929]1972. “Can Lloyd George Do It?” In Collected Works, Vol. 9. Pp. 86-125.

Quinn, Susan. FuriousImprovisation. New York: Walker Publishing Co. 2008

Responses to Blog #31: Functional Finance

2012-01-11T20:54:00.000-06:00

By L. Randall Wray

All: thanks to some for attempts to come up with some realworld JG jobs suggestions in answer to my challenge last week. We will move onto the JG after dealing with a few more issues related to JG. Keep thinking! Ialso saw that Neil has done a good job around the blogosphere defending JG.Keep it up!

We are more than half-way through the MMP. My responses toquestions/comments are going to become more focused. In part because manyquestions concern issues we already covered, or those we will cover. But moreimportantly, I’ve put a lot of work to the side to do the Primer over the past6+months and now must catch up with a variety of other work and deadlines. So,the Primer will continue, maybe with fewer side issues, but my responses willbe more focused on those questions/comments that respond to the current week’sblog.

So just a few responses today.

Q1: I thought it was the MMT position that adjustments tothe interest rate are not and cannot be matters of open market purchases, whichare only used defensively to maintain the target rate. Instead, the Fedchanges interest rates by announcing the new rate (it's unclear to me what theactual threat is for the rate to change) or paying IOR at the target rate(unless this is the threat???).

A: That is pretty much what the blog says and what Lernerthought. If banks are short reserves, they drive fed funds rate (in US) abovetarget, Fed buys bonds (OMP), provides reserves, increases the ratio ofreserves/bonds. Just like Lerner (and I) said. On the other hand, when Fedannounces new interest rate target (say, increase from 1% to 2%) it does notneed to change Res/Bonds ratio at all since it is likely banks have the ratiothey want and the demand for reserves is not interest elastic. So I thinkyou've confused two different things—using bond sales/purchases to satisfyprivate sector demands for high powered money (to hit a rate target), versusannouncing a new interest rate target (which normally does not require any openmarket sales or purchases).

Q2: What is the government budget constraint?

A: OK this is the idea that even sovereign currency-issuinggovernment is subject to a spending constraint. I’m sure BillyBlog has writtenon this. It came to life in the late 1960s—government is like a household andmust “finance” its spending: taxes, borrowing, or (unlike households) printingmoney. But that is false. Government spends through keystrokes. Yes it canself-impose budget constraints (ie in the US we pass a budget and we alsoimpose a debt limit). But this is nothing like a household, that faces a marketimposed constraint.

Q3: What drove inflation?

A: This is not the time for that. We already talked abouthyperinflation and a bit about CPI inflation. We might return to it againlater; and note that the JG is a price stabilizer. We can have full employmentwithout stoking inflation pressure—a topic for later.

Q4: Can the Euro nations create net financial assets?

A: I already discussed this. Domestically, yes, in the sensethat claims on the Greek government are net financial assets for thenongovernment sector. But I do take the point that ultimately Greece (etc) areusers of the currency so it all depends on the ECB to create true NFA for thesystem as a whole. (or the US which can create NFA in dollars for Eurolandersto hold)

FDR's Second Bill of Rights: An Unrealized Dream

2012-01-11T16:14:00.003-06:00

By Stephanie Kelton

Sixty-eight years ago today, Franklin Delano Roosevelt laid out what he referred to as a "Second Bill of Rights" in his State of the Union address to Congress. Those of us who've been part of the MMT movement for well over a decade have worked tirelessly to advance an understanding of the way modern monetary systems operate so that we might one day replace suffering with opportunity and a minimum standard of economic security for all.

Roosevelt's Second Bill of Rights

“This Republic had its beginning, and grew to its presentstrength, under the protection of certain inalienable political rights—amongthem the right of free speech, free press, free worship, trial by jury, freedomfrom unreasonable searches and seizures. They were our rights to life andliberty.

As our Nation has grown in size and stature, however—as ourindustrial economy expanded—these political rights proved inadequate to assureus equality in the pursuit of happiness.

We have come to a clear realization of the fact that trueindividual freedom cannot exist without economic security and independence."Necessitous men are not free men." People who are hungry and out ofa job are the stuff of which dictatorships are made.

In our day these economic truths have become accepted asself-evident. We have accepted, so to speak, a second Bill of Rights underwhich a new basis of security and prosperity can be established for allregardless of station, race, or creed.

Among these are:

The right to a useful and remunerative job in theindustries or shops or farms or mines of the Nation;

The right to earn enough to provide adequate food andclothing and recreation;

The right of every farmer to raise and sell hisproducts at a return, which will give him and his family a decent living;

The right of every businessman, large and small, totrade in an atmosphere of freedom from unfair competition and dominationby monopolies at home or abroad;

The right of every family to a decent home;

The right to adequate medical care and theopportunity to achieve and enjoy good health;

The right to adequate protection from the economicfears of old age, sickness, accident, and unemployment;

The right to a good education.

All of these rights spell security. And after this war iswon we must be prepared to move forward, in the implementation of these rights,to new goals of human happiness and well-being. ”

Greenspan’s Laissez Fairy Tale

2012-01-10T00:33:00.003-06:00

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

We continue to witness remarkable developments inthe intersection of the related fields of economics, finance, ethics, law, andregulation. Each of these five fieldsignores a sixth related field – white-collar criminology. The six fields share a renewed interest intrust. The key questions are why wetrust (some) others, when that trust is well-placed, and when that trust isharmful. Only white-collarcriminologists study and write extensively about the last question. The primary answer that the five fields giveto the first question is reputation. Thefive fields almost invariably see reputation as positive and singular. This is dangerously naïve. Criminals often find it desirable to developmultiple, complex reputations and the best way for many CEOs to develop asterling reputation is to lead a control fraud. Those are subjects for futurecolumns.

This column focuses on theoclassical economics’ useof reputation as “trump” to overcome what would otherwise be fatal flaws intheir theories and policies. FrankEasterbrook and Daniel Fischel, the leading theoclassical “law and economics”theorists in corporate law, use reputation in this manner to explain why seniorcorporate officers’ conflicts of interest pose no material problem. The most dangerous believer in the trump,however, was Alan Greenspan. Hisstandard commencement speech while Fed Chairman was an ode to reputation as thecharacteristic that made possible trust and free markets. I’ve drawn on excerpts from one example, his May15, 2005 talk at Wharton.

I find Greenspan’s odes to reputation as theantidote to fraud to be historically inaccurate and internally inconsistent intheir logic. Here, I ignore his factualerrors and focus on his logical consistency.

“The principles governing business behavior are an essential support to voluntary exchange, the defining characteristic of free markets. Voluntary exchange, in turn, implies trust in the word of those with whom we do business.

Trust as the necessary condition for commerce was particularly evident in freewheeling nineteenth-century America, where reputation became a valued asset. Throughout much of that century, laissez-faire reigned in the United States as elsewhere, and caveat emptor was the prevailing prescription for guarding against wide-open trading practices. In such an environment, a reputation for honest dealing, which many feared was in short supply, was particularly valued. Even those inclined to be less than scrupulous in their personal dealings had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business.

To be sure, the history of world business, then and now, is strewn with Fisks, Goulds, Ponzis and numerous others treading on, or over, the edge of legality. But, despite their prominence, they were a distinct minority. If the situation had been otherwise, late nineteenth- and early twentieth-century America would never have realized so high a standard of living.

* * *

Over the past half-century, societies have chosen to embrace the protections of myriad government financial regulations and implied certifications of integrity as a supplement to, if not a substitute for, business reputation. Most observers believe that the world is better off as a consequence of these governmental protections. Accordingly, the market value of trust, so prominent in the 1800s, seemed by the 1990s to have become less necessary. But recent corporate scandals in the United States and elsewhere have clearly shown that the plethora of laws and regulations of the past century have not eliminated the less-savory side of human behavior. We should not be surprised then to see a re-emergence of the value placed by markets on trust and personal reputation in business practice. After the revelations of recent corporate malfeasance, the market punished the stock and bond prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. There may be no better antidote for business and financial transgression. But in the wake of the scandals, the Congress clearly signaled that more was needed.

The Sarbanes-Oxley Act of 2002 appropriately places the explicit responsibility for certification of the soundness of accounting and disclosure procedures on the chief executive officer, who holds most of the decisionmaking power in the modern corporation. Merely certifying that generally accepted accounting principles were being followed is no longer enough. Even full adherence to those principles, given some of the imaginative accounting of recent years, has proved inadequate. I am surprised that the Sarbanes-Oxley Act, so rapidly developed and enacted, has functioned as well as it has. It will doubtless be fine-tuned as experience with the act's details points the way.

It seems clear that, if the CEO chooses, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave ethically. Companies run by people with high ethical standards arguably do not need detailed rules on how to act in the long-run interest of shareholders and, presumably, themselves. But, regrettably, human beings come as we are--some with enviable standards, and others who continually seek to cut corners.

I do not deny that many appear to have succeeded in a material way by cutting corners and manipulating associates, both in their professional and in their personal lives. But material success is possible in this world, and far more satisfying, when it comes without exploiting others. The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake.

* * *

Our system works fundamentally on trust and individual fair dealing. We need only look around today's world to realize how valuable these traits are and the consequences of their absence. While we have achieved much as a nation in this regard, more remains to be done.”

Greenspan appears to have relied on the trump ofreputation as the basis for causing the Fed to oppose financial regulationgenerally and at least five specific examples of proposed or existingregulation designed to deal with conflicts of interest. He supported the repeal of the Glass-SteagallAct despite the conflict of interest inherent in combining commercial andinvestment banking. He supported thepassage of the Commodities Futures Modernization Act of 2000 despite agencyconflicts between managers and owners of firms purchasing and selling creditdefault swaps (CDS). He opposed usingthe Fed’s unique statutory authority under HOEPA (1994) to regulate banfraudulent liar’s loans by entities not regulated by the Federalgovernment. He opposed efforts to cleanup outside auditors’ conflict of interest in serving as auditor and consultantto clients. He opposed efforts to cleanup the acute agency conflicts of interest caused by modern executivecompensation. He opposed taking aneffective response to the large banks acting on their perverse conflicts ofinterest to aid and abet Enron’s SPV frauds.

Greenspan’shypothesis: reputation trumps perverse incentives

Greenspan’s overall anti-regulatory hypothesis seemsto be that laissez faire led tosubstantial control fraud, which gave business actors a strong incentive toavoid being defrauded. This caused themto care a great deal about reputation, which successfully prevented fraud. Indeed, the frauds “had to adhere to a more ethicalstandard in their market transactions, or they risked being driven out ofbusiness.”

The mostobvious logic problem with this hypothesis is why laissez faire led to substantial control fraud. Here is his key sentence, discussing businesslife under laissez faire: “In such an environment, a reputation forhonest dealing, which many feared was in short supply, was particularly valued.” How could “many” American business peopleoperating under laissez faire fearthat reputations for honest dealing were “in short supply” among theircounterparts? Under Greenspan’s logicreputations for honest dealing should have been omnipresent among Americanbusiness people during laissez faire. Greenspan assures us that under laissez faire even frauds “had to adhereto a more ethical standard in their market transactions, or they risked beingdriven out of business.” If this istrue, then the “many” who “fear[ed]” that “a reputation for honest dealing “wasin short supply” must have been irrational. Reputations for honest dealing should have been virtually universalunder Greenspan’s logic.

Markets make the Mensch

Greenspanasserted that unethical CEOs who act like scum in their personal lives engagedin a daily “Road to Damascus” conversion whenever they worked. Greenspan concedes that CEOs dominatecorporations and that a honest CEO will prevent any material corporate fraud (“ifthe CEO chooses, he or she can, by example and through oversight, inducecorporate colleagues and outside auditors to behave ethically”). In short, Greenspan asserts (contrary to AdamSmith’s warnings) that there is no serious “agency” problem caused by theseparation of ownership and control in corporations. Markets force CEOs to act as if they werehonest because a good reputation is essential to the CEO. The CEO, in turn, is able to ensure thatsubordinates act ethically. ButGreenspan then contradicts his logic again, despairing that: “regrettably, human beings come as weare--some with enviable standards, and others who continually seek to cutcorners.” Greenspan has just assertedthat humans do not “come as we are”to business. Markets force us to behaveas if we are moral regardless of our actual morality. When we are in our business mode we are atour patriarchal Grandfather’s house on our best behavior in constant fear ofarousing his ire.

Greenspan claimed that we were inthe midst of a renewal of CEO honesty – in 2005

InSeptember 2004, the FBI warned that there was an “epidemic” of mortgage fraudand predicted that it would cause a financial “crisis” if it were notcontained. The fraud epidemic grewmassively, and I have shown why we know that it was overwhelmingly lenders whoput the lies in liar’s loans – at a rate of roughly a million fraudulentmortgages annually at the time that Greenspan gave his talk at Wharton inmid-2005.

“We should not be surprised then to see a re-emergence ofthe value placed by markets on trust and personal reputation in businesspractice. After the revelations of recent corporate malfeasance, the marketpunished the stock and bond prices of those corporations whose behaviors hadcast doubt on the reliability of their reputations. There may be no betterantidote for business and financial transgression.”

Again, myemphasis here is on Greenspan’s logic. It does not follow that because “the market punished the stock and bondprices of those corporations” that collapsed because they were looted by theirCEOs this served as the best “antidote” to prevent future accounting controlfrauds. George Akerlof and Paul Romerpublished their famous article in 1993 (“Looting: the Economic Underworld ofBankruptcy for Profit”). Indeed, GeorgeAkerlof received the Nobel Prize in economics in 2001. Greenspan was Charles Keating’s principaleconomic expert and had seen him loot Lincoln Savings in the late 1980s. Accounting control frauds are funded by stockand bond sales. The markets fundaccounting control frauds, and they do so massively even when the CEO islooting the firm and causing losses principally to the shareholders andcreditors. The CEO walks away wealthyfrom the husk of the failed corporation. Almost everyone agrees that leverage is one of the great causes oflosses in our recurrent, intensifying financial crises here and abroad. Debt drives leverage. Debt is supposed to provide the “privatemarket discipline” that prevents accounting control fraud, and reputation issupposed to be the piston that adds immense power to this great brake. But accounting control fraud, as Akerlof& Romer (and we criminologists) emphasize is a “sure thing” – it producesrecord (albeit fictional) profits in the near-term. When there are epidemics of accountingcontrol fraud, bubbles hyper-inflate. The combined result is that loss recognition is hidden byrefinancing. Reporting record profitsand minor losses via accounting control fraud is the surest means for a CEO togrow wealthy and develop a strong reputation. Creditors rush to lend to corporations reporting stellar results, whichis what produces the extraordinary leverage. Far from acting as an “antidote” to accounting control fraud, reputationhelps explain why private market discipline becomes an oxymoron. Reputation is the great booster shot aidingand encouraging accounting control fraud.

In anyanalogous context we would consider Greenspan’s “antidote” claim to be faciallyinsane. If the head of the public healthservice announced proudly that the service had triumphed because, while onemillion Americans had died of an epidemic of cholera, the death rate had beenso severe and rapid that the epidemic had burned out, we would consider him tobe delusional and heartless. The deathof the pathogen’s host (us) does not constitute a triumph over cholera. It also does not leave the survivors who werenot exposed to the pathogen with additional antibodies that will prevent futureepidemics.

“Texas Triumphs”

In an article I wrote in 2003 during the unfolding Enron-era frauds I calledsimilar claims by prominent Texas politicians that Enron’s failure representeda triumph of capitalism “Texas triumphs.”

I distinguished Texas triumphs from Pyrrhic victories. The origin of that phrase comes from King Pyrrhus’ (of Epirus in Greece) victory over theRomans in 279 BC at the battle of Asculum in Apulia (on the Eastern side of theItalian peninsula). The Roman legionswere elite and outnumbered Pyrrhus’ forces (which had many mercenaries). Nevertheless, he twice defeated the Romanforces, inflicting significantly greater casualties on their forces. After the battle of Asculum he responded tocongratulations by remarking that one more such victory would undo him. He was a great commander who defeated highlycompetent opponents defending their own lands.

Only theoclassical economists could call thefailure of our most elite firms that were looted by their CEOs a triumph ofcapitalism. I wrote:

“MartinWolf repeated the well-worn claim that Enron’s failure demonstratescapitalism’s virtues in 2003. It is aview most famously stated by Larry Lindsey, a member of George W. Bush’s first(failed) economic team, when he saidin January 2002 that Enron’s failure was “a tribute to American capitalism.” Thethen treasury secretary, Paul O’Neill, wasn’t to be outdone. He insistedEnron’s failure proved “the genius of capitalism.””

Our family’s rule that it isimpossible to compete with unintentional self-parody remains intact. Adiscipline (economics) that counts massive looting by the CEOs of elite controlfrauds as its greatest triumphs desperately needs an intervention. None of these control fraud failures (andthat includes Fannie and Freddie) involves valiant efforts by economists toprevent the looting. The theoclassicalfailures to prevent control fraud did not occur because the economists stroveto prevent the looting but were defeated by impossible odds. Theoclassical economists were theanti-regulatory architects of the criminogenic environments that produce ourepidemics of control fraud. They are theelite frauds’ most valuable allies.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

Real Financial Regulators Love Prosecutions of Fraudulent Bank CEOs

2012-01-09T00:00:00.000-06:00

By William K. Black

The New YorkTimes published a column by its leading financial experts, GretchenMorgenson and Louise Story, on November 22, 2011 which contains a spectacularcharge against the Obama administration’s financial regulatory leaders. I have waited for the rebuttal, but it is nowclear that the administration does not contest the charge.

The specific example that prompted the NYT article (“Financial Finger-PointingTurns to Regulators”) was a civil action against a former executive ofIndyMac. IndyMac was supposed to beregulated by the Office of Thrift Supervision (OTS). OTS was the worst of the federal financialregulators – which is a large statement. It was so bad that the Dodd-Frank Act killed it. I used to work for OTS. One of the things Idid to make myself unemployable during the S&L debacle was to testifybefore Congress against the head of our agency, Danny Wall, and our head ofsupervision, Darrell Dochow. Wall resignedin disgrace and Dochow was demoted and sent back to run the obscure office hehad once run in Seattle.

Ms. Story and Ms. Morgenson’s column discusses howan IndyMac manager is defending himself against suit by arguing that Dochowtold him to file false financial statements. OTS’ senior leaders knew from my book exactly what they were gettingwhen they promoted Dochow and made him the top (anti) regulator for all the topS&L originators of fraudulent liar’s loans.

This column addresses a more general point, thecharge that Obama’s financial regulatory leaders actively oppose theprosecution of elite financial criminals and the regulators who conspired withthem (to use the term the article quotes Professor Kane as insisting upon).

“Any financial crisis case that named a regulatorprobably would turn into a huge political battle, because it would questionmany of the nontransparent acts that bank regulators take while trying to savebanks, said Denise Voigt Crawford, former commissioner of the Texas securitiesboard and now a law professor at Texas Tech University.

In any prosecution of bank regulators, she said,“you’d have the Justice Department in a fight with the policy goals of theDepartment of Treasury. Particularly in this environment, you know the bankingregulators would fight it tooth and nail.”

Some longtime lawyers go further and say theoverall scarcity of cases related to the financial crisis might be in partbecause regulators want to avoid scrutiny of their own kind.

“It’s not just one 30-year-old wunderkind who wasresponsible for the financial crisis,” said Dennis C. Vacco, who was the NewYork State attorney general in the 1990s and now is a lawyer at Lippes MathiasWexler & Friedman. “Once you start pulling the string through in thesecomplex cases, you might be surprised what you find at the other end.”

Mr. Vacco continued: “What’s at the end of thestring? The defense may be that ‘at the highest echelons of the financialinstitutions, we were in regular contact with the government.’”

These charges are exceptionally severe. Senior former regulators are willing to bequoted by name asserting that Obama’s (not Bush’s) financial regulatory leadersare blocking lawsuits against fraudulent financial elites and theiranti-regulatory co-conspirators because they fear embarrassment. That would be a disgraceful policy. Indeed, it is hard to think of a worse reasonfor granting the elite white-collar criminals that caused the crisis and theGreat Recession immunity from prosecution. The fact that Obama has no response rebutting this grave charge againsthis administration’s integrity sounds loud, but not proud.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @WilliamKBlack

MMP Blog #31: FUNCTIONAL FINANCE: Monetary and Fiscal Policy for Sovereign Currencies

2012-01-08T16:42:00.003-06:00

By L. Randall Wray

This weekwe begin a new topic: functional finance. This will occupy us for the nextseveral blogs. Today we will lay out Abba Lerner’s approach to policy. In the1940s he came up with what he called the functional finance approach to policy.In one of those amazing historical coincidences, Lerner happened to teach atUMKC when he published one of his most famous papers, laying out the approach.Maybe there is something special in the air in Kansas City?

Lerner’s Functional Finance Approach. Lerner posed two principles:

First Principle: if domestic income is too low, governmentneeds to spend more. Unemployment is sufficient evidence of this condition, soif there is unemployment it means government spending is too low.

Second Principle: if the domestic interest rate is too high, itmeans government needs to provide more “money”, mostly in the form of bankreserves.

The idea ispretty simple. A government that issues its own currency has the fiscal andmonetary policy space to spend enough to get the economy to full employment andto set its interest rate target where it wants. (We will address exchange rateregimes later; a fixed exchange rate system requires a modification to thisclaim.) For a sovereign nation, “affordability” is not an issue—it spends bycrediting bank accounts with its own IOUs, something it can never run out of.If there is unemployed labor, government can always afford to hire it—and by definition,unemployed labor is willing to work for money.

Lernerrealized that this does not mean government should spend as if the “sky is thelimit”—runaway spending would be inflationary (and, as discussed many times inthe MMP, it does not presume that government spending won’t affect the exchangerate). When Lerner first formulated the functional finance approach (in theearly 1940s), inflation was not a major concern—the US had recently livedthrough deflation in the GreatDepression. However, over time, inflation became a serious concern, and Lernerproposed a form of wage and price controls to constrain inflation that hebelieved would result as the economy nears full employment. Whether or not thatwould be an effective and desired way of attenuating inflation pressures is notour concern here. The point is that Lerner was only arguing that governmentshould use its spending power with a view to moving the economy toward fullemployment—while recognizing that it might have to adopt measures to fight inflation.

Lernerrejected the notion of “sound finance”—that is the belief that government oughtto run its finances as if it were like a household or a firm. He could see noreason for the government to try to balance its budget annually, over thecourse of a business cycle, or ever. For Lerner, “sound” finance (budgetbalancing) was not “functional”—it did not help to achieve the public purpose(including, for example, full employment). If the budget were occasionallybalanced, so be it; but if it never balanced, that would be fine too. He alsorejected any attempt to keep a budget deficit below any specific ratio to GDP,as well as any arbitrary debt to GDP ratio. The “correct” deficit would be theone that achieves full employment.

Similarlythe “correct” debt ratio would be the one consistent with achieving the desiredinterest rate target. This follows from his second principle: if governmentissues too much debt, it has by the same token issued too few bank reserves andcash. The solution is for the treasury and central bank to stop selling bonds,and, indeed, for the central bank to engage in open market purchases (buyingtreasuries by crediting the selling banks with reserves). That will allow theovernight rate to fall as banks obtain more reserves and the public gets morecash.

Essentially,the second principle just says that government ought to let the banks,households, and firms achieve the portfolio balance between “money” (reservesand cash) and bonds desired. It follows that government bond sales are notreally a “borrowing” operation required to let the government deficit spend.Rather, bond sales are really part of monetary policy, designed to help thecentral bank to hit its interest rate target. All of that is consistent withthe modern money view advanced previously.

Functional Finance versus Superstition. The functional finance approach ofLerner was mostly forgotten by the 1970s. Indeed, it was replaced in academiawith something known as the “government budget constraint”. The idea is also simple:a government’s spending is constrained by its tax revenue, its ability toborrow (sell bonds) and “printing money”. In this view, government reallyspends its tax revenue and borrows money from markets in order to finance ashortfall of tax revenue. If all else fails, it can run the printing presses,but most economists abhor this activity because it is believed to be highlyinflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’s experience, or in moderntimes, Zimbabwe—as a cautionary tale against “financing” spending throughprinting money.

Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes using government’sown IOUs; banks use government’s own IOUs to buy bonds from government.

Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in theUS—is far more confused. For example, President Obama frequently assertedthroughout 2010 that the US government was “running out of money”—like ahousehold that had spent all the money it had saved in a cookie jar.

So how didwe get to this point? How could we have forgotten what Lerner clearlyunderstood and explained?

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:

"I think there is anelement of truth in the view that the superstition that the budget must bebalanced at all times [is necessary]. Once it is debunked [that] takes away oneof the bulwarks that every society must have against expenditure out of control. There must bediscipline in the allocation of resources or you will have anarchistic chaosand inefficiency. And one of the functions of old fashioned religion was toscare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he would say "uh, oh what you havedone" and James Buchanan argues in those terms. I have to say that I seemerit in that view."

Originallythe myth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation and endangering the dollarpeg to gold. But like many useful myths, this one eventually became a harmfulmyth—an example of what John Kenneth Galbraith called an “innocent fraud”, anunwarranted belief that prevents proper behaviour. Sovereign governments beganto believe that the really could not “afford” to undertake desired policy, onthe belief they might become insolvent. Ironically, in the midst of the worsteconomic crisis since the Great Depression of the 1930s, President Obamarepeatedly claimed that the US government had “run out of money”—that it couldnot afford to undertake policy that most believed to be desired. Asunemployment rose to nearly 10%, the government was paralysed—it could notadopt the policy that Lerner advocated: spend enough to return the economy towardfull employment.

Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional$600 billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.

Thatindicates just how dysfunctional the myth has become.

Next week, we’ll show that some Kansas City airmight have drifted northeast to the bastion of free market economics: theUniversity of Chicago

Geithner’s Ploy: Saving U.S. Banks at Taxpayer Expense, Once Again

2012-01-08T16:29:00.002-06:00

By Michael Hudson

U.S. and foreign stockmarkets continue to zigzag wildly in response to expectations about whether theeuro can survive, in the face of populations suffering under neoliberalausterity policies being imposed on Ireland, Greece, Spain, Italy, etc. Here’sthe story that I’m being told by Europeans regarding the recent turmoil inGreece and other European debtor and budget-deficit economies. (The details arenot out, as the negotiations have been handled in utter secrecy. So whatfollows is a reconstruction.)

In autumn 2012, it became apparentthat Greece could not roll over its public debt. The EU concluded that debtshad to be written down by 50 percent. The alternative was outright default onall debt. So basically, the solution for Greece reflected what had happened toLatin American debt in the 1980s, when governments replaced existing debts andbank loans with Brady bonds, named for Reagan Treasury Secretary Nicolas F.Brady. These bonds had a lower principal, but at least their payment was deemedsecure. And indeed, their payments were made.

This write-down seemed radical, butEuropean banks already had hedged their bets and taken out default insurance.U.S. banks were the counterparties to much of this insurance.

In December (?) 2011, a quartercentury after Mr. Brady, Mr. Obama’s Secretary Geithner went to Europe met withEU leaders to demand that Greece make the write-downs voluntary on the part ofbanks and creditors. He explained that U.S. banks had bet that Greece would notdefault – and their net worth position was so shaky that if they had to pay ontheir bad gambles, they would go broke.

As German bankers have described thesituation to me, Mr. Geithner said he would kill the European banks andeconomies if they did not agree to take it on the chin and suffer the lossesthemselves – so that U.S. banks would not have to pay off on the collateralizeddefault swaps (CDOs) and other gambles for which they had collected billions ofdollars.

Europeans were enraged. But Mr.Geithner made a deal. OK, he finally agreed: The White House would indeedpermit Greece to default. But America needed time.

He agreed to open a credit line fromthe Federal Reserve Bank to the European Central Bank (ECB). The Fed wouldprovide the money to lend to banks during the interim when European governmentfinances faltered. The banks would be given time to unwind their defaultguarantees. In the end, the ECB would be the creditor. It – and presumably theFed – would bear the losses, “at taxpayer expense.” The U.S. banks (andprobably the European ones too) can avoid taking a loss that would wipe outtheir net worth.

What really are the details? What wedo know is that U.S. banks are pulling bank their credit lines to Europeanbanks and other borrowers as the old ones expire. The ECB is stepping in tofill the gap. This is called ‘providing liquidity,’ but it seems more to be acase of providing solvency for a basically insolvent situation. A debt thatcan’t be paid, won’t be, after all.

Geithner’s idea is that what workedbefore will work again. When the Federal Reserve or Treasury picks up a bankloss, they simply print government debt or open a Federal Reserve bank depositfor the banks. The public doesn’t view this as being as blatant as simplyhanding out money. The government says it is “saving the financial system,”without spelling out the cost at “taxpayer expense” (not that of the banks!).

It’s a giveaway.

Pavlina Tcherneva - Bottom Up Fiscal Policy: Direct Employment of the Unemployed

2012-01-06T00:00:00.000-06:00

via INET

What’s MMT About Anyway and is the Job Guarantee Crucial to the Project?

2012-01-05T13:19:00.000-06:00

By Pavlina R. Tcherneva

This post is primarily addressed to the MMTcommunity and whoever considers himself/herself a follower of Modern MonetaryTheory. It deals with the question ofwhat is in the purview of MMT.

A number of MMT supporters from the blogosphere haveargued that MMT has a descriptive and prescriptive part and, more recently, thatthe Job Guarantee program (JG) falls in the category of prescriptions and that itis not as essential to the MMT project as the description of the operationalrealities of modern economies.

The argument is that once we have understood howsovereign governments fund themselves and how the banking system operates underdifferent currency regimes, then we can pick from a menu of policy options thatthe monetary regime affords, depending on our individual political preferences. Some MMT followers have claimed thatthey would prefer tax cuts to spending due to their more conservative leaning, whileothers still seem unconvinced that full employment is possible or evendesirable. By contrast, most first generation MMTers have made the fullemployment objective a salient feature of our work.

Though clearly there is an aspect of MMT that ispurely descriptive, I have always considered this division between thedescriptive and prescriptive part of MMT to be a fundamentally flaweddichotomy. Why are MMTers busydescribing what governments can and cannot do under different currencyregimes? Why have NewEconomicPerspectives,MoslerEconomics,BillyBlog,PragmaticCapitalism,MikeNormanEconomics,CreditWritedowns,to name just a few, spilled so much ink about the flaws of the Euro, thedifficulties with quantitative easing, or the impact of austerity policies inthe U.S. and abroad? Because producing an adequate description of monetaryoperations in and of itself is a useless exercise, but when it sheds light onthe policy options before us it is invaluable. And when we illuminate policychoices, we MMTers inevitably make a choice between one policy prescriptionover another.

The adoption of a currency board, a monetary union, orgold standard is a political choiceand to claim that MMTers are mainly interested in describing the problems withthe EU or dollarization or the gold standard without imparting any normative judgmentor preference of one currency regime over the other would be disingenuous. Idoubt anyone would claim otherwise.

When we discuss monetary policy we are not simplyimpartially evaluating the actual monetary operations, we bet, we trade, wemake claims, assertions and forecasts. Do we not hypothesize a monetarytransmission mechanism different from that of monetarism? Do we not theorize about the multipliereffects from spending on primary/direct employment and in turn on secondary/indirectunemployment? Do we not have a theory about the Fed’s ability to grow theeconomy, about the impact of discontinuing the payroll tax cuts on the economy,or of imposing draconian austerity measures on any nation? Certainly we do. We are not just describing, we are alsoforecasting and ultimately prescribing.

All of this requires some theory about how all thepieces of the reality we’ve just described fit together to produce someeconomic results. And to our credit, MMT has been righton the money on pretty much everything from theimpact of austerity, to the relative ineffectiveness of QE, to the movements inbond yields. This is the true test ofour effectiveness as economists or pundits—it is how well our theory and ourconceptualization of reality stand the test of time.

I realize that it is somewhat of a philosophicalpoint to say that facts do not exist in a vacuum and that we need to have atheory to make sense of these facts. But it is important to make this point,because MMT supporters are doing a disservice to the MMT project by drawingflawed boundaries between what can be called objective and what can be called subjectivein the MMT project.

And whereas a number of bloggers and friends haveembraced the merits of a sovereign monetary system, have renounced the flawedmonetary arrangement of the EMU, and have forcefully debated proponents of thegold standard, the JG has recently received considerable skepticism andcriticism from them (recent critiques can be found here,hereand here).

Now I welcome criticism of the program any day andlike many of my colleagues have answered questions and concerns about the JG formany years. We have also modeled, simulated, and studied specific direct jobcreation programs around the world. Thoughwe may not have a universal JG to study today, we have good many examples thatmimic or at least have important features of the JG that permit us to study themerits of direct employment.

TheJG is not just an afterthought to MMT but a crucial component that has so faroffered the most coherent counter-cyclical economic stabilizing mechanism.

If MMTers want to be technocrats in analyzingmonetary policy, then the same has to hold true for fiscal policy as well. So I ask that critics/skeptics/supporters of theJG apply to it same technocratic scrutiny that they apply to every other aspectof MMT. If you claim that you canobjectively explain the merits and demerits of one currency regime over theother, then the same has to be done with respect to the JG or any other fiscal policy.

Make your case against the JG based on its intrinsicfeatures, not on its political viability. Tell me why your policy of choice ismore sound and more effective than the JG. Tell me why and how tax cuts will produceand maintain high (full) employment betterthan direct job creation. What are your assumed transmission mechanisms, yourmultipliers, your estimated effects on prices and wages? Let’s debate thesetypes of issues, as I do not think that tax cuts and direct job creation arepolicies of equal merit. Tell me why subsidies or contracts to private firmsare more expedient and efficient stabilization methods than direct investmentby government. I may disagree but will be happy to engage.

But to claim that fiscal policy is somehow moresusceptible to crony capitalism, corruption, inefficiency than monetary policy(Fed lending facilities, anyone?) or any other private sector behavior (Enron,WorldCom… heck, all the pervasive control fraud in the financial andnon-financial sectors!) is simply a nonstarter.

The fact that any program like the JG can facevarious problems does not mean in and of itself the program is bad. It’s likearguing that we should scrap voting in the U.S. since elections have beenplagued by voting fraud and a good portion of the electorate has been deliberatelydisenfranchised and prevented from voting. A genuinely pragmatic and technocratic attitude would be to ask thequestion “What is the problem to be solved” (unemployment, corruption, inefficientallocation of resources, inadequate education) and then to find a solution.

I suspect that JG has received a lot of flak, notbecause the program is ineffective, but because at bottom some MMTers from theblogosphere disagree that unemployment is an economic and social evil that hasto be eradicated. If that is the position, then let’s bring it out in the openand let’s have that debate. I am happy to make the case that unemployment is a seriousmacroeconomic problem of capitalist economists that requires a long term solution which cannot bedelivered by the private sector, and that the solution we propose does not rest on some authoritarian controlof the government over the economy. I will gladly argue that an economic systemwith an “employment buffer stock” is a more stable, sound, efficient, and justthan one with an “unemployment buffer stock”. If you think the opposite, thenmake your case, but let’s have a debate on these technical terms, not on thebasis of some people’s visceral “dislike” for government-provided jobs or onthe basis that such a program is politically infeasible. These arenon-arguments.

If you asked me 5 years ago if the U.S. would electa black president in the next election, I would have told you that this was anear political impossibility because many Americans were still not ready for itand wouldn’t like it.

Economists not only have the responsibility toadequately conceptualize, describe, and analyze the economic reality, but alsoto be ready with effective policy tools to solve the most important problems ofour time, no matter how the political winds blow.

As John Maynard Keynes wrote in a letter to T.S.Eliot, good intentions are never the problem; the trouble with formulatingpolicies for full employment is that economists lack both the intellectualconviction of their feasibility and the cleverness to design them (Keynes 1980:384).

MMT-JG advocates justmight be the exception.

Responses to Blog #30: What is Modern Money?

2012-01-04T22:02:00.001-06:00

By L. Randall Wray

Q1: A fewquick questions:
(1) Isn't Charles Goodhart essentially a neoclassical who accepts thechartalist approach to money?
(2) Would it be accurate to say the sources of modern chartalism/MMT are:
    (a) Mitchell Innes's work
    (b) G. Frederick Knapp's work
    (c) Keynes and Abba Lerner's functional finance model
    (d) Post Keynesianism
    (e) some contribution from Minsky? (i.e, FIH)
In this sense it is a new macrotheory sharing many ideas with older PostKeynesians (uncertianty, endogenous money, subjective expectations) but thathas done innovative work in shattering myths about how the central bank andtreasury really function, even though one might argue that Abba Lerner was thetrailblazer in this work:
Lerner, A. P. 1943. “Functional Finance and the Federal Debt,” Social Research10: 38–51
Lerner, A. P. 1944. The Economics of Control, New York, Macmillan.
I'll just end by saying that when Keynes finally read Lerner's he appeared toendorse it.

A: The first MMT conference I recall was organized by WarrenMosler at Bretton Woods in 1996. At that time, he called it "Soft CurrencyEconomics", but most of the pieces of the MMT puzzle were there. The 3economists invited by Warren were: Charles Goodhart, Basil Moore, and YoursTruly. I would not accept "essentially neoclassical" as an accuratedescription of Charles. However, to say that he marches to his own drummerwould be accurate! We don't agree on everything, but we agree on much. A bitmore on that conference: a) the one who actually did the work of organizingWarren's conference was none other than Pavlina Tcherneva, who at the time wasan undergrad student of Mat Forstater;
b) my memory is notoriously bad and someone will probably correct me byreminding me that the BW conference was not the first meeting of MMT, butit was certainly the first time I met Warren and Pavlina! I think I hadmet Mat before, and had known Stephanie for quite some time; I think I had metBill before 1996--but memory is foggy. I knew all of these people on-line andwe had been working on MMT for several years, but I think the meetings andconferences began in 1996.

Q2: Does Basil J.Moore subscribe to MMT? I know his work on endogenous money. Just to clarify:the founders of MMT are Warren Mosler, Charles Goodhart, Basil Moore, RandallWray, Bill Mitchell, Pavlina Tcherneva, Stephanie A. Kelton and Mat Forstater?Since Basil Moore was obviously a Post Keynesian, is it correct to say thatmany of the founders were influenced by Post Keynesianism ? Does not WarrenMosler have a connection with Paul Davidson? And good old Hyman Minskyinfluenced you, Profesor Wray? Finally here are my brief thoughts on thehistory of MMT: http://socialdemocracy21stcent...

A: Looks good. Look at the first MMP blog which has a list of contributors, andstudents etc that I thank. It is impossible to formulate a complete, definitivelist. Kelton is Bell. Except for my "students" (Tcherneva, Tymoigne,Kaboub, Nersisyan, Leclaire, Fullwiler, Bell, etc, too many to list here)most of us originally met on the old PKT internet discussion group. Others,like Moore and Davidson and Minsky and Kregel are "fathers" in somesense of the PK approach--so I knew them from early 1980s. They accept elementsof MMT, but except for Kregel it probably would not be good to list them asMMTers. We all learned from them. Note I have been negligent in forgetting tolist Ed Nell--and will do so--because he was a supporter from the earliestdays. And he helped to organize meetings at the New School. Minsky is withoutquestion the greatest economist of the second half of the 20^thcentury. So, yes, we were influenced.

Q3: Would Henry C. Carey be considered as a kind ofprecursor to MMT? Was he an influence in your intellectual formation?Could this be the source? http://www.amazon.com/Modern-M...

A: Professor Mat Forstater isour resident historian of thought. He might know Carey or this Burstein; thenames do not ring a bell with me.

Q4: John Carney's piece referring to crony capitalismwas most interesting as was Mitchell's response talking about the JG. I alsosaw your blog on the JG. These all have a great appeal and I hope you willcomment more. There is no doubt there is just plain corruption when thegovernment tries to stimulate the economy directly but even the JG will besubject to that. I suppose corruption or whatever name you give it exists inall endeavors. The JG has some problems in this world, not least of whichis a base for effective political support. So, again, I hope you willspend some time on those issues. At some point the economics has to come togrips with political power and society.

A: We will deal with most of these issues in coming blogs.But if we all agree on the theory then all we need to do is put our headstogether to make it work. What amazes me is that upward of 95% of theobjections now—20 years later—are about program implementation, politicalfeasibility, and corruption. OK I think some of you are smart. Put your darnedheads together. Stop criticizing. Start solving problems. I cannot see any useof economics or any other branch of human endeavor if it does not try to tackleproblems. Finding useful work for a JG employee seems to me to be on the orderof difficulty as finding a pot for your 2 year old to pee in. If you cannotresolve that problem, you are up the creek without a paddle, so to speak. Haveany of you ever put a diaper on your damned kid? You began as all thumbs andsharp pins. After a few months you could do it with eyes closed, one-handed, ina restaurant while serving your guests with your other hand. As Keynes said,this is like dentistry. Solve the damned problem. Stop complaining. All of you,every single one of you, should be able to resolve all these issues before Ieven start posting blogs about the JG. That’s a challenge. My upcoming posts onJG should be completely redundant. Get your buns in gear. You’ve been here formore than half a year; all the pieces are in place. Go for it. Prizes and fameawait.