The Root Causes of Recurring Global Financial Crises

May 21, 2010Henry Liu

euro_banknotes-150The causes of recurring  financial crises reach far back, even to neo-liberal ideas in the Medieval Ages.

euro_banknotes-150The causes of recurring  financial crises reach far back, even to neo-liberal ideas in the Medieval Ages.

Severe global financial crises have been recurring every decade: the 1987 crash, the 1997 Asian financial crisis and the 2007 Credit Crisis. This recurring pattern had been generated by wholesale financial deregulation around the world. But the root causes have been dollar hegemony and the Washington Consensus.

The Case of Greece

Following misguided neo-liberal market fundamentalist advice, Greece abandoned its national currency, the drachma, in favor of the euro in 2002. This critically consequential move enabled the Greek government to benefit from the strength of the euro, albeit not derived exclusively from the strength of the Greek economy, but from the strength of the economies of the stronger Eurozone member states, to borrow at lower interest rates collateralized by Greek assets denominated in euros. With newly available credit, Greece then went on a debt-funded spending spree, including high-profile projects such as the 2004 Athens Olympics that left the Greek nation with high sovereign debts not denominated in its national currency. Further, this borrowing by government in boom times amounted to a brazen distortion of Keynesian economics of deficit financing to deal with cyclical recessions backed by surpluses accumulated in boom cycles. Instead, Greece accumulated massive debt during its debt-driven economic bubble.

The Euro Trap

By adopting the euro, a currency managed by the monetary policy of the super-national European Central Bank (ECB), Greece voluntarily surrendered its sovereign powers over national monetary policy, and rested in the false comfort that a super-national monetary policy designed for the stronger economies of the Eurozone would also work for a debt-infested Greece. As a Eurozone member state, Greece can earn and borrow euros without exchange rate implications, but it cannot print euros even at the risk of inflation. The inability to print euros exposes Greece to the risk of sovereign debt default in the event of a protracted fiscal deficit and leaves Greece without the option of an independent national monetary solution, such as devaluation of its national currency.

Notwithstanding a lot of expansive talk of the euro emerging as an alternative reserve currency to the dollar, the euro is in reality just another derivative currency of the dollar. Despite the larger GDP of European Union (EU) as compared to that of the US, the dollar continues to dominate financial markets around the world as a bench mark currency due to dollar hegemony which requires all basic commodities to be denominated in dollars. Oil can be bought by paying euros, but at prices subject to the exchange value of the euro to the dollar. The EU simply does not command the global geopolitical power that the US has possessed since the end of WWII.

Dollar Hegemony and the Washington Consensus

Economic growth under the dollar hegemony regime requires market-participating nations to follow the rules of the Washington Consensus, a term coined in 1990 by John Williamson of the Institute for International Economics to summarize the synchronized ideology of Washington-based establishment economists, reverberated around the world for a quarter of a century as the true gospel of economic reform indispensable for achieving growth in a globalized market economy. It is an ideology that has landed much of the world in recurring financial crises.

Initially applied to Latin America and eventually to all developing economies, the Washington Consensus has come to be synonymous with the doctrine of globalized neo-liberalism or market fundamentalism to describe universal policy prescriptions based on free-market principles and monetary discipline within narrow ideological limits. It promotes for all economies macroeconomic control, trade openness, pro-market microeconomic measures, privatization and deregulation in support of a dogmatic ideological faith in the market's ability to solve all socio-economic problems more efficiently, and to assert a blanket denial of an obvious contradiction between market efficiency and poverty eradication or income and wealth disparity.

Return on Capital vs Wages

Financial capital growth is to be served at the expense of human capital growth. Sound money, undiluted by inflation, is to be achieved by keeping wages low through structural unemployment. Pockets of poverty in the periphery are deemed as the necessary price for the prosperous center. Such dogmas grant unemployment and poverty, conditions of economic disaster, undeserved conceptual respectability. State intervention has come to focus mainly on reducing the market power of labor in favor of capital in a blatantly predatory market mechanism.

The set of policy reforms prescribed by the Washington Consensus is composed of 10 propositions: 1) fiscal discipline; 2) redirection of public expenditure priorities toward fields offering high economic returns; 3) tax reform to lower marginal rates and broaden the tax base; 4) interest-rate liberalization; 5) competitive exchange rates; 6) trade liberalization; 7) liberalization of foreign direct investment (FDI) inflows; 8) privatization; 9) deregulation and 10) secure private-property rights.

Abdication of Government Responsibilities

These propositions add up to a wholesale reduction of the central role of government in the economy and its primary obligation to protect the weak from the strong, both foreign and domestic. Unemployment and poverty then are viewed as temporary, transitional fallouts from wholesome natural market selection, as unavoidable effects of economic evolution that in the long run will make the economy stronger.

Neo-liberal economists argue that unemployment and poverty, deadly economic plagues in the short term, can lead to macroeconomic benefits in the long term, just as some historians perversely argue that even the Black Death (1348) had long-range beneficial economic effects on European society.

The resultant labor shortage in the short term pushed up wages in the mid-14th century, and the sudden rise in mortality led to an oversupply of goods, causing prices to drop. These two trends caused the standard of living to rise for those still living. Yet the short-term shortage of labor caused by the Black Death forced landlords to stop freeing their serfs, and to extract more forced labor from them. In reaction, peasants in many areas used their increased market power to demand fairer treatment or lighter burdens. Frustrated, guilds revolted in the cities and peasants rebelled in the countryside. The Jacquerie in 1358, the Peasants' Revolt in England in 1381, the Catalonian Rebellion in 1395, and many revolts in Germany, all served to show how seriously the mortality had disrupted traditional economic and social relations.

Neo-liberalism in the past quarter century created conditions that manifested themselves in violent political protests all over the globe, the extremist form being terrorism. But at least the bubonic plaque was released by nature and not by human ideological fixation. And neo-liberalism keeps workers unemployed but alive with subsistence unemployment aid, maintaining an ever-ready pool of surplus labor to prevent wages from rising from any labor shortage, eliminating even the cruelly derived long-term benefits of the Black Death.

Bashing of the State

The Washington Consensus has since been characterized as a "bashing of the state" (Annual Report of the United Nations, 1998) and a "new imperialism" (M Shahid Alam, "Does Sovereignty Matter for Economic Growth?", 1999). But the real harm of the Washington Consensus has yet to be properly recognized: that it is a prescription for generating failed states around the world among developing economies that participate in globalized financial markets. Even in the developed economies, neo-liberalism generates a dangerous but generally unacknowledged failed-state syndrome. (Please see my February 3, 2005 10-part series: World Order, Failed States and Terrorism - Part I: The Failed State Cancer)

This is an excerpt from a recent article.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

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Latvia's Infernal Devaluation

May 19, 2010Marshall Auerback

jobless-man-150Latvia will have to crush its own workers to exit the recession.

jobless-man-150Latvia will have to crush its own workers to exit the recession.

Ojars Kalnins, director of the Latvian Institute, today told the LNT show that Latvia will go down in economic history as an example of a calm exit from a crisis. This from the man who helped plan Latvia's economy from the start. Kalnins was a Latvian-American Madison Avenue PR man who worked with the Clinton Administration and USAID to bring the whole neoliberal package to Latvia.

He is a champion of the idea of the "internal devaluation," with no room to adjust the exchange rate (because they keep the currency, the Lat, pegged to the euro). The only other way to make the currency lose value is to engineer a real depreciation -- that is, reduce labor costs and prices in order to make tradable products more attractive. This is euphemistically being described as an "internal devaluation," a one-off coordinated reduction of wages and prices across the board. It is, in reality, more like an "infernal devaluation." It amounts to a domestic income deflation -- as wages are crushed -- in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth.

The reasoning is a bit like what we saw in Vietnam: destroying a village to save it (presumably from the perils of communism, although there wasn't much to "save" once the place was turned into an ash heap). Kalnins forgets that rapidly cutting fiscal deficits, without considering the impact of such moves on private sector financial balances, is a shortsighted, if not dangerous, policy direction. Sector financial balances -- the difference between saving and investment, or income and expenditures -- are interconnected, and cannot be treated in isolation. The "exit" for Latvia appears to be the dumpster at the end of the trash shoot.

I can see why they call that excellent show on 1960s advertising executives "Mad Men."

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

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Fiscal Austerity Fever Goes Global

May 17, 2010Marshall Auerback

euro_banknotes-150A look at fiscal austerity fever and exposes the faulty economics that fuel it.

euro_banknotes-150A look at fiscal austerity fever and exposes the faulty economics that fuel it.

Virtually the entire world's press is now focusing on the travails of the euro zone, but continues to draw the wrong lessons from what now afflicts the region. But Americans might be pleased to know that this collective economic insanity is not restricted to the pages of the right wing press or the rantings of Fox News commentators such as Glenn Beck. No America, you can rejoice! This has become a fully fledged global disease. You are not alone.

As I have pointed out before, no euro zone government issues its own currency. Consequently, they have to "finance" every euro they spend. And, as Bill Mitchell notes, if tax revenues do not cover pre-existing spending desires, then all of these countries (including Germany) have to issue debt. The current crisis is manifested by the bond markets' unwillingness to lend to the PIIGS governments any longer because they are beginning to query the PIIGS' national solvency.

These funding constraints do not apply to the US government, which is sovereign in the US dollar and can never be revenue constrained.

The same applies to the UK government, although to judge from the comments of the new coalition Conservative-Liberal Democratic Government Cabinet, one would be hard-pressed to discover that fact. Will someone please remind the UK's new Chancellor of the Exchequer, George Osborne, that the UK is not Greece? Osborne attended Eton, one of Britain's elite private educational institutions, but they clearly didn't do a good job of teaching him economics out there, if one is to judge by his recent statements: "If anyone doubts the dangers that face our country if we do not, they should look at what is happening today in Greece and in Portugal."

The UK is a sovereign nation that issues its own currency and freely floats it on foreign exchange markets. Perhaps the keyboard operators have gone on strike (like British Airways), or the country has a paper shortage and can no longer write checks, but given the plethora of comments emanating from virtually all members of the UK commentariat, one has to assume plain ignorance. Just today, the incoming Chief Treasury secretary, David Laws, warned the British electorate that the UK has well and truly "run out of money." Hold on to those pounds, or you're doomed.

In defense of the current Greek, Spanish and Portuguese governments, they find themselves in a fiscal straitjacket not of their own making. It is a by-product of the Maastricht Treaty and the Stability and Growth Pact. The UK, by contrast, is willingly choosing to commit economic suicide. If the government had some understanding of the characteristics of its monetary system and the position of the currency in that system, they would stop worrying about debt ratios and deficit ratios and focus more on reversing the job loss and doing nothing to undermine the economy's capacity to recover. The Labour Party opposition ought to be secretly screaming with delight, although the Brown Administration clearly didn't know any better and therefore fully deserved to lose the last election.

The new UK coalition government has a choice. So do the Baltic nations, where a much more severe, more devastating and downright deadly crisis in the post-Soviet economies is taking place. Somehow the travails of countries such as Latvia and Estonia have escaped widespread press notice. The US and UK would do well to take note, because the Baltic Republics have well and truly imbibed the neo-liberal Kool-Aid peddled by the likes of the IMF.

On June 2009, the newly-appointed Latvian Prime Minister, Valdis Dombrovskis, made a national public radio address and said that his country had to accept major cuts in the budget because they would allow the country to receive the next installment of its IMF/European Union bail-out loans. He said the country was faced with looming "national bankruptcy" and then proceeded to ensure the validity of that claim by implementing the economic equivalent of carpet bombing. In effect, he turned the Baltic republic into an industrial wasteland via the most virulent form of neo-liberal economics.

Having broken free from the chains of the former Soviet Empire, Latvia promptly surrendered its currency sovereignty by pegging its currency against the Euro. This means it has to use monetary policy to manage this peg. The domestic economy also has to shrink if there are downward pressures on the local currency emerging in the foreign exchange rates. So instead of allowing the currency to make the adjustments necessary, the Latvian government handled the "implied depreciation" by devastating the domestic economy. (Public sector pay has been cut by 40 percent over the last year, while the economy has contracted by almost a third.)

But now, cries the government, there is light at the end of the tunnel! In the first quarter, GDP declined by a mere 6%! Well, when a country experiences a cumulative decline greater than anything sustained by the US during the Great Depression, I suppose a mere 6 per cent contraction seems like positive boom times again. And sure enough, Prime Minister Dombrovski has proclaimed this as "confirmation of the economy's flexibility" - what is left of it - and "yield from reforms and the fiscal consolidation program, the so-called internal devaluation," according to The Baltic Course. "Infernal devaluation" is a more appropriate description.

The currency peg is nonsensical, even though devaluation would be severely disruptive given the current nominal contracts held by the Latvian private sector. Around 80 percent of all private borrowing in Latvia is in euros, with the Swedish banks being the most exposed in Latvia. And, of course, the devaluation would undermine Latvia's ambitions to join the EMU (hardly an exclusive club worth joining these days, as any Greek, Spaniard or Italian would likely tell the Latvians). The debate in Latvia about the EMU is that it will provide financial stability for the country. The fact that membership destroys their fiscal sovereignty is never raised in the public debate, narrowing the range of policy options that the political classes are prepared to discuss, and thereby legitimizing nonsensical ideas that a contraction of a "mere" 6% is something worth celebrating.

All of this pain for an exclusive club -- the euro zone - which today looks on the verge of imploding.

And Latvia is not alone. By virtue of its low public debt, and low inflation rate, Estonia has become the new poster boy for the IMF. Its budget deficit was 1.7 percent of gross domestic product in 2009, well within the 3 percent Maastricht limit, while its government sector debt was the lowest in the EU at 7.2 percent, according to the Statistics Estonia. Estonia could pay off all its public debts and still have reserves left over, which is why the country has been provisionally admitted to join the European Monetary Union in 2011.

So, should Greece, with public deficit of 13% and public debt of 113% (both as percentage of GDP), follow Estonia, bite the bullet and get down to slashing budget and wages? Or Spain? Like all of the euro zone nations, Estonia has no exchange rate policy option because the Kroon is pegged to the euro, so its fiscal policy is similarly externally constrained. The euphoria around Estonia should die rather quickly when one looks at the GDP performance in 2009. It fell nearly 15%; Greece's GDP contracted just 2%. More recently, according to the Baltic Post, the number of jobs in Estonia is the lowest in almost 25 years. The release of Estonia's first quarter labor statistics show that the unemployment rate grew by nearly four percentage points in comparison to the end of 2009 and reached nearly 20%. God help the rest of the world if it manages to emulate this "success story." While their governments seems to think that by joining the EMU they will be "shock-proofed," they should just get rid of the "proofed" part and realize that they will shock their citizens into a new kind of indentured servitude.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

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Growth Needs to Come from Development, not Trade

May 14, 2010Henry Liu

workers-200The inequalities in global trade need to be leveled for both moral and economic reasons.

workers-200The inequalities in global trade need to be leveled for both moral and economic reasons.

Not withstanding the fact that in 2010, despite the global financial crisis, the EU and the US still remain the world’s two largest economies by GDP (EU=$16.5 trillion, US=$14.8 trillion, about 50% of world total at $61.8 trillion), the days are numbered when theses two economies can continue to play the role of the world’s main consumption engines and act as markets of last resort for the export-dependent economies. For sustainable growth in the world economy, all national economies will have to concentrate on developing their own domestic markets and depend on domestic consumption for economic growth.

International trade will return to playing an augmentation role to support the balanced development of domestic economies. The world can no longer be organized into two unequal halves of poor workers and rich consumers, which has been an imperialist distortion of the theory of division of labor into a theory of exploitation of labor, and of the theory of comparative advantage into a cruel reality of absolute advantage for the rich economies.

Wealth Should Be Shared Equitably between Workers and Capital

Going forward, workers in all countries will have to receive a fair and larger share of the wealth they produce in order to sustain aggregate consumer demand globally and to conduct fair trade between trading partners. Capital is increasingly sourced from pension and savings of workers. Thus, it is common sense that returns on capital cannot be achieved at the expense of fair wages. Moreover, capital needs to be recognized as belonging to the workers, not to the financial manipulators.



The idea that workers doing the same work are paid at vastly different wages in different parts of the world is not only unjust but also uneconomic. For example, there is no economic reason or purpose, much less moral justification, why workers in the US should command wages five times more than those of workers in China doing the same work. The solution is not to push down US wages, but to push up Chinese wages to reach bilateral parity between the two trading partners. International trade, driven by cross border wage and income disparity globally, will wither away from its own internal contradiction, which ultimately will lead to market failure. Low-paid workers are the fundamental obstacle to growth from operative demand management at both the domestic and international levels. Pitting workers in one country against workers in another will only destroy international trade with counterproductive protectionism, which is not to be confused with economic nationalism.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

*For the full article, click here.

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Repeat After Me: the USA Does Not Have a 'Greece Problem'

May 14, 2010Marshall Auerback

greek-flag-150It's time to understand that there is a fundamental difference between Greece and the US.

greek-flag-150It's time to understand that there is a fundamental difference between Greece and the US.

To paraphrase Shakespeare, things are indeed rotten in the State of Denmark (and Germany, France, Italy, Greece, Spain, Portugal, and almost everywhere else in the euro zone). An entire continent appears determined to commit collective hara-kiri, while the rest of the world is encouraged to draw the wrong kinds of lessons from Europe's self-imposed economic meltdown. So-called "serious" policy makers continue to legitimize the continent's full-fledged embrace of austerity on the allegedly respectable grounds of "fiscal sustainability."

The latest to pronounce on this matter is the Governor of the Bank of England, Mervyn King. This is a particularly sad, as the BOE - the Old Lady of Threadneedle Street - has actually played a uniquely constructive role among central banks in the area of financial services reform proposals. King, and his associate, Andrew Haldane, Executive Director for Financial Stability at the Bank of England, have been outspoken critics of "too big to fail" banks, and the asymmetric nature of banker compensation ("heads I win, tails the taxpayer loses"). This stands in marked contrast to America's feckless triumvirate of Tim Geithner, Lawrence Summers, and Ben Bernanke, none of whom appears to have encountered a banker's bonus that they didn't like.

But when it comes to matters of "fiscal sustainability," King sounds no better than a court jester (or, at the very least, a member of President Obama's National Commission on Fiscal Responsibility and Reform). In an interview with The Telegraph, the Bank of England Governor suggests that the US and UK -- both sovereign issuers of their own currency -- must deal with the challenges posed by their own fiscal deficits, lest a Greece scenario be far behind:

"It is absolutely vital, absolutely vital, for governments to get on top of this problem. We cannot afford to allow concerns about sovereign debt to spread into a wider crisis dealing with sovereign debt. Dealing with a banking crisis was bad enough. This would be worse."

"A wider crisis dealing with sovereign debt"? Anybody's internal BS detector ought to be flashing red when a policy maker makes sweeping statements like this. The Bank of England Governor substantially undermines his own credibility by failing to make three key distinctions:

1. There is a fundamental difference between debt held by the government and debt held in the non-government sector. All debt is not created equal. Private debt has to be serviced using the currency that the state issues.

2. Likewise, deficit critics, such as King, obfuscate reality when they fail to highlight the differences between the monetary arrangements of sovereign and non-sovereign nations, the latter facing a constraint comparable to private debt.

3. Related to point 2, there is a fundamental difference between a sovereign government's public debt held in its own currency and public debt held in a foreign currency. A government can never go insolvent in its own currency. If it is insolvent because it holds foreign debt, then it should default and renegotiate the debt in its own currency. In those cases, the debtor has the power, not the creditor.

Functionally, the euro dilemma is somewhat akin to the Latin American dilemma, which countries like Argentina regularly experienced. The nations of the European Monetary Union have given up their monetary sovereignty by giving up their national currencies and adopting a supranational one. By divorcing fiscal and monetary authorities, they have relinquished their public sector's capacity to provide high levels of employment and output. Non-sovereign countries are limited in their ability to spend by taxation and bond revenues. This applies perfectly well to Greece, Portugal and even countries like Germany and France. Deficit spending in effect requires borrowing in a "foreign currency."

King implicitly recognizes this fact, as he acknowledges the central design flaw at the heart of the European Monetary Union -- "within the Euro Area it's become very clear that there is a need for a fiscal union to make the Monetary Union work."

This is undoubtedly correct. To eliminate this structural problem, the countries of the EMU must either leave the euro zone or establish a supranational fiscal entity that can fulfill the role of a sovereign government and deficit spend to fill a declining private sector output gap. Otherwise, the euro zone nations remain trapped -- forced to forgo spending to repay debt and service their interest payments via a market-based system of finance.

But King then inexplicably extrapolates the problems of the euro zone, which stem from this design flaw unique to the euro, and exploits it to support a neo-liberal philosophy fundamentally antithetical to fiscal freedom and full employment.

The Bank of England Governor and others of his ilk are misguided and disingenuous when they seek to draw broader conclusions from this uniquely euro zone-related crisis. Think about Japan -- they have had decades of deflationary environments with rising public debt obligations and relatively large deficits to GDP. Have they defaulted? Have they even once struggled to pay the interest and settlement on maturity? Of course not, even when they experienced debt downgrades from the major ratings agencies throughout the 1990s.

Retaining the current bifurcated monetary/fiscal structure of the euro zone leaves individual countries within the EMU in the death throes of debt deflation, barring a relaxation of the self-imposed fiscal constraints or a substantial fall in the value of the euro (which will facilitate growth via the export sector, at the cost of significantly damaging America's own export sector). This week's €750bn rescue package will buy time, but will not address the insolvency at the core of the problem. And it may well exacerbate it, given that the funding is predicated on the maintenance of a harsh austerity regime.

José Luis Rodríguez Zapatero, Spain's Socialist prime minister, angered his trade union allies but cheered financial markets on Wednesday when he announced a surprise 5 percent cut in civil service pay to accelerate cuts to the budget deficit.

The austerity drive -- echoing moves by Ireland and Greece -- followed intense pressure from Spain's European neighbors and the International Monetary Fund on the spurious grounds that such cuts would establish "credibility" with the markets. Well, that wasn't exactly a winning formula for success when it was tried in East Asia during the 1997/98 financial crisis, and it is unlikely to one this time.

Indeed, in the current context, the European authorities are simply trying to localize the income deflation in the "PIIGS" through strong, orchestrated IMF-style fiscal austerity, while seeking to prevent a strong downward spiral of the euro. But the contradiction in this policy is that a deflation in the "PIIGS" will simply spread to the other members of the euro zone with an effect essentially analogous to that of a competitive devaluation internationally.

The European Union is the largest economic bloc in the world right now. This is why it is so critical that Europeans get out of the EMU straightjacket and allow government deficit spending to do its job. Anything else will entail a deflationary trap, no matter how the euro zone's policy makers initially try to localize the deflation. And the deflation is almost certain to spread outward if sovereign states such as the US or UK absorb the wrong lessons from Greece, as Mr. King and his fellow deficit-phobes in the US are aggressively advocating.

There are two direct contagion effects from the fiscal retrenchment being imposed on the periphery countries of the euro zone: first, on the banking systems of the periphery and core nations, as private loan defaults spread on domestic private income deflation induced by the fiscal retrenchment; second, to the core nations that export to the PIIGS and run export-led growth strategies. So 30-40% of Germany's exports go to Greece, Italy, Ireland, Portugal and Spain directly, while another 30% to the rest of Europe.

These are far from trivial feedback loops. And the third contagion effect is to the rest of world growth as domestic private income deflation, combined with a maxi euro devaluation, means exporters to the euro zone and competitors with euro zone firms in global tradable product markets are going to see top line revenue growth dry up before year end.

Let's repeat this for the 100th time: the US government, the Japanese Government, and the UK government, among others, do NOT face a Greek style constraint -- they can just credit bank accounts for interest and repayment in the same fashion as they would buy some helmets for the military or some pencils for a government school. True, individual American states do face a fiscal crisis (much like the EMU nations) as users of the dollar. That is why some 48 out of 50 now face fiscal crises (a problem that could easily be alleviated were the US Federal Government to undertake a comprehensive system of revenue sharing on a per capita basis with the various individual states). But, if any "lesson" is to be learned from Greece, Ireland, or any other euro zone nation, it is not the one that Mr. King is seeking to impart. Rather, the lesson is the futility of imposing arbitrary limits on fiscal policy devoid of economic context. Unfortunately, few are recognizing the latter point. The prevailing "lesson" being drawn from the Greek experience, therefore, will almost certainly lead the US and the UK to the same miserable economic outcome, along with higher deficits in the process. As they say in Europe, "Finanzkapital uber alles".

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

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There Is Still a Way Out for Greece

May 3, 2010Marshall Auerback

greek-flag-150Will a rescue package bring regional recovery and stability? Or will it expose the EU's  underlying weaknesses? Much depends on what Greece can do with the funds in the event of a default.

greek-flag-150Will a rescue package bring regional recovery and stability? Or will it expose the EU's  underlying weaknesses? Much depends on what Greece can do with the funds in the event of a default.

As you may have heard, a 110 billion euro rescue package for Greece was announced in an effort to prevent a Greek default and inject confidence in the euro zone. This package will have dramatically higher chances of success at both goals if Greece is allowed to use the funds to pay taxes. Greece has a chance to fund itself at low interest rates. It also has a chance to serve as an example for the rest of the euro zone and thereby ease  funding pressures on the entire region. But it must do the following: Insert a proviso that in the event of default, the newly issued securities can be used to pay tax. The trick? Make the provision state that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are "money good" and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes.

Let's take a step back and consider the purpose of taxation. Contrary to the commonly held perception, our tax dollars do not "fund" government spending, which is created at the push of the stroke of an electronic keyboard. So why, then, do we tax?

One is a more obvious reason which jibes with our own personal experience. The government taxes to regulate aggregate demand. In essence, that means if the economy is "too hot" raising taxes will cool it down, and if it's "too cold" cutting taxes will warm it up. Taxes aren't about getting money to spend but rather are about regulating our spending.

And that appears obvious. Clearly, if a government taxes 40% of your income, as opposed to 5%, that leaves you with less disposable income and therefore cuts down your discretionary spending power.

But tax serves another function which is less intuitive, particularly in a post gold standard world in which we have "fiat" currencies - that which the government designates by fiat to be the monetary unit of account to be deployed in our day to day transactions.

How does the government confer value on these seemingly worthless pieces of paper with pictures of dead presidents on them? These "greenbacks" are neither backed by gold, nor are they, strictly speaking, backed by the "full faith and credit" of the US government. Rather, their value comes because the government guarantees that we can use this unit of account - the dollar - to extinguish your liabilities to the state, which we otherwise call taxes.

The public would not give up goods and services to the government in return for otherwise worthless coins or paper notes unless there were good reasons to do so. The primary reason the public accepts what we call "fiat money" is because it has tax liabilities to the government. If the tax system were removed, the government would eventually find that its fiat money would lose its ability to purchase goods and services on the market. In the words of the economist Abba Lerner: "The modern state can make anything it chooses generally acceptable as money...It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state's absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done." Taxes, then, are what give value to government created currency.

What does this have to do with Greece? It is our contention that this is precisely what Greece should attempt to do, given the new funding arrangements agreed with the EU and IMF over the past weekend.

We recognize, of course, that this proposal it would also introduce a new "moral hazard" issue, as this newly found funding freedom, if abused, could be highly inflationary and further weaken the euro. If you don't have a consolidated fiscal entity (i.e., a "United States of Europe") which can enforce common fiscal rules for all of the nation states, then buying up national government debt constitutes a form of moral hazard as represents a race to the bottom. The country that deficit spends the most, wins. The end result is probably too much inflation. It is comparable to a situation where a nation like the US, for example, did not have national insurance regulation. In this kind of circumstance, the individual states got into a race to the bottom, where the state with the laxest standards stood to attract the most insurance companies, forcing each State to either lower standards or see its tax base flee. And it tends to end badly with AIG-style collapses.

What Europe's policy makers would like to do is find a way to isolate Greece and mitigate the contagion effect; hence, the huge "shock and awe" proposal, the rumors of which did engender an 8% jump in the Greek stock market last Thursday.

On the face of it, it would appear that the package announced - a 110 billion euro rescue package for Greece to prevent a default - does mitigate the risk of the contagion from spreading through the rest of the bloc. But these proposals don't really get to the nub of the problem. Any major package weakens the others who have to fund it in the market place because none of the others have the means to do fiscal properly (as they don't create currency). A massive (say, 2 trillion euro) per capita distribution might be the only short-term answer, but nobody in the ECB is thinking along these lines because they think it would be "inflationary".

And the size is almost too big. The size of the package to which the EU and IMF have agreed, though necessary, seems to make it clear that there is a much broader problem afoot. If 110 billion is required to "solve" the Greek problem, how much more for the next country? Instead of successfully engendering "shock and awe" in a manner which impresses the markets, the package could simply highlight the EU's underlying financial weaknesses.

Nor does the ECB or the Economic Council of Finance Ministers (ECOFIN) have the means to enforce their austerity demands and keep them from being reversed once it's known they've taken the position that it's too risky to let any one nation fail.

The euro zone nations are all still in a bind, and their austerity measures mean they won't keep up with a world recovery. Additionally, a Greek restructuring that reduces outstanding debt is a force that strengthens the euro as it reduces outstanding euro financial assets, but they need a weaker euro to get growth via exports.

It does not appear that the markets have truly thought through what a Greek default actually means. If one uses a Chapter 11 bankruptcy analogy, consider that large parts of the country could well be shut down as part of this restructuring exercise in order to allow the "company" (i.e. "Greece Inc") to function at a smaller size, in theory giving the Greeks time to grow again and restructure their debts. But where do they get the euros from? They don't create them and so it seems to us that if they default, they have to go back on the drachma. Otherwise, do you try to stop all euros from leaving Greece? Do you shut down the military or police department, so that the government is not spending as much? Eliminate the state pension scheme? Already, we are seeing signs of massive political disaffection.

The ability of Greece to use the funds from the rescue package as a means to extinguish Greek state liabilities would improve their financial ratios and stave off financial collapse, at least on a short-term basis, with the side effect of a downward spiral in output and employment, while the sovereign risk concerns are concurrently transmitted to Spain, Portugal, Ireland, Italy, and beyond. Those sovereign difficulties also morph into a full-scale private banking crisis, which can quickly extend to bank runs at the branch level.

Our suggestion will rescue Greece and the entire euro zone from the dangers of national government insolvencies. It will also turn the euro zone policy maker's attention 180 degrees, back to their traditional role of containing the potential moral hazard issue of excessive deficit spending by the national governments through the Stability and Growth Pact. If the member states ultimately decide that the Stability and Growth Pact ratios need to be changed, that's their decision. But the SGP represents the euro zone's "national budget," precisely designed to prevent the hyperinflationary outcome that the "race to the bottom" could potentially create. At the very least, our proposal will mitigate the deflationary impact of markets disciplining credit sensitive national governments and halting the potential spread of global financial contagion, without being inflationary.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator and Warren Mosler is President of Valance Co.

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The Deficit: Nine Myths We Can't Afford

Apr 27, 2010

deficit-150Has the federal government run out of money? Will we have to slash Social Security? Will we have to borrow dollars from China for our children to pay back?

deficit-150Has the federal government run out of money? Will we have to slash Social Security? Will we have to borrow dollars from China for our children to pay back?

The national debate over fiscal responsibility and sustainability is entering a new, critical phase. Today, an 18-member bipartisan commission to examine the government's fiscal problem will meet for the first time. Everything is on the table, including Social Security and Medicare.

With so much at stake, the time has come to examine our fundamental assumptions about government deficits and debt. The danger of accepting oft-repeated orthodoxies has been clearly demonstrated in the recent financial crisis. For decades, free market fundamentalism went virtually unquestioned, and we've all seen the result - an epic economic catastrophe. We can't afford to make the same mistake on fiscal responsibility. It's time to consider alternatives perspectives before we rush down potentially destructive policy paths that could compromise our future.

The Roosevelt Institute's New Deal 2.0 asked seven economic thinkers to address what they see as the most dangerous myths currently circulating on the deficit. Several of these experts will be on hand to educate the public on April 28, 2010 at George Washington University in Washington, D.C. at a "Fiscal Sustainability Teach-In."

Myth #1: The government should balance its books like a private household.

Reality: Our federal government is the issuer of the currency, which makes its budget fundamentally different than the average citizen's.

Discussion of government budget deficits often begins with an analogy to a household's budget. People say: "No household can continually spend more than its income, and neither can the federal government". But there are big differences between a household and the federal government. You don't have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.

A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn't "have" or "not have" dollars. There is no vault or lock box where it "keeps" its money. In fact, it makes all of its payments simply by electronically crediting private bank accounts and there is no practical limit to which it can change those numbers up. Spending by the federal government always creates new money in the system, while taxation destroys it. When households and firms pay taxes, the money does not go anywhere; the government simply debits those private bank accounts by electronically reducing the amount of reserves they hold, i.e., by changing the numbers in those bank accounts down.

Government is constrained only by the inflation it can create by over-spending, but its ability to spend is numerically unlimited. Households are constrained by their ability to get dollars from some form income and from borrowing, and both of those have real limits.

~Pavlina R. Tcherneva, Assistant Professor, Franklin and Marshall College

Myth #2: Fixing Social Security and Medicare will require "tough choices".

Reality: Social Security and Medicare are not facing a financial crisis.

A new poll by the Pew Research Center suggests that nearly 80% of Americans don't trust the federal government. Unfortunately, we appear all-too-willing to trust the government when it tells us that Social Security and Medicare are heading for bankruptcy. Indeed, the same poll shows that fewer than half of us now hold a favorable opinion of the Social Security Administration (down 13% from a decade ago). No wonder. The drumbeat over the so-called "crisis" facing Social Security and Medicare has reached a fever pitch.

The government's message is clear: Both programs face significant trouble ahead, due primarily to the aging of our population. In order to deal with the looming problems, we will have to make "tough choices." Not everyone can have the money they were promised.

If you've been around a while, you've heard this all before. Remember the Greenspan Commission? This is the group that President Reagan appointed to "fix" Social Security in the early 1980s, the last time the system was on the brink of "collapse." Thanks to the "reforms" that were enacted in 1983, Americans are working longer (they raised the retirement age) and paying more (they accelerated increases in the payroll tax rate). And now we're being told it was all for nothing -- the system is broken again?

The truth is, the system was never broken in the first place, because the government's ability to pay benefits does not in any way depend on the balance in the Social Security or Medicare Trust Funds. Benefit checks come directly from the Treasury, and, as Alan Greenspan has admitted, "[A] government cannot become insolvent with respect to obligations in its own currency."

And so the question is not whether the government needs to make "tough choices" in order to keep these vital programs afloat. The question is, will politicians make the toughest choice of all and tell the American people the truth: Social Security and Medicare face no financial crisis now or in the future.

~Stephanie Kelton, Associate Professor, University of Missouri-Kansas City, Missouri

Myth #3: We are passing on debt to our grandchildren.

Reality: Payments on Treasury securities are a matter of data entry, not a financial burden.

Most people don't realize that government debt -- Treasury securities -- are nothing more than savings accounts at the Federal Reserve Bank in Washington.

There are about 13 trillion dollars in Treasury securities at the Fed. Collectively, these savings accounts are known as the national debt. The national debt represents a portion of the combined savings of US residents, corporations, banks, and foreign governments. And most folks probably don't know that when a person buys them, the Fed simply transfers the dollars from her checking account to a savings account at the Fed called a "Treasury security."

Tens of billions of dollars of these Treasury securities come due every week. When that happens, the Fed pays off that "debt" simply by transferring the dollars, plus interest, out of these savings accounts and back to the holders' checking accounts.

In the future, when our grandkids make payments on Treasury securities, they will simply credit accounts at the Fed-just as we do today, and as our grandparents did before us. It is a simple matter of data entry, and not a financial burden.

If the government spends and taxes wisely today, our grandchildren inherit roads, dams, parks, public buildings, and, most importantly, an educated and healthier workforce. These things are admittedly hard to value precisely-but there can be no doubt that our grandkids will be much better off having been born into a society that has modern infrastructure and services that our government policies can help to provide.

~Randall Wray, Professor of Economics, University of Missouri-Kansas City, Missouri

MYTH #4: What we don't tax we have to borrow from the likes of China for our children to pay back.

Reality: Paying our debt holders back consists of transferring funds between accounts.

One constantly hears that the Chinese (and other external creditors) "fund" our deficit. The folklore is that when China finally sells off its US bond holdings, those yields will sky-rocket. The dollar will then crash, no one else will want the debt, and it will be the end of America as we know it.

To debunk this myth, you need to know two things. First, all foreign governments have checking accounts at the Federal Reserve Bank called "reserve accounts." Second, US Treasury securities are nothing more than savings accounts at the same Federal Reserve Bank.

How does China get its dollars? It sells things to us. And when China gets paid, those dollars go into China's checking account at the Federal Reserve Bank.

And when China buys US Treasury securities, what happens? The Fed transfers China's dollars in its checking account at the Fed to its savings account at the Fed. We call that "borrowing from China" and "going into debt to China." But it's not really "borrowing" in the sense of creating an external constraint whereby we have to defer spending to "pay back" China. The Fed simply pays off China's "debt" by transferring the dollars, plus interest, back to the holder's checking account, which it can create at the stroke of a keyboard as the monopoly issuer of dollars.

The dollars are nothing more than data entry on the Fed's computer. They have no other existence. And it has no impact on the government's ability to spend as to whether China's dollars are in their checking account or savings account.

All we owe China is a bank statement that shows them where their dollars are. Sadly, they know this. But they also know that we think we are dependent on them, and take advantage of our error.

~Marshall Auerback, Senior Fellow at the Roosevelt Institute and Warren Mosler, President, Valance Co.

Myth #5: The government must tax or borrow to get money to spend.

Reality: Government spending is not constrained by revenue.

As explained above, the Federal government neither "has" nor "doesn't have" dollars. The government spends by creating new money and taxes by destroying money, which simply involves changing numbers in bank accounts. Suppose the government pays Social Security benefits to a retired teacher, Mrs. Jones, in the amount of $1,500 a month. At the end of the month, the checking account of Mrs. Jones is credited by $1,500. Did the government need your tax revenue to pay Mrs. Jones? No! It simply changed the numbers up in Mrs. Jones's bank account, basically creating new money. On April 15 Mrs. Jones sends a check to the IRS to pay her taxes. When the government gets the check, what does it do? It simply changes numbers down in Mrs. Jones's bank account, destroying the money.

What about selling government bonds, which is mistakenly called borrowing? These are simply interest-earning assets, similar to a savings account. Suppose Mrs. Jones has $1,000 dollars in her checking account on which she would rather earn interest. So she buys a Treasury security. What happens? Basically a bond sale involves moving funds from checking accounts to savings accounts (Treasuries) at the Federal Reserve Bank.

So if the government doesn't need to tax to be able to spend, why does it tax at all? There are two reasons. First, the government creates demand for its currency through taxation. If the public didn't need the dollars to pay its taxes, it wouldn't be willing to sell goods and services to the government in return for pieces of paper (or numbers in a checking account). Taxes, then, are what give value to money. Second, the government uses taxes to control the public's spending power. When the public has too much spending power, government taxes some of it away to avoid inflation. When there is too little spending so that unemployment results, it lowers taxes to boost private spending.

Any and all financial constraints on government spending such as issuing government bonds dollar for dollar against deficit spending, debt ceilings, and restrictions on the Fed's ability to buy treasury securities are purely political and necessarily self imposed, because they are imposed on us by our chosen institutional arrangements and not by something inherent in our economic system.

~Yeva Nersisyan, Doctoral candidate in economics, University of Missouri-Kansas City, Missouri

Myth #6: Deficits and government borrowing takes away savings.

Reality: Deficits add to income and savings.

The truth is that deficits add to the total monetary savings held outside of government. To the penny. That's right, if the government deficit was 1 trillion dollars last year, then total net savings of everyone outside of government went up by 1 trillion. Not a penny more or a penny less.

Let's look at a simple transaction where the government deficit spends $100. Say the government sells US $100 of new treasury securities. We buy them and our bank account goes down by $100 when we pay for them, but we have the $100 of treasury securities we bought. Are we any poorer? Of course not! In fact, since we bought the securities voluntarily, we probably did it because we think that purchase made us richer. All we did was exchange $100 that was in our checking account for a $100 Treasury security.

After we pay the $100 for the Treasury securities, the next thing that happens is the government then spends $100 by buying something from us. So we now have both the $100 the government just spent and the $100 of Treasury securities we just bought.

So because of the $100 of deficit spending, we got our $100 back in our checking account, and we also have $100 in Treasury securities. Our monetary wealth is now $100 more than it was before.

The deficit spending of $100 added $100 to our savings. Yet all of our leaders insist that deficits take away from our savings.

You can now understand the reason our savings went up so much last year. It was because the government deficit was so much higher. Now you know more about that than anyone on TV.

~Warren Mosler, President, Valance Co.

Myth #7: We'll end up just like Weimar Germany or Zimbabwe.

Reality: Hyperinflation in both countries was caused by circumstances far different than ours.

The minute you challenge the assumption that the government should not spend when it has a large deficit, out comes the charge that we'll get some horrible hyperinflationary outcome like Weimar Germany or Zimbabwe.

Yes, once the economy gets to full employment, then extra government deficit spending can start driving up prices. But what happened in Weimar Germany was very different. During that time, the government was forced to pay extremely large war reparations in foreign currencies which it didn't have. So it had to aggressively sell its own currency and buy the foreign currency in the financial markets. This relentless selling continuously drove down the value of its currency, causing prices of goods and services to go ever higher in what became one of the most famous inflations of all time. By 1919, the German budget deficit was equal to half of GDP, and by 1921, war reparation payments represented one third of government spending. And guess what? On the very day that government stopped paying the war reparations and selling its own currency to buy foreign currency, the hyperinflation stopped.

In Zimbabwe, the situation is also very different from ours. There, the conditions for hyperinflation were caused by the destruction of nearly half of the country's domestic food production via misguided land reforms, plus a civil war which eliminated much of the economy's productive manufacturing capacity. In response to food shortages, the Bank of Zimbabwe used valuable foreign exchange reserves to buy imported food, leading to a lack of foreign currency to purchase essential raw materials. Manufacturing output collapsed, but the government used much of the remaining foreign exchange to dole out political favors, rather than adding to the country's productive capacity. The end result was inflation and then hyperinflation.

In the US, hyperinflation will not be an issue if the government spends while it has a large deficit because with high unemployment and unused yet functioning factories all across the country, there is plenty of room to cut taxes and/or increase spending to get us to full employment. This is true no matter what the size of the federal deficit. Ultimately, inflation (and then hyperinflation) is about competing distributive claims over real resources, such as oil, gas, water, etc. A "sustainable" fiscal policy, especially with respect to hyperinflationary risks, then, is really about both the establishment of full employment and the implementation of well-crafted policies which deal with the constraints created by, for example, depleting natural resources.

~Marshall Auerback, Senior Fellow at the Roosevelt Institute and Rob Parenteau, sole proprietor of MacroStrategy Edge

MYTH #8: Government spending increases interest rates and ‘crowds out' valuable private sector investment.

Reality: Banks can lend essentially without limit, and the Fed can hit any interest rate target it chooses.

Ask an economist what determines the interest rate, and she'll probably mutter something about supply and demand or "market forces." Ask the same economist what determines the level of saving and investment, and the answer probably won't change very much. This is because most economists were trained using textbooks that have not been rewritten since the United States went off the gold standard after WWII.

Back then, we had a monetary system that really did limit the growth of the money supply, and too much government spending really could force rates higher and crowd out other forms of spending. It is all based on something economists know as Loanable Funds Theory, which describes a market in which there is some limited pool of savings available to satisfy the demand for credit. Thus, deficit spending required the government to compete (with private borrowers) for a portion of these limited resources. Because the capacity to lend was constrained under the gold standard, the added competition could drive borrowing costs (i.e. the interest rate) higher.

Decades later, the monetary system looks completely different. But economists continue to treat governments as if they are the users of the currency (as opposed to the issuers) and to treat banks as passive money lenders -- there simply to broker deals between savers and borrowers. In truth, banks can lend essentially without limit, regardless of what the federal government is doing, and the Federal Reserve can hit any interest rate target it chooses.

~Stephanie Kelton, Associate Professor, University of Missouri-Kansas City, Missouri

Myth #9: The money spent paying interest on the national debt could be spent elsewhere.

Reality: Interest rates can easily be brought to zero and are not an obstacle to federal spending.

Government spending is not operationally constrained by revenues (as outlined above). So interest payments are not an obstacle to any other payments. Further, the Fed (a branch of government) sets the overnight rate-thus, it is a policy variable and can be set wherever policy wants to set it. Right now short term rates are set near 0%, and the Fed could leave them there permanently, which would bring down interest on Treasury securities to near 0%. Finally, Treasury can elect to issue only 3 month bills, which would bring government interest payments towards 0 over time.

Conclusion: Interest on the debt is not currently an obstacle to increased federal spending and/or tax cuts. And it's a very simple matter to bring interest payments down to 0 in any case.

~Randall Wray, Professor of Economics, University of Missouri-Kansas City, Missouri

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Troubles in the EuroZone: Will the Contagion affect the U.S.?

Apr 20, 2010Marshall Auerback

euro_banknotes-150Could euro devaluation increase the size of the U.S. deficit? Marshall Auerback explores the possibility, and what it means if deficit hysteria continues unchecked.

euro_banknotes-150Could euro devaluation increase the size of the U.S. deficit? Marshall Auerback explores the possibility, and what it means if deficit hysteria continues unchecked.

A recent poll by Douglas Schoen and Patrick Caddell suggests that swing voters in the US, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs.

But the latter two goals are generally incompatible, especially during major recessions.

In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as "stimulus packages") the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country's aversion to increased government deficit spending. The German government's reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here) . Last week's Greek "rescue" is Europe's "Bear Stearns event". The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America's external deficit, given the unlikelihood of America becoming an export super power again. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other "PIIGS" countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country's industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany's industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro's weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of 'inflation' flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the European Central Bank (ECB) may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default, the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It all could get very ugly for the ECB. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The 'support' scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary 'race to the bottom' of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone's external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates perceived incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America's external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either "virtuously" (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America's trade deficit. Possibly even higher.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. But this becomes virtually impossible if the euro zone's problems continue, as we suspect that they will.

President Obama, however, has long decried our "out of control" government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we've sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages - just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always "afford" to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today's budget deficit "Chicken Littles", we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That's the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided -- the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses.

In the 220 year experience of the United States there have only been a few years when we've not had deficits and each time the surpluses were immediately followed by a depression or a recession. History shows that we can run nearly permanent deficits and that when we do, it's better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

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Two Different Banking Crises - 1929 and 2007

Apr 13, 2010Henry Liu

spending-money-150Henry C.K. Liu continues his analysis of the global post-crisis economy by examining how the banking industry of the 1920s became the byzantine financial sector of today.

spending-money-150Henry C.K. Liu continues his analysis of the global post-crisis economy by examining how the banking industry of the 1920s became the byzantine financial sector of today.

The 1929 banking crisis that launched the Great Depression was caused by stressed banks whose highly leveraged retail borrowers were unable to meet margin calls on their stock market losses, resulting in bank runs from panicky depositors who were not protected by government insurance on their deposits.

In the 1920s, there were very few traders beside professional technical types. The typical retail investors were long-term investors, trading only infrequently, albeit buying on high margin. They bought mostly to hold based on expectations that prices would rise endlessly.

By contrast, the two decades of the 1990s and 2000s were decades of the day trader and big time institutional traders. New powerful traders in major investment banking houses overwhelmed old fashion investment bankers and gained control of these institutions with their high profit performance. They turned the financial industry from a funding service to the economy into a frenzy independent trading machine. Many of the investing public aspired to be the Master of the Universe, as caricatured in Tom Wolf's Bonfire of the Vanity, which was turned into a movie starring Tom Hanks. Derivative trading by hedge funds was routinely financed through broker dealers funded by banks at astronomically high leverage.



Greenspan - the Wizard of Bubble Land

But the debt joyride was by no means all smooth sailing in a calm sea. Repeated mini crises were purposely ignored by regulators who should have known better. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash serial equity bubbles, had this to say in 2004, three year before the 2007 tsunami of a century, in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion." The Greenspan Fed adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's one-note monetary melody throughout his 18-yesr-long tenure as the nation's central banker had been when in doubt, ease.



LTCM - the Crisis that the Fed Papered Over

In the 1920s, there were no derivative markets. In the case of Long Term Capital Management, the hedge fund that failed in 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. But even that it was conservative when compared to the 40 to 1 ratio used by investment banks in the 2000s.

LTCM had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equaling to 5% of the entire global market. LTCM also invested in other derivatives such as equity options. LTCM was bailed out by its counterparty creditors under the guidance of the NY Fed. (Please see my December 3, 2009 series: Reform of the OTC Derivative Market - Part One: The Folly of Deregulation)

The Enron Fraud

In the 1920s, there was no structured finance or securitization of debt. The case of Enron, a large brave new energy trader, and its spectacular bankruptcy marked the high watermark of legalized financial fraud. The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. In a December 18, 2001 Senate Commerce Committee hearing on the Enron collapse, Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterizes corporate financial statements as "a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South Carolina, characterized Enron Chairman Kenneth Lay's political prowess as "cash and carry government". Embarrassingly, the New York Times reported the following day that Hollings had received campaign contributions from Enron and its auditor Arthur Andersen dating from 1989.

Until Enron filed for bankruptcy in 2001, the system's top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering" and the vehicle was structured finance or derivatives. (Please see my August 1, 2002 article: Capitalism's bad apples: It's the barrel that's rotten)



Greenspan - Enron Prize Recipient

Chairman of the Federal Reserve since 1988, Alan Greenspan gave a lecture at Stude Concert Hall sponsored by the James A. Baker III Institute for Public Policy on November 13, 2001. Following his lecture, he received the Baker Institute's Enron Prize for Distinguished Public Service. The prize, made possible through a generous and highly appreciated gift from the Enron Corporation, recognizes outstanding individuals for their contributions to public service.

Greenspan's speech offered an assessment of what lies ahead for the energy industry to an admiring audience. In the wake of the September 11 attacks and the then weakened state of the economy, Greenspan stressed the need for policies that ensure long-term economic growth. "One of the most important objectives of those policies should be an assured availability of energy," he said.

Greenspan said that this imperative has taken on added significance in light of heightened tensions in the Middle East, where two-thirds of the world's proven oil reserves reside. He noted that the Baker Institute is conducting major research on energy supply and security issues.

Looking back at the dominant role played by the United States in world oil markets for most of the industry's first century, Greenspan cited John D. Rockefeller and Standard Oil as the origin of US pricing power, notwithstanding the nation saw fit to break up the Rockefeller/Standard Oil trust. Following the breakup of Standard Oil in 1911, he said this power remained with American oil companies and later with the Texas Railroad Commission. This control ended in 1971 when remaining excess capacity in the US and oil pricing power shifted to the Persian Gulf. Greenspan was saying better Standard Oil than OPEC. He seemed oblivious to the development since the 1973 oil embargo that US oil companies have been working hand in glove with OPEC producers to keep oil prices high.



The Power of Markets against Market Power

"The story since 1973 has been more one of the power of markets than one of market power," Greenspan said. He noted that the projection that rationing would be the only solution to the gap between supply and demand in the 1970s did not happen. While government-mandated standards for fuel efficiency eased gasoline demand, he said that observers believe market forces alone would have driven increased fuel efficiency. Greenspan appeared to be the only one who sincerely believed that a free market existed or could exit for the trading of oil. All oil traders know that the price of oil is one of the most manipulated components in world trade.

"It is encouraging that, in market economies, well-publicized forecasts of crises more often than not fail to develop, or at least not with the frequency and intensity proclaimed by headline writers," Greenspan credited free markets with mitigating the oil crisis.

As it turned out, the California energy crisis of rolling blackouts was not caused by Middle East geopolitics. It was the handy work of Enron fraudulent trading strategies.



Greenspan against Reform

All though the 1990s and early 2000s, there were much talk of reform that led nowhere near what was actually needed. Less than a decade later, a financial crisis that Greenspan characterized as the market failure of a century imploded with a big bang.

On Greenspan's 18-year watch at the Fed, government-sponsored enterprises (GSE) assets ballooned 830%, from $346 billion to $2.872 trillion. GSEs, namely Fannie Mae and Freddie Mac, are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency MBSs (mortgage-backed securities) surged 670% to $3.55 trillion. Outstanding ABSs (asset-backed securities) exploded from $75 billion to more than $2.7 trillion.

Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US gross domestic product (GDP). Grated that much of the derivative trades were hedged, meaning the risks are mutually canceling. But the hedges would only hold without counterparty default. All that was needed to unleash a systemic failure was for the weakest link to fail. Greenspan created a monetary situation that permitted the market to speculate on risks that it could not afford.

Having released synthetic credit of dangerously high notional value, Greenspan raised the Fed funds rate target to 5.25% on June 29, 2006 from its lowest point of 1% set on June 23, 2003, to dampen inflation expectations, adding aggregate interest payments to the financial system greater than US GDP in 2006. That was like striking a match to like a candle in a dark kitchen filled with leaked gas. Under such fragile and explosive conditions, there was little wonder that the market collapsed a year later. (Please see my March 16, 2007 article: Why the US sub-prime mortgage bust will spread to the global finance system, written at a time when mainstream opinion was that the housing market, being geographically disaggregated, would not spread.)

Much of the precautionary measures instituted during the New Deal to prevent a reply of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed, as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).

Wholesale Credit Market Failure

Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the current financial crisis that began in mid-2007 was caused not by bank runs from depositors, but by a melt down of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.

The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, public-listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.

To read the full article, please visit HenryCKLiu.com.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

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The PIIGS Problem: Maginot Line Economics

Apr 12, 2010Marshall Auerback

maginot_line_150Marshall Auerback warns that Germany's obsession with a defense against the external threat of inflation is blinding them to the real risks facing Europe.

maginot_line_150Marshall Auerback warns that Germany's obsession with a defense against the external threat of inflation is blinding them to the real risks facing Europe.

The Maginot Line, named after French Minister of Defense André Maginot, was a line of defenses which France constructed along its borders with Germany and Italy after suffering appalling damage and casualties during World War I. The French thought they were now protected from a repeat, and believed the defenses impenetrable.

Chatting to a number of German participants at last week's Institute for New Economic Thinking (INET) conference, we couldn't help getting a sense of the economic parallel in regard to Germany's deep resistance to greater fiscal expansion as means of dealing with the problem of the "PIIGS".

The Problem:

Germany's fiscal deficit fetishism is largely a product of that country's own hyperinflation experience during the Weimar Republic. As deeply ingrained as that trauma remains in the German psyche, it is now taking on an almost hysterically irrational quality as evidenced by the latest "rescue package" for Greece. Its EMU "partners", led by Greece and soon to be followed by Portugal, Spain, Ireland and Italy, are increasingly being forced to embrace Germanic-style hair shirt economics, because the obvious fiscal response is constrained via self-imposed rules inherent in the rules governing the European Monetary Union. These rules are regarded, almost to a man, as "sound economics" by Germany's policy makers and the vast majority of its citizens (if one is to measure this via the national polls, which continue to indicate visceral hostility to "bailouts" for "lazy Greek scroungers and tax dodgers"). We wonder if they'll still be feeling that way if the contagion extends to Berlin and Paris.

Historians all know how effective the Maginot Line ultimately proved for the French in terms of defending a German occupation of their country during the Second World War: the Germans were able to avoid a direct assault on the Maginot Line by violating the neutrality of Belgium, Luxemburg and the Netherlands, whilst the Luftwaffe simply flew over it.

Likewise, we think Germany's "Weimar 2.0" phobia is based on similarly flawed "Maginot Line" thinking, thereby generating a correspondingly ineffectual response to the EMU crisis. It's becoming a story of intellectual hubris, defending "good economics", Germanic-style, over common sense.

Judging from the market's reaction to the 45m euro rescue package of Greece, it appears that the EMU and, by extension, the euro, have dodged a bullet for now. But the PIIGS problems remain. The terms and conditions include IMF 'austerity' measures, which will act to slow the economy of Greece and the entire EU -- which is already dangerously weak to the point of promoting higher budget deficits through low tax revenues and high transfer payments. All of which serves to further weaken the creditworthiness of all the member nations.

It also increases the euro debts of the other contributing nations because they are being forced to contribute to this funding package for Greece. The implication of the same type of 'rescue' for the larger euro nations is not pretty. Expect much higher levels of stress for the remaining euro member nations presumed to be 'strong' as the same kind of forced austerity appears in store for other "violators" of the Maastricht Convergence Criteria. Think about Spain, which now has 20% unemployment, or Ireland, which has a classic Iceland problem, given that the liabilities of its banking system vastly exceed the country's overall GDP.

The underlying assumption of the rescue package is not sound. The stronger nations still think by offering a big enough "guarantee" the markets will take up the slack and finance Greece for them. But the markets now want to see the cash and, more importantly, they want a firm demonstration that the funding guarantees provided will help to sustain the ability of nations like Greece to service its debt without turning the nation into an industrial wasteland. The markets no longer believe in a "contingent liability" model, which is something akin to indicating that you have a rich relative who can help you out if needed. The EMU's "rich relative" has already indicated that this is verboten, but it has denied Greece and the other PIIGS nations the means to grow adequately to service debt going forward.

The Prognosis:

The euro should therefore fundamentally remain on the weak side after a temporary bout of short-covering, as the high levels of euro national government deficits are adding the non government sectors' holding of euro denominated financial assets. And the austerity measures are likely to increase euro government deficits and thereby exacerbates potential national insolvency problems amongst the euro zone nations.

The common Germanic retort to this line of thinking is that a default in, say, California, would no more threaten the viability of the dollar than a Greek default would endanger the euro. Perhaps, although the Lehman experience should have taught us all that the negative externalities of such an event can seldom be determined in advance, given the opacity of today's funding mechanisms. Additionally, the United States of America is an existing NATIONAL fiscal authority which can respond to the growing problem of state insolvency via dollar creation and corresponding revenue sharing with the states. No such comparable fiscal entity yet exists in the euro zone.

Although we have hitherto characterized Greece as the EMU's "Lehman" problem, the rescue package announced on Monday makes us that think that the better parallel for Greece might well be Bear Stearns. Bear's "rescue" in March 2008, initially looked like it enabled the global financial markets to avert a growing crisis in the asset backed securities markets. What it did in reality was kick the can down the road, as the underlying structural problems which created the crisis in the first place remained unresolved. The credit crisis that began in August 2007 involved failure of both the liquidity and the solvency risk systems. The consequent freeze-up arose because the subsequent bankruptcy of Lehman and collapse of AIG destroyed the markets' expectations (built up by years of bailouts) of their being an ultimate market maker, which would always be able to deal in these securitized instruments.

By the same token, the creation of a common currency via monetary union has created market expectations that one country's paper is as good as another, which explains why, for so many years, "fiscally profligate" nations such as Italy were able to borrow at Germanic level interest rates. But the decision a few months ago by the European Central Bank to block a basic "repo" function -- namely, the purchases of a number of European commercial banks of Greek government debt and exchanging this debt via repos with the ECB for German and French government paper is what appears to have initially triggered the Greek crisis and raised issues of Athens's potential insolvency.

From what we understand, the cessation of this repo function was largely done at the behest of the Germans, who saw this activity as a kind of "back door monetization" which would lead inevitably to inflation. This, despite the fact that the entire euro zone is characterized by huge unemployment , high output gaps, and collapsing domestic consumption. All of this at the core is being driven by Germany's pathological fear of inflation which they see as the inevitable consequence of excessive government budget deficits.

But Germany's irrational fears of inflation are storing up the conditions for a far greater crisis down the line. The euro contagion could now very well spread to Italy Portugal Spain and Ireland, all of which (under the terms of this package) have to lend to Greece, at around 5%. So what happens to their funding costs? They go north of 5% as a next step. In the US, when good banks took over bad banks, they became bad banks themselves (see Bank of America and Countrywide). And what about the seniority structure of these loans? Do they subordinate Greek Government Bond holders? One assumes yes, but this is not made clear by the rescue package. In short, this appears to be a cobbled together solution, and it won't work for a Spain or an Italy. There's no clarity even on how it gets ratified. The EU says it's done, but Germany and Holland say they need Parliamentary approval (which can easily be delayed).

Let's be clear: in the aftermath of World War I, German production capacity was either significantly damaged, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany's manufacturing base. All of these measures significantly restricted Germany's capacity to produce, fueling the distributional conflict that fed the hyperinflation.

There is nothing like that today in Germany, yet "Weimar 2.0" thinking predominates in much the same way that "Maginot Line" thinking dominated French thinking in its defense establishment. The obsession with a"defense" against the "external" threat of inflation, is blinding Germany. It doesn't see the risk that the collapse of aggregate demand within the European Monetary Union will ultimately lead to a collapse in Germany's export sector (a large chunk of which is the product of intra-European trade), and the corresponding extension of the "PIIGS" disease of slow growth and high unemployment to the heartland of the euro zone. We know how it ended for France, once the Maginot Line proved to be a defense more apparent than real.

We hope that Germany's similarly "successful" defense of inflation does not lead to a comparably disastrous result for Europe today.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

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