Wall Street Swindled Local Governments, Too. Here’s How They Can Get Their Money Back.

Sep 17, 2014Saqib Bhatti

Predatory lenders drove municipal governments and taxpayers into debt with risky interest rate swap deals that may have violated federal regulations.

The story of how Wall Street banks steered unsuspecting homebuyers towards complex mortgages with hidden risks and hidden costs has been well-documented. In fact, the typical sales pitch for adjustable-rate mortgages was premised on the false notion that home values never fall and that borrowers could refinance their loans before interest rates jumped.

Predatory lenders drove municipal governments and taxpayers into debt with risky interest rate swap deals that may have violated federal regulations.

The story of how Wall Street banks steered unsuspecting homebuyers towards complex mortgages with hidden risks and hidden costs has been well-documented. In fact, the typical sales pitch for adjustable-rate mortgages was premised on the false notion that home values never fall and that borrowers could refinance their loans before interest rates jumped.

Less widely understood is the fact that a very similar story played out with cities, states, and other municipal borrowers that were also steered into predatory interest rate swap deals riddled with hidden risks and hidden costs. Banks pitched these deals as a way for municipalities to save money on bond issuances: instead of issuing a traditional bond that had a fixed interest rate, they could take out a cheaper variable-rate bond that had an adjustable interest rate, but use a swap to protect against the risk of interest rate spikes.

Under this structure, municipalities made fixed-rate payments to banks on their swap deals, while the banks gave them back a variable-rate payment that was intended to offset the interest rate that the municipality had to pay its bondholders. The idea was that this would allow borrowers to get a “synthetic fixed rate” on their debt that was cheaper than what they would have to pay on a comparable conventional fixed-rate bond.

However, there were numerous risks embedded in these deals. For example:

  • The variable interest rate that the banks paid to the municipality could fall short of the rate that the municipality owed bondholders, creating a shortfall.
  • These deals contained many termination clauses that would allow the banks to cancel the deals and charge municipalities tens or even hundreds of millions in termination penalties.
  • Rather than rising, interest rates could crater, causing the net payments on the swap deals to skyrocket and leaving the municipalities unable to take advantage of the low-interest environment unless they terminated their swaps and paid hefty termination penalties.

Even though banks tried to downplay or dismiss these risks in order to push interest rate swaps, all of them materialized in the aftermath of the 2008 financial crisis:

  • When interest rates on a type of variable-rate bond known as an auction rate security shot up, the bank payments on the corresponding swaps could not cover those payments, and cities and states across the country were stuck paying double-digit interest rates to bondholders.
  • When Lehman Brothers filed for bankruptcy and defaulted on its swap payments with municipalities, it triggered termination clauses on the bank’s swaps. In an ironic twist, cities and states actually had to pay penalties to Lehman because of the way the termination clauses were written.
  • When the Federal Reserve slashed interest rates in response to the financial crash, it also drove down variable rates on swaps, causing the net payments on the swaps for cities and states to soar and preventing taxpayers from enjoying any of the benefits from the low rate environment.

As a result, municipalities across the country have been hit with large bills to Wall Street at the same time that they are trying to close record budget shortfalls amid the biggest economic downturn in 80 years. The Detroit Water and Sewage Department is shutting off water to families who have missed just a couple of payments on their water bill so that it can pay off more than $500 million in termination penalties on its swaps. The City of Chicago is now paying $72 million a year on its swaps as a result of the low interest rates, even as entire neighborhoods on the south and west sides of the city fall into disrepair. The school district in Chicago is paying another $36 million a year on swaps, while the Board of Education is invoking budget problems to justify the largest mass school closing in national history. In Wisconsin, the state is now paying $25 million a year on its swaps and making catastrophic cuts to state healthcare programs. These are just a few examples of a trend cropping up everywhere in the U.S.

It is no accident that the same communities that were disproportionately targeted for predatory mortgages are also bearing the brunt of these predatory municipal finance deals. Across the country, working class communities of color are disproportionately impacted by cuts to public services, and austerity measures serve to exacerbate the crisis in those communities in particular.

Luckily, there is something that public officials can do to stop the bleeding. Under Rule G-17 of the Municipal Securities Rulemaking Board (MSRB), a federal regulator charged with protecting the interests of municipal borrowers, banks that pitch deals to public officials must “deal fairly” with them. According to the MSRB, this means that they “must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with the municipal issuer.” In other words, they must not downplay the risks associated with deals like interest rate swaps, and they must not mislead public officials about the likelihood of such risks materializing. The banks must ensure that public officials truly understand the risks of the deals they enter into.

This is a burden that was not met in the typical swap transaction. As a rule, bankers highlighted the upside and minimized the potential downside in pitching these deals. This was in violation of MSRB Rule G-17 and municipalities like Chicago and Detroit have legal recourse to potentially win back hundreds of millions from Wall Street. Cities, states, and other municipal borrowers can pursue these legal claims by filing for arbitration with the Financial Industry Regulatory Authority (FINRA).

The Baldwin County Sewer Service, a privatized utility in Alabama, successfully used a similar legal argument earlier this year to win back its swap payments and get out of its deals without any termination penalties. The total value of the award was approximately $10 million. The potential claims could be many magnitudes higher for cities and states that had significantly greater swap exposure.

However, officials in municipalities with swaps need to act fast, because time may be running out. FINRA has a six-year eligibility period on these claims. Because many of the risks associated with swaps materialized in October 2008, when interest rates plummeted as a result of the federal response to the financial crisis, it is possible that the clock could run out on these claims as early as October 2014. Public officials like Mayor Rahm Emanuel in Chicago and Governor Scott Walker in Wisconsin should act now to potentially recover millions for their constituents before it is too late.

Saqib Bhatti is a Fellow at the Roosevelt Institute and Director of the ReFund America Project.

Image via Thinkstock

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Daily Digest - September 10: Could a Left-Wing Tea Party Unite Progressives?

Sep 10, 2014Rachel Goldfarb

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Why We Need a Left Wing Tea Party (The Daily Beast)

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Why We Need a Left Wing Tea Party (The Daily Beast)

Sally Kohn calls on progressive factions to follow the Tea Party's lead and throw all their weight behind uncompromising candidates who are strong on every progressive issue.

Labor Market Unchanged According to July Job Openings Data (EPI)

Comparing job openings data to unemployment, Elise Gould points out that over half of the unemployed were not going to find work in July no matter what they did, because the jobs don't exist.

Government Debt Isn't the Problem—Private Debt Is (The Atlantic)

Richard Vague writes that financial crises can be tied to too-high and rapidly growing private debt, which means policy solutions need to focus on debt relief for low- and middle-income people.

Were Fast-Food Workers Paid to Strike and Protest? (The Guardian)

The answer is no, writes Jana Kasperkevic. That rumor is a corruption of the union strike fund, a pool set aside to help pay for striking workers' arrest fines and lost wages.

Warren Faults Banking Regulators for Lack of Criminal Prosecutions (WSJ)

While Senator Warren focused on the Federal Reserve, Senator Shelby blamed the DoJ for seeking fines instead of jail time for banking executives, report Ryan Tracy and Victoria McGrane.

Want to Fix the Jobs Crisis? Build a Federally Funded Worker Education Infrastructure (TAP)

Good job training programs – the kind that see both students and employers as clients – can be highly successful, writes Paul Osterman, but they're small and difficult to scale up.

The OECD’s Latest Report is Burdened by Economic Myths (AJAM)

Philip Pilkington says that until economic policymakers stop assuming that economies rebalance themselves and that high government debt is the real problem, good policy change is unlikely.

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Taxes Are Never Just a Class Issue

Sep 4, 2014Joelle Gamble

Tax reforms can't solve all economic inequality, because they won't change the reality of race in the U.S. economy.

Tax reforms can't solve all economic inequality, because they won't change the reality of race in the U.S. economy.

The threat of corporate inversions to the American tax base sprung an interesting political dialogue around tax reform in the United States. We’ve seen debates on how to stop the spread of inversions and arguments that they aren’t a problem at all. Some call for the abolition of the corporate tax rate as a whole and others completely reject such suggestions. I find these discussions of tax reform and its effects on the economy informative yet simultaneously slightly disappointing.

What bothers me about how tax reform debates shake out is how absent they can become of socio-political realities, particularly the reality of race.

One line of progressive argumentation follows simply: If everyone pays their fair share of taxes, we can support public spending and job growth, and we’ll all do better. The argument firmly stands, but there is an important caveat.

It’s easy to harken back to the 1950s when tax rates were high, social services were relatively steady and economic security stretched across economic strata. But who was really secure then? Even the high points of job security for the American economy still left African Americans (and other racially marginalized groups) behind. This a structural phenomenon, instituted by socially racist institutions and a deep history of systemically harming the Black community.

We can’t take race out of conversations around economic inequality. The reality of race is that even fixes to the broader federal revenue landscape don’t always address the structural barriers of racism. A rising tide can’t lift all boats, if some boats are bolted to the seafloor.

Black unemployment consistently exceeds that of whites, both post-Recession and since such data has been available. Gaps between white unemployment and black unemployment shrank in 2009. This was not due to falling black unemployment but instead due to skyrocketing white unemployment.

This racial gap in economic success extends beyond the employment rate. In fact, it is deeply entrenched in the way wealth is distributed in the U.S. The gap between median Black wealth and median white wealth stands at about $236,000 dollars. Flagrant discrimination, in part, contributes to this gap. But it is perpetuated by generations of asset accumulation policies that are targeted at those who already own assets.

Corporate tax reform alone isn’t sufficient to fix the effects of decades of second-class status conferred on African Americans. The government does not just need sufficient funding to create equality within the economy. Distribution of these dollars is equally important. It needs to reflect the nuances of structural inequalities built into multiple aspects of our tax code.

Take federal housing spending policies as a prime example. Ending ineffective tax incentives, such as the mortgage interest reduction, can start to tilt the scales toward those who are not already wealthy. Seventy-seven percent of the benefits of the mortgage interest reduction accrued to homeowners with gross incomes of above $100,000. We need to rethink housing subsidies so that the benefits of federal programs do not heavily favor those who already own homes.

We need corporate tax reform to ensure that all participants in our economy are paying their fair share. But we also need a federal benefits structure that ensures that the concept of a "fair share" considers our history of discrimination when determining which Americans need those benefits most.

Joelle Gamble is the National Director of the Roosevelt Institute | Campus Network.

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Daily Digest - August 29: A Rising Minimum Wage Lifts All Boats

Aug 29, 2014Rachel Goldfarb

There will not be a new Daily Digest on Monday, September 1, in observance of Labor Day. The Daily Digest will return on Tuesday, September 2.

Click here to receive the Daily Digest via email.

Who Stands to Benefit from San Diego’s Minimum Wage Hike (Voice of San Diego)

There will not be a new Daily Digest on Monday, September 1, in observance of Labor Day. The Daily Digest will return on Tuesday, September 2.

Click here to receive the Daily Digest via email.

Who Stands to Benefit from San Diego’s Minimum Wage Hike (Voice of San Diego)

Lisa Halverstadt speaks to Roosevelt Institute Fellow Annette Bernhardt about her research team's estimate that 172,000 workers could get a raise from San Diego's minimum wage hike.

The Biggest Tax Scam Ever (Rolling Stone)

Tim Dickinson looks at the range of multinational tax avoidance strategies in use today, from inversions to offshoring. It's all legal, he says, but the law itself is broken.

De Blasio Zeroes in on Expanding Living Wage (Capital New York)

New York City's mayor looks to require more businesses, including retail tenants of subsidized developments, to pay a living wage, report Dana Rubinstein and Sally Goldenberg.

Market Basket's Popular CEO Arthur T Goes Rogue and Wins – Now What? (The Guardian)

After months of employee protests on his behalf, Market Basket's former CEO has bought out his cousins to regain control. Jana Kasperkevic says he'll face new challenges from shareholders.

AFL-CIO’s Trumka: Democrats Need New Economic Team in 2016 (WSJ)

The labor union president wants 2016 candidates to avoid economics advisors who have participated in the revolving door of government and Wall Street, reports Eric Morath.

Americans Foresee Unending Economic Doom (Vox)

Danielle Kurtzleben looks at a new study from Rutgers which shows that a growing number of Americans believe the last recession permanently scarred the economy and that government can't help.

Pregnant Women Just Earned More Workplace Rights in Illinois (The Nation)

The new law establishes civil rights protections for pregnant workers, which will help them to stay in the workplace if they want to, writes Michelle Chen.

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Daily Digest - August 26: Corporations Shouldn't Get a Free Pass on Tax-Dodging

Aug 26, 2014Rachel Goldfarb

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Cutting the Corporate Tax Would Make Other Problems Grow (NYT)

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Cutting the Corporate Tax Would Make Other Problems Grow (NYT)

Jared Bernstein counters recent suggestions for eliminating the U.S. corporate income tax by pointing out the extreme difficulty of capturing that revenue through personal income taxes.

  • Roosevelt Take: Roosevelt Institute Chief Economist Joseph Stiglitz proposes more viable reforms to the corporate income tax.

Stigmatizing Poor Kids in Our Public Schools (PolicyShop)

Matt Bruenig suggests that free lunch at school is the target of so much ire because it's seen as a "poor people thing," even though public schools are themselves a welfare program.

When Workplace Training Programs Actually Hinder Workers (The Nation)

The low-structure, free-choice-based model of the Workforce Investment Act limits its effectiveness, writes Michelle Chen, since it doesn't allow for prioritizing funding for the best training programs.

Another GOP State May Be Signing up for Medicaid, and the Reason is Obvious (LA Times)

Michael Hiltzik says the money being left on the table is finally proving enough to get Republican governors like Wyoming's to push for Medicaid expansion even though it's part of Obamacare.

Back to School, and to Widening Inequality (Robert Reich)

Kids who live in poor neighborhoods are at a disadvantage when it comes to school funding, writes Robert Reich, so economic inequality hobbles these students from an early age.

Central Banks to Lawmakers: You Try Growing the Economy (WaPo)

Ylan Q. Mui reports that the general attitude coming out of the annual Jackson Hole gathering was that monetary policy can only do so much, and legislatures need to step it up.

Cities Can Ease Homelessness With Storage Units (City Lab)

Kriston Capps looks at an innovative program in San Diego that creates stability by providing homeless people with transitional storage where they can safely leave their belongings each day.

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Daily Digest - August 22: Sunshine the Cure for Tax Avoidance?

Aug 22, 2014Rachel Goldfarb

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Shareholders, Public Deserve Tax Transparency (WaPo)

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Shareholders, Public Deserve Tax Transparency (WaPo)

Catherine Rampell argues that requiring publicly traded companies to make their tax returns public would cause companies, over time, to invest fewer resources in tax avoidance.

Homeowner Help Remains Elusive in $16.5bn Bank of America Fine (The Guardian)

David Dayen says homeowners shouldn't count on relief from bank settlements: banks will choose to "pay" as much of the penalty as permitted without helping homeowners.

Injustice in Ferguson, Long Before Michael Brown (Bloomberg Businessweek)

Peter Coy looks at how the frequently racist origins of the St. Louis area's municipal fragmentation created the inequalities that people in Ferguson are protesting today.

How a Part-Time Pay Penalty Hits Working Mothers (NYT)

Claire Cain Miller looks at a new analysis from Harvard economist Claudia Goldin, which shows that across the board, working fewer hours leads to a lower wage in the same job.

Obama Alums Accused of Selling Out (MSNBC)

Many Democrats are particularly concerned by influential Obama campaign staff working in roles that are not supportive of unions, writes Alex Seitz-Ward.

Low-Paid Jobs Now Pay Even Worse Than Before The Recovery Began (ThinkProgress)

Bryce Covert writes that the worst of the declining wages lie in particular sectors like food service, home and care workers, and retail, which employ many low-wage workers.

New on Next New Deal

Campus Network Looks Ahead for Policy Engagement

Roosevelt Institute | Campus Network National Director Joelle Gamble considers the Network's nine years of successes, and lays out some of the goals for the year ahead.

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Daily Digest - August 21: Time to Consider the Mortgage Deduction?

Aug 21, 2014Rachel Goldfarb

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How a Widely Beloved Tax Deduction Really Just Benefits the Well-Off and Exacerbates Inequality (TAP)

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

How a Widely Beloved Tax Deduction Really Just Benefits the Well-Off and Exacerbates Inequality (TAP)

The mortgage interest deduction primarily benefits those who make at least $100,000 a year, and dwarfs funding for housing programs for the poor, writes Alex Ulam.

  • Roosevelt Take: In his latest white paper on tax reform, Roosevelt Institute Chief Economist Joseph Stiglitz suggests changes to the mortgage interest deduction that would make it more equitable.

What Would Real Economic Justice Look Like in Ferguson? (The Nation)

Michelle Chen reports on organized labor's involvement in Ferguson, MO, where a millennial labor group called Future Fighters is asking protesters want they want their community to look like.

Fed Dissenters Increasingly Vocal About Inflation Fears (NYT)

The newly released minutes from the Federal Reserve's July meeting show that some Fed officials feel the central bank has done all it can to improve the economy, writes Binyamin Appelbaum.

CEOs are Dumb When it Comes to This (MarketWatch)

Simon Constable reports on a new study that shows that stock option compensation isn't really considered in dollars: CEOs tend to get the same number of options regardless of the stock's value.

Why Bank of America Probably Won’t End Up Actually Paying US$17B in Mortgage Securities Settlement (Financial Post)

Consumer relief as negotiated in this settlement and others rarely cost the banks much at all, says Jeff Horwitz. But with few other sources of consumer relief, advocates welcome this one.

The Latest Attack on Labor, From The Group That Brought Us ‘Harris v. Quinn’ (In These Times)

Moshe Marvit explains the National Right to Work Committee's latest tactic, which aims to end exclusive representation in public sector unions and weaken collective bargaining.

New on Next New Deal

Mean and Lean Local Government

In his video speculation for the Next American Economy project, Stefaan Verlhurst, Co-Founder of GovLab, projects how municipal governments might shift tactics to take advantage of broader resources.

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Stefaan Verlhurst: Mean and Lean Local Government

Aug 21, 2014

The Next American Economy project brought together 30 experts from various disciplines to envision tomorrow's economic and political challenges and develop today's solutions. Their assignment: be bold, and leave the conventional wisdom -- and their own opinions -- behind. In today's video, Stefaan Verhulst of GovLab speculates on future municipal policy that allows cities to do more with less.

The Next American Economy project brought together 30 experts from various disciplines to envision tomorrow's economic and political challenges and develop today's solutions. Their assignment: be bold, and leave the conventional wisdom -- and their own opinions -- behind. In today's video, Stefaan Verhulst of GovLab speculates on future municipal policy that allows cities to do more with less.

Stefaan Verhulst, Co-Founder and Chief Research and Development Officer of GovLab, speculates on future municipal policy that allows cities to do more with less. Combining open-source data with crowd-sourcing networks, city government will be able to connect experts with public problems more efficiently. An enlightened municipal agenda can help battle the recent governance deficit and lack of government trust rising in the US, Stefaan said.

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Daily Digest - August 18: Looking for Strong Statements on Ferguson

Aug 18, 2014Rachel Goldfarb

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Did Obama’s Response to Ferguson Fall Short? (Melissa Harris-Perry)

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Did Obama’s Response to Ferguson Fall Short? (Melissa Harris-Perry)

Roosevelt Institute Fellow Dorian Warren questions why President Obama has avoided unequivocal language to condemn the police state in Ferguson. His segment begins at 6:40.

Why the Liberal Love for Rand Paul is Wrong (MSNBC)

Senator Paul blames big government for what he calls the "erosion" of Black civil liberties, but Dorian Warren counters that local governments do plenty to earn the distrust of the Black community.

Phony Capitalism (Harper's Magazine)

In this excerpt from his recent white paper, Roosevelt Institute Chief Economist Joseph Stiglitz suggests better tax policies could lead to a less economically stratified economy.

‘Slack’ in Job Market Hurts Wage Growth, Chicago Fed Paper Says (WSJ)

The paper notes that the slack labor market, with so many unemployed, has an even stronger impact on wage growth for those whose wages are already low, reports Pedro da Costa.

Paul Ryan’s Welfare Reform Ideas Are Even Worse Than You Think (The Nation)

Michelle Chen says that Ryan's proposal for welfare reform marks poor people as the problem in need of fixing, rather than the economic and social structures that hold up poverty.

20 Tax Dodgers: $240 Million for CEOs, Big Loss for the American People (The Fine Print)

Scott Klinger ties tax-deductible CEO pay to a USA Today list of companies that paid no federal income taxes last quarter, and says the combination highlights just how broken our tax system is today.

New on Next New Deal

Rioting Mainly for Fun and Profit: The Neoconservative Origins of Our Police Problem

Roosevelt Institute Fellow Mike Konczal ties increased use of police force to neoconservative notions of the "urban crisis" as a failure of liberalism to be targeted with harsh enforcement.

Suspensions are Keeping Students of Color from their Diplomas

Roosevelt Institute Summer Academy Fellow Bassem El Remesh argues that Minnesota needs to adopt stricter rules for when suspensions are permitted due to the impact on graduation rates.

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Daily Digest - August 8: The Man with the Misguided Anti-Poverty Plan

Aug 8, 2014Rachel Goldfarb

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Paul Ryan’s Magical Thinking (The Baffler)

Paul Ryan's belief that poverty is rooted in personal failure isn't the only problem with his anti-poverty plan, writes Ned Resnikoff. It's also impractical to implement and too easily abused.

Click here to subscribe to Roosevelt First, our weekday morning email featuring the Daily Digest.

Paul Ryan’s Magical Thinking (The Baffler)

Paul Ryan's belief that poverty is rooted in personal failure isn't the only problem with his anti-poverty plan, writes Ned Resnikoff. It's also impractical to implement and too easily abused.

An Interview With the President (The Economist)

While discussing corporate responsibility in this wide-ranging interview, President Obama points out that companies profess to care about social issues, but only lobby for their tax breaks.

Let's Do It! Let's Bring Back Earmarks! (HuffPo)

Ending earmarks has done nothing to reduce American cynicism about government's motives, and has contributed to congressional gridlock, writes Jason Linkins.

When U.S. Companies Skip the Country to Dodge Taxes, Their Shareholders Can Foot the Bill (Quartz)

Since shareholders are hit with a capital gains tax bill when companies use inversion (merging with a foreign company) to avoid taxes, Tim Fernholz says raising those rates could slow the problem.

These 7 Charts Show Why the Rent Is Too Damn High (MoJo)

Erika Eichelberger and AJ Vicens lay out the data explaining shifts in rental housing. They say that reducing government's role in housing finance could direct funds toward affordable rental housing.

New on Next New Deal

Without Public Investment, the U.S. Will Fall Into Chaos

In her video speculation for the Next American Economy project, Sarah Burd-Sharps, Co-Director of Measure for America, predicts that fiscal moderates will push public investment out of fear of a more costly future.

The Pragmatic Libertarian Case for a Basic Income Doesn't Add Up

Roosevelt Institute Fellow Mike Konczal says that Matt Zwolinski's case for a basic income guarantee makes faulty assumptions about what government is already providing through welfare.

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