naked capitalism

By George Washington of Washington’s Blog.

Yesterday, Elliot Spitzer said that the White House’s defense of the financial status quo will give Republicans powerful ammunition in the 2010 elections.

Democratic cheerleader Markos Moulitsas (the “Kos” behind Daily Kos) wrote the following about the Democratic losses in several state elections:

Democratic turnout collapsed. This is a base problem, and this is what Democrats better take from tonight:

… If you water down reform in favor of Blue Dogs and their corporate benefactors, you will lose votes…

If you forget why you were elected — … financial services … reform — you will lose votes.

Tonight proved conclusively that we’re not going to turn out just because you have a (D) next to your name, or because Obama tells us to. We’ll turn out if we feel it’s worth our time and effort to vote, and we’ll work hard to make sure others turn out if you inspire us with bold and decisive action.

The choice is yours. Give us a reason to vote for you, or we sit home.

People elected Obama in the hope that he would be different from Bush. But in the most important ways, he is just continuing Bushand Clinton’s (think repeal of Glass-Steagall) worst policies.

Both the Republican and Democratic party leadership have become lapdops for the big banks and the status quo. Neither are open to real reform or change.

The Democrats haven’t broken up the too big to fails.  They haven’t restored Glass-Steagall.  They haven’t really reined in credit default swaps.  They haven’t pushed for honest accounting or forced the giants to put their toxic SIV-hidden assets back on their books.

People are sick and tired of both parties’ catering to the big boys.  Indeed, given last night’s election results and the Dems’ utter failure to institute any real financial reform, trend forecaster Gerald Calente’s prediction that a third party candidate will win the 2012 presidential election is sounding a little less crazy.

Submitted by Edward Harrison of Credit Writedowns

I am posting this in the interest of widening the discussion at Naked Capitalism to include some topics in Europe.

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-.  That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin’s finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit.  It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland’s rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month’s Budget may set the economy back further, but without it the country’s national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month’s Budget into account, because the details are not yet known.

“Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded,” the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy’s problems might give more support to consumption and investment by helping confidence.

The Government’s plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission’s estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn’t rule out temporarily nationalising the country’s banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

“Further recapitalisation may be necessary as assets are being purchased below book value,” the Paris-based OECD said in a report today. “Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether.”

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

“Substantial” banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the “utmost reluctance,” the OECD said.

The FT’s Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today’s bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

By Edward Harrison of Credit Writedowns

Yves is tied up in the never-ending ordeal that is writing a book, so I will fill in a few gaps by posting on NC today. Let’s wish Yves well in getting this thing sorted.

The power grab at the Federal Reserve is a topic I first broached back in February when the Federal Reserve was creating its alphabet soup of liquidity programs to pull us back from the brink of financial disaster. I was troubled about Fed policy then and I am still troubled today.

I am equally disturbed by what is happening in shift in the balance of power to the executive branch. The Obama Administration seems to be following in the footsteps of the Bush Administration and making its own power grab and Congress has only just begun to wake up to this and start to push back.

At the risk of making this post overly broad, I want to make a few general comments about how executive power in government operates before I take on the specifics of the cases at hand. Everyone who has studied political science is aware that dictators and oligarchies use crises to invoke fear that allows them to usurp power using the cloak of ‘national security’ as a Trojan horse to consolidate power.

I would argue, this is what has just happened in the U.S. post-9/11 and again after the Panic of 2008. I see these developments undermining Americans’ faith in the political process and I hope an appropriate restoration of the checks and balances laid out in the Constitution can be restored. Having made my editorial statement, let me move to the specifics.

Executive Branch power grab

In September, after Lehman Brothers failed, US Treasury Secretary Hank Paulson asked for and received a blank check to disburse $700 billion to former colleagues and rivals in the financial services industry as he and his staff saw fit. In a brilliant act of cunning, Paulson had gotten approval to do anything he wanted from a gutless Congress more interested in loading the bill with sweeteners. This bill was not unlike the Patriot Act, passed after the 9/11 attacks, in that it increased the executive branch’s ability to intervene in the economy as they saw fit. I called it the Economic Patriot Act.

Originally, the Economic Patriot Act was about marking to market. However, once Gordon Brown started recapitalising Britain, Paulson made an about-face and proceeded to dispense the money in a similar fashion (albeit with much fewer strings attached than in the UK).

When the Obama Administration came to town, the modus operandi were not much different. Other support programs were forthcoming and bailouts at Citi and BofA ensued.

With the economy and banks on sounder footing and much of the money returned to taxpayers, the Obama Administration has turned to regulatory reform – and, what do you know – they are looking for a blank check again to do as they please in resolving too big to fail institutions that run into trouble. Again, as with Bush in 2002, if Congress gives the executive branch any blanket authority, it will be used and Congress will be cut out of the process. This is NOT how the American system of government is supposed to be run.

The Fed is grasping for the brass ring too

Enter the Federal Reserve. The Fed has been engaged in a policy of acting in concert with the Executive Branch in a non-arms length fashion since this crisis began. All of the liquidity programs and backstops the Fed has implemented are not just about liquidity, they are subsidies that lower the cost of capital and increase profits in the banking sector. As such, these subsidies are actually a part of America’s fiscal policy – stimulus, if you will. It is a clear no-no for the Federal Reserve to inject itself into fiscal matters. And to top it off, the Fed is refusing to be transparent about the process. Why would we make it the Systemic Risk Regulator?

Willem Buiter says it best so I will just quote him verbatim from his article, “Should central banks be quasi-fiscal actors?”:

Any action going beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury – an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

The two arguments against the central bank acting as a quasi-fiscal agent are, first, that acting as a quasi-fiscal agent may impair the central bank’s ability to fulfil its macroeconomic stability mandate and, second, that it obscures responsibility and impedes accountability for what are in substance fiscal transfers.  In the US such actions subvert the Constitution, which clearly states in Section 8, Clause 1, that the power to tax and spend rests with the Congress: “The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.”.

If, as happened in the USA on a vast scale, the central bank allows itself to be used as an off-budget and off-balance-sheet special purpose vehicle of the Treasury, and refuses to provide to the Congress some of the information essential for the quantification of the fiscal transfers it has made, the central bank not only subverts the constitution.  By attempting to hide contingent commitments and to disguise de-facto subsidies by not divulging relevant information on the terms on which the central bank has offered financial assistance, it undermines its own independence and legitimacy and impairs political accountability for the use of public funds – ‘tax payers’ money’.  It is surprising that a country whose creation folklore attributes considerable significance to the principle of ‘no taxation without representation’ would have condoned without much outcry such a blatant violation of the equally important principle of ‘no use of public funds without accountability’.  This indeed amounts to a quiet usurpation of the power of the legislature by the central bank.

Qualitative easing, or whatever you call it, must end.  With the FOMC starting its two-day meeting tomorrow, and with the Reserve Bank of Australia having already hiked twice, it will be interesting to see if the Fed retracts its “extended period” language as many of us expect. While I think it premature in regards to the robustness of the economy, the Fed needs to show it is an independent actor.

Once lost, independence will not be easily restored.

Eliot Spitzer explains how the White House defense of the status quo will give Republicans powerful ammunition in the 2010 elections.

Few things are as potent in politics as calling for change at a moment of fundamental dissatisfaction with the status quo. Nobody should know this better than the current White House. Gauzy words describing the possibilities for change are always more comforting than defending the current dire straits. That is why — in addition to all the substantive arguments — the current White House plan for banking reform is so troubling.

Let us fast forward a couple of months. Momentary GDP pops notwithstanding, the economy next year is likely to be in pretty sad shape. Consumer spending is sagging; foreclosures are still climbing (and may surge as ARMs re-set); unemployment is likely to be hovering in the 9.5-10.0 range; federal deficits and state deficits will be soaring; and Goldman profits will still be setting new records.

Added to this toxic political brew will be a new, and perhaps counter-intuitive, but highly successful political attack from the RIGHT: break up the banks. Imagine this: by next spring, an intellectual consensus will have emerged that the concentration in the banking sector that developed from the 1980s until the crash of ‘08 was misguided. Voices as disparate as Former Fed Chair Paul Volcker, Bank of England Governor Mervyn King, meta- investor George Soros, and the Wall Street Journal editorial page will be in agreement on this point.

A few brave souls on the Right — recognizing that the Republican Party has been bereft of ideas in its attacks on President Obama — will then try to re-define a populist, conservative attack by asserting that the White House has been captured by Wall Street. Real populism and change, they will argue, will come from the Republican, not the Democratic, party.

The power of such an attack from the Right should not be underestimated. There will be a huge first mover advantage that goes to the candidates who grab the real banner of attacking the structure of Wall Street as having been the root of the crash of ‘08. We Democrats are spending way too much time wringing our hands over the new, “reformed” structure of regulation, and not nearly enough focusing on restructuring the banks. Congress continues to mediate the intramural battle among regulators who are defending turf in the next regulatory flow chart. Yet the real debate should be how to take the big banks and make them smaller: how to peel off proprietary trading and other high-risk endeavors that are now being funded and guaranteed by taxpayers.

In addition, there is too much attention being paid to the one recent idea thrown into the mix by the White House: how to place a tax on big financial institutions after the next crash, so that they shoulder the cost of the next bail out. The notion that a levy on surviving big banks when the next crisis hits can pay for the bail out seems wrong in at least three ways:

First, applying a levy at the moment of crisis will merely accentuate a down turn. At a time when we will presumably need more liquidity and lending to revive a stalling economy, the federal government is going to apply a significant tax to healthy institutions capable of lending? Not likely.

Second, having the healthy institutions cover the losses of the sicker institutions takes us right back into the land of moral hazard. Profligate, risk taking entities will be bailed out by those that exercised caution.

Third, any downdraft significant enough to bring “too big to fail” institutions to the brink of the precipice is likely to be broad based enough so that virtually all the other major institutions are troubled, probably leaving them in a no position to cover the cost of the bailout.

So the simple question remains: why aren’t we focusing on the problem that got us here in the first instance — the scope, range, and size of the mega-institutions whose risk taking has so far inflicted only enormous harm on our economy? If the Republicans pick up this issue before we do, the elections of 2010 could be even worse than we are now fearing.

Cross posted with the permission of New Deal 2.0.

By George Washington of Washington’s Blog.

As I have repeatedly written, the largest U.S. banks have repeatedly gone bankrupt due to wild speculation which was blessed by the Fed, and then the government covered up their bankruptcy.

Indeed, the New York Times writes today about one of the too big to fails:

Over the past 80 years, the United States government has engineered not one, not two, not three, but at least four rescues of the institution now known as Citigroup.

But prominent economist James Galbraith recently told Bill Moyers:

JAMES GALBRAITH: The overwhelming emphasis, in the administration’s program, I think, has been to return things to a condition of normalcy, to use a 1920s word, that prevailed five and ten years ago. That is to say, we’re back to a world in which Wall Street and the major banks are leading, and setting the path–

BILL MOYERS: To restore what was.

JAMES GALBRAITH: To restore what was–

BILL MOYERS: Instead of reform what is.

JAMES GALBRAITH: And I don’t think what was can be restored.

BILL MOYERS: And you say that’s the objective of the administration’s policies? Geithner, Bernanke, Summers, the President himself?

JAMES GALBRAITH: To the extent that there’s a defined objective, that’s it, yes. I think in the immediate day-to-day work, they’ve largely been preoccupied with keeping the existing system from collapsing. And the government is powerful. It has substantially succeeded at that, but you really have to think about, do you want to have a financial sector dominated by a small number of very large institutions, very difficult to manage, practically impossible to regulate, and ruled by, essentially, the same people and the same culture that caused the crisis in the first place.

In other words – as I have repeatedly written – the administration’s talk of reform is just talk … the boys are just trying to restore the status quo.

Galbraith also pointed out – as many other experts have – that confidence in the system cannot be restored unless the fraud which led to the crash is investigated:

JAMES GALBRAITH: That’s the point about the crisis, is that it could have been prevented. The people in authority two, three, five years ago, knew how to prevent it. They chose not to act, because they were getting a political and an economic benefit out of the speculative explosion that was occurring.

BILL MOYERS: You mean, the people who could have prevented the dam from breaking were too busy fishing above it, and reaping big rewards to want to fix the crack in it?

JAMES GALBRAITH: Sure. The Federal Reserve, in particular, knew that the dam was cracking. Alan Greenspan, I think, almost surely knew this, and chose to wait until it had washed away.

BILL MOYERS: Why?

JAMES GALBRAITH: They let all of this run, because they were getting a superficially stronger economy out of it. The ownership society, all that was a scam, basically, designed to lure people who could never afford these mortgages into accepting them. And yes, I think they, any rational person, certainly people in the industry, knew that this was not going to last. There was a little industry code, I’ve learned, IBGYBG. “I’ll be gone. You’ll be gone.”

BILL MOYERS: Really?

JAMES GALBRAITH: Yeah.

BILL MOYERS: The industry being the securities industry?

JAMES GALBRAITH: Well, and the mortgage originators and the bankers, generally.

BILL MOYERS: But that’s criminal fraud.

JAMES GALBRAITH: Oh sure. There was a huge amount of it. The Bush administration did not actively investigate the fraud that they knew, that the FBI knew was occurring, from 2004 onward. And there will have to be full-scale investigation and cleaning up of the residue of that, before you can have, I think, a return of confidence in the financial sector. And that’s a process which needs to get underway.

As the New York Times article notes, the lack of transparency is ongoing, even as between different branches of government:

Representative Lloyd Doggett, a Texas Democrat on the House Ways and Means Committee, recently registered unease about the government’s guarantee of $300 billion in Citigroup assets and how effectively the Treasury secretary, Timothy F. Geithner, was monitoring the bank.

“We cannot know the full scope of the taxpayers’ potential cost from these hasty guarantees,” Mr. Doggett said last week in an e-mail message. “Inexplicably, Secretary Geithner appears unwilling to commit to conduct an analysis, despite my specific request to him in March. A critical and transparent examination of the response to the financial crisis is essential not only to learn from past mistakes, but also to prevent further erosion of the public’s trust in government.”

Mario Seccareccia – editor of the International Journal of Political Economy – points out:

The Great Crash of 1929 taught us that a modern monetary market economy is governed by confidence. As John Maynard Keynes put it, monetary relations and, more precisely, asset values, are held up by one’s belief in the future. Without it, the whole credit-driven economic system comes to a halt and economic agents scramble for cover by seeking to acquire liquidity.

While in a non commodity-based monetary system a central bank can quite easily supply liquidity in its role as lender of last resort, a central bank cannot single-handedly instill confidence in the future. When confidence is lost, monetary policy is impotent in building up asset values, which can only be sustained if people believe in future revenue arising from future production. The economy remains trapped in a state of paralysis in which everyone is seeking to remain liquid. History tells the tale: Excessive optimism prior to the Great Crash turned to hopelessness during the early 1930s.

Without a thorough investigation like the Pecora Commission, and without prosecuting those who are guilty, confidence and hope in the future will not be restored, consumer confidence will remain depressed, and we will remain in an economic slump.

By George Washington of Washington’s Blog.

Preface:  Please read to the end to see the humorous quote.

I have previously debunked numerous false arguments used to defend the too big to fails. See this and this.

But the apologists for the TBTFs are now arguing that breaking up the beached whales … er, giant banks … will harm America’s ability to compete with foreign banks.

Joshua Rosner (managing director of an independent financial services research firm), has written an important essay debunking this argument:

Those who argue against a more proactive reduction in risk and size of TBTF institutions will, as always, revert to an argument that strikes a natural chord in every American’s heart: ‘Doing so would create an unleveled international playing field for our institutions relative to their international competitors’. Level playing fields are a worthy goal, but this is not a relevant argument. Instead, this tired bromide must be resoundingly dismissed on several counts:

• Those countries with the largest banks as a percentage of GDP (Iceland, Ireland, Switzerland) demonstrated that a concentration of banking power can cause significant sovereign risk and tilt global economic playing fields away from that country.

• The likely breakups of ING, Lloyds and KBC suggest that it is we who seek to support an unlevel playing field where we subsidize our TBTF banks while other nations recognize the policy failures of moral hazard. If we continue down this path we will likely be at risk of violating international fair trade regimes.

• When the “unlevel playing field” argument is cited, keep in mind this reasoning supports the disadvantaging of 8000+ community banks relative to our largest banks, all in the name of protecting big banks from governmentally- subsidized international competition.

• There is no longer any evidence that, beyond a cost of capital advantage that comes with implied government support, there are sustainable and tangible economies of scale arising from being the largest. The financial supermarket concept has been proven a failure. The only ones who benefit are the high-level executives.

• We must demand that our legislators no longer allow unelected officials at the independent Federal Reserve to sign international accords created by the TBTF banks through supra-national bodies like the Basel Committee.

• Are we to believe that if we did not have such large and globally dominant firms, US borrowers might be paying more that the 29% interest that several of the TBTF firms are now charging on their card accounts? Perhaps we should think about what advantage our population has gained as a result of our financial institutions being such a large part of our economy or being globally dominant.

• Since when did we accept a national strategy of following rather than leading? When we do what is right, others follow. As example, consider the bank secrecy havens – they made money for a bit. Now, even the Swiss and the Cayman authorities are coming around to our view.

• We are already at a disadvantage given that the largest foreign banks operate in the US without any tier one capital requirement and yet mostlarge foreign banks have not built a bricks and mortar presence here. Nobody screams about their undercapitalization nor has that undercapitalization caused deposits to migrate to foreign banks.

What fake excuse will the apologists for the TBTFs throw out next?

That breaking up the giants and letting small and mid-sized banks, credit unions and state public banks compete fairly will shift the Earth’s gravitational field as deposits shift away from the money centers?

Note: Rosner has a funny and potentially effective idea for putting pressure on Congress. He suggests that we all call our representatives and ask how much the lobbyists have paid them to destroy America’s economy by propping up the too big to fail banks.

Rosner’s actual language is somewhat over-the-top:

Harper’s Magazine has written up the lengths to which the authorities will go in censoring views that dissent with what is the unstated official policy: that no demand of the banking industry is too unreasonable not to be catered to.

The object lesson is the gutting of the falsely-branded derivatives reform bill. It arrived with a loophole so large you could drive a truck through it, namely that customized derivatives were not covered. So this bill will do nothing to impede the growth of complex opaque products; in fact, it encourages it, since banks will have no oversight if they tweak a product so that is can be deemed “customized.” It was further weakened by excluding most of the banks in America and by excluding a whole swathe of end users. The final insult was making the derivatives clearing house self-regulating.

The hearings on the bill had testimony scheduled only from what amounted to industry flacks. Someone apparently realized at the 11th hour that that might not go over with the correctly angry public too well. So less than 24 hours prior to the session before the House Financial Services Committee, an invitation was issued to Rob Johnson, a former managing director at Bankers Trust Company and former economist at the Senate Banking Committee and Senate Budget Committee.

So what transpired? As Ken Silverstein recounts:

Johnson, who came last, offered the only serious critical viewpoint… After about five minutes of his testimony, Congresswoman Melissa Bean—another industry-funded committee member who chaired the hearing because Frank was absent—had heard enough. “I’m just going to ask you to wrap up because we’re running out of time,” she told Johnson.

Johnson gamely continued. “When I hear the testimony today that are largely financial institutions and end users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States,” he said.

“I do need a final comment,” Bean interjected seconds later.

That put an end to Johnson’s testimony. “I was just called to this hearing last night, so I will provide detailed comments on your bill and a statement for the record that will finish my comments,” he concluded.

So what happens next? >The House Financial Services Committee has refused to publish his testimony, offering “the dog ate my homework” level excuses, first that they hadn’t gotten it, then that it was in the wrong format, then that their IT department was experiencing difficulties (always a good one when real reasons are running thin). The last one was pure Catch-22: that he had gotten his written testimony in too late.

You can read his statement, which is obviously too offensive to powerful interests for it to see the light of day in any officially-sanctioned venue, at the Roosevelt Institute.

By Edward Harrison of Credit Writedowns.

DoctoRx, Rob Parenteau and Marshall Auerback have each written articles here to bring clarity to some issues I first raised at the beginning of the month in my post, “The recession is over but the depression has just begun.”

As I see it, the issue we are debating has to do with how the government responds when large debts in the private sector constrain demand for credit in the face of a severe economic shock and fall in aggregate demand. In short, if private sector debt levels are so high that a recession precipitates private sector credit revulsion, how should government respond?

Frankly, this question is as much philosophical and political as it is economic.  So I want to wait to answer it and first frame the monetary system in a way which reveals the political nature of the question. Afterwards, I hope it is apparent that there is no one answer to this question and that any society’s answer depends on and reveals its priorities as a people. I will try to make some concluding marks about government debts and taxes in a fiat currency system given the analysis Marshall’s post.

Money and the sectors of the economy

Money is a tool, a medium of exchange, which derives its value from its utility in allowing individuals in an economy to trade goods and services. It eliminates the need to barter and make direct exchanges of goods and services in order to trade. Think of any economy as a collection of individuals or groups which trade goods and services with each other and with the outside world in exchange for a money-value of those goods and services. Each transaction is an exchange of a good or service for a equivalent value amount of money.

So, in any country, the flow of goods and services should be a one for one mirror image of the money flows. Now, if you break an economy down into sectors like the government sector, the private sector, and the foreign sector, the same is also true. Two accounting identities flow from this.

• In any particular time period, the changes in both money value of goods and the changes in the financial balances must sum to zero.  As Rob, illustrated: Household FB + Business FB + Government FB + Foreign FB = 0
• One sector’s deficit is another sector’s surplus. Think of it this way, if you and I are the only ones in the economy. If I spend more than I earn in, say, one particular month to buy your goods and services, you must have spent less than you earned in that same month to buy my goods and services.

If you take Rob’s formula and combine the two sectors of households and businesses into one sector, the private sector, you are left with Private FB + Government FB + Foreign FB = 0. What this means is that in any given time period, the private sector financial balance is offset by the government and foreign sectors’ balance such that they all sum to zero.

Private sector debts and credit revulsion

Given the framework above, it should be clear that when the private sector has a net surplus, the government and foreign sectors must have a combined net deficit.

So what happens when the economy lapses into recession because of a financial crisis caused in large part by excessive leverage and debt?

The answer is credit revulsion, also known as deleveraging. And this is what we have just seen in the U.S. economy.  Credit revulsion means that the private sector (businesses and households) reduce or are forced to reduce their debt burdens. This change in behavior induces a net surplus in the private sector; the private sector increases savings.

I’m sure you know where this is going. If the private sector moves to a net surplus, the combined government/foreign sectors must axiomatically move to a deficit.

A foreign sector deficit means that we are net exporting i.e. foreigners are buying more stuff from us than we are from them. We are talking money flows here not goods and service: more money coming in than going out (FB deficit) means fewer goods coming in than going out (current account surplus). Since the U.S. is not going to run a current account surplus, I am going to leave this out of the discussion to focus on the real issue: Government.

We can try and reduce private sector savings

So, the result for the U.S. of a private sector which is net saving is government deficits – this what naturally flows from a credit-revulsion induced private sector deleveraging. By saying this, I am stating fact, I am not making a political argument for or against deficit spending.

However, this is where the political/philosophical discussion starts. Two questions come to mind.

• Do we want the private sector to net save at this point in time?
• If so, do we want this savings to occur in an environment of more aggregate demand or less?

Policymakers today have answered no to the first question. They have said, “we do not like credit revulsion and our preferred policy choice is to work against it by reducing private-sector savings.” How do they do this? They lower interest rates in such a way that there is less incentive to save. Policymakers are in effect voting to continue the asset-based economic model.

But, there are several problems with this policy decision: it rewards debtors over savers, it prevents deleveraging from occurring, it creates asset bubbles, it keeps zombie companies and overcapacity alive, and it misallocates resources by artificially lengthening time preferences for money. In short, it is poor policy and it will end poorly as well.

Or we can maintain it and decide to either increase or decrease aggregate demand?

If you reject this policy path, you then have two options. In one, aggregate demand is reduced. In the other aggregate demand is increased.  Which option we choose, again, depends on politics.

In a July post, I outlined the choices. (Note the labels ‘surplus’ and ‘deficit’ should really be labeled ‘financial balance.’ For simplification the foreign sector isn’t depicted but one could assume it is aggregated with the government sector.):

In the Minsky world, the increase in net savings in the private sector and reduction of the current account deficit is axiomatic when the government is increasing deficits.  The point is that the private sector net saving and current account deficit must equal the government deficit.  So, when the combined private savings and current account deficit increases, the government’s financial balance must become more negative.

What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):

To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.

1. We start where the red circle is.
2. When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
3. However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically.  That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.

The cult of zero imbalances

In the depression post which kicked off this debate, I said “I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively.” Consider me a card-carrying member of the cult of zero imbalances. My preference is to see a neutral state where the sectors are balanced as the average long-term outcome. We may deviate from a zero imbalance state over the short-term, but we should be working toward it over the longer-term.

However, in the interim, what we want is to get back to that red circle in the chart and higher GDP and stay away from the green circle and lower GDP – also known as depression.  The difference between these two is government deficit spending.

Depressions are downward economic spirals. And when I invoke the term spiral, you should not be thinking of some stable equilibrium like the Great Moderation, Goldilocks economy, Nash equilibrium or some other close facsimile of economic Nirvana. You should be thinking war, famine and pestilence because those are the events which are historically associated with periods of high deflation and depression.

For me, the choice is clear.

The key is liquidation of overcapacity

While the picture I presented above represents a single point in time, what we want to know is how we get back to the green circle over time. In the depressionary example, we contract immediately and violently as aggregate demand is reduced in both the public and private sectors. The result is a liquidation of overcapacity and a depression. In the pro-growth example, aggregate demand is boosted by government spending whilst the private sector deleverages. In this scenario, liquidation of overcapacity also occurs if the government allows it to do so.

And this is the key: to the degree that government deficit spending is used as a vehicle for channeling funds to so-called systemically important businesses to prevent them from failing, we are merely kicking the can down the road. With the deleveraging, malinvestment must be purged for the economy to right itself on a sustainable growth path.

Government’s hidden debt?

That brings me to the last point: government debt. The first issue I want to address is unfunded liabilities.  This is something of great concern to many (including myself).  However, when we are talking about debt and credit, it is not particularly relevant. I mention this because of my statement in the original post:

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted.

A lot of people want to bolt the unfunded liabilities onto government debt to make the government’s debts appear larger than they actually are.  But when talking about the credit system, we have to be careful and distinguish between obligations and actual debt – related but different terms.

In a period of credit revulsion, the key issue is the overall credit in the system. At issue is a debtor’s inability to meet large existing obligations such that the debtor defaults, the obligation is written down, and the overall credit in the system contracts by the amount of capital that has been allocated to that writedown. The issue is credit writedowns and how they suck capital out of the system, reducing credit and leading to a potential deflationary spiral. It has absolutely nothing to do with unfunded obligations.

The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.

Government and its money

The difference between GM and the federal government is vast, however. General Motors is a private organization which must fund its obligations by selling products.  To quote Ben Bernanke’s now infamous words:

the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

The U.S. government has monopoly control of the currency and no other entity can print money as a medium of exchange in the United States (see my post “The origin of the U.S. dollar as legal tender and its link to Depression” for how this came to be.)  When anyone else attempts to print money, it is called counterfeiting. In saying this, I am stating fact, I am not making a political argument for or against legal tender laws.

This is a problem for states – which cannot print their own money – and for Eurozone countries – which also cannot print their own money (as I laid out in my post, “Depressionary bust in Ireland is echoed in California”) – but it is not a problem for the U.S. government. If the U.S. government so chooses, it can ‘fund’ any purchase with additional money it prints. It is not constrained in the same way private sector actors or even states and local municipalities are.

It is disingenuous for economic pundits like Marc Faber to suggest the U.S. is going to go bust. The United States will not literally be declared insolvent as long as it issues debt in its own currency. Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

Inflation is another issue altogether.  When the economy is operating at potential, money printing leads to consumer price inflation. But this is not the case right now, there is an enormous output gap that is not going to be closed anytime soon.  So the government can print all the money it wants and buy all the Treasuries it wants; none of this will lead to consumer price inflation in the short run except via dollar depreciation and import prices. Again, I have to remind you that in saying this, I am stating fact, I am not making a political argument for or against quantitative easing.

I should point out that the output gap is why money printing is leading to an asset price bubble both in the U.S. and globally and one reason we should reject QE even in the absence of consumer price inflation (this line was added because the initial comments suggested readers thought I am advocating quantitative easing when I am not).

I hope this post adds to the debate Marshall, Rob, and DoctoRx have taken on.

By Marshall Auerback, an investment strategist and analyst who writes for New Deal 2.0.

How appropriate that with Halloween just around the corner, the Fed and Treasury have announced a coordinated effort that will put the central bank at the forefront of pay regulation on the zombie firms now kept alive courtesy of US government largesse. Trick or treat for the US taxpayer?

The new pay regulations are ostensibly designed try to align the financial incentives of managers with the longer-term performance of their firms. The Federal Reserve will have direct oversight over the pay of tens of thousands of executives, bankers, and traders. The oversight is being justified as a “safety and soundness issue“, according to Fed Chairman, Ben Bernanke.

Had the Fed and Treasury demonstrated similar concerns about the overheating housing market, the degeneration of lending standards, and the proliferation of dangerous Over The Counter (OTC) derivatives during the past 10 years, it could have done much to alleviate today’s still profound financial instability.

This measure, by contrast, reeks of bogus populism. In the words of Reuters’ columnist, Jeffrey Cane:

By making executives at seven companies wear hair-shirts, some of the populist anger over bonuses and Wall Street may be assuaged – anger that should rightly be channeled into calls to prevent banks from engaging in risky activities. There’s no reason that banks that are back-stopped by the government should be in the securities business. Taxpayers – voters – should ignore the media fascination with pay and urge that Congress heavily regulate and tax such risky activities.

As Cane acknowledges, the curbs only apply to the newest wards of the state, the likes of AIG, Chrysler, GM, Bank of America, and Citibank. The more than 700 banks and other companies that have directly benefited from the government’s largesse are not affected – even those who are minting profits from credit markets propped up by trillions of dollars of the taxpayers’ money, and who continue to benefit as a consequence of the FDIC guarantees of their commercial paper, which substantially reduced borrowing costs at a time of uniquely high financial stress. Yet we’re still neither proposing any kind of serious regulation, nor any kind of resolution mechanism to deal with the problem of “too big to fail” banks.

The Fed has other big ideas: Federal Reserve Chairman Ben S. Bernanke has also called on Congress to ensure that the costs of closing down large financial institutions are borne by the industry instead of taxpayers. He has called for a “credible process” for imposing losses on the shareholders and creditors, saying “any resolution costs incurred by the government should be paid through an assessment on the financial industry.” That would be the very same financial industry that has already received trillions of dollars in financial guarantees and aid by the Federal Government, wouldn’t it? The left hand giveth, and the right hand taketh away. It’s all a big shell game. Given the absence of structural changes in the industry, this will simply increase the cost of credit, so the taxpayer will end up paying again.

What’s with the Fed’s new-found populism? It’s as if Ben Bernanke has started to channel his inner Huey Long. There could well be other motivations at play here.

The Federal Reserve, as we know, is now under uncomfortably high public scrutiny and its hitherto secretive actions are being subject to the greatest degree of Congressional and press scrutiny that the institution has experienced in its 96-year history. True, in the 1970s, the then-Chairman of the Committee of Financial Services, Henry Reuss, sought to challenge the constitutionality of the Federal Open Market Committee’s ultimate decision-making power on monetary policy, but he was denied standing. The Supreme Court never ruled on the issue. But now, like so many other things, the Fed’s privileged status in our society is again being queried. A healthy dose of skepticism in regard to their actions is well merited.

And what of the Obama Administration itself? It demonstrates a similar kind of cognitive dissonance evinced by the Federal Reserve. Having left open the gates of the asylum, the President and his main economic advisers profess shock, (”shock!”) that the sociopaths who run our investment banks are back to their old tricks, daring to gamble in a totally uninhibited manner with the taxpayers’ dollars. These are the same dollars which have been all but guaranteed by Treasury Secretary Geithner, who promised that there would be “no more Lehmans”. These are the very same tax dollars now being deployed to lobby against financial reforms, which will mitigate the practices that created the mess in the first place. The next time, these same banks are likely to leave a catastrophe far scarier than any Halloween costume. Having been duped, the President now seeks to deploy a cheap political trick. He is attacking an easy political target, but as usual, doing nothing concrete to ameliorate credit conditions. Indeed, his actions will likely increase the cost of credit.

Just over the weekend, the President again lambasted the banks for failing to enhance credit availability. During his weekly address, the President said banks should “return the favor” of their recent taxpayer-financed bailout by lending more money to small businesses. As a taxpayer, I don’t recall ever granting this “favor”, but that aside, the President still demonstrates huge conceptual confusion when it comes to the economy. Under the guidance of Larry Summers and Timmy Geithner, policy has continued to preserve the interests of big financial companies, rather than implementing government programs that directly sustain employment and restore states’ finances. To make matters worse, the Obama Administration is already preoccupied with “paying for” additional spending through tax hikes or spending cuts elsewhere. It does not appear to be willing to let the fiscal position of the federal budget grow as needed to meet current challenges.

All of which collectively will serve to cause incomes to stagnate and personal balance sheets to deteriorate, thereby diminishing creditworthiness. Repeat after me, Mr. President: “Enhance creditworthiness and improved credit conditions will follow; personal balance sheets before bank balance sheets.” You improve aggregate demand, and incomes will rise, as will the borrowers’ capacity to borrow. All of which makes it easier for lenders to lend.

It’s so simple that even a banker can figure it out.

And here is why the whole model of securitization itself precludes improving credit conditions. In the words of L. Randall Wray and Eric Tymoigne in “It isn’t Working: Time for More Radical Policies“,

When a commercial bank makes a loan, the loan officer wonders “how will I get repaid”. Because the loan is illiquid and will be held to maturity, it is the ability to repay that matters-and it is most prudent to rely on income flows rather than potential seizure and forced sale of the asset at some time in the possibly distant future and in unknown market conditions. On the other hand, when an investment bank makes a loan, the loan officer wonders “how will I sell this asset”. The future matters only to the degree that it enters the value of the asset today because it will be sold immediately.

It’s Halloween at the end of this week, so it wouldn’t be right to conclude this post without a bit of Halloween imagery. Last week, I described the bankers as vampires (with full tribute to Matt Taibbi ) and the banks as zombies. I have also noted (as has my colleague, Anat Shenker) the tendency of many deficit terrorists (many of whom are the largest beneficiaries so far of taxpayer bailouts, but who still claim we “can’t afford” to help the vast majority of Americans) to deploy imagery relating to our government spending as something unnatural or unhealthy. We hear characterizations of the budget deficit as a “national cancer” (former Illinois Senator, Paul Simon), or government spending as something akin to a heroin addiction (a description I heard last week at a Financial Forum in Denver, Colorado). True to my love of Hammer Film horror classics, I prefer a different image to describe our government spending. It’s a necessary blood transfusion, without which the patient (in this case, the US economy) dies.
But like any blood transfusion, you want to give it to a sick patient who has a chance to get better, not a terminally ill one (i.e. like our TBTF banks), who are being propped up by phony accounting (what we might call a life support system, where the government steadfastly refuses to pull the plug).

Unfortunately, these “blood transfusions” have hitherto been misallocated. No amount of populist grandstanding by the President or the Fed can change that. When we aid banks in this way, it is like using our blood to feed vampires instead of giving that blood to people who could genuinely use a transfusion. This causes those vampires, in turn, to prey on the rest of us. By the same token, introducing pay restrictions on the likes of AIG, BofA, or Citi is akin to complaining about the quality of the clothing being worn by the zombies as they rampage and munch away on the living.

Happy Halloween everybody.

By George Washington of Washington’s Blog.

Financial insider and commentator Yves Smith wrote an essay last week entitled “MSM Reporting as Propaganda” arguing that the government has been using propaganda to make people think that things are getting better, no one is angry, and – therefore – no one should get upset:

The message, quite overtly, is: if you are pissed, you are in a minority. The country has moved on. Things are getting better, get with the program…

Per the social psychology research, this “you are in a minority, you are wrong” message DOES dissuade a lot of people. It is remarkably poisonous. And it discourages people from taking concrete action.

Is Smith right? And even if she is, isn’t “propaganda” too strong a word?

Think Positive

Sure, William K. Black – professor of economics and law, and the senior regulator during the S & L crisis – says that that the government’s entire strategy now – as during the S&L crisis – is to cover up how bad things are (”the entire strategy is to keep people from getting the facts”).

Admittedly, 7 out of the 8 giant, money center banks went bankrupt in the 1980’s during the “Latin American Crisis”, and the government’s response was to cover up their insolvency.

It’s true that Business Week wrote on May 23, 2006:

President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations.

I can’t deny that the Tarp Inspector General said that Paulson and Bernanke falsely stated that the big banks receiving Tarp money were healthy, when they were not.

Okay, the government and Wall Street have traditionally tried to dispense happy talk when there is an economic crash, and Arianna Huffington recently pointed out:

And I’ll give you that a recent Pew Research Center study on the coverage of the crisis found that the media has largely parroted what the White House and Wall Street were saying.

But that’s not propaganda . . . its just positive thinking, right?

The Other Guy

And the whole word propaganda is a Nazi, communist kind of thing which has no place in the same sentence as America. Right?

Granted, famed Watergate reporter Carl Bernstein says the CIA has already bought and paid for many successful journalists.

And sure, the New York Times discusses in a matter-of-fact way the use of mainstream writers by the CIA to spread messages.

True, a 4-part BBC documentary called the “Century of the Self” shows that an American – Freud’s nephew, Edward Bernays – created the modern field of manipulation of public perceptions, and the U.S. government has extensively used his techniques (but the BBC isn’t American, so it doesn’t count).

True, the Independent discusses allegations of American propaganda (but that’s a British paper, doesn’t count).

And (ho hum) one of the premier writers on journalism says the U.S. has used widespread propaganda.

And (are we still talking about this?) an expert on propaganda testified under oath during trial that the CIA employs THOUSANDS of reporters and OWNS its own media organizations (the expert has an impressive background).

And (I can’t believe we’re still talking about this) while the U.S. government has repeatedly claimed that it was launching propaganda programs solely at foreign enemies, it has actually used them against American citizens. For example:

• In 2002, the Pentagon announced that it was considering spreading false propaganda in the foreign press. However, the military has spread propaganda within the U.S. in an operation so aggressive that one participant, a military analyst, called it “psyops on steroids“

• Raw Story confirmed yesterday the use of propaganda on Americans

• The U.S. government long ago announced its intention to “fight the net”.

• As revealed by an official Pentagon report signed by Rumsfeld called “Information Operations Roadmap”:

The roadmap [contains an] acknowledgement that information put out as part of the military’s psychological operations, or Psyops, is finding its way onto the computer and television screens of ordinary Americans.”Information intended for foreign audiences, including public diplomacy and Psyops, is increasingly consumed by our domestic audience,” it reads.

“Psyops messages will often be replayed by the news media for much larger audiences, including the American public,” it goes on.***

“Strategy should be based on the premise that the Department [of Defense] will ‘fight the net’ as it would an enemy weapons system”.

And (when’s the next episode of American Idol on?) CENTCOM announced in 2008 that a team of employees would be “[engaging] bloggers who are posting inaccurate or untrue information, as well as bloggers who are posting incomplete information.”

And (who do you think will win the playoffs?) the Air Force is also engaging bloggers. Indeed, an Air Force spokesman said:

“We obviously have many more concerns regarding cyberspace than a typical Social Media user,” Capt. Faggard says. “I am concerned with how insurgents or potential enemies can use Social Media to their advantage. It’s our role to provide a clear and accurate, completely truthful and transparent picture for any audience.”

And (did you see that crazy photo?) it is well known that certain governments use software to automatically vote stories questioning their interests down and to send letters favorable to their view to politicians and media (see – as just one example – this, this, this, this and this). The U.S. government is very large and well-funded, and could substantially influence voting on social news sites with very little effort, if it wished.

The Bottom Line

Yeah yeah, people say this or that, whatever, I’m too busy to think about it.

Even if true, propaganda is too strong a word for attempts to convince people that important issues are boring, that no one else is angry about them, and that everything is normal.

Perhaps “herding the wayward sheep” would be better . . .