naked capitalism

Submitted by Marshall Auerback, an investment manager who also writes at New Deal 2.0:

Republicans and Democrats alike embraced legislation last week that would make California IOUs acceptable payment for all taxes, fees and other payments owed to the state – an action that effectively would mean that California is entering the currency business. Some commentators, notably Lex of the FT, have suggested that the proposed California “IOUs” “would create a vicious circle for the cash-strapped state, forcing issuance of even more IOUs.”

Quite the contrary: In fact, California’s innovative IOU proposal represents a way of alleviating the state’s fiscal crisis, not exacerbating it.
While it might appear that the new law seems merely to allow California to deficit spend just like the Federal Government – in actuality, the effect is far more profound than that. Allowing the IOUs to become an acceptable payment method for state taxes, instantly imparts value to them – in effect, what you have is a state of the union creating a parallel currency right under the noses of the Treasury, alleviating its fiscal straitjacket in the process.
So why are so objections being raised? The confusion seems to arise because of a mistaken understanding of the nature of modern money. Modern money has no intrinsic value in the absence of state sanction. In the words of economist Abba Lerner:

The modern state can make anything it chooses generally acceptable as money…It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done.

The modern state, then, imposes and enforces a tax liability on its citizens and chooses that which is necessary to pay taxes. The unit of account has no real value if not ultimately sanctioned by use from the State. By extension, the state is never revenue constrained because it alone determines what is money. The tax is what gives the currency its value insofar as it functions to create the notional demand for federal expenditures of fiat money, not to raise revenue per se. Value has been given to the money by requiring it to be used to fulfill a tax obligation, but the money is already in existence, not “created” by the revenue.

It is in this context that one has to look at the California IOU proposal. It is important to note that the IOU would not replace the dollar, but operate in parallel to extinguish state liabilities. And if the IOU becomes functionally like a currency, then California’s bankruptcy problems are over. By imparting a value to these IOUs (i.e. letting them be used to settle state tax) this will ensure a demand for the state’s IOUs. Each individual vendor, contractor, or even state employee will accept the state’s new warrants up to the individual’s expected tax liability. Eventually the warrants will also be accepted by retail establishments and others, including banks, which also have liabilities to the state of California—meaning that the state could (eventually) issue a number of warrants equal to the total of all such obligations owed to the state, on an annual basis.

There are other historic examples of local currencies operating in parallel with national ones. As economist L. Randall Wray has noted, in Argentina as the financial crisis deepened after 2000, local governments began to issue “Patacones” (bonds with interest) as local currencies, paying workers and suppliers, and accepting them in tax payment. Utility companies began to accept them—knowing they could pay part of their taxes with them–and acceptance spread even to international corporations such as McDonald’s. (http://wallstreetpit.com/8333-berkshares-buckaroos-and-bear-dollars-what-makes-a-local-currency-tick)

It is true that this legislation represents a profound break from all federal laws. But this is another instance where Obama’s obliviousness to the ramifications of the states’ respective fiscal crises has come back to haunt him. He and his advisors keep thinking that if they provide “liquidity” to banks, the banks will go out and lend. They don’t seem to understand that credit is not a “flow” but a two-way contract between lender and borrower: Incomes have to improve first before credit conditions can improve. Rising incomes create improved credit worthiness and ultimately improving asset values, thereby enhancing lending activity.

Of course, if the Federal government truly finds California’s proposals far too radical, then there is a simpler solution at hand: a payroll tax holiday and revenue sharing with the states will go a long way toward alleviating the states’ respective fiscal crises and almost instantaneously improve private sector incomes and aggregate demand.

Is the leopard changing its spots? First we have the Wall Street Journal, of all places, lambasting Goldman, while incredibly, the Washington Post springs to its defense. If that isn’t bizarre enough, today we have the Wall Street Journal, which along with just about every mainstream media outlet, likes to inveigh about coming Social Security deficits, points out something quite underappreciated: that the combo plate of ceilings on payroll taxes and more income flowing to the top echelon of society (some in the form of compensation that comes via tax advantage capital gains) means there is a lot of labor-related income that is not subject to Social Security taxes.

A dose of Koyaanisqatsi is in order.

As an aside, the hysteria about Social Security is way overdone. Yes, it needs to be fixed, but on the one to ten degree of difficulty, this one is not hard. Social Security was created when the average lifespan was 69. We need to do some combination of raising the age at which workers can receive payment, eliminate the ceiling on payroll taxes, and end the tax breaks (at a minimum) for the upper middle income and wealthy (85% of Social Security payments are exempt from taxes). Eliminating the ceiling alone would mean Social Security was adequately funded for the next 75 years.

Back to the Journal. 1/3 of all pay goes to “highly compensated employees,” meaning those who earn more than the Social Security ceiling, and their pay has been rising faster than for the rest of the workers. And that exclude stock-based pay.

From the Journal:

Executives and other highly compensated employees now receive more than one-third of all pay in the U.S.,…
Highly paid employees received nearly $2.1 trillion of the $6.4 trillion in total U.S. pay in 2007, the latest figures available. The compensation numbers don’t include incentive stock options, unexercised stock options, unvested restricted stock units and certain benefits.

The pay of employees who receive more than the Social Security wage base — now $106,800 — increased by 78%, or nearly $1 trillion, over the past decade, exceeding the 61% increase for other workers, according to the analysis. In the five years ending in 2007, earnings for American workers rose 24%, half the 48% gain for the top-paid. The result: The top-paid represent 33% of the total, up from 28% in 2002.

The growing portion of pay that exceeds the maximum amount subject to payroll taxes has contributed to the weakening of the Social Security trust fund…

The data suggest that the payroll tax ceiling hasn’t kept up with the growth in executive pay. As executive pay has increased, the percentage of wages subject to payroll taxes has shrunk, to 83% from 90% in 1982. Compensation that isn’t subject to the portion of payroll tax that funds old-age benefits now represents foregone revenue of $115 billion a year.

The magnitude of executive pay has been difficult to measure, even as policy makers grapple with ways to rein in compensation at companies receiving taxpayer bailouts…But payroll taxes provide an indirect way to calculate amounts executives receive…

Social Security data show that 6% of wage earners have pay that exceeds the taxable earnings base, and that their “covered earnings” above the taxable maximum totaled $1.1 trillion in 2007. Adding the portion of their pay below the taxable wage base, $991 billion, totals $2.1 trillion.

The $2.1 trillion figure understates executive pay, however, because it includes just salary and vested deferred compensation, including bonuses. It doesn’t include unvested employer contributions and unvested interest credited to deferred-pay accounts. Nor does it include unexercised stock options (options aren’t subject to payroll tax until exercised), and unvested restricted stock (which isn’t subject to payroll tax until vested; the subsequent appreciation is taxed as a capital gain).

Also not included in the total compensation figures is executive pay never subject to payroll tax. This category includes incentive stock options (which are generally taxed as capital gains), “carried interest” income received by hedge-fund and private-equity fund partners (also taxed as capital gains), and compensation characterized as a benefit (benefits generally aren’t subject to any taxes).

Benefits, a category that includes employer-provided health care and contributions employers make to rank-and-file pension plans, totaled nearly $1 trillion in 2007; it isn’t possible to tell what portion represents benefits for executives, such as life insurance.

The ability to delay paying payroll taxes on compensation, something that generally is available only to highly paid employees, is in itself an economic benefit that ultimately boosts paychecks…

Social Security Administration actuaries estimate removing the earnings ceiling could eliminate the trust fund’s deficit altogether for the next 75 years, or nearly eliminate it if credit toward benefits was provided for the additional taxable earnings.

The first time I every heard of value added taxes was in the early 1970s, and all the stuff I saw then said the VAT was a bad tax, you raised as much from a sales tax with far lower administrative costs. The economic and policy literature was as one-sided as I have ever seen on a topic, saying that the alternative to VAT, a simple retail sales tax, was cheaper to administer and yielded the same revenue. But both are regressive.

But many of our higher-tax OECD compatriots have VATs. If you ever have to contend with them, they are a huge pain for businesses (I had a wee taste with Australia’s GST, ugh). And those economists of years past missed a few bureaucratic virtues of the VAT:

1. It appears to hide the tax, Dumb as that sounds, it appears to work. Not adding the tax at the till seems to go over better with the chump populace, This is not trivial. Jean Baptiste Colbert once said, “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”

2. VAT is a great tool for increased information capture. VAT leads to more frequent, and for some businesses, more detailed reporting Welcome to the total surveillance society.

VAT, like all sales taxes, is particularly regressive. And it should in theory reduce consumption. Given the duty assigned by China, to shop so as to keep their factories running, a VAT would not endear us to them.

However, Greg Mankiw is raising alarms about income taxes, with a 5.4% surtax proposed fpr “top earners”, which his blog does not mention are defined as those earning over $1 million a year . Quelle horreur! Raise those marginal tax rates and everyone will give up and act just like the French and decide to have two and a half hour lunches.

Hhhm, Marginal tax rates are high in New York City (we even have city income taxes) and our sales tax is over 8% (atlthough this being a liberal enclave. food and clothing items below a certain price point are exempt) yet this is a famously workaholic town. Of course, you can only conclude so much from one data point, but it still suggests that high taxes are not necessarily a disincentive to income-earners.

In all seriousness, a VAT is a bad idea. Higher taxes are in our future, so we might as well get used to them. And the more visible the better, The more obvious it is how much we are taxed, the more the average guy is likely to demand a higher level of government services. Despite the often loudly trumpeted distaste for the European model, the Europeans I know do not seem unhappy about their taxes because they perceive that they are getting good value for their tax dolllar (before you think this to be too Pollyannish, they actually do complain less than Americans and even have the occasional nice word, In fact, the Germans and Austrians I know think our system is nuts. However, my sample excludes southern Europe). We’ve done the reverse here, taking as a given that low taxes (for an advanced economy) means we should reign ourselves to crappy service.

What is more than a tad distressing about this piece by Albert Hunt is that it show Bob Rubin still has a very influential role in policy, and appeasing the markets is seen as a major policy objective. That has the effect of putting considerable power in the hands of those who claim to know what it takes to appease the gods keep them happy.

From Bloomberg:

The Center for American Progress, run by former President Bill Clinton’s one-time chief of staff John Podesta, serves as unofficial kitchen cabinet and idea catalyst for this administration.

The center had three recent private sessions of economic heavyweights, ranging from ex-Treasury chief Robert Rubin to liberal activist Bob Greenstein; one participant described the almost universal mood as “gloomy.”

Podesta will soon unveil plans for a public forum in September laying out the daunting fiscal challenges, while trying to fashion a “progressive” agenda to deal with them. Any serious effort will almost certainly include substantive spending cutbacks.

The centerpiece might be moving to a consumption tax, which is fraught with political and economic implications…

Some nervous congressional Democrats, prominent liberal economists and Warren Buffett believe another stimulus injection may be necessary. That might not be achievable politically, however, unless the economy really tanks or it is done in conjunction within a more comprehensive strategy dealing with the long-term, mind-numbing budget shortfall.

Roger Altman, an investment banker, doesn’t dispute the case for addressing economic sluggishness and only later turning to the looming fiscal crisis. He questions whether the public or the markets have such patience. Deficits don’t usually resonate much with voters….

Compared to boosting taxes directly on middle-income earners or slashing domestic programs, a value-added tax as a partial replacement for income and possibly some payroll taxes may be a more attractive alternative, Altman believes. A growing number of Democrats, such as Senate Budget Committee Chairman Kent Conrad and Obama tax-reform adviser Paul Volcker, concur.

If so, it will cause a political bloodbath, particularly if it is a big net revenue-raiser. The “sales tax” label can be lethal. Consumption levies are usually regressive, hurting middle class and poorer people the most, and almost three decades later there remains a belief that espousing such a measure cost the former House Ways and Means Committee Chairman Al Ullman, now deceased, his supposedly safe seat in 1980….

The Obama administration would like to defer any major action on closing the budget gap, certainly until after Congress deals with health care.

I always enjoy reading the Financial Times’ editor, Martin Wolf, but I sometime forget how refreshing and pointed he can be when he decides to let loose at a deserving target. Today’s lesson is the almost ludicrous efforts of the financial services industry to explain why the debacle that they just foisted on all of us isn’t sufficient cause to put it on a choke chain.

Wolf pillories a report produced by some leading lights of the UK’s banking industry. Its main failing, as Wolf points out, is that the industry has already captured Alistair Darling, chancellor of the exchequer, who sponsored the effort and sat on the committee. The verdict was pre-deetermined: “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

Ulp. Darling lives in a parallel universe, preoccupied with saving the perps who took down the economy with their recklessness. But he is hardly alone in how badly he has been captured by the industry.

Wolf has a remarkably straightforward recommendation.. The industry produces extenalities, like polluters, so tax it. I’ve long been a fan of Tobin taxes without being able to prove my pet suspicion, that too much ease of trading benefits intermediaries more than the principals, by encouraging more speculation than is needed to lubricate markets. Wolf provides another rationale. And he dismisses the notion that innovation is ever and always good (radiation tonics were innovative too, and killed people) and that determined regulators cannot restrain big financial players.

From the Financial Times:

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

The fiscal costs of this crisis will be comparable to those of a big war….Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly….This is a time for self-examination.

A recent report on the future of UK international financial services…fails to provide such self-examination…the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

Kansas is in the middle of a budget brawl, and tax refunds may be on hold if it isn’t resolved pronto. From the Kansas City Star:

The Kansas Finance Council was to meet at 1 p.m. today to vote on whether to borrow $225 million from healthy state funds to cover expected payments to schools, state workers and taxpayers. The state did the same thing last December when it ran into a cash-flow problem.

But Republican leaders said they wouldn’t authorize the new loans until Sebelius, a Democrat, signs legislation designed to erase the state’s current year budget deficit. That bill, passed Thursday, cuts statewide school funding by $32 million and makes millions more in cuts to other state agencies.

State officials are scrambling right now to determine what the cash flow problem will mean. Budget director Duane Goossen said it’s likely to mean a delay in tax refunds, state employee pay, reimbursement to Medicaid providers and school districts.

The Kansas City Business Journal reports that the state has only $5 million in the till (versus a $6.5 billion annual budget) so they do indeed appear to be out of cash.

Now this showdown can be seen as politics as usual; budget brinksmanship is hardly unheard of in the US. But there are a couple of noteworthy threads here. One is the insistence on a balanced budget, which folks like Paul Krugman maintain is nuts in times like these (he worries that spending cuts at the state level will offset any federal fiscal stimulus).

But second is bringing refunds into the fray. This is potentially explosive. Cutting or freezing budgets usually hits specific groups: state employees, contractors who have the state as an important client. people who depend on certain programs. But a tax rebate cut hits a broad swathe of people. Even thought the amount at issue may often be small, it sticks in voters’ craws.

I have long thought it would take a lot to rouse Americans to action. We tend to complain but not do much. But if moves like this become more common, we might see a big shift in the collective attitude. Consider these remarks in the Star’s comment section:

donshapley is right it is not even their money it is ours. I personally recommend that everyone who is owed a refund change their withholdings to 9 on the W-4. It will reduce your withholdings. Not sure if it is true but a friend who did payroll told mw putting 10 triggered a red flag.

Now the key is you must be disciplined enough to put the additional money from each check in savings so you have it to pay when you come up owing taxes next year.

Think how the state would freak out if a third of the people who work did this……….would love to see the state have to wait until 4/15 to get the bulk of their money……….

And this via reader Marshall:

Why is it when the state is hurting and strapped for cash we are all just suppose to sit back and say, “it’s okay, just keep my refund until you are good and ready to send it to me”? however, if it were the other way around and I owe them then there is NO excuse for my lateness. Seems a bit double sided if you ask me. EVERYONE is hurting in today’s economy and I understand that the state isn’t any different…but it frustrates me that when the shoe is on the other foot then its okay for the government but not okay for the citizens. I think that the state should pay US interest on our refunds in the same amounts that we have to pay them when we are late!

And I suspect we are going to see more of this sort of thing, both suspension of refunds and citizens at least contemplating tax gaming, perhaps disobedience. But I also suspect the only thing that will focus the minds of the officialdom would be bona fide collective action, and Americans aren’t inclined towards that sort of behavior.

Dear God, let’s just kiss the US economy goodbye. It may take a few years before the loyalists and permabulls throw in the towel, but the handwriting is on the wall.

The Obama Administration, if the Washington Post’s latest report is accurate, is about to embark on a hugely expensive “save the banking industry at all costs” experiment that:

1. Has nothing substantive in common with any of the “deemed as successful” financial crisis programs

2. Has key elements that studies of financial crises have recommended against

3. Consumes considerable resources, thus competing with other, in many cases better, uses of fiscal firepower.

The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).

Why is this a bad idea? Let’s turn to a study by the IMF of 124 banking crises. Their conclusion:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

In case you had any doubts, propping up dud asset values is a form of forbearance. Japan had a different way of going about it, but the philosophy was similar, and the last 15 year illustrates how well that worked.

What we have from Team Obama is a bigger abortion of a “throw money at bad bank assets” plan that I feared in my worst nightmare. And (when we get to the Post preview), they have the temerity to invoke triage to make what they are doing sound surgical and limited.

Those who remember the origin know that triage means focusing on the middle third of the wounded on the battlefield : abandoning the goners to die, leaving those wounded but stable to fend for themselves for the moment (they were in good enough shape to wait to be transported or hold on to be treated later). The middle third, those in immediate danger but who might nevertheless be salvaged, get top priority.

The concept of “triage” recognizes that resources are limited, tough decision need to be made, and some are beyond any hope. But in Team Obama Newspeak, triage means everyone can be saved because resources are presumed to be unlimited:

The basic problem confronting the government is that banks hold large quantities of assets that they value on their books for much more than investors are willing to pay…

Yves here. The spin is so thick I have to interject after one sentence. Note how the problem is that the investors don’t want to pay enough, not that the assets are in most cases fetid? Back to the article:

Since the early days of the financial crisis, officials have struggled to unwind that knot. If the government buys the assets at prices that banks consider fair, the Treasury would take a huge loss when it ultimately sells the assets for much less. If, instead, the government insists on paying market prices, the banks may not survive their losses.

Yves here. See how saving the banks in their current form is presumed to be necessary? This is the phony policy constraint that is leading to all the distortions. The savings and loan crisis’ Resolution Trust Corporation is touted as a good “bad bank” model (it’s far from the only one). But guess what? It got those bad assets from banks that died. That little detail seems to be neglected in modern accounts.

Back to the article:

Instead of taking a single approach, the Obama administration plans to divide assets and other loans into three categories, each with its own solution, according to sources familiar with the discussions, speaking on condition of anonymity because the details are not finalized.

The government would buy and hold on to those assets whose falling prices are putting banks under the most pressure. Officials want to limit these purchases because of the vast expense.

The centerpiece of the plan would be a guarantee to limit losses on a second group of troubled assets that can be kept by the banks because they have more stable prices.

And it would allow banks to retain and profit from their healthiest assets.

Beyond these initiatives, the government also is likely to inject more capital into troubled institutions.

Yves again. This sounds completely arbitrary, despite the pretense of faux science. Do they want to buy the assets most underwater? The assets most at risk of further price declines? The assets with that are the hardest to value (like lower rated CDO tranches?). It may simply be that the Post reporter doesn’t appreciate the issues at work, but I wonder if the extreme vagueness reflects instead failure to come to grips with the real objectives (which means Wall Street will be able to manipulate them) or that they don’t want the public to know what is going on (per the persistent stonewalling of efforts to find out what securities the Fed has bought and taken as collateral).

As John Paulson pointed out, a lot of poor quality paper is trading. The idea that it is illiquid is a myth.

The problem is not a lack of price discovery, as the discussion above pretends, it’s a lack of investor willingness or ability to take losses. And readers have said if a particular piece of paper doesn’t fetch a bid, that’s because its real value is not materially above zero. But per above, that’s the sort of dreck that Team Obama would buy.

And what, pray tell, is the point of the guarantee? The loss exposure on a guarantee (versus a purchase) at the same nominal price is the same, although the initial cash outlay is considerably different. Ah, but if the paper is guaranteed, then your friendly bank welfare recipient can bring the junk to the Fed and get nice cash back.

So we the taxpayers are going to eat a ton of bank losses that should instead be borne first by stockholders and bondholders This program should be labeled the Pimco bailout plan, since the giant bond fund holds a lot of bank debt. That shows what a fiction Obama’s populism is. It’s mere posturing and empty phrases. Look at where the dough goes, and it is going first and foremost to the big money end of town.

Now I do not labor under the delusion that there are cheap or easy ways out of our financial sinkhole. People are suffering, and we are only partway through the process of contraction and writeoffs. I heard of a suicide today, a jewelry dealer who was $400,000 in debt (also owed a lot of money but unable to collect) who threw himself off 10 West 47th Street (from someone else in the building, this is no urban legend). A tragedy, and a visible one, and there is plenty of less acute but no less real trauma afoot.

But Team Obama is taking the cowardly approach of distributing the costs among the most disenfranchised group in the process, namely the taxpayer, when there far more obvious and logical groups to take the hits. Shareholders and bondholders bought securities KNOWING there was the possibility of loss. A lot of big financial institutions have been on the ropes for over a year. A security holding is not a marriage. When conditions change, prudent investors reassess and adjust course accordingly. If anyone is long a lot of dodgy bank paper now, they have only themselves to blame. Any why are rank and file bankers still exempt from pay cuts when the workers in another failing US industry, autos, expected to take big hits?

This is the most roundabout and probably the most costly way to not solve this problem. Another warning from the IMF paper:

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

The most amazing bit is the government acts as if it has no leverage. Look how Paulson sent teams in to inspect the accounts of Fannie and Freddie and put them into conservatorship. The reason it is obvious that this program is a crock is that it has been cooked up in the complete and utter absence of any serious due diligence on the toxic holdings of the big banks.

As we discuss in a separate post, the one punitive element, executive comp restrictions, are mere window-dressing. Welcome to change you can believe in.

Reader Tim C pointed us to a post on Tim Price’s blog, “The Price of Everything,” which provides astute financial and sometimes social commentary. Below is an excerpt:

Dear Western banking establishment,

I notice that your unauthorised credit facility from international lenders of last resort now totals approximately $10 trillion. As a taxpayer and therefore your largest shareholder I would be grateful if you could repay this facility at your earliest convenience. I have charged you an additional £30 for this letter and a monthly unauthorised overdraft fee of £28. If you do not repay this facility shortly I will have no choice but to become further massively impoverished along with legions of fellow taxpayers for multiple generations to come.

I would also be grateful if the strategists and economists who work for you could abstain from publishing their unsolicited opinions about resolving the banking crisis within the financial media. I am sure you will agree that hearing from the same strategists who worked for the architects of such widespread financial destruction is likely to irritate those of us who were not actually complicit in the extraordinary and venal credit boom of the last several decades. There is an expression that if you’re not part of the solution, you’re part of the problem. Those of your employees who were the public face of the problem are, I think you will agree, unlikely to represent the solution, unless perhaps they are fired – en masse, from a giant howitzer, into an area where they can do no further harm. Alaska, perhaps. I would further suggest that the high profile commentators who work for you and who have implicitly played their part in marketing and then amplifying this catastrophe might consider quietly entering another field with superior ethics and enhanced value to society at large: perhaps as piano players in brothels. This note has been copied to the letters editors of The Financial Times and The Wall Street Journal (which I understand is shortly to be renamed simply The Journal on the basis that Wall Street no longer actually exists – as was noted this week by Messrs Wen Jiabao and Vladimir Putin at Davos. Don’t worry about not being there – you weren’t missed).

Since the start of the year is always a time for slimming and working off the excesses of the festive period, I wonder whether your industry would consider operating along similar lines. Just as there is no real need to have 18 different coffee bars all touting their wares along my High Street, there is probably no real need to have 18 different banks, not all of which are subsidiaries of Santander, clogging the High Street and busily not wanting to extend me back any of my own money so generously lent to them.

I would also be interested in your views as to the wisdom and efficacy of the monstrous pile of credit being shovelled at you and your peers by governments when it was overmuch credit creation that precipitated this crisis. I do not, of course, expect anything other than a self-interested response. But you may find the following observations pertinent. If they seem acutely relevant today it is because they were written in the early 1930s, by one Garet Garrett (and a grateful hat tip to M. Gandon):

“The general shape of this universal delusion [that is, credit] may be indicated by three of its familiar features.. First, the idea that the panacea for debt is credit.. The burden of Europe’s private debt to this country now is greater than the burden of her war debt; and the war debt, with arrears of interest, is greater than it was the day the peace was signed.. Debt was the economic terror of the world when the war ended. How to pay it was the colossal problem. Yet you will hardly find a nation, state, city, town or region that has not multiplied its debt since the war. The aggregate of this increase is prodigious, and a very high proportion of it represents recourse to credit to avoid payment of debt.

“Second, a social and political doctrine, now widely accepted, beginning with the premise that people are entitled to certain betterments of life. If they cannot immediately afford them.. nevertheless people are entitled to them, and credit must provide them.. Result: Probably one half of all government, national and civic, in the area of western civilization is either bankrupt or in acute distress from having over-borrowed according to this doctrine.. Now as credit fails and the standards of living tend to fall from the planes on which credit for a while sustained them, there is political dismay.. When [people] have been living on credit beyond their means the debt overtakes them. If they tax themselves to pay it, that means going back a little. If they repudiate their debt, that is the end of their credit. In this dilemma the ideal solution, so recommended even to the creditor, is more credit, more debt.

“Third, the argument that prosperity is a product of credit, whereas from the beginning of economic thought it had been supposed that prosperity was from the increase and exchange of wealth, and credit was its product.”

The post continues here. Enjoy!

This comment by Jeffrey Sachs in the Financial Times is broader than its title suggests. It says that the US should not run willy-nilly into enacting massive spending plans in haste. Sachs makes two core points: a lot of compromises are being made that will render big chunks of the plan ineffective and/or wasteful, and that the focus is strictly on Doing Something, Now, and the intermediate term effects are given nary a thought. If the plan merely reduces the amplitude of the downturn (likely) at the cost of hamstrung future performance, have we really come out ahead?

Obama’s willingness to compromise is serving him badly here. The Reagan Administration fought hard for what it wanted, and got about 75% (of course, the easy 75%, the tax cuts and defense spending, but not other budget cuts). Obama is willing to settle for less, and was too quick to offer the tax cuts as a compromise, which has merely emboldened the Republicans to seek even more, targeted to the affluent. Today, the Senate Appropriations Committee added $70 billion to the stimulus package in the form of alternative minimum tax relief, which will aid households earning from $100,000 to $500,000.

That is most decidedly NOT stimulus. The experience of the Bush tax rebate, which was spread across more income brackets, was that (according to a detailed analysis by Gary Shilling) over 80% was saved. A similar outcome is a given with higher income cohorts.

Admittedly, Sachs is a controversial figure. He devised the shock therapy approach used by the IMF for hyperinflation and transition from controlled economies, and later in the Asian crisis. The approach has vocal opponents (and many of the loudest are the ones who lived through it). Some of Sachs’ neoliberal/cold water Yankee mindset comes through in this piece. But Sachs more recently has argued for targeted aid for the poorest nations, contending that they are in a poverty trap, and assistance to get them to a higher level of agricultural productivity could give them the boost they need to overcome chronic deprivation.

Whether you agree with all of Sachs’ argument, his caution about undue haste is well founded and is consistent with the worries of other macroeconomists such as Willem Buiter.

From the Financial Times

:

The US debate over the fiscal stimulus is remarkable in its neglect of the medium term – that is, the budgetary challenges over a period of five to 10 years. Neither the White House nor Congress has offered the public a scenario of how the proposed mega-deficits will affect the budget and government programmes beyond the next 12 to 24 months. Without a sound medium-term fiscal framework, the stimulus package can easily do more harm than good, since the prospect of trillion-dollar-plus deficits as far as the eye can see will weigh heavily on the confidence of consumers and businesses, and thereby undermine even the short-term benefits of the stimulus package.

We are told that we have to rush without thinking lest the entire economy collapse. This is belied by recent events. The spring 2008 stimulus package of $100bn (€76bn, £71bn) in tax rebates was rushed into effect in a similar way and we now know it had little stimulus effect. The rebates were largely saved or used to pay down credit card debt, rather than spent. The $700bn troubled asset relief programme bail-out was also rushed into effect and its results have been notoriously poor.

The Tarp has not revived the banks or their lending, but it has supported a massive transfer of taxpayer wealth to the management and owners of well-connected financial institutions. Some of those transfers – as in the case of Merrill Lynch using its government-financed sale to Bank of America to enable $4bn in bonuses last month – are beyond egregious. Yet the US is now inured to corruption and in such a rush that even billions of dollars of public funds shovelled into Merrill’s private pockets in broad daylight barely merited a day’s news cycle.

The most obvious problem with the stimulus package is that it has been turned into a fiscal piñata – with a mad scramble for candy on the floor. We seem all too eager to rectify a generation of a nation saving too little by saving even less – this time through expanding government borrowing. First it was former US Federal Reserve chairman Alan Greenspan’s bubble, then Wall Street’s, and now – in the third act – it will be Washington’s.

The White House and Congress have stated an amount – $825bn to be spent mostly over two years – on top of a deficit that is already projected to reach $1,186bn in fiscal year 2009 without the stimulus package. Many of the details of allocating the $825bn are being left to Congress with the aim of reaching a bipartisan consensus. The result is shaping up to be an astounding mish-mash of tax cuts, public investments, transfer payments and special treats for insiders.

What we need is a medium-term fiscal framework, one that lays out an anticipated schedule of taxes and spending consistent with the needs of the economy and government functions. Rather than soundbites about ending pork-barrel projects or scouring the budget for waste, or about the relative multipliers of tax cuts versus spending increases (both of which depend on expectations about the future, a point mostly overlooked in the debate), we should be reflecting on certain basic fiscal facts, the most important of which is that the US government faces huge and potentially debilitating structural deficits as far as the eye can see.

In rough numbers, the US federal tax system collects about 18 per cent of gross national product, while the total of just five categories of public spending – Social Security (retirement and disability), health (Medicare, Medicaid), veterans’ benefits, defence and homeland security and interest payments – eat up about 18 per cent of GNP. Yet government has more to do – for example, providing the justice system; help for the poor and unemployed; science and technology research; energy systems, transport and other infrastructure; diplomacy and international aid; natural hazards mitigation; training; and the future costs of financial clean-up. Let us add in the fact that state and local governments are broke and need increased federal transfers, and that America’s ageing population, broken healthcare system and growing underclass all require increased fiscal attention. We currently pay for all of this, if we do so at all, by borrowing from China and from the future.

If the present stimulus package is adopted without a medium-term plan, it will go the way of the earlier stimulus package and the Tarp, yet also put the US into a fiscal straitjacket that could paralyse public sector action in critical areas for a decade or more to come. This is especially true if we allow further tax cuts during a time of fiscal haemorrhage, or give into “bipartisan” demands to make the Bush tax cuts permanent, even for the rich, as seems increasingly likely.

There are many valuable things proposed in President Barack Obama’s spending plans – such as the sums to be spent on energy, healthcare and education – but these should be incorporated into medium-term strategies rather than a grab bag of hasty short-run spending. The tax cuts that he is likely to approve in the stimulus package, and the extension of Bush-era tax cuts if that comes to pass, could close the door to these longer-term programmes; haphazard spending on these vital programmes could do the same.

Perhaps Mr Obama should reflect on the fact that the Clinton-era boom began in 1993 with tax rises and a congressional rejection of a fiscal stimulus package. This time, there is certainly a cyclical case for deficit- financed public spending, but accompanied by phased-in tax increases to provide proper financing of crucial government functions in the medium term.

Even if there were a rationale for Citi buying a corporate jet now (which I cannot fathom, given their horrid financial condiiton), why buy new? There are no doubt plenty of used jets for sale right now.

This incident illustrates the degree to which a corporate/financial elite has developed in the US. Top executives feel they have a right to fly on private jets. If the company is, say, a Wal-Mart, with a lot of operations in remote areas where access by commercial flights is indirect, private jets make sense (Sam Walton famously flew his own plane to visit stores). But for Citigroup, where the vast majority of their operations are in major, well served financial centers, it’s hard to justify (the usual rationale is that the top brass can discuss business on a private plane, while they cannot do so on commercial flights. Funny how that was seldom seen as a justification in the early 1980s, when executives were for the most part content to fly first class).

From the New York Post (hat tip reader Marshall):

Beleaguered Citigroup is upgrading its mile-high club with a brand-new $50 million corporate jet – only this time, it’s the taxpayers who are getting screwed.

Even though the bank’s stock is as cheap as a gallon of gas and it’s burning through a $45 billion taxpayer-funded rescue, the airhead execs pushed through the purchase of a new Dassault Falcon 7X, according to a source familiar with the deal.

The French-made luxury jet seats up to 12 in a plush interior with leather seats, sofas and a customizable entertainment center, according to Dassault’s sales literature. It can cruise 5,950 miles before refueling and has a top speed of 559 mph.

There are just nine of these top-of-the-line models in the United States, with Dassault’s European factory churning out three to four 7Xs a month.

Citigroup decided to get its new wings two years ago, when the financial-services giant was flush with cash, but it still intends to take possession of the jet this year despite its current woes, the source said….

It’s not uncommon for large companies to pay a deposit on a new plane then cancel the order before delivery, according to a source in the corporate aviation business.

Citigroup execs are also quietly trying to unload two of their older Dassault 900EXs.

Those jets, nearly 10 years old, are worth an estimated $27 million each. They were still listed for sale yesterday on the Web site of Citigroup’s aviation broker, Aviation Professionals.

Update 9:00 AM, 1/27 Bloomberg reports that Citi is not backing down:

Citigroup Inc., the bank that received $45 billion in U.S. government funds, said it plans to buy new aircraft and sell older ones.

The transactions may lower operating costs because the new jet would be more fuel efficient, the bank said in a statement e- mailed to Bloomberg News.

“We signed a contract in 2005 for replacement aircraft, which was part of our plan to reduce the number of aircraft Citi owns and use more fuel-efficient aircraft,” the e-mail said. “Refusing delivery now would result in millions of dollars in penalties.”

The New York-based company said funds from the Troubled Asset Relief Program, or TARP, wouldn’t be used to buy aircraft. It didn’t provide details of the purchase plan in the e-mail.

Repeat after me: money is fungible.

The Administration has evidently launched a campaign to warn the American public that the black hole banking industry will need more in the way of recapitalization funding than is currently on offer.

Mind you, we are NOT opposed to this sort of thing were it done correctly: tough minded banking industry reforms, seizure of the dud banks, installation of new management (trust me, there are a lot of good bankers over 50 who were cashiered or retired because they were not on board with the credit party). And like it or not, the financial services industry is so badly impaired that more money is almost certainly necessary. But throwing money at sick banks with no plan as to how to shrink and rationalize the industry does not strike us as a sound way to proceed (and the TARP II notion of buying bad assets at certain to be inflated prices is a cosmeticized equity infusion and not a real solution).

Perhaps as important, the public is sufficiently outraged over TARP I that something quite different (as in more punitive to incumbent management, stockholders, and in some cases, bondholders) is required to muster Congressional support. I don’t have the sense that Team Obama fully appreciates that.

From the Financial Times:

Lawrence Summers, head of the White House National Economic Council, said the administration would use the $350bn remaining of the $700bn that Congress provided to start tackling the financial crisis. He suggested, however, that it would later have to assess whether that amount was sufficient to stabilise the financial system.

“We can make important progress and get started with the support that has been provided . . . What ultimately will be necessary is something that will play out over time,” Mr Summers told NBC television.

His comments were made after Nancy Pelosi, the Democratic speaker of the House, suggested that Congress might have to provide more money for the so-called troubled asset relief programme….

Speaking to ABC television, Mrs Pelosi said she was “open to resolving the financial crisis”, explaining that there might be a need for “some increased investment” to shore up the banks. But she stressed that any future funding for the banks would have to be dispersed with more transparency.

“Whatever we have to do will have to be clearly explained to Congress and to the American people as to what the purpose of the money is, why it’s urgent, and then accountability for it as it is distributed,” said Mrs Pelosi…

Asked whether the best way to shore up the financial system was to nationalise US banks, Mrs Pelosi said any future relief programmes should be structured to allow the American taxpayer to benefit from “some of the upside” that arises from the strengthening US banks.

She stressed that she was “not talking about total ownership” for the government but added that the “taxpayer should have equity”.

The last notion is a crock. The scale of the infusions relative to market values of equity DOES put the taxpayer in a control position in any of the seriously flagging banks. And the taxpayer is not getting commensurate rewards for the risk. Given that most banks would be insolvent if there assets were valued realistically (off balance sheet exposures consolidated, tougher marks on Level 2 and 3 assets), Uncle Sam would rightfully own these banks. But no one in power is willing to be honest about what is going on here.

Bloomberg reports on the Summers interview and other Administration efforts to prepare the public for higher government expenditures:

White House officials warned Americans that economic prospects are darkening as they sought to ensure rapid Congressional approval of President Barack Obama’s $825 billion stimulus package.

Vice President Joe Biden told the CBS program “Face the Nation” that “it’s worse, quite frankly, than everyone thought it was.” Larry Summers, Obama’s top economic adviser, said the economy faces “very difficult” months, speaking today on NBC’s “Meet the Press.”…

Yves here. Everyone? Please. “Everyone” clearly is limited to those within the Beltway. He is obviously omitting Nouriel Roubini and George Soros (people like Nassim Nicholas Taleb, Benoit Mandelbrot, Marc Faber, and Jim Rogers don’t even register in Summer’s universe). Back to the piece:

“It’s getting worse every day,” Biden said today. “There’s been no good news, and there’s no good news on the immediate horizon.”….

“The next few months are, no question, going to be very, very difficult and it may be longer than that,” said Summers..