Several notable economists prognosticated on what Japan should do to get out of their malaise in the 1990s but none of them understood the problem or the options available to the sovereign government. They all gave poor advice. The way Japan recovered after that decade of poor economic outcomes was through fiscal policy. Monetary policy had little to do with it, as Richard Koo has demonstrated in his recent book on the country.

Let’s eliminate a few misconceptions.  Japanese households do not fund the deficit.  A government default is not possible (unless Japan chooses to do it, which I suppose they could do as they are pretty clueless).We learned that interest rates do not sky-rocket and inflation does not accelerate when deficits and debt issuance are on-going and huge – quite the opposite. If the BOJ should want to increase the money supply, devotees of the money multiplier model (including numerous Nobel Prize winners) would have the BOJ purchase securities. When the BOJ buys securities reserves are added to the system. However, the money multiplier model fails to recognize that the added reserves in excess of required reserves drive the funds rate to zero, since reserve requirements do not change until the following accounting period. That forces the central bank to sell securities, i.e., drain the excess reserves just added, to maintain the funds rate above zero. If, on the other hand, the BOJ wants to decrease money supply, taking reserves out of the system when there are no excess reserves places some banks at risk of not meeting their reserve requirements. The BOJ has no choice but to add reserves back into the banking system, to keep the funds rate from going, theoretically, to infinity.

In either case, the money supply remains unchanged by the BOJ’s action. The multiplier is properly thought of as simply the ratio of the money supply to the monetary base (m = M/MB). Changes in the money supply cause changes in the monetary base, not vice versa. The money multiplier is more accurately thought of as a divisor (MB = M/m).

Their export model is dead, the Chinese are eating their lunch, so the Japanese have to switch to a domestic consumption based model.  How do you do that without spurring lots of unemployment in the absence of government spending?

It is clear to me that the neo-liberal period in Japan has devastated the security of the middle class which accounted for more than 80 per cent of the population. A person could rely on retaining full-time employment on good wages for life as long as they completed secondary school. The 1991 recession which followed the real estate collapse and poor investments by the financial sector led to the “lost decade”. The Japanese government under the neo-liberal helm of Prime Minister Koizumi started deregulating things that had previously been integral to providing this security, including cutting back government spending. See Koo’s book. His evidence is very compelling here.

Around 30 per cent of Japanese workers are employed in low-paid, casual jobs that offer no security. While Japan enjoyed stable growth this was not a problem. But the numbers of temporary workers has risen as the revered life-time employment system that generate prosperity in the Post-World War II period for the vast majority of workers has been steadily dismantled under neo-liberal urging.

I can do no better than to relay discussions I had on this point with Professor Bill Mitchell of the University of Newcastle in Australia.  Bill eloquently summarises the neo-liberal insanity which is destroying this country:

The neo-liberals are running rampant now and predicting a maelstrom. This dominance of neo-liberal thinking will be a major constraint on the new government and it is already showing a compliance to the views.

The family-first policy proposals are a sop to the intergenerational debate.

The decision to shift spending priority to welfare away from national infrastructure provision is an example. The new Prime Minister has already said he will raise taxes to “pay for” the new spending initiatives. He has also promised to cut spending on major infrastructure.

The private investment jackals who have been indulging in wasteful, inefficient yet highly profitable private equity projects in the West are poised to capitalise on this shift in Japanese sentiment. They see Yen-signs before their eyes and are on the move already.

One commentator in today’s Australian says Australia investors are “primed and ready, as Japan rebounds from the global downturn with more resilience and speed than expected …”

The upshot according to the Australian commentary (consistent for a News Limited journalist) is that there will be:

… a focus on public-private partnership projects – a new concept for Japan. They are now essential as government debt soars past double the country’s annual economic output, with public infrastructure spending totalling $7.5 trillion since 1991. And the latest central government stimulus package crowded out bond-raising opportunities for regional governments.

Infrastructure is emerging as a new “asset-class” in Japanese financial markets. We never learn!

If they really understood the fiat monetary system they could continue to provide public infrastructure and extend better safety net protection for the poor. The large deficits that the Japanese government runs is symptomatic of the huge saving desire of the domestic population. Not even the traditionally strong net export performance can offset the high saving ratio.

The saving ratio will also decline as more safety net provisions are extended to the population, who at present feel as though they have to provide for their own retirements. The introduction of a national superannuation scheme would also help.

In that sense, the deficit would fall anyway as consumption increased.

Related posts:

• Japan’s easy money policy was the trigger for the tech wreck
• Is Japan next on the road to quantitative easing?
• Japan does not demonstrate the failure of stimulus
• Japan: stimulus without reform leads to a policy cul de sac
• The Japanese Problem is now ours

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

Marshall Auerback here. You saw Ed’s last post on China, quoting from Peter Tasker, one of the top analysts in Japan when I lived there. I take Peter’s insights very seriously. His analysis implies something a lot more in regards to currencies, trade and credit.

China’s bank credit expansion is so great that even if nominal GDP is up five to ten percent, the credit to GDP ratio will rise by about thirty percentage points.  It took Japan ten years to  take it up by fifty or sixty percentage points, and it has already been high in China before this credit boom. How high, no one knows because there is no good data on debt outside the banking system.  But there is such debt.  The debts of households and firms outside the banking system could be thirty percent of GDP.  The total ratio now could be 185%.  This is the same as Japan at the peak and close to the US now. 

This could keep China going for quite some time, but the consequences for Japan could be disastrous.  Indeed, for most of Asia, which could precipitate another crisis for them down the road.

One relatively unexplored aspect of the emerging Asia crisis of 1997 was what pushed these countries heavily into current account deficits.  But between 1992-94, China devalued the RMB by close to 60% (she was already running a current account surplus when she did it the second time), which created huge competitive pressures for the other countries and pushed them rapidly into deficit.  This time, China is devaluing along with the US dollar and reflating a credit bubble — not to encourage domestic demand, but to create a renewed export juggernaut, at a time of weak external demand.  This could really be problematic for the rest of the world.

I wonder how long before the protectionist pressures emerge?

Related posts:

• China is now on the same bubble path as Japan post-1987 crash
• The bullish argument for China
• G-20: China is clearly looking for a new world order
• Japanese defend dollar’s status while China tears it down
• China is now America’s largest creditor

Marshall Auerback here with a few thoughts on money, the Federal Reserve’s balance sheet, and the alphabet soup of emergency liquidity facilities.

The expansion of the Fed’s balance sheet has been widely misunderstood within the economics profession, because it has been viewed through the lens of a pre-existing debate about the monetary transmission mechanism. Those who emphasized the importance of the money supply (on nominal spending) saw the expansion as quantitative easing, and warned about eventual inflationary consequences. Those who emphasized the credit channel (as Bernanke) saw the expansion as providing credit that was temporarily unavailable in the private market. The fact that the balance sheet expanded on both sides, and in both cases with the private sector as counterparty, tells us that something else was going on.

I would argue that the Fed’s actions after Lehman should be understood as moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. Deleveraging provides one answer why the expansion was not even larger. But the deeper answer, I think, comes from an appreciation that the Fed was acting as lender of last resort, and in doing so supporting continued lending in the private money market that would otherwise have frozen. In effect the Fed was offering a standing facility at prices away from market prices, so only those who most needed it took advantage. Simply knowing it was there made others willing to deal privately at more reasonable prices.

Thus, the commercial paper lending facility expanded and then contracted as private lending recovered. The central bank liquidity facility has followed a similar course. The important thing to realize is that, as these temporary liquidity facilities have wound down, the Fed has ramped up additional facilities, now aimed at restarting the securitized lending system more generally.

Related posts:

• Chart of the day: Fed Balance Sheet
• Fed is buying money market fund assets
• Will banks exiting TARP take back their toxic waste now?
• Flooding the system with money?
• Why is Zero Hedge claiming the Fed is intervening in equities markets?

I was heartened to hear that Alan Greenspan has repudiated the Too Big to Fail doctrine (as practiced in the Bush and Obama Administrations) in such unequivocal terms. He almost sounded like a Teddy Roosevelt trust buster.

Nevertheless, President Obama clearly believes the line fed to him by Wall Street. He is no Teddy Roosevelt. The question you should be asking is, will the tentative reforms proposed by the Obama Administration have any kind of positive effect?  The answer is probably in a very temporary fashion, but that is more a function of the impairment of the capital markets themselves.  However, if you don’t deal with a cancer fully, it comes back and spreads – even if you conduct surgery to take out some of the tumour.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It’s a bit like Lincoln saying, "Well, this slavery thing has a few problems, but we can ‘reform’ it and make it better.”  As any student of horror films knows, you cannot reform zombies. Zombie banks must be killed. In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:

• All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and—more importantly—to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.
• All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
• Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.
• The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.
• In its examination, the FDIC will determine which of these banks is insolvent based on current market values—after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG).  And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behaviour. 

As "Credit Insurer of Last Resort" (see Professor Perry Mehrling’s paper inventing this term – pdf), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behaviour of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule – i.e. "lend freely but at a high rate during a crisis"): “Insure freely but at a high premium.”

Source

Shadow Banking: What It Is, How it Broke, and How to Fix It – Atlantic Magazine

Related posts:

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• Financial sector losses near $1 trillion
• Two more FDIC Friday Night Specials brings total to 55 failed banks
• FDIC moves in at Great Basin Bank
• Seven more bank failures brings total to 64

This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis. Edward linked to this in this morning’s links, saying “I don’t agree 100% but this is a good overview” – tied to the Austrian business cycle theory as he is!

He asked me to post this here as well. I hope this will help identify some of the flaws in conventional economic orthodoxy.

Fears about the falling dollar are stoked by neo-liberal money myths that harken back to the gold standard system.

It seems there isn’t a day that goes by without more commentary on the demise of the dollar and the concomitant risk of a collapse of the world’s reserve currency. Again, the reasoning here appears largely to be based on the tyranny of orthodox neo-liberal economics. Orthodox economists view dollar depreciation as an imminent danger which raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, they argue that depreciation leads to expectations of further depreciation and fuels the run out of the currency.

So, in the logic of this view, there may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default, which means that there will be no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default, especially given our supposedly “reckless” and “irresponsible” government spending, which is supposedly robbing future generations of growth and prosperity.

Large deficits are not the problem

Let’s all take a deep breath here: Whilst the dollar index has fallen some 15% from the high sustained earlier this year, it is still above the lows sustained at the height of the credit crisis reached about a year ago. Secondly, there seems to be a fear that the current fall in the dollar could well engender inflation, and create a panicked response from policy makers where the Fed actually does raise rates and the Treasury begins to reduce government spending. Given high prevailing debt levels and the weak state of the consumer’s personal balance sheet, this would be an unmitigated disaster.

It is true that excessive government deficit spending can be inflationary, and could therefore cause some impact on exchange value of dollar. But this can’t be viewed in some sort of vacuum. The size of the deficit is irrelevant in itself. There is no meaning in the terms ‘large deficit’ or ’small deficit.’ You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 16 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message – the deficit is not large enough.

So the correct policy response is to spend until we get to full employment. That is the only consequence of excessive deficits — insolvency is not possible. Your social security check will never bounce in a country issuing debt in its own freely floating non-convertible currency.

The size of our government deficit is endogenously determined, which is to say that it has no external cause; it is a function of internal, domestic phenomena. Today, the deficit is largely a function of weaker spending power and concomitantly lower economic growth. (”Good government spending” more or less seeks to fill private output gaps; “bad government spending” is a consequence of government not taking responsibility for filling the spending gap and instead letting this occur via the automatic stabilisers). So the scenario of ever-increasing deficits is unlikely because as economy heats up, deficit shrinks and turns to surplus (as during the Clinton years and also the 1920s).

The orthodox interpretation of a nation with a declining currency and a large current account deficit appears to indicate that the nation concerned is “living beyond its means” — with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that the resultantly large deficit must be “financed” by flows of foreign reserves, which, for the most part, must be attracted by high returns and a stable political, economic, and social environment.

From the US perspective, this means that if America cannot continue to attract these needed reserves, it must raise rates to attract new foreign capital, which in turn will slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations is then used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them. In other words, an emerging markets’ crisis writ large.

Deflation or inflation?

But the reality is not so much that the US is inflating, so much as that the rest of the world is deflating relative to the dollar. Import prices are still generally falling, inflation remains quiescent and private credit growth is now contracting. These are hallmarks of deflation, not inflation. Additionally, the US is not borrowing in a foreign currency (in contrast to Iceland or Latvia or the Asian countries during the 1997/98 emerging markets’ crisis), so it does not face an external funding constraint.

What about China? True, there may be some indications that there is some shifts in terms of private portfolio preferences. Perhaps the Chinese don’t want to buy as many dollars as they did before. Perhaps hedge funds are now laying on a big “short dollar” trade in the markets. These are one-off portfolio preference shifts and it seems inadvisable for US policy makers to respond to every single vicissitude of changing market sentiment. That way leads to Latvia and economic implosion.

It’s hard to believe that a nation with 10% official unemployment and likely double that when one factors in underemployment is actually “living beyond its means.” It is even crazier to suggest that we should scale back government spending and private consumption, when there is substantial unused capacity and under-utilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means.

What about those terrible “global imbalances” that we are told must be rectified, what I call “the cult of zero imbalances”?

Well, let’s consider that as a possible policy response.

Policy fables

According to the G20 communiqué, those countries running current account deficits, most notably the U.S., would have to define ways to boost savings. Nations running surpluses – China, Germany and Japan, among others – would detail how they propose to reduce any reliance on exports. The U.S. would likely need to commit to a sharp deficit reduction by government. Europe would need to commit to improving competitiveness. That could mean introducing “labour market reforms” (an interesting choice of language here), which generally is code for being able to sack workers and destroy the power of trade unions.

The collective impact of these measures? We want more domestic led consumption in Asia and the EU (especially Germany), but then the two largest economic areas (the US and Europe) would have to deflate their economies. The former, by reducing the public net spending which would thwart the goal of “boosting” saving, and the latter, by widespread shedding of workers and the resulting collapse in consumption (and rising deficits via the automatic stabilizers as welfare payments and crime rose).

These, of course, are the traditional “remedies” proposed by the IMF — and we can see what a great job this organisation has done. Just ask any Argentinean. Neo-liberal-based policy recommendations almost invariably make things worse. We have ample examples of this in Asia, Russia and Brazil during the 1997/98 emerging markets and more recently in Iceland and the emerging market economies of Eastern Europe.

Goldbug mentality still dominates

It is important to understand that much of the economic orthodoxy is still dominated by the “gold standard paradigm”.

Under the Gold Standard, the leading economies of the world, through their monetary authorities, agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate). The currency was strictly convertible into gold at the fixed parity. So this was a convertible, fixed exchange rate system.

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. Money literally did “flow” between countries (which is why we still speak in terms of “capital inflows” and “capital outflows” even though the reality of current modern monetary operations is that we electronically credit and debit bank accounts).

This inflow of gold into surplus countries allowed them to expand their money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the gold-currency parity. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline. The trade deficit country would lose gold reserves and this would force their government to withdraw paper currency which drove up unemployment and drove down the price level. The latter improved the competitiveness of that economy. The two adjustments – for the surplus and deficit countries — helped to resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

So under the Gold Standard, the government could not expand base money if the economy was in trade deficit. It was considered that this constraint acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balances. The domestic economy, however, was forced to make the adjustments to the trade imbalances.Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade).

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment). Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

We no longer have this currency system, but traditional economic thinking and modelling is still based on it, which is why notions of “affordability” and “sustainability” still dominate our economic discourse. But given that we operate under a fiat currency system (where government declares money to be legal tender), we face no operational constraint per se, or issues of national solvency.

So, in regard to the dollar, what is our advice to Lawrence Summers, Tim Geithner, and Ben Bernanke? Do nothing. In the words of the English poet, John Milton, “They also serve, who only stand and wait”.

Related posts:

• The dollar is rising against floating currencies
• The Cult of Zero Imbalances
• Hyperinflation, national bankruptcy, dollar crash and other exaggerations
• Japan does not demonstrate the failure of stimulus
• Japanese defend dollar’s status while China tears it down

Marshall Auerback here.  I want to add a few thoughts on the situation in Latvia which Ed has highlighted on several occasions. His allusion to Argentina to describe the situation in the Baltics last July was on the money. I have a solution here out of the Argentine playbook.

In Latvia, the neo-liberal insanity continues.  The EU and IMF have told the government to borrow foreign currency to stabilize the exchange rate to help real estate debtors pay the foreign-currency mortgages taken out from Swedish and other banks to fuel its property bubble, raise taxes, and sharply cut back public spending on education, health care and other basic needs to “absorb” income. Higher taxes are to lower import demand and also domestic prices, as if this automatically will make output more competitive in export markets.

But Latvia doesn’t produce much to export. The Baltic States have not put in place much production capacity since gaining independence in 1991. Latvia, like other post-Soviet economies, has scant domestic output to export. Industry throughout the former Soviet Union was torn up and scrapped in the 1990s. (Welcome to victorious finance capitalism, Western-style.) What they had was real estate and public infrastructure free of debt – and hence, available to be pledged as collateral for loans to finance their imports. Ever since its independence from Russia in 1991, Latvia has paid for its imported consumer goods and other purchases by borrowing mortgage credit in foreign currency from Scandinavian and other banks. The effect has been one of the world’s biggest property bubbles – in an economy with no means of breaking even except by loading down its real estate with more and more debt. In practice the loans took the form of mortgage borrowing from foreign banks to finance a real estate bubble – and their import dependency on foreign suppliers.

So instead of helping it and other post-Soviet nations develop self-reliant economies, the West has viewed them as economic oysters to be broken up to indebt them in order to extract interest charges and capital gains, leaving them empty shells.

The sad part about this whole episode is that Latvia’s problems could be fixed over a weekend. Here’s what I would do:

1. Drop the peg to the euro, which functionally acts like an gold standard external constraint.
2. Don’t answer the phone when the foreign creditors call the government.
3. Have the banks declared insolvent, convert their external debt to equity, and then have them reopen that way on Monday with full deposit insurance guaranteed in the now free floating local currency.
4. Enact a 0% rate policy (use fiscal policy to regulate demand going forward).
5. Offer a local currency minimum wage job that includes healthcare to anyone willing and able to work as was done in Argentina after the Kirchner regime repudiated the IMF’s toxic package of debt repayment.

Full employment and economic prosperity would come in no time at all.

The last line is the key.  Improve employment and aggregate incomes and demand follows – as does creditWORTHINESS.  At the final stage, credit will follow.

Even a banker can figure that one out.

Related posts:

• China is set up for a big fall
• China issues bonds to “promote the RMB in neighbouring countries”
• Bloomberg talks Eastern Europe as Latvia downgraded
• Latvia as the new Argentina redux
• China can handle collapse of speculative inflows

Marshall Auerback here with a few thoughts on employment policy and the limit to government spending in a fiat currency regime.

The Detroit story Edward just posted illustrates that we should start by eliminating the notion that society requires a buffer stock of unemployed people to discipline wage demands and protect profits.  Not only is this immoral and inhumane, but economically inefficient.  We can have both full employment and price stability via a Government as Employer of Last Resort.

This new class of government employees, which could be called supplementary, would function as an automatic stabilizer, the way unemployment currently does. A strong economy with rising labor costs would result in supplementary employees leaving their government jobs, as the private sector lures them with higher wages. (The government must allow this to happen, and not increases wages to compete.)

The reduction of government expenditures is a contractionary fiscal bias. If the economy slows, and workers are laid off from the private sector, they will immediately assume supplementary government employment. The resulting increase in government expenditures is an expansionary bias. As long as the government does not change the supplementary wage, it becomes the defining factor for the currency- the price around which free market prices in the private sector evolve.  It will also enhance the effectiveness of traditional policies designed to improve aggregate demand because it will create a buffer stock of EMPLOYED personnel for the private sector to draw upon, rather than a reserve army of unemployed.

There is no reason for President Obama and his economic advisors blithely to repeat truisms that “unemployment is a lagging indicator” as a means of justifying further government spending (the truisms you cite here should reflect the myths you’ve mentioned, not introduce entirely new ones).  The reality of a double digit unemployment rate is de facto proof that government spending is too restrictive.  His concern for the welfare of America and for the nation’s future is no doubt genuine. However, in the haste to renounce financing decisions which would, in fact, be very harmful if not impossible for a private business or a household, in their eagerness to accept uncritically the myths of neo-classical economics, the Obama Administration is overlooking the important differences between private finance and public finance. Only a misunderstanding of money and accounting prevents Americans from achieving a higher quality of life that is readily available.

Apropos money, we need to get over this notion that the government can’t “afford” something. Functionally, dollars have the same value to our government that Super Bowl tickets have for the stadium.

As you go into the stadium, you hand the man a ticket that was worth maybe $1000, and then he tears it up and throws it away. Why? Because the ticket has served its function: it has enabled you to gain entry to the event in question; similarly, a tax is paid to extinguish a state liability, but as soon as the tax is paid, it has no further value to the government. The tax receipt can be sent to the shredder. How does the govt taking your cash and throwing it in a shredder pay for anything?

The answer is that it doesn’t.

Taxes function to reduce aggregate demand, also known as spending power, and not to collect what the govt needs to spend on something else. As a matter of conceptual clarity, it makes no sense to say that a government ever “builds up a store of savings” that allows for higher spending capacity in the future. The govt neither has or doesn’t have any dollars.It spends by changing numbers upwards in our bank accounts.  Government is the score keeper for the monetary system.  Just like the stadium is the score keeper for the football game.

Awarding 6 points for a touchdown doesn’t use up some stock of points held by the stadium. We can always get another “3 points” each time a team kicks a field goal. We don’t have to “pay it back”.

You don’t “save” what you have the option of creating or not creating (i.e. fiat currency). Not spending, not “creating currency” via crediting bank accounts, simply means less present day economic output.

We all learned this as the paradox of thrift. There is nothing to “save” . The government is never revenue constrained. This is in contradistinction to the way users of the currency, vs. the issuer of a currency, such as a household functions. For them, spending is constrained by income. their checks will bounce if there is no money in their accounts. And for users of the currency monetary savings can be stored to permit higher consumption in the future.

Related posts:

• Unemployment claims stuck at 570,000
• Unemployment numbers still point to partial recovery
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• ADP report shows 371,000 jobs lost
• Rosenberg: U.S. unemployment rate headed for 12.0-13.0%

Marshall Auerback here. This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis.

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts. The anodyne communiqué from last weekend’s Pittsburgh summit makes clear that this is not the case. Western policy makers appear determined to consign us to years of additional economic misery because of the continued embrace of a flawed market fundamentalist economic paradigm.

So far, instead of trying to revive the productive economy, most of the G20’s resources have consisted of mouth-to-mouth resuscitation for a dying financial sector. This has not “worked” to the extent that last weekend’s communiqué advertised. The best analogy to describe the current state of our financial system is that we have placed scaffolding over a decaying building, but done little to repair the underlying structure. What happens when the economic scaffolding is removed via “exit strategies”, as the G20 participants have advocated?

For many generations, we didn’t face the unprecedented financial fragility we are experiencing today. But there are good reasons why we avoided this until recently. We have spent the past quarter century eviscerating what was fundamentally a robust structured originally devised during New Deal, a system which basically saved the US capitalist system and served the interests of its citizens very well until it was hijacked by a bunch of corporate predators under the guise of deregulation and neo-liberalism.

To read the communiqué from the Pittsburgh summit is to gain insight into an ideology which views government, not as a stabilizing influence protecting us from private sector rent seeking monopolists. Rather it’s an unwanted stepchild, brought out on display as a necessary evil, and destined to be shoved away as soon as we get back to a “normal” economic state of affairs, where the government minds its own business and lets the magic of the “free market” operate. Hence, the emphasis by the Pittsburgh summiteers on “sustained, strong and balanced growth“, the usual code words designed to encourage budget surpluses, more private sector savings and shift from public to private sources of demand.

There is little understanding that if households and firms try to net save (save more out of income flows than they tangibly invest) incomes collapse, and desired private net saving is thwarted. The private “excess saving” cannot exist without a budget deficit or a trade surplus. Many people make this mistake. At best, we can talk about planned private saving being in excess of planned private investment, but other than that, we are violating double entry book keeping principles.

And consider this: in 1998, 1999 and 2000 (increasing each year), the US government “virtuously” ran budget surpluses. And guess what happened? The private sector became more heavily indebted than before as the fiscal drag squeezed liquidity and destroyed aggregate demand and incomes. Along with our misconceived embrace of financial deregulation, the combined result was sharply rising unemployment and a major recession in 2001-02 with unemployment rising sharply and the automatic stabilizers pushing the budget back into deficit.

Unfortunately, that was the yellow flag for what was to follow, a warning signal blithely ignored by our economically illiterate policy makers. Instead, we perpetuated a massively leveraged financial system via Frankenstein financial products such as collateralized debt obligations, and credit default swaps. We squeezed private sector incomes via constrictive fiscal policy, thereby inducing the debt-fueled consumption that is now regularly decried by our officialdom and the commentariat.

The bottom line is that if we want habitual private sector savings, we need habitual government deficits.

And government deficits are not an aberration; they are the norm. Our first (and possibly greatest) Treasury Secretary, Alexander Hamilton, called the national debt a “national blessing”. Similarly, Paul Krugman and L Randall Wray have argued that it was World War II and the subsequent cold war that ended the depression, which created the foundations for a significant expansion of government debt, which in turn set the stage for the “Golden Age.” The government deficit reached 25 percent of GDP during the war, providing a massive amount of private sector saving in the form of safe financial assets that strengthened balance sheets. From 1960 onward, the baby boom drove rapid growth of state and local government spending, so that even though federal government spending remained relatively constant as a percent of GDP, total government spending grew rapidly until the 1970s. This pulled up aggregate demand and private sector incomes, and thus consumption.

This is unsurprising: The private sector cannot create “net nominal wealth” because every private financial asset is offset by a private financial liability. Over the long term, the maximum that a government can hope to collect in the form of taxes is equal to its purchases of goods of services. There is no hope of running long-term budget surpluses because the government cannot possibly collect more than the income it has created as it paid out dollars. When the government attempts this, as it did during the Clinton Administration, the public finds that its net financial assets would be less than its tax liability, requiring households to dip into its “reserves” of accumulated savings, which gradually become depleted. In the absence of other factors, demand slows and the government almost invariably falls back into deficit.

If an external creditor is added (such as China or Japan) it merely delays or extends the process, since for a time, countries running current account surpluses with the US can use their surplus dollars to accumulate additional US dollar financial claims. But in the absence of any increase in US government spending (which is the only source of NEW NET FINANCIAL ASSETS), the end result is still a massive accumulation of private sector debt, which is what got us into this mess in the first place. By contrast, assuming a non-convertible, freely floating fiat currency, a government can never be insolvent even if its tax revenue declines significantly. Its balance sheet can never become precarious in the same way that a household balance sheet can.

In the abstract, this always sounds controversial to those uncomfortable viewing the world within a financial balances construct. It also helps to explain the intellectual incoherence at the heart of the G20 communiqué and the Obama Administration’s economic policies, which has been dominated by Wall Street interests.

So it’s worthwhile considering some historic examples, which illustrate the point better. During WWII, the US government generated huge deficits and bond issues. The record expansion of government deficits not only facilitated the war effort, but created full employment. (As an aside, it is always interesting to pose the following question to “deficit terrorists “: if government budget deficits are so awful, and so egregious for the long term performance of an economy, then why run them at all during wartime, when presumably we need the economy to be functioning in an optimal manner?) After the war, the Fed was concerned with potential inflationary pressures and raised interest rates. President Truman, a hard money man par excellence, drastically cut defense spending from $90.9bn to $10.3bn and the US accumulated huge fiscal surpluses. Post war surpluses, combined with Fed tightening, contributed to a recession in 1949. Unfortunately, it took the “military Keynesianism” brought on by the Korean War to shift Truman away from his aversion to deficit spending, which was continued by Eisenhower, and sustained via his national highways building program. During that period, unemployment decreased. Similarly benign effects on unemployment were manifested in the wake of the Kennedy tax cuts and those of Reagan in the early 1980s.

Today, budget deficits are the highest as a percentage of GDP, but they are overstated to some degree, because they include the TARP measures to stabilize the financial system which brought the global economy to its knees in 2007/08. Classic Treasury expenditures deal with the purchase of real goods and services; Federal Reserve functions deal with the purchase and sale of financial assets. And yet, the focus of policy makers is quickly reverting to “exit strategies” and a reduction of budget deficits, where the Pittsburgh communiqué pledged to “prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a co-operative and co-ordinated way, maintaining our commitment to fiscal responsibility.”

If only that were true. The only way one could politically justify a government running a sustained surplus would be to make the case that unemployment created a more functional way of ensuring high profits (via wage discipline) than full employment. Put in those terms, it’s not a particularly compelling message, but it has the virtue of being consistent with modern monetary theory.

Oddly enough, the G20 communiqué devotes considerable attention to the government’s “exit strategies”, which came in response to the destructive private sector financial practices which created this catastrophe. There has been less attention directed to the underlying causes themselves. Thus the IMF, in its latest “Global Financial Stability Report”, suggests that restarting securitization markets is “critical” to a wider economic recovery, and that current US and European proposals to force banks that originate loans to hold on to the first 5% of losses in all securitizations, were not sufficiently flexible and might backfire. In the words of Credit Lyonnais Asia strategist, Christopher Wood:

“[The IMF] is yet again doing the world a disservice by acting as a lobbying group for the securitised debt peddlers. It is clearly fundamentally correct that the agents of securitisation should be made to retain some ’skin in the game’ after the terrible damage they have inflicted. It is true that the collapse of securitisation represents a massive deflationary risk for the global economy. But that does not mean that the answer is to allow a new free-for-all in securitisation assuming, charitably, there is demand for the securitised product.” (”Greed and Fear”, 24 Sept. 2009, CLSA, Asia Pacific Markets)

The IMF, the G20, indeed virtually all policy makers — including the Obama Administration — will make themselves far more relevant when they emphasize that full employment and prosperity can only be achieved to the extent that governments are prepared to spend up to a level justified by non-government saving. That does not mean unconstrained government spending. But the spending ought to be set with regard to results desired and competencies to execute plans — not out of some pre-conceived notion of what is “affordable”. Our federal government can afford anything that is for sale in terms of its own currency. And if it spends too much after getting us to a state of full output, it can get inflationary. But let’s get to that state of affairs first before we start worrying about perpetuating the flawed model of the past. That got us transitory prosperity and wage gains. And it promises years of economic misery if we do not move beyond neo-liberal economic fairy tales.

Related posts:

• Minsky: Turning neoclassical economics on its head
• The Cult of Zero Imbalances
• Low savings, high debt and interest rate policy
• Stephen Roach: Americans’ abandonment of overconsumption is a good thing
• UK consumers don’t save

Marshall Auerback here. I have been posting at an interesting new site called New Deal 2.0. You may have seen Edward linking out to articles on the site.

Edward saw an article I wrote there recently and asked me to post it here as well to highlight a recurrent theme at Credit Writedowns – namely that economic recovery necessarily means a return to business as usual.

Please do comment.

The President has marked the anniversary of the demise of Lehman Brothers with a new speech designed to breathe new life into his financial reform proposals. But the Obama administration already forfeited its best chance to reform the banking system when the crisis was at its height.

For all of the lofty talk about establishing “the most ambitious overhaul of the financial system since the Great Depression”, Obama’s reforms amount to nothing more than a reshuffling of the deckchairs on the Titanic.

Why? Because Too big to fail (TBTF) banks have grown even more bloated in the past 2 years. And because leverage has increased across the board. Bank of America, the biggest of the “TBTF” institutions, now holds 12% of all US deposits. The top four (Bank of America, JPMorgan Chase, Citigroup and Wells Fargo) now have 46% of the assets of all FDIC-insured banks, up from 37.7% a year ago. Goldman Sachs, the biggest securities firm before it was handed a bank charter, has plunged into even riskier business and upped its trading and investment profits by two-thirds over the past year.

Systemic banks benefit from implicit and explicit government backstops. But a resolution regime for all systemically large and complex institutions like Fannie and Freddie — arguably one of the most important measures– is stalling in Congress amid waning political support. And — surprise! – lobbyist are gearing up to fight the Consumer Financial Protection Agency, whose fate is unclear as the bill works its way through Congress.

We haven’t yet even determined who will be the systemic risk regulator. Could be the Fed. Or it could be the Systemic Risk Council (a new body proposed to keep an eye of financial markets ). Given the Federal Reserve’s dismal record in anticipating this crisis and promoting the wrong-headed economic models that blew up the bubble, it is extraordinary that we are even discussing the notion of providing the central bank with yet more power. But is a Systemic Risk Council really the answer? Why reinvent the wheel, when the obvious alternative is the Federal Deposit Insurance Corporation (FDIC)?

Professor James Galbraith warns that the key ingredients in systemic risk regulation are accountability and supervision.

It would be all too easy for the Federal Reserve Board to open an internal Office of Systemic Risk Assessment, to staff it with mathematical risk modelers, and to let the matter rest there. Then, when the next crisis hits, the Fed would say that it was something ‘no one could have foreseen’ – just because their internal model-builders failed to foresee it. This is probably not the outcome Congress seeks…

….Essentially, the job is to recognize emerging patterns of dangerous behavior. This function is best taken on by an agency with experience, expertise, and focus on these functions, an agency with no record of regulatory capture or institutional identification with the interests of the regulated sector.

In Gailbraith’s view, the FDIC fits the bill. And he is right. The FDIC is the logical home for systemic regulation. Yet as far as we can see, Obama is not considering it in his proposals. Perhaps part of this reluctance reflects animus toward Sheila Bair, who is definitely not part of the “old boys’ network”. It also likely reflects the comfort level of Wall Street, given its incestuous relationship with the Fed, and the concomitant embrace by both groups of a like-minded market fundamentalist ideology.

Clearly a regulator should not be chummy with the entities it is charged with regulating. The FDIC is charged with taking over any bank it deems insolvent, and then either selling that bank, selling the bank’s assets, reorganizing the bank, or any other similar action that serves the public. This largely explains why the FDIC is not particularly beloved by Wall Street or Wall Street’s main benefactors in Washington DC.

Indeed, the TARP program was at least partially established to allow the US Treasury to subvert the role of the FDIC. By injecting equity in specific banks, the Treasury managed to keep them from being declared insolvent by the FDIC, and ostensibly allow them to continue to have sufficient capital to continue to lend. The end result? TARP entrenched the dominance of the largest financial institutions, preserving many which were de facto insolvent, at the expense of the better run local, community banks (which are in effect being penalized for the sins of Citi and Bank of America). The big bank problem is one of insolvency; further big banks cannot be and should not be saved. They do not hold the key to recovery; if anything, they are a barrier to sustainable recovery. Given a chance, they will try (in fact, ARE trying) to re-inflate the bubble conditions that led to this crisis. There is nothing in the proposed new regulatory framework which will prevent this.

Additionally, the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Our key recommendations:

• Banks should not be allowed to have subsidiaries of any kind. No public purpose is served by allowing bank to hold any assets ‘off balance sheet.’ Banks should not be allowed to accept financial assets as collateral for loans. Forget about leverage ratios: no public purpose is ever served by financial leverage of any kind.

• Banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. CDSs lead investors to be indifferent to a bankruptcy, and in many cases to push for it. Since they own a CDS, they will get their payoff, while negotiating a restructuring takes time and money. Why bother if you can collect immediately via the profits proceeds of a credit default swap? These “Frankenstein” products by all rights ought to be banned outright, but the most the Obama/Geithner reforms dare to propose is a clearinghouse system to reduce potential knock-on effects (systemic risk) from the failure of a large player. But the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings. Naturally, Wall Street opposes this.

The FDIC should be directed to examine the books of the largest insured banks to uncover all CDS contracts held. The gross positions should be netted out amongst these financial behemoths, canceling CDS contracts held on one another. CDS contracts with foreign banks should be unwound; the American taxpayer should not be in the business of bailing out non-US banks. In its examination, the FDIC will have to determine which of these banks are insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. The ultimate objective must be to minimize the cost to FDIC and minimize impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution. And finally, the Treasury and Fed will be directed to work to reduce concentration of the financial sector by avoiding resolution methods that favor large institutions. There will be a bias toward rescue of smaller institutions, and use of the resolution process to break-up the larger institutions.

The past few months have provided ample demonstration that Wall Street intends to recreate the conditions that existed in 2005. And make no mistake, the current situation is worse than it was in 2007 before the collapse, particularly in relation to large, systemically-significant financial institutions. President Obama, Fed Chairman Bernanke and Treasury Secretary Geithner have made many bold claims about their new financial reforms, but these reforms in no way represent a radical shift in its framework of analysis and policy implementation. The reality all three of them continue to turn a blind eye to the underlying problems in the hope that these will not return and blow up again on their watch. This is precisely the recipe for disaster followed by Alan Greenspan, Robert Rubin, and Henry Paulson.

Related posts:

• How to downsize the US financial sector
• Mark to market is beside the point
• A brief note on the fake reform agenda
• FDIC list of problem banks
• Two more FDIC Friday Night Specials brings total to 55 failed banks

Marshall Auerback here with some thoughts on the UK given the recent stellar performance of Sterling.

“The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts…Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense.” – J.M. Keynes in a pamphlet to support Lloyd George in the 1929 election.

Is the UK once again the economic sick man of Europe? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries, which can recover if given the right dose of fiscal medicine? We suspect the latter, assuming that the government avoids listening to the siren songs about “national insolvency” and continues to be “profligate” from a public sector perspective as Lord Keynes urged as early as the 1920s. There is ample historic precedence for this: During WWII, a radically different approach was initiated in the United States. Government spending exceeded tax collections in 1942, 1943, 1944, and 1945 by 14.5%, 31.1%, 23.6%, and 22.4% of GNP respectively. Unemployment was under 2% by 1943, and output increased from $209.4 (billions of 1958 dollars) to $337.1 by 1943. By comparison, what the UK is borrowing today is modest.

No question, the numbers announced in last month’s budget certainly look grim: the IMF is now forecasting a UK general government deficit at 9.8 per cent of GDP in 2009 and 10.9 per cent next year. In the UK Budget, the Treasury forecasts the general government deficit at 12 per cent of GDP, or over, in 2009-10 and 2010-11.

To hear the pundits, this level of borrowing leaves the UK on the threshold of another 1970s-style currency crisis of the kind that could mean the UK would have to go cap in hand to the International Monetary Fund. The fear is that the explosion of public debt and gilt issuance, exacerbated by the UK government’s increasing financial exposure to the banking system, will lead to a sovereign default crisis in which sterling would collapse. It is a good scare story, and it is also a hysterically inaccurate one. In a fiat currency world, a sovereign government that issues its own floating rate currency can never become insolvent in its own currency. This is not Iceland writ large. In fact, we would argue that the UK’ s high level of government borrowing is a necessary precondition to economic recovery, as it offsets private sector deleveraging and prevents the onset of Fisherian style debt deflation dynamics. If anything, the only flaw we saw in this budget was the decision to implement any tax increases of any kind, no matter how great the political appeal. Instead of piling on new taxes that threaten recovery, the Budget should merely have conceded, as President Obama’s did, that tough decisions on taxes and spending may be needed in the future. But the unpredictability of the economic outlook and the danger of prolonging the recession make it foolish to decide right now on the fiscal adjustments required.

There is no question that the UK has some unique features which make it more than just another casualty of the global credit crunch. Weekly wages fell at the fastest rate in 60 years in February as City bonuses were slashed and workers agreed to reduced hours in the wake of recession, the latest official figures show. Of the 219,390 “announced job losses” recorded across the EU in the first quarter of 2009, the highest number (63,314) was in the UK, followed by Poland (38,975), Germany (17,461) and France (11,779). There is a good reason for this: a large number of these losses are concentrated in finance. For many years, policy makers placed a big bet leveraging London up as the centre of finance, thereby rendering the country uniquely vulnerable to the current contraction of finance as a percentage of GDP. Furthermore, the sectors of the UK economy that have collapsed – housing and finance – are particularly revenue-intensive. As a result, notes Martin Wolf of the Financial Times:

The ratio of current receipts to GDP is expected to shrink from 38.6 per cent in 2007-08 to 35.1 per cent in 2009-10 – a fall of 3.5 percentage points. Moreover, as a general rule, the debt-fuelled spending of the private sector was highest that have seen the largest swings in the balance between private income and spending. The shift in this balance in the UK’s private sector between 2007 and 2010 is forecast (implicitly) by the IMF at 9.6 per cent of GDP (from minus 0.2 per cent to plus 9.4 per cent). The swing in Germany, in contrast, is just 0.6 percentage points.

That said, the overall consensus for the UK is that it will be amongst the worst performing economies in the world, worse than the euro zone, and we think the level of fiscal expenditures being planned by the government might make its performance one of the best IN A RELATIVE SENSE.  In these times of economic stress, it is worth remembering the old expression:  In the land of the blind, the one-eyed man is king, particularly in a country which can do fiscal policy, a state of affairs uniquely not present in the European Union. As strange as it sounds, public sector profligacy is preferable to prudence, because as the private sector’s spending and borrowing go into hibernation, government borrowing must expand significantly to compensate.

Some paint a morbid picture of the UK government having to absorb $4,500bn (€3,400bn, £3,100bn) of UK bank foreign currency liabilities – three times GDP – and ending up in a debt default and a situation akin to Iceland or Ireland. No one should take this argument too seriously. If these liabilities, which include non-UK banks, were to become part of public debt, so too would a matched £4,600bn of foreign currency assets. The total balance sheet would rise sharply but, on a net basis, nothing much changes. In this vital respect, the UK is unlike Iceland, Russia and many other countries with foreign currency asset and liability mismatches. Moreover, the UK’s much feared current account deficit is now a benign 2 per cent of GDP and falling precisely because of sterling’s weakness, which has acted as a shock absorber for the British economy, not a harbinger of impending currency flight.

The solvency canard, which seems to underlie most of the phobia surrounding the UK’s finance, is based on flawed reasoning. Credit or fiat money systems cannot be analyzed as if they were commodity money systems, and conventional economics still does not get that. In fact, assumption of a gold standard lurks behind many parts of contemporary mainstream economics, including the view that governments are somehow budget constrained, as illustrated by the commentary underlying the recent UK budget. Problems would only arise if a large portion of the UK’s debt was foreign currency denominated, as was the case for the Asian NIEs in the 1997/98 financial crisis.

As soon as Darling mentioned the headline figure that public finances would be an additional 175 billion pounds in the red next year, the shock reverberated around City dealing rooms, pushing the pound and government bonds lower. The figure in question represents an eighth of Britain’s national income, that the government will be forced to borrow this year, more than four times what the chancellor expected a year ago.

For all of the bloviating from the press on this issue, sterling actually closed the week up against the dollar post the budget and is now some 10% above its crisis lows, when the fashionable talk was all about “Reykjavik on the Thames”. In a country with a currency that is not convertible upon demand into anything other than itself (no gold “backing”, no fixed exchange rate), the government can never run out of money to spend, nor does it need to acquire money from the private sector in order to spend. This does not mean the government doesn’t face the risk of inflation, currency depreciation, or capital flight as a result of shifting private sector portfolio preferences, but the budget constraint on the government, the monopoly supplier of currency, may be different than we have been taught from classical economics, which is largely predicated on the notion of a now non-existent gold standard. The UK Treasury cuts you a benefits cheque, your cheque account gets credited, and then some reserves get moved around on the Bank of England’s balance sheet and on bank balance sheets to enable the central bank (in this case, the Bank of England) to hit its interest rate target. If anything, some inflation would probably be a good thing right now, given the prevailing high levels of private sector debt and the deflationary risk that PRIVATE debt represents because of the natural constraints against income and assets which operate in the absence of the ability to tax and create currency.

In addition to ideological opposition to high levels of government spending, many critics of the UK government’s approach display an ignorance of simple financial balances accounting. A high level of private sector debt delinquencies and defaults suggests private debt burdens got too high relative to private income flows. Liquidating or restructuring existing private debt then makes more sense than getting banks to loan more money to the private sector. Private debt liquidation, which is the Austrian solution, can take the whole system down if enough people try to do it at the same time, or if a large enough institution does it in a disorderly fashion. As Irving Fisher noted, attempts to pay down debt can lead to higher real debt burdens as forced asset and product sales drive prices into the ground. We had a taste of that with the Lehman bankruptcy. Debt liquidation might form some part of the solution when seeking to eliminate private sector indebtedness, but it cannot be the main course.

If not, then the private sector needs to be in a position to net save and pay down debt. That cannot happen unless some other sector is willing and able to deficit spend. Some of this can be achieved through increased exports, although if every country sought to depreciate their currency in the manner of sterling, the result would likely be a further collapse in trade, since “beggar thy neighbour” devaluations mark protectionism by another name: two potential candidates, the government sector or the foreign sector.

Given the contraction in foreign demand and rapidly diminishing trade flows, that leaves government to deficit spend if the private sector is going to net save. This is not high Keynesian theory – it is double entry book keeping, which we have been doing for 5 or 6 centuries now. Think T accounts, 2, sides to every transaction, rather than micro household behavior, and you will avoid the more obvious fallacies of composition. At the lowest level of manufacturing capacity utilization in post WWII history, and a rapidly rising employment rate of 7% in the UK (and rising), the crowding out perspective is not terribly relevant, is it?

There is therefore a built-in contradiction in a recent Financial Times editorial, (“Sudden debt?”, April 25, 2009), which readily distinguishes between the UK’s current economic plight and that of an emerging market:

There is, however, a vital difference with most emerging countries, which labour under what economists call “original sin”: they cannot issue debt in their own currency. That multiplies their vulnerability, since currency depreciations automatically add to their debt burden, reducing their ability to repay.

This, at least, is a problem the UK does not have – yet. The yield on 10-year gilts has spiked since the Budget speech but remains a moderate 31 basis points above the bund. The short and long ends of the yield curve have barely budged. And although the record deficits will cause the UK’s public debt to double – the government expects it to stabilise at 79 per cent of gross domestic product – that only brings it just above German levels. Japan, whose debt stands at about twice its GDP, shows that this is perfectly affordable so long as the bond markets are happy to refinance it.

And yet the editorial still goes on implicitly to raise the issue of solvency by noting that “if gilt investors began to doubt its commitment or ability to close the deficit, the market’s willingness to refinance UK sovereign debt could come to a sudden halt. The government must pre-empt perilously self-fulfilling doubts before it is too late.” A commitment to close the deficit is precisely what doomed Japan throughout most of the 1990s, when premature attempts at “fiscal consolidation” actually increased budget deficits by foolishly deflating incipient economic activity. It is the reversal of trade deficits and the increase in fiscal deficits, which gets a country to an increase in net private saving. That in turn will stabilise growth and improve the deficit picture. Once this is achieved, any notions of national solvency should go out the window.

So who will buy the massive new quantities of gilts? Phrased in this manner, the question still reflects a lack of understanding of a monetary system in a fiat currency world. The real question, posed by Professor Charles Goodhart (a former member of the Bank England’s Monetary Policy Committee), is: why issue so many gilts? Like all other governments, Her Majesty’s Government in the United Kingdom spends by crediting bank accounts (bank deposits go up and bank reserves are credited by the Bank of England). All else being equal, this generates excess reserves that are offered in the overnight interbank lending market, putting downward pressure on overnight rates. The purpose of gilt sales, then, is to substitute interest bearing gilts for undesired reserves, which would suggest that government deficits per se do not exert upward pressure on interest rates. Quite the contrary: they put downward pressure that is relieved through gilt or bond sales. But if the objective is to keep long rates down, why issue so many long dated instruments? There is no reason that the central banks could not simply offer a whole spectrum of maturities with spectrum of rates and let markets choose what they want to hold.

Yes, there may well be practical political constraints. The problem of course is that if enough investors read significant government spending as an inflationary expansion of the monetary supply (even if deflation is getting printed in the monthly CPIs as is the case today in the UK), then a shift to inflation hedges, which can include equities since they are after all claims on real productive assets, can occur.

In addition, if the Bank of England continues to pursue a quantitative easing program designed to trash yields on cash and near cash instruments, and if it is successful, fewer private investors by definition will be interested in owning gilts (especially if they realize at some point the BOE will be abandoning quantitative easing, as would be expected once a recovery is underway).

Plugging existing holes in the balance sheets of financial institutions does not really accomplish anything that improving private sector money income flows through fiscal deficit spending does not accomplish better. Loans that are getting serviced do not go into default. Some of these loans were Ponzi loans from the get go, and would only fly if home price appreciation continued forever. Those loans need to be liquidated, and while there may be a place for the central bank to lower mortgage rates to try to stabilize home prices, the Bank of England has no business trying to set off another housing bubble. Better to bolster private income growth so existing loans can be serviced rather than have the public sector taking positions in banks.

Which again brings us back to the government’s fiscal spending: The more fiscal deficit spending is trained on building out infrastructure or encouraging new investment growth in leading industries (say by procuring solar panels for federal buildings to help that industry reach economies of scale and lower unit costs to be more competitive with oil based technologies, or say by getting government out of the way on stem cell research), the less we have to worry about a) a new growth model that replaces the UK/US consumer debt driven model, and b) nominal income or wealth being created with no real output or productive capital stock being created. In this way, government as employer of last resort programs is preferable to more transfer programs to keep households limping along. In fact, an employed labor buffer stock is a more effective price anchor than today’s unemployed buffer stock, because all studies show business prefer to hire people already working rather than the unemployed.

The notion of government as employer of last resort is a very interesting fiscal policy option that has been hinted at tentatively by the Labour government, but generally with great reluctance, because of the fear that it may result in a larger budget deficit. But the real key toward a substantial UK recovery (as is the case in the US) is not restrained fiscal activism, but substantially more government spending to offset the implosion of private sector demand. Once the government honestly addresses the solvency issue of a government spending and borrowing in its own currency, there is nothing that could in theory prevent the UK Government from offering a job to anyone who applies, at a fixed rate of pay, and let the deficit float. This would result in full employment, by definition. It would also eliminate the need for such legislation as unemployment compensation and a minimum wage.

Of course, this is a fairly revolutionary notion, albeit an accurate picture of what can be achieved in a fiat currency environment with gold standard constraint. Gordon Brown’s government has a credibility problem and a problem of political fatigue. They need to figure out how their emperor with no clothes story can be best revealed to the general public. If budget deficits do not require Treasury financing, then this needs to be made plain and palatable for the citizenry to embrace, painted as an opportunity rather than a risk. This new class of government employees, which could be called supplementary, would function as an automatic stabilizer, the way unemployment currently does. A strong economy with rising labor costs would result in supplementary employees leaving their government jobs, as the private sector lures them with higher wages. (The government must allow this to happen, and not increases wages to compete.) This reduction of government expenditures is a contractionary fiscal bias. If the economy slows, and workers are laid off from the private sector, they will immediately assume supplementary government employment. The resulting increase in government expenditures is an expansionary bias. As long as the government does not change the supplementary wage, it becomes the defining factor for the currency- the price around which free market prices in the private sector evolve.

So where do we go from here? In many respects, the UK is an interesting test case for the global economy and the success or failure of its future fiscal policies have huge implications, given that the country stands at the crossroads between the two competing approaches embodied by the US and European Union respectively. One thing we can say with some degree of certitude is that the UK should not fear a public sector led expansion, given that private sector-led expansions are almost always inherently unsustainable because (as the past 20 years has demonstrated), they generate growing debt burdens that must eventually be reversed. That reversal can be cushioned and, indeed, largely offset by public sector debt expansion (assuming that the debt is denominated in the “home” currency), which does not suffer from the same need to be reversed, given the government’s monopoly role as the creator of currency and ability to tax.

It is important to get rid of the fallacious reasoning that government expenditures are in any way comparable to typical household expenditures. The government is sovereign. This fact gives to government authority that households and firms do not have. In particular, government has the power to tax and to issue money. The power to tax means that government does not need to sell products, and the power to issue currency means that it can make purchases by emitting IOUs. In the words of James Galbraith:

No private firm can require that markets buy its products or its debt. Indeed taxation creates a demand for public spending, in order to make available the currency required to pay the taxes. No private firm can generate demand for its output in this way. Neither of these statements is controversial; both are matters of fact. Nor should they be construed to imply that government should raise taxes or spend without limit. However, they do imply that federal budgeting is different from private budgeting, and should be considered in its proper, public context.

While it is common to regard government tax revenue as income, this income is not comparable to that of firms or households. Government can choose to exact greater tax revenues by imposing new taxes or raising tax rates. No firm can do this; even firms with market power know that consumers will find substitutes if prices are raised too much. Moreover firms, households, and even state and local governments require income or borrowings in order to spend. The federal government’s spending is not constrained by revenues or borrowing. This is, again, a fact, completely non-controversial, but very poorly understood, as evidenced by the persistent cries of UK profligacy in the context of its recent budget. We need to proceed boldly, but can only do so by disposing of a number of traditional bogeymen that no longer apply in a post-gold standard world: public debt burdens, national solvency, and “crowding out”. Above all, it is crucial to understand that the global desire for private sector deleveraging depends on another sector to do the opposite if it is not to become economically disruptive. For one sector to run a surplus, another must run a deficit. This is a basic accounting identity that seems to have been lost by the vast majority of economists and pundits. In principle, there is no reason why one sector cannot run perpetual deficits, so long as at least one other sector wants to run surpluses. But certainly for the current environment there is nothing, nor should there be anything, which should stop the UK government from running large deficits so that the private sector can happily build up its savings again, as was the case in the US in the aftermath of World War II.

Related posts:

• China cuts holding of U.S. Treasury securities
• Massive debt issuance in the U.S. and elsewhere
• China issues bonds to “promote the RMB in neighbouring countries”
• Depressionary bust in Ireland is echoed in California
• Obama takes middle road on stimulus and taxes that leads nowhere

Marshall Auerback here with a few thoughts about the monetary policy end game.

Bernanke has to continue to make hawkish comments about inflation so as to avoid a complete blow out in bond yields, but the the dirty little secret is that inflation is the way out of the debt trap, along with dollar weakness. Both reduce the real cost of debt servicing.

But Bernanke is in a real policy cul de sac of his own making since he initiated Fed purchases of longer dated Treasuries. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds. In other words, even before we get to the day when quantitative easing is removed, when investors face the likely renormalization of policy rates and the removal of implicit ceilings on government bond yields, there is a glaring inconsistency in the QE approach which no one seems to have noticed..

If government yields back up, either because private sector portfolio preferences are shifting toward riskier assets as central banks trash cash and suppress government bond yields, or because fiscal stimulus is helping “green shoots” take root and thereby encouraging riskier portfolio exposures, then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.

Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.

Over to you Ed!

Edward Harrison here.  Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

The problem with this inflationary policy response is that it invites a currency and asset revulsion.  Why do you think the Chinese have been talking so much about inflation in the west?  They are pretty unhappy about the prospect that quantitative easing will depreciate the value of their U.S. dollar assets. So they are looking to apply some pressure on the U.S.

But, policy makers are going to say one thing in public and to the Chinese and do another thing altogether different.  Hence, the hawkish talk by Bernanke in Washington this week about withdrawing liquidity.  Their hope is that the U.S. economy can right itself enough BEFORE the inflation becomes apparent and yields start marching upward.

But, the appetite for risk is fully manifest in U.S. markets, causing yields to back up and this is going to require an increasing “monetization” of the U.S. debt, making the inflationary policy that much more transparent.  While Marshall has already mentioned the flight to commodities and real assets as a likely response, you can expect the dollar to lose value in this scenario.

What the Chinese response will be is the $1 trillion in dollar reserves question.

Related posts:

• Trashing cash
• Pimco sees inflation in America’s future
• China to diversify out of U.S. dollars
• Kasriel: ‘greater risk for the global economy…is inflation’
• China warns that the west’s quantitative easing is inflationary

Marshall Auerback here.  Yesterday, Ed made a big to-do about China’s increase in gold reserves.  I am going to take a different view here.

CLSA is saying that the increase is from purification and miscellaneous transactions since all the way back to 2003 so that it was not a recent open market purchases but accumulation of 6 years of this process. If this is the situation, then this news really is not as significant as people think.

I think this is probably true. If you look at the Chinese forex reserves, for years, they had the same number on gold for years (always around 500 tonnes despite massive increases in forex reserves). They don’t fully disclose. I can recall in the early part of this decade noting that platinum imports in China were going through the roof (the Johnson Matthey data on this was excellent) and it was largely for jewellery consumption! But gold imports never seemed to move and I was always told that this is because the Chinese preferred platinum which I thought was rubbish.

Every single economic model pointed toward increased consumption of gold, but that was never reflected in the statistics, and I always thought that this was being concealed for political reasons.

The more interesting question is this:  why is China tipping its hand now – perhaps as an implied threat to the US?

Comments appreciated.

Related posts:

• China to diversify out of U.S. dollars
• European gold sale blunder reaches $40 billion
• China cuts holding of U.S. Treasury securities
• China slams U.S. profligacy
• Is China avoiding using US dollars?

Marshall Auerback here with a few thoughts about this economic cycle, external imbalances, fiscal stimulus, and current account deficits.

This is not the Great Depression. We are going to have “muddle through” here precisely because we lack the courage to deficit spend on the magnitude we did in World War II. We are spending too much time fretting about “external imbalances” (Martin Wolf’s latest piece in the FT, “The Urgency of Now” is an illustration of this:  The resolution of external imbalances is the main problem and should be the policy objective right now.)

We are no longer operating under a fixed exchange rate regime or a quasi gold standard (much as some countries curiously want to recreate this). We have a flexible exchange rate regime, where capital inflows have to equal the current account deficit. Dollars flow out through the trade deficit (which is a large part of the current account deficit) as the US spends more on imports than it earns on exports. Those dollars are net saved by our trading partners and they are reinvested in dollar-denominated assets. If portfolio preferences of foreign net savers shift away from holding US dollar denominated assets, asset prices have to adjust until they are willing holders of the dollars they earn in trade (that is, interest rates must rise, equity prices must fall, until expected returns are attractive enough for foreigners to maintain their US dollar holdings). Also, if foreign net savers of dollars favor particular assets, like US Treasury bonds, for a variety of institutional reasons, then relative US asset prices can also be influenced.

The money that flows out through the current account deficit flows back in through the capital account. For a nation with a flexible exchange rate, there is no change in the money supply from trade activity. This is just the opposite of a fixed exchange rate system, of which gold based systems are one type, and that is why James Grant advocates leaving flexible exchange rate systems in the dustbin of history. In a fixed exchange rate system, money balances of trade deficit nations are drained off to the trade surplus nation, and the trade deficit can only be run until the existing money balances of the trade deficit are exhausted.

Neither foreign private or public entities can create US dollar reserves out of thin air. That is the charge of the US central bank and commercial banks. Foreigners have to earn dollars from sales of goods or assets to US dollar holders. So it seems to me that the imbalances Wolf describes are almost a necessity as far as the US goes.

That means the ultimate source of the credit to support US trade deficit spending could not have come from abroad as some have alleged. Rather, credit was created in the US as households engaged in mortgage equity withdrawal during the housing boom, and spent more than the earned. Neither foreign savings nor foreign capital inflows were required to create this credit. All that was required was a household willing to borrow with identifiable equity in their home, and a bank willing to expand its balance sheet, with new home equity loans creating new deposits out of thin air. The loan is made, which shows up on the banks asset side of the balance sheet, and the homeowner has a credit line it can draw down, which shows up on the liability side of the bank balance sheet. Nobody here or abroad needed to save beforehand for this money deposit and credit loan to be created.

So what happens when the housing bubble bursts? Equity in homes shrinks, mortgage equity withdrawal shrinks, bank balance sheet growth reverses, household deficit spending reverses as they begin to net save, the trade deficit begins to turn, foreign net saving is reduced, and foreign capital inflows to the US are also reduced. The trade deficit is the twin of the household deficit spending, and the household deficit spending was made possible by credit expansion by US financial institutions on the back of the housing bubble.

In other words, foreign saving and capital inflows are at the tail of the dog, not the head. The only way the tail wags the dog is if foreign portfolio preference shift suddenly or persistently against US dollar denominated assets or specific US asset classes, in which case asset prices must adjust to keep foreign investors willing holders of US dollar denominated assets. We must always be careful to distinguish between shifts in preferences with regards to existing holdings, and shifts in saving out of income flows. The two are not the same, but they often get conflated.

That is not to say the threat of foreign investors dumping US assets isn’t a danger, but it may not be the central risk, which as far as I can see remains the concerns of people who fret about today’s imbalances. To me, the central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons – loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.

The risk of this necessary adjustment arises because if the private sector moves to a net saving position – spending less than it earns – the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. In other words, we should be applauding this increased fiscal deficit because the alternative would be disastrous, not just for the US, but the world as a whole.
For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so called paradox of thrift comes from, as you well know. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.

In Q4 2008, US nominal GDP fell. Incomes have started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.

I suppose you could argue that from a US only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn’t going to happen. China earns about 10 times as much on its external sector than the domestic market, so its decision to become an export juggernaut, taken in isolation, was perfectly understandable. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade. The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. And the reality is that we don’t need a G20 summit to accomplish this. The US can do this on its own, as can Japan (as PM Aso indicated on the front page of your paper today). As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In that sense, if you agree private sector deleveraging is necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6% of GDP to 4% of GDP. Let’s say further consumer and inventory contraction gets us to 2% of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12% of GDP. I think that’s a bit high, as it incorporates TARP. But even assuming a trailing deficit of 8% (which is roughly what we’ve got now in the US), the private sector can net save around 7-8% of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9% of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial.

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Does that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once 40% of commercial bank balance sheets. They were below 1% last I checked. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve. The Fed used to hold 70-80% of its assets in Treasuries, now down to 20%. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall.. Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated, and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could. But I think the alternative of focusing first on the external imbalances between China and the US is the wrong way to go about it. Look at what happened to budget deficits during W.W. II: at its peak, the US budget deficit as a percentage of GDP went to 30.3% in 1943. Yet by the end of the war, US households and the private sector were once again in a position of massive savings surplus. This is the financial correlative to those huge government deficits on the side of the ledger.
Remember, there is no ‘cost’ to a federal deficit.  It’s not a free lunch, it’s a free tool to prevent loss of output.

One last point about “muddling through.”  Here are some graphs to illustrate the differences between now and the Great Depression (hat tip Warren Mosler).

Nothing remotely like this is currently in the cards. It was the last gold standard collapse. The US gold standard was abandoned domestically in 1934.

Nothing remotely like this will happen this time around. World War II deficits exceeded 20% of GDP annually. Currently Personal Income is muddling through with flat to modestly positive gains month over month. This is not the Great Depression.

Related posts:

• What are the consequences of the huge U.S. deficit?
• The dollar is rising against floating currencies
• The US Dollar – don’t just do something, stand there!
• The G20 Summit: Hijacked by neo-liberalism
• Why I am bearish on the U.S. Dollar

Marshall Auerback here. Remind me again what Larry Summers was talking about when he spoke of the US as being a “nation of laws”, where “sanctity of contract” is sacrosanct?

In a case of first impression that could have far-reaching implications, a bankruptcy judge in California recently determined that municipalities that file petitions under Chapter 9 of the Bankruptcy Code (reorganization for municipalities) can reject existing collective bargaining agreements with public employee unions. In re City of Vallejo, Case No. 08-26813-A-9 (E.D. Cal. Mar. 13, 2009). Facing a $9 million budget shortfall, largely from collectively bargained payroll costs and benefits for firefighters and police officers, the City of Vallejo filed a petition for bankruptcy protection under Chapter 9 in May 2008, which allowed the City to attempt to re-negotiate contracts with employees, vendors and others. When efforts to re-negotiate the collective bargaining agreements with the unions representing firefighters (International Association of Firefighters, Local 1186) and electrical workers (International Brotherhood of Electrical Workers, Local 2376) failed, the City petitioned the bankruptcy court to void the contracts with those unions.

The primary issue before the bankruptcy court was whether a particular statutory bankruptcy provision, 11 U.S.C. section 1113 – which prevents outright rejection of union contracts in the private sector by requiring Chapter 11 debtors (reorganization of corporations or partnerships) to satisfy certain procedural and substantive prerequisites before they can void a collective bargaining agreement – is applicable to municipalities seeking protection under Chapter 9. After reviewing the statutory history, the bankruptcy court determined that section 1113 was specifically not incorporated by Congress into Chapter 9, and therefore, was not applicable to municipalities.

However, the bankruptcy court found that other, albeit less stringent, procedural requirements established by the United States Supreme Court in NLRB v. Bildisco & Bildisco,1 did apply to municipalities petitioning for bankruptcy under Chapter 9. In Bildisco, the Court determined that a collective bargaining agreement can be voided only if the debtor can establish that: (1) the collective bargaining agreement burdens a debtor’s ability to reorganize by proposing and implementing a viable plan of adjustment; (2) after careful scrutiny, the equities balance in favor of contract rejection; and (3) “reasonable efforts to negotiate a voluntary modification have been made and were not likely to produce a prompt and satisfactory solution.”2 Because the City of Vallejo had already successfully re-negotiated contracts with the unions that represented the police officers and managerial employees, and negotiations with the remaining unions were ongoing, the bankruptcy court deferred a final determination on whether those agreements were void.

Some observers believe that if this groundbreaking decision holds up, other financially strapped municipalities will use this decision as a blueprint to void their union obligations.

Source
United States: Municipalities Can Void Public Employee Union Contracts Through Bankruptcy – Littler

Related posts:

• The coming collapse of the municipal bond market
• Ireland: government blew the boom
• Obama ready to put Chrysler into bankruptcy
• Chrysler: bulls make money, bears make money, pigs get slaughtered
• Opel and Fiat spells bankruptcy for Chrysler and GM

OK, well this is just an actor in a comedy skit from Saturday Night Live getting angry.  But, it is pretty funny.

Related posts:

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It is almost like they are trying to manipulate the market prices on a day to day basis.

At best the total $300 billion is probably less than 1/5th of total treasury issuance (not counting TARP, etc, for fiscal 2010).

By the way, I calculated that Treasury interest cost has decreased and is running around $250 Billion, down significantly from two years ago due to much lower rates and short duration of treasury maturities. Now that’s really smart isn’t it?

But… in 4-5 years the total outstanding debt (not just publicly-held debt) should be in the $15 Trillion range and if rates back up (oh no, never) to say, just to be conservative, 6%, then total gross interest cost would be $900 Billion or 25% of the gross federal budget at today’s estimated levels (ha-ha to that too).

It’s almost a mirror image of when the Bank of England pre-announced gold sales in 1999 (at the bottom of the market). Except this time, they are trying to drive the asset concerned UP, rather than down. I suspect that Bernanke will have the same success here ultimately that Gordon Brown did. Gold did originally go DOWN after the BOE announcement and took a few months to recover, but we all know now that the Bank of England sale marked the low in the bullion market. Could Bernanke’s first long dated Treasury purchases represent the peak in the long bond?

	OPERATION DATE	SETTLEMENT DATE	OPERATION TYPE	MATURITY/CALL DATE RANGE
	March 25, 2009	March 26, 2009	Outright Treasury Coupon Purchase	02/29/16 – 02/15/19
	March 27, 2009	March 30, 2009	Outright Treasury Coupon Purchase	03/31/11 – 04/30/12
	March 30, 2009	March 31, 2009	Outright Treasury Coupon Purchase	08/15/26 – 02/15/39
	April 1, 2009	April 2, 2009	Outright Treasury Coupon Purchase	05/31/12 – 08/31/13
	April 2, 2009	April 3, 2009	Outright Treasury Coupon Purchase	09/30/13 – 02/15/16

Related posts:

• Treasury yields go below zero
• China cuts holding of U.S. Treasury securities
• Demand for Treasury securities is still high
• Mea Culpa: The Fed is not going to buy treasuries
• Don’t underestimate the power of printing money

Marshall Auerback here.

I do not like the Geithner Plan because it is needlessly expensive. Nevertheless, it could well work. My main objection is that it constitutes the most regressive transfer of wealth in history and it’s being done BY A DEMOCRAT ADMINISTRATION!!!! Unbelievable.

It has to be done this way in terms of securing funding for the banks because after AIG, there is no way Congress would give them the money. As I predicted in a post I wrote here a week ago, the 1994 Mexico rescue package, where Robert Rubin raided the Exchange Stabilisation Fund to get the money to Mexico (or, more accurately, the Wall Street banks who lost a fortune playing the Tesobono market in Mexico) is the template here.

Sorry, Ed, I know you like Rubin.

Now, the market has gone up (rationally in my opinion) because they are aware that the Wall Street interests have triumphed. If the FDIC does 80 percent and treasury does 80 pc of remaining 20 pc then private sector only on hook for 4 pc. Does anyone report that FDIC is out of money — so, it is all treasury? By using different agencies here, there is this façade that government is on hook for less (feigned laughter). Maybe. The bond market is figuring this out?

Do you realize that various government programs may now be north of $5 trillion, while the total market cap of us equities is $8 trillion. Basically fed and treasury have already nationalized banking and shadow bank system without saying so. And there was no reason to do this (as my friend Warren Mosler says) because: “We already have a regulated banking system. We just have to regulate them!!”

Equities are seeing this and ready to vault. Meanwhile, the furore over AIG is very similar to the 1933 Pecora hearings which began in January 1933. The Dow went up over 100 percent as the hearings disclosed terrible behavior. AIG is very similar.

Related articles
Take the Steering Wheel out of Geithner’s Hands – Huffington Post

Related posts:

• Greed is not good
• The Obama-Geithner Plan will fail
• China sovereign wealth fund diversifies into a massive loss
• Barney Frank rips Hank Paulson’s bait and switch
• Goldman and Morgan Stanley are now banks

From the Wall Street Journal:

In the latest dramatic move by federal authorities to prop up the nation’s banking system, regulators late Friday seized control of the two largest wholesale credit unions in the U.S. after finding that their losses on mortgage-related securities were even larger than previously thought.

U.S. Central Corporate Federal Credit Union and Western Corporate Federal Credit Union, which have a total $57 billion in assets, were taken into conservatorship by federal regulators. Under conservatorship, the government will continue to run the institutions.

Michael E. Fryzel, chairman of the National Credit Union Administration, the industry’s federal regulator, said the seizure was necessary to maintain the integrity of the credit union system and the already-strained insurance fund that backs up deposits in thousands of retail credit unions.

The affected institutions don’t serve the general public. Instead, they provide critical financing, check-clearing and other tasks for the retail institutions. These wholesale credit unions, known in industry parlance as corporate credit unions, are owned by their retail credit-union members.

U.S. Central and Western Corporate have been grappling for more than a year with large paper losses on a slew of assets, mostly mortgage-related. In January, regulators moved to prop up U.S. Central with a $1 billion infusion after it took big writedowns on some of the securities.

Mr. Fryzel said regulators moved after becoming convinced that the two institutions were underestimating the true scope of their losses. “With us in control we’d get honest numbers,” he said. Mr. Fryzel said regulators plan to replace top management at both institutions.

Using the Geithner logic, we should be buying shares in these Credit Unions at vastly inflated prices, leaving the management in place, and pretending that these are two perfectly functioning credit intermediaries.

Curious, isn’t it — that somehow the “government” is perfectly able to assume management of these 2 credit unions and 17 other banks, but somehow we can’t possibly do the same for Citi.

As for BofA, I suspect there were some dealings done whereby the Fed pressured BofA to buy Countrywide and Merrill and basically to cover up the horrendous nature of that mistake. They are now too politically inhibited to do an FDIC treatment on them.

Contrast that episode with WaMu and JPMorgan Chase.

Oh, and the FDIC seized a bank as well – FirstCity Bank of Georgia. That makes 18 banks this year.

UPDATE 610 MT: The FDIC has seized two more institutions. This makes five seized today.

Banks in Colorado, Georgia and Kansas were closed by regulators, bringing the number of bank failures this year to 20, while the National Credit Union Administration Board seized corporate credit unions in California and Kansas that have a combined $57 billion in assets. Corporate credit unions are chartered to act as a sort of clearinghouse for the credit unions that serve consumers.

Sources
Regulators Seize Control of Two Largest Corporate Credit Unions – WSJ
Georgia’s FirstCity Bank becomes 18th failure of 2009 – Market Watch
Calamitous day sees banks, credit unions seized – Market Watch

Related posts:

• Credit Unions in trouble
• Credit Unions aren’t immune
• Florida credit union put into conservatorship
• Seven banks seized by FDIC
• IndyMac: Another Banking Bankruptcy

You may have seen Ed’s post “Gillian Tett: Washington is talking to Swedes about banking crisis solutions” a week back about how the U.S. government was getting ready to talk to Swedish officials regarding the banking crisis. This is a very important development and I have a lot more to provide below on the issue as it pertains to today’s events and Japan’s crisis early this decade.

Bo Lundgren, one of the original architects of Sweden’s successful banking bailout program, went to Tokyo in 2001 (I wrote about it in “Prudent Bear”) and a lot of his ideas were subsequently adopted by Heizo Takenaka, Japan’s Economics Minister in Prime Minister Junichiro Koizumi’s administration.

It is also worth noting that Sweden only nationalised two banks, so the key challenge is minimising the contagion effect (i.e. if you take over Citi and BofA, how can you spare JP Morgan or Wells Fargo?).

But one of the key aspects of the Swedish plan which helped it gain widespread public acceptance was the notion of SHARED SACRIFICE. This gave the nationalisation tremendous public legitimacy. Geithner’s plan looks like it is being directed by Wall Street and in TALF you give them a huge political weapon — i.e., we don’t partner with you if you continue to adopt measures we don’t like.

US calls on Sweden’s “Mr Fix It” Bo Lundgren

The Swedish financial chief known as “Mr Fix It” has been summoned to Washington to advise on how Sweden’s model might avert a global banking meltdown.

Bo Lundgren, the steely-eyed head of Sweden’s National Debt office, played a leading role in averting the collapse of the Swedish banking sector when a property bubble burst in the early 1990s.

Sitting in his office in downtown Stockholm before his trip to Washington, Mr Lundgren chuckled at the Wall Street joke that “Swedish models used to only attract attention if they were blonde and leggy”.

Now, US President Barack Obama cites Sweden as a possible model of how best to tackle failing banks. Mr Lundgren, who was fiscal and financial affairs minister at the time of the last crisis, yesterday outlined the Swedish solution to the Congressional Oversight Panel, which supervises the US administration’s troubled asset relief programme.

“I am a market liberal. I was even called the nearest Sweden had every come to having a party one could call libertarian,” said Mr Lundgren, the former head of the Moderate Party with links to the Conservatives.

This did not stop him nationalising two failing major banks in 1992: the already majority state-owned Nordbanken, and the privately owned Gota bank.

“In the case of a crisis, the state needs to be strong,” he said. “If it decides to act, it should become an owner.”

After initial hesitation, when the Swedes chose to act they soon reached a broad political consensus.

The first, and in his eyes crucial step Mr Lundgren took was to restore liquidity by issuing a so-called “blanket guarantee” for all non-equity claims on Swedish banks.

This was vital to restore confidence, he said, and is something that has not been done in the US and UK.

It was also crucial not to put a figure on the guarantee, according to Stefan Ingves, the governor of the Riksbank, Sweden’s central bank. Mr Ingves was a finance ministry official in the early 1990s and led the Bank Support Authority, created to resolve the crisis.

“If you pick a very low figure, people will say: ‘That’s not credible, we think the problem’s bigger than that.’ If you pick a very high figure, then people say: ‘Oh gosh, is it that big a problem?’,” he said.

The government did not extend its credit guarantee to shareholders of the nationalised banks, who were wiped out.

In the UK, the Royal Bank of Scotland has refused to go this far, but the Swedes insist this acts as a wake-up call to shareholders of troubled but still solvent banks to shape up or ship out. This decision spurred two private banks to raise private capital.

A “stress test” was worked out to determine how bad the problems were in each bank for the coming three years.

Banks were then ranked as healthy or as candidates for nationalisation, and those in between were told to clean up their act or face being taken over by the state.

Next, the toxic assets of the nationalised banks were ring-fenced into two separate bad banks and run by independent asset-management companies. The good assets were placed in a single, merged bank.

As central banks and supervisors “don’t do corporate restructuring”, the Swedish authorities decided to bring in investment bankers from the private sector to run the corporate finance side of the bad banks’ assets. “Huge numbers” of bankers and auditors were flown in from London to do the “daily running of these businesses,” said Mr Ingves.

Private banks were also urged to place their non-performing loans in separate bad banks. However, unlike what has been mooted in the US, there was never any question of the authorities buying bad assets from banks that remained in any way privatised. “We refused to do that because we could never agree on the price. If you pay too much it’s a giveaway to the shareholders. If you pay very little then the transaction simply won’t happen,” said Mr Ingves.

Despite calling it a “political value judgment”, it is clear he disapproves of countries such as Britain and the US who have committed huge sums to insure bad assets of private or part-private banks.

Once split, the two Swedish bad banks managed to liquidate their assets by 1997 and the state recouped at least half the funds it had made available.

While the process worked back then, the two Swedes recognised that the 1990s crisis, essentially home-grown and involving half a dozen national banks, was very different from the current global meltdown, involving far more banks and complex “packaged and repackaged” assets. Still, the solution remains the same, said Mr Ingves, even if far more co-ordination is today required.

“Clearly, one of the lessons that comes out of all this is that in Europe, the financial integration between countries ran way ahead of the EU’s willingness to have a regulatory framework following at the same pace,” said Mr Ingves.

The Swedes also expressed concern that other countries’ handling of this crisis was still too piecemeal.

“In the US, certainly early on, there was no consistent policy over capital injection and bad assets. Now it’s better but there are still too many loose ends,” he said.

“To restore confidence you have to show exactly how big the problems are and how you are going to take care of that.”

Here’s what I had to say on this very topic in 2002 in Prudent Bear as it relates to Japan’s own struggles:

Two Visitors to Tokyo
03/26/02

“Government intervention is unavoidable if non-performing loans and bank loans are mounting in an economy…In order to limit moral hazard problems and to secure public support…it is important to enforce the principle that losses are to be covered in the first place with the capital provided by the shareholders. If that means the banks must be nationalized, so be it.” – Bo Lundgren, former Swedish Minister for Fiscal and Financial Affairs

In addition to President Bush, there have been two other important foreign visitors to Japan in the past month: the leader of Sweden’s parliamentary opposition, Bo Lundgren, and chairman of the executive committee of Citigroup, Robert Rubin. During their time in Tokyo, both men commented on the state of the country’s financial crisis, the gravity of which is being debated yet again in light of the recent strong rise in the Japanese stock market. Needless to say, the visit of the former US Treasury Secretary occasioned much more coverage and corresponding press commentary, but it was Mr. Lundgren, in his discussions of Sweden’s own banking crisis and its unstated implications for Japan, who ultimately imparted far greater wisdom to his hosts.

Reading Mr. Lundgren’s recent speech on the so-called Swedish Solution (delivered at Tokyo’s Swedish Embassy), one is struck by the government’s sheer decisiveness to overcome its problems that struck in the early 1990s. The Swedish financial crisis was entirely resolved within 6 years at minimal cost to the taxpayer, at which point the Japanese authorities were still debating the question as to whether public money was actually required for their ailing banks. In the words of HSBC Securities banking analyst Brian Waterhouse, “The Swedes have finished the ‘race’ and have dealt with their banking crisis; the Japanese are still stuck in the starting gate”. The huge costs of Tokyo’s inactivity are increasingly apparent to many outside observers. The inevitable policy response, which is coming closer in time as crisis conditions intensify, will likely be widespread bank nationalization, a collapse in the value of the yen, and the onset of a rapid rise in inflation.

This might seem an unduly alarmist viewpoint now that Tokyo’s bureaucrats have successfully engineered another year-end ramp of the Japanese stock market over the past month and familiar talk of recovery is in the air. But as appears to be always the case in Japan, the country’s politicians and bureaucrats have yet again wasted valuable time and resources on eradicating the symptoms, rather than the underlying disease of deflation, of which the inexorable rise of non-performing loans in the commercial banking system is the most visible manifestation. The rally in Japanese bank shares has merely deferred the day of reckoning as well as engendering complacency yet again amongst the country’s policy makers. Hence, the respective insights of Messrs. Rubin and Lundgren take on added significance.

First Mr. Rubin. He told Japanese Prime Minster Junichiro Koizumi that the central bank should set an inflation target as a means of alleviating the deflationary pressures current afflicting the banks real estate portfolios and, indeed, the economy as a whole. The case for inflation targeting is certainly not new. Paul Krugman urged this course of action in 1998 when he proposed that the Bank of Japan opt for a policy of controlled inflation. Krugman’s argument for a controlled inflation for Japan arises out of his application of a model that does not incorporate private debts and debt related behavior. To our mind, this would seem to miss the basic issue that most realize is paramount in the current Japanese crisis. Nonetheless, Krugman’s argument has merit and his policy prescription has since been echoed by other commentators.

Economist Andrew Smithers has argued for an eventual inflation in Japan for, in our opinion, the right reasons: namely, that the change from price deflation to price inflation would lead to a consequent reduction in private indebtedness in real terms that would allow for a recovery of domestic demand, the weakness of which is the root cause of Japan’s current economic woes. Whether one accepts the Smithers or Krugman framework, Rubin’s reiteration of this advice is a most surprising departure for a figure who prominently advocated Western style restructuring as the optimal means of turning around the moribund Japanese economy during his time as US Treasury Secretary. Indeed as Treasury Secretary, Rubin publicly warned Japan against pursuing a devaluation policy in the pursuit of economic recovery.

Yet as Japan’s deflationary pressures have intensified, even Mr. Rubin appears to have undergone a Damascene type of conversion on this issue. But the fact remains that an inevitable consequence of establishing a positive inflation target as Rubin now advocates means substantially higher rates of monetary growth and a correspondingly weaker yen. Whether he realises it or not, the former Treasury Secretary’s advice invariably leads back to the export led growth strategy for Japan that he once repudiated.

It is also difficult to speak any longer of a policy of “controlled inflation” that would lead to a gradual decline in the value of the yen. When Krugman and Smithers first began urging this course of action on Japan’s monetary authorities years ago, the deflationary pressures were not quite as severe and the non-performing loans in the banking system had not exploded to the degree they have more recently. Such has been the cost of inactivity amongst Tokyo’s policymakers, however, that far more aggressive and unorthodox measures are needed today than would have been the case some 5-6 years ago when the calls for an explicit inflation target were first publicly made.

What are the consequences of Japan’s wasted decade? If private sector (as opposed to government) estimates of the extent of the bad debt problem in the banking system are correct (anywhere from 25-70 per cent of GDP), then the scale of money now required to nationalize the banks will almost certainly entail huge additional monetary stimulus. The likely aftermath therefore will not be a yen/dollar rate of 135-140, but something closer to 200 yen to the dollar, or possibly higher. Such has been the consequences of a decade of inactivity in Japan that (in the words of AIG economist Bernard Connolly): “– there is no happy medium in Japan, we fear, between deflation and very rapid inflation, and that in turn, we think, means that a yen collapse and very rapid inflation are all but inevitable and are coming much closer in time.”

In light of Japan’s abysmal record on economic policy making over the last decade, it seems ludicrous to analyse the potential consequences of a “successful” inflation targeting strategy. But were the Japanese monetary authorities able to weaken the yen and enable inflation to develop, it would almost certainly be accompanied by a sharp fall in JGBs.

This creates two interrelated problems: The Japanese banking system, which by virtue of its high proportion of non-performing loans, is unable or unwilling to act as a financial intermediary borrowing short from the central bank and lending to Japan’s private sector. Instead, Japan’s banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up a small additional 15 or 20 basis points of yield on those government notes. This is virtually their only source of profitability right now.

In this process, Japan’s banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks. As the banks are already heavily exposed to a weak bond market, a weak yen will consequently add to their disinclination to buy more, thereby complicating the BOJ’s efforts to reflate, since bond buying on the part of the banks is essential to keep the money supply from contracting. In the absence of huge increased purchases by the Japanese central bank, the resultant losses stemming from a rout in the bond market will also put the commercial banking system one step closer to insolvency. Hence, we come back to the question of bank nationalization, since a crash in the market value of the banks’ JGB portfolio would in effect merely represent an immaterial accounting transfer within the government were the banks nationalized, rather than another huge private sector loss that would intensify existing deflationary pressures in the absence of public ownership.

The recent visit to Tokyo of Bo Lundgren, currently Sweden’s parliamentary opposition and a former minister for fiscal and financial affairs is highly significant in this regard. Lundgren was a central figure in helping to resolve successfully Sweden’s own banking crisis in the early 1990s. Unfortunately, for the Japanese, while the Swedish solution does provide a blueprint, Lundgren’s analysis also serves to highlight Tokyo’s own remarkable delinquency and the reasons why resolution of the Japanese banking crisis is likely to be more problematic and costly.

To be sure, Sweden’s crisis was not nearly as big as Japan’s, but they might have become as large had the Swedish authorities dithered to the extent that their Japanese counterparts have done throughout the past 12 years. In Sweden, troubled loans were 20 percent of outstanding credit, 12 percent of gross domestic product, compared with (by estimates other than those officially advanced in Tokyo) 20 to 25 per cent of credit outstanding and anywhere from 40 to 70 per cent of GDP in Japan. And Lundgren himself made no explicit comparison between Sweden’s banking crisis and that of Japan. His was a low-key speech made in the Swedish Embassy, in itself quite a contrast from the hectoring “gaiatsu” that one normally associates with “helpful” advice from the West. So conditioned are the Japanese to high volume public lectures, that this might explain the comparative lack of publicity.

If the scale of the problems were not strictly comparable, there are still many similarities between the two crises. Hence, there are lessons for the Japanese to draw from the Swedish experience. In each case, there was a rapid expansion in the real economy generated by an explosion of credit interacting, on the way up, with an explosion in asset prices of one kind or another. Swedish banks got into trouble when the resultant speculative bubble that inflated during the second half of the 1980s lost its air in the early 1990s. Then property prices collapsed. The markets crashed, overexposed banks headed toward the wall, and the economy was imperiled.

But the Swedes dealt with the resultant banking crisis quickly and with total transparency. There was little attempt to mask the size of the bad debts and an entity was quickly set up, the Bank Support Authority, whose political independence enabled the government to avoid any conflict of interest and thereby secure greater public acceptance for the use of public money. The Authority was quickly able to get to the root of the problem. It divided banks into three categories: long- term profitable with short-term problems; long-term profitable with uncertain capital-adequacy ratios and medium-term problems; basket cases likely to be beyond reconstruction.

These classifications allowed the BSA to decide quite easily how to handle each bank: Some required no more than increased capital contributions from shareholders, some were to be nationalized, and some were to be closed altogether. Troubled loans were transferred to a separate company. In all, the government’s intervention was devised on a commercial basis to minimize the cost to the taxpayer. But taxpayers’ money was required, as a large chunk of the banking system was de facto nationalized, given the government’s unconditional guarantees to bank creditors (which lasted for almost 6 years).

While the global recovery undoubtedly helped to mitigate the extent of the problem loans faced by the Swedish monetary authorities, it is undeniably the case that their prompt, aggressive actions prevented a bad crisis from turning into a total disaster. According to Lundgren, within 6 years the BSA was wound up, nationalized banks were sold back to the private sector, and the total cost of the bailout ended up being around the equivalent of 6 per cent of GDP, half the number originally feared by the Swedish authorities.

Needless to say, the scale of the problem is considerably higher in Japan. But the fact of the matter is with the economy in depression, Japan’s monetary and financial authorities have virtually no good options left, as Bernard Connolly clearly recognizes. In the end, even Mr. Koizumi’s determination to stick to his policy of holding new bond issues to 30 trillion yen annually will likely prove untenable, Mr. Rubin’s reported support for this fiscal restraint notwithstanding. (In fact, it is somewhat inconsistent for Rubin to laud Mr. Koizumi’s self-imposed limit on bond issuance on the one hand in order to prevent interest rates from rising excessively if the target is dropped, yet on the other hand, to propose a policy of inflation targeting, the ultimate consequence of which would almost surely be the same as renewed fiscal profligacy – namely, sharply rising bond yields.) The government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be even greater.

Commenting on the “Swedish solution”, Brian Waterhouse identified eight keystones which ensured its success: 1. Early recognition of a crisis. 2. Acknowledgment that action is pressing. 3. Unconditional official support for the banking system. 4. Political leadership and unified public opinion. 5. Intervening legislation. 6. Independent supervision of the reconstruction process. 7. Nationalization if necessary. 8. Determination to denationalize as soon as possible.

There is an additional factor unmentioned by Waterhouse. Sweden had proper functioning, politically legitimate institutions, thereby enabling the government to mobilize public opinion and deal with the problem from a position of responsible and accountable public leadership. Mr. Lundgren himself noted that the job was basically achieved with a core committee of just three Cabinet ministers, a total of six senior government officials regularly involved, and the use of two independent consulting firms, rather than the usual morass of backroom committees and bureaucrats, which constitute the essence of the Japanese polity. In other words, Sweden had something approaching true democracy. We have often made the point that politically responsive institutions are totally lacking in Japan, and that the resultant policy paralysis brought about by 50 years of corrupt LDP leadership (and Washington’s continued patronage) has exerted a huge economic and social cost. The messy resolution of the country’s long-standing financial crisis, when it comes, will probably constitute the most vivid illustration of this point.

Source
US calls on Sweden’s “Mr Fix It” Bo Lundgren – Telegraph

Related posts:

• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• The Swedish roots of the UK bailout plan
• Lessons from Swedish bank resolution policy
• Lessons from Japan’s Bank Crisis
• Bernstein: America is turning Japanese

As understandable as the Congressional response to the AIG bonuses was, the reality is that this does create a number of disturbing precedents. We have a stupid Congress mindlessly lashing out to compensate for its own complicity in political corruption (Congress has long been a major recipient of Wall Street largesse, including AIG) It all goes back to Tom Ferguson’s analysis in “The Golden Rule”. (Golden Rule: The Investment Theory of Party Competition and the Logic of Money-Driven Political Systems (American Politics and Political Economy Series))

That said, I hate the bill the House introduced for five reasons:

1. The law is being pushed through quickly and the old warning about “legislate in haste, repent at leisure” appears to apply here;
2. It is retroactive, and we should always discourage laws that are retroactive;
3. It is clearly politically motivated and applies to a very small number of people (who will be next? liberal bloggers?); as a general rule, we should discourage laws that are not general in application;
4. It is, at least in part, motivated by a punitive impulse that isn’t necessarily the best thing for our politics; and, 
5. Most obviously, it attacks the symptoms, rather than the disease. Maine style political reforms which introduce public funding into our politics, and an independent commission which constructed real Congressional constituencies rather than these absurd exercises in gerrymandering, would do much to deal with the problem of political corruption at the top.

I also take Steve Waldman’s point in Interfluidity, “If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly.”

Anyway, I see that one of the kings of late night television, Jay Leno, agrees with me:

President Obama took to Jay Leno’s stage and compared life in Washington to “American Idol,” where ‘”everybody’s got an opinion.” The appearance on “The Tonight Show with Jay Leno” was itself a sign of just how much the culture has changed in America, where comedy and politics often mix.

From there, he went on to pitch his long-stated proposals to change the tax code by increasing taxes on all upper-income Americans, specifically families earning more than $250,000 a year and individuals earning more than $200,000 annually.

“The important thing over the next several months is making sure that we don’t lurch from thing to thing, so we try to make steady progress, build a foundation toward long-term economic growth,” he said. “That’s what I think the American people expect.”

Mr. Leno was even more negative to the House plan, saying it “kind of scared me.”

“If the government decides they don’t like a guy, all of the sudden hey we’re going to tax you, and, boom, and it passes, that’s seems a little scary,” he said. “It was frightening to me as an American that Congress or whoever could decide I don’t like that group, let’s pass a law and tax them 90 percent.“

Sources
On ‘Tonight Show,’ Obama Urges Steadiness in Face of Crisis – WSJ
HR 1586: Not a good tax clawback – Steve Waldman

Related posts:

• The Paulson plan is not going to make it
• Bush: ever the opportunist, lifts oil drilling ban
• AIG: worst damage yet to come
• S&L crisis chronology and accounting rules
• The House defeats the bailout plan and shares plunge

Marshall Auerback here. I have a few thoughts about AIG and what it means politically and for American banks.

The episode may have already made it much harder to get any support in Congress for bailing out more banks in the future. The Obama administration, and some outside experts, believe the economy will only get worse if big banks start to fail. Which means the worst damage that AIG’s adventures in high finance have caused might be yet to come.

We had a broadly similar type of situation in 1994, and as Lawrence Summers was one of the key actors, it is worth considering the episode in details, as recounted in “The New Republic”

In December of 1994, the Mexican finance ministry alerted Summers’s assistant secretary, Jeff Shafer, that the country was nearing a currency crisis. During the early ’90s, Mexico had started down two paths that, together, proved unsustainable. First, the country ran large trade deficits. To pay for all the goods it was importing, Mexico needed dollars, which meant it had to sell government bonds. This led to the second problem: To appease all the foreign investors who worried the peso would lose value, Mexico issued certain short-term bonds–called “Tesobonos”–that were linked to the dollar.

This worked fine for a while. Foreign money flooded in as investors snatched up the Tesobonos. But, as the years passed, creditors began doubting that the government would pay off its bonds at the fixed exchange rate. Many began withdrawing their money, forcing the Mexicans to redeem the bonds for dollars. By the time Treasury tuned in, in late 1994, the dollars had almost run out and the government could no longer defend the peso-dollar exchange rate. The imminent decline of the peso would make Mexico’s foreign debt more expensive and raise the risk of a default.

Worse, Treasury itself was in limbo. Then-Secretary Lloyd Bentsen had announced his retirement, but Bob Rubin, his successor, had yet to replace him. It fell to Summers–whose team included Shafer and a young deputy assistant secretary named Tim Geithner–to figure out the consequences of a Mexican collapse. By January 10, 1995, the Summers group had a tentative answer: The fallout could be several hundred thousand U.S. jobs and a 30 percent spike in illegal immigration. If Mexico infected other emerging markets, it could wind up shaving a point off U.S. GDP growth.

That same day, Summers accompanied Rubin to his Oval Office swearing in. Once President Clinton administered the oath, Rubin recalls in his memoir, the new Treasury secretary turned to the president and urged a massive loan package. He then gave the floor to Summers, who briefed the president and concluded that something on the order of $25 billion would be necessary. Surely he meant twenty-five million, George Stephanopoulos interjected. No, Summers said, “billion with a ‘B.’” Clinton swallowed hard and, after weighing every angle, signed on.

The initial response from congressional leaders was also favorable. But the rank and file was hostile. Vermont’s then-congressman, the socialist Bernie Sanders, told Rubin to “go back to your Wall Street friends [and] tell them to take the risk and not ask the American taxpayers.” A freshman Republican named Steve Stockman accused Rubin of arranging a bailout to protect the investments he’d made while a partner at Goldman Sachs. Soon, even the once-supportive leaders were either quietly backtracking (Senate Majority Leader Bob Dole) or railing against the package outright (Banking Committee Chairman Alfonse D’Amato). It was what High Noon might have looked like if Gary Cooper had played a policy wonk.

As it became obvious that cooperation from Congress wouldn’t be forthcoming, Rubin and Summers began to consider plan B. Back in 1934, Congress had given Treasury a pool of money called the “Exchange Stabilization Fund” (or ESF) to help smooth out exchange rates. Sixty years later, the fund stood at about $35 billion, and Treasury lawyers believed they had the authority to draw on it. And so, on January 30, with no congressional help in sight, Summers, Rubin, and Clinton’s top White House aides decided to tap the ESF to the tune of $20 billion.

I continue to believe that nationalisation will be the political scalp demanded to assuage taxpayer anger and facilitate passage of more bailout money. But if Congress proves equally recalcitrant, are there other mechanisms that could be deployed to circumvent Congress as was the case in 1994? The Exchange Stabilization Fund is clearly too small, but could one of the Fed’s new entities, such as the TALF, play such a role? Lawrence Summers clearly has experience in terms of doing end-arounds Congress, so I wouldn’t put anything past him.

Source
Free Larry Summers – The New Republic

Related posts:

• 1995
• Rubin resigns from Citigroup
• Geithner and Summers consolidate power
• Obama White House: Add Larry Summers and Robert Gibbs
• Fannie, Freddie to get $15 Billion from U.S. government

Marshall Auerback here.

Here is my take on Chinese Premier Wen’s recent statements. At the end of the day, too many people seem to be working on an old gold standard type of model in the sense that there are implied limits in terms of what the US can do as an issuer of a fiat currency. I have always seen this as relevant only to the extent that China insists on being paid back in another currency other than dollars. The irony is too wonderful here, for what China has become expert at is manipulating the Obama administration. Think from the Chinese perspective about the wonders of getting Secetary Clinton to grovel and thank them for buying our paper.

The Chinese, in recent closed door meetings of which I am aware, have openly (albeit implicitly) threatened U.S. government officials about their future willingness to purchase our agency debt. This is a grand bluff, for China would suffer the greatest loss of (paper) wealth were it to attack the value of our paper. It is proving an effective bluff. I never thought Geithner’s attack on China’s efforts to hold down the exchange rate on the yuan made any sense from a U.S. perspective, so I don’t waste my time bashing the administration on its 180 degree reversal of position on China “manipulating” the yuan. But we are being played successfully. China will conclude that they have leverage over us and will use it in future disputes that will be far more important.

In a pure operational sense, when China’s US securities mature, the Fed debits their securities account at the Fed and credits their bank account at the Fed. So in theory no fuss. Of course, the real world is a bit more complicated, even when a sovereign currency is assumed (i.e. fixed exchange rate, no fixed gold conversion).

The limit to trade deficits is then the willingness of foreign investors to net save in your currency.

If foreigners perceive your productivity capacity is not growing fast enough, or the money value of those products is not growing fast enough, the only reason they net save in your currency (by holding assets in your currency) is to speculate on asset bubbles or engage in financial engineering or store value in the perceived reserve currency of the world.

Remember, foreign trading partners can demand settlement from a country in a different currency. There is a first mover disadvantage to exporters trying to enforce this, but we have seen currency conventions change, so we know it does happen. And I am presuming this is the implied threat from China.

All 3 of the above (asset bubbles, financial engineering, reserve currency status), one would think, are eventually constrained by the first two items, physical productivity of the country and the money value of that output. We’ve seen in a world of serial asset bubbles, with no country yet willing or able to replace the US as hegemon, that “eventually” can take a long time. Not every hegemon, however, can hold on to its “exorbitant privilege” for so long…and there is only one hegemon, so not every country has this privilege.

Similarly, a fiscal deficit is constrained by the willingness of the domestic and foreign private sector to net save in the deficit country currency. The private income is created by the purchases of products or labor from the private sector, so there is still production.

This circles back to our discussions about confidence and policy sequencing. Keynes, who was a policy maker and an investor, clearly recognized this and it is part of why he spilled so much ink against the Treasury View of fiscal responsibility. He wanted to change conventional views of the suitable role of government intervention. It is currently Obama’s practical problem, as he does not seem to feel the need or ability to address the Treasury View. Instead, he has taken the tack that he will promise to reduce the deficit by the end of his term.

A lot of staunch Keynesians probably believe that Obama’s problem goes away once the fiscal stimulus hits the real economy. Practically, we know investors here and abroad are skeptical of how this all gets financed (a non-issue in our friend Warren Mosler’s model – government credits private sector as deficit spending proceed), and entrepreneurs and the wealthy are beginning to figure out the tax burden is being shifted on to them. So that might induce capital flight and tax evasion, which isn’t something readily accounted for in a classic financial balances approach.

Reality is more complicated than the model, and that must be dealt with by practical policy makers.

Related posts:

• China cuts holding of U.S. Treasury securities
• China is now America’s largest creditor
• Beijing starts a ‘Buy China’ policy
• More thoughts on the switch from dollars as reserve currency
• China wants to get rid of the dollar

Marshall Auerback here.

Everyone is talking about marking to market as if its elimination is a silver bullet. So far as the economics goes, I am not sure that mark to market is such a big deal. The whole point of the banks is to make loans and hold them. Look at it this way- why should banks own anything that IS marked to market?

They should only own what they originate, and not buy any securities or other assets, apart from maybe their buildings. They have no reason to have access to any secondary markets. We then give them special protection so they effectively leverage government; they are intermediaries between government and the non-governmental sector. However, I think the objections raised are mostly political: how can the supervisors/regulators resist powerful private interest. And that is why banks must be kept small.

Furthermore, we had ‘mark to market’ when BofA bought Countrywide and Merrill. I don’t think the so-called “transparency” actually helped that much, did it? Banking isn’t a mark to market model, it’s a credit analysis model. You don’t want a banking system that makes a loan to a grocery store based on where it could sell it at 3am on a Tuesday.

The public purpose behind banking is government-insured funding and lending based on credit analysis- coverage ratios, sources of incomes, payment records, etc. etc.- all standards set by the government that does the funding. Banking is a big government loan program that uses private capital with profit incentives presumably to make sound choices to avoid losing their own capital.

When the regulators come into a bank the check all the credit aspects of our loans and if they fall short declare the loans impaired, write them down, etc. etc. If they are not doing that with the major banks that’s a failure of regulation and supervision.

If it turns out the FDIC has been negligent or acting fraudulently by knowingly funding what they have determined to be insolvent institutions as per regulation then they are guilty of what should be criminal activity and get 150 years in the electric chair!

This has nothing to do with gaming the accounting. For an extreme example, we have US Treasury securities that are trading at discount prices of Libor plus 70 basis points. Should banks who hold them take a loss that reflect the price of credit risk for the US government (not interest rate risk- that’s a different story and covered in gap regulation)???

Regulate them like utilities. It will never happen, but that’s the key.

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• Bradford & Bingley is being shopped by the FSA
• A reminder about new mark-to-market rules in Europe
• Mark-to-market is dead
• Repayments will make banks weaker and could lead to more failures

Marshall Auerback here.

Let’s talk a little about the economic data released on Friday. On the plus (contrarian) side, everybody is talking about the unemployment number and NOBODY happened to mention that consumer credit was UP on Friday, even before TALF. I think we are very close to the bottom. I think that New York Fed President Dudley is screaming to the investment funds, hedge funds, private equity to do these deals with TALF.

Think of it this way.

A well funded PE fund takes $100M out of a fund of say $1B and does TALF at 10-times leverage and makes, say, a conservative 600 bp (maybe much more — I just don’t know where these ABS credit card and auto spreads are trading right now).

That’s $60M profit on the $100M investment or 60% per year. Put another way, that’s an incremental 6% on their overall fund returns on the entire $1B sized fund. If they get more aggressive as a percent of total fund invested in TALF the numbers are much bigger.

The Shadow Banking System will be back in vogue.

If this money then gets re-loaned to consumers as the asset is cleared off the banks’ balance sheets, the consumer starts spending and because the Fed has provided the tinder in the form of the Monetary Base, the Velocity of Money picks up — and then money supply and bank deposits and then the economy starts to turn up. And then the demand for commodities and equities participate until the Fed has to take away the “punchbowl” but they will not follow William McChesney Martin as to his prompt responses and that’s when commodities and gold shine.

The issue, short term, is that equities can really blossom if Velocity picks up because the monetary tinder has been just sitting there waiting for the gasoline to be added to the fire.

Am I oversimplying this or leaving something material out?

Related articles
Consumer credit: Surprise $1.8 billion jump – CNN Money

Related posts:

• TALF: ‘the great liquidation’ begins for hedge funds and shadow banks
• Kasriel says that Fed could get stuffed under TALF
• TALF: A bailout if one reads the fine print
• Liquidity trap of a different sort
• Quote of the day: William White and inflation