Author: Warren Coats

I specialize in advising central banks on monetary policy and the development of the capacity to formulate and implement monetary policy.  I joined the International Monetary Fund in 1975 from which I retired in 2003 as Assistant Director of the Monetary and Financial Systems Department. While at the IMF I led or participated in missions to the central banks of over twenty countries (including Afghanistan, Bosnia, Croatia, Egypt, Iraq, Israel, Kazakhstan, Kenya, Kosovo, Kyrgystan, Moldova, Serbia, Turkey, West Bank and Gaza Strip, and Zimbabwe) and was seconded as a visiting economist to the Board of Governors of the Federal Reserve System (1979-80), and to the World Bank's World Development Report team in 1989.  After retirement from the IMF I was a member of the Board of the Cayman Islands Monetary Authority from 2003-10 and of the editorial board of the Cayman Financial Review from 2010-2017.  Prior to joining the IMF I was Assistant Prof of Economics at UVa from 1970-75.  I am currently a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  In March 2019 Central Banking Journal awarded me for my “Outstanding Contribution for Capacity Building.”  My recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. I have a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. My dissertation committee was chaired by Milton Friedman and included Robert J. Gordon. I live in National Landing Va 22202

The Egyptian Coup

Ousted Egyptian President Muhammad Morsi had been a miserable leader. He broke many promises starting with the Muslim Brotherhood’s promise not to run a candidate for President just yet and to lead an inclusive government. He forced through a new constitution without proper consultation or broad support, and failed to address Egypt’s many economy and political problems. He deserved to be replaced, but doing so by military coup seriously harms Egypt and the entire Middle East in several ways. The failure of the Obama administration to acknowledge the act as a coup deprives the English language of any meaning.

Obviously it is a set back for democracy. Morsi’s growing opposition should have organized to defeat him in the next election. Given his miserable performance it shouldn’t have been difficult. That would have strengthened democracy rather than weakened it.  One coup begets another until a leader can coop the military.

The more serious harm is to the social and political conditions needed for diverse people (Muslims, Christians, secularists, Jews) to live peacefully together. What, pray tell, do the secularists and military think the Brotherhood and their supporters will do after being removed from their elected positions and arrested? Go sulk in the Old Cataract in Aswan (of which I have very fond memories)? There is a high probability that they will resort to violence. As the Army kills more and more demonstrating Morsi supporters, the prospects of an insurgency increase rapidly, as occurred in Iraq and so many other places.

It has already started. In Egypt’s Sinai Peninsula: “The rapid thud of machine-gun fire and the explosions of rocket-propelled grenades have begun to shatter the silence of the desert days and nights here with startling regularity, as militants assault the military and police forces stationed across this volatile territory that borders Israel and the Gaza Strip.” (The Washington Post, July 29, 2013, page 1) Hundreds have already been kill by the military or insurgents and the violence is growing rapidly. How could it be otherwise?

And it is spreading. Tunis has been the most promising model of transition to democracy. Following the assassination of two opposition leaders in Tunis, mass demonstrations have escalated into terrorist attacks that killed eight Tunisian solders Monday. President Moncef Marzouki, Tunisia’s moderate Islamist president, stated in a television address that “In all countries of the world, when the state faces a terrorist attack people come together. But I don’t see anything like that happening in Tunisia. All we see is divisions and chaos.”

U.S. law requires the administration to cut off aid to governments that came to power by coups. This is clearly the case in Egypt and aid should be immediately suspended. For decades U.S. aid to Egypt has ranged between 1.5 and 2 billion dollars per year, over 80% of which is to the military. Congress would surely quickly suspend this provision for Egypt but should attach conditions for any resumption of aid. These conditions should call for restraint on the part of the military, free and open public debate, quick elections, and broad participation in the redrafting of the constitution.

The already troubled Arab Spring has had a series set back.

Trayvon Martin and George Zimmerman Tragedy Update

Over a year ago I expressed confidence that our judicial process and public good will would clarify the facts of the tragic shooting death of Trayvon Martin by George Zimmerman:  https://wcoats.wordpress.com/2012/04/01/the-trayvan-martin-tragedy/. Indeed, after carefully listening to and weighing the evidence presented to it the six women jury rendered its unanimous verdict a week ago that Zimmerman had lawfully, but no less tragically, shot and killed Martin in self-defense and was therefore not guilty of the charges against him. At the time a year ago, the failure of local Florida law enforcement officials to arrest Zimmerman, a neighborhood watch volunteer, seemed to me and many others a potentially racially tinged judgment. I supported the call for his arrest. Once all of the obtainable facts had been presented and evaluated by the Jury that earlier decision turned out to be a sound professional judgment by the police. But I still think it was desirable to go through the process of this trial.

I did not follow the trial closely but have no reason to question the judgment of the jury. The utterly disgraceful misreporting and doctoring of the conversation between Zimmerman and the 911 dispatcher aired by NBC made it seem that Zimmerman might be racist in his reaction to Martin (a claim no one made during the trial because there is apparently no basis for it) tarnishing the professionalism of at least NBC. https://wcoats.wordpress.com/2012/04/03/the-trayvon-martin-tragedy-continues/.  Sadly the press has continued to reproduce the young, handsome picture of Martin and the thuggish picture of Zimmerman long after more neutral pictures became available.

The slanted reporting of the press is nothing, however, compared to the highly inappropriate statements from our increasingly discredited Attorney General, who suggested that the federal government was investigation the possibility of trying Zimmerman for civil rights violations for which no evidence was introduced in the just finished trail. But my heart stopped when President Obama chimed in that “Trayvon Martin could have been me 35 years ago.” How could the President of the United States join the cheap political babbling of Attorney General Holder? And thus I started this blog.

This is an example of how fragments out of context can be totally misleading. The President’s full statement yesterday, when he joined the White House press briefing unannounced, was quite the opposite of my impression from the news headline. President Obama has disappointed me on many things (promoting bigger government generally, higher taxes, expanding snooping on Americans, drone assassinations of Americans without trial, and poor leadership in general), but I have always found him an honest and thoughtful commenter on race issues. His statements yesterday were no exception. Zimmerman’s trial produced no evidence of racism in anything that happened that tragic night in Florida, but the President rightly noted that each of us carries impressions (“priors”), often from personal experience, that frame our views of the world and events and that it is better that we acknowledge them and open ourselves to an examination of the role they play in our everyday judgments. This was exactly the point I was trying to make a year ago, though Obama said it better. The President is right on this issue and an excessive political correctness has stifled this discussion for too long.

Government Surveillance and the Right to Privacy

We will be discussing Edward Snowden and his revelations for some time (I hope).  His observations are worth serious thought. As quoted in the Washington Post by Barton Gellman “Man who leaked NSA secrets steps forward” /2013/06/09  ‘“I believe that at this point in history, the greatest danger to our freedom and way of life comes from the reasonable fear of omniscient State powers kept in check by nothing more than policy documents.” The steady expansion of surveillance powers, he wrote, is “such a direct threat to democratic governance that I have risked my life and family for it….” “We managed to survive greater threats in our history . . . than a few disorganized terrorist groups and rogue states without resorting to these sorts of programs,” he wrote. “It is not that I do not value intelligence, but that I oppose . . . omniscient, automatic, mass surveillance. . . . That seems to me a greater threat to the institutions of free society than missed intelligence reports, and unworthy of the costs…”  “Analysts (and government in general) aren’t bad guys, and they don’t want to think of themselves as such,” he replied. But he said they labored under a false premise that “if a surveillance program produces information of value, it legitimizes it. . . . In one step, we’ve managed to justify the operation of the Panopticon” — an 18th-century design by British philosopher Jeremy Bentham for comprehensive surveillance of a prison population.”’

It is not generally acceptable for individuals to decide whether it is OK to violate a law we don’t like (though we all do it all the time), but there can be circumstances that are sufficiently serious that our conscience may dictate that we must.  Snowden made that determination and is prepared to accept the consequences. The courts will determine what those are. In my opinion his motives are above question.

I hope, however, as does Snowden, that the public discussion will focus on the issue of the proper balance between government’s desire to protect us from harm and invading our privacy, a favorite tool of totalitarian regimes, rather than on whether Snowden was justified in breaching his confidentiality commitment or not. The very nature of government is that of a slippery slope toward ever larger activities and powers. These risks, of course. were very well-known by our founding fathers who did their best to introduce limits and checks and balances on government power.

Sir Tim Berners-Lee, inventor of the World Wide Web, called PRISM “deeply concerning,” stating that: “Unwarranted government surveillance is an intrusion on basic human rights that threatens the very foundations of a democratic society. I call on all Web users to demand better legal protection and due process safeguards for the privacy of their online communications, including their right to be informed when someone requests or stores their data. A store of this information about each person is a huge liability: Whom would you trust to decide when to access it, or even to keep it secure?”

Contrary to his promises, President Obama has not reversed the dangerous excesses of the eternal War on Terror and other political abuses promoted by Bush/Chaney. Examples are the IRS anti-tea party abuses, and the administration’s frightening attack on the press: “The Justice Department secretly obtained two months of telephone records of reporters and editors for The Associated Press.” govt-obtains-wide-ap-phone-records-probe. But these pale compared to Obama’s expansion of our secret, undeclared wars in Somalia and Yemen and elsewhere in the form of assassinations of “bad guys.”

The most deeply disturbing of these was the assassination of Anwar al Awlaki, an American citizen who had lost faith in the intentions behind the American government’s attacks on Muslims around the world. Anwar, an initially moderate Muslim Imam,frequently interviewed by the American press following 9/11, ultimately became sharply critical of U.S. behavior and moved from Falls Church Va. back to his native Yemen to rejoin his parents. U.S. authorities came to believe that his blogs and sermons were influencing others to take violent acts against Americans. President Obama authorized his death without formal charges and without any convincing evidence of crimes other than the exercise of his free speech, which had become embarrassingly critical (and is not yet a crime). Our government claimed that he had become an al Qaeda leader but presented no evidence of any connection at all.

The day Awlaki’s death was announced  (September 30, 2011) syndicated columnist Glenn Greenwald stated: “Remember that there was great controversy that George Bush asserted the power simply to detain American citizens without due process or simply to eavesdrop on their conversation without warrant. Here you have something much more severe. Not eavesdropping on American citizens, not detaining them without due process, but killing them without due process.” Former Bush CIA director Michael Hayden stated: “We needed a court order to eavesdrop on [Awlaki], but we didn’t need a court order to kill him. Isn’t that something?” (Both of these quotes are taken from Jeremy Scahill’s shocking book “Dirty Wars; The World is a Battlefield”)

If you are not alarmed by our President ordering the death of Americans without due process, you will surely be sicken that our secretive special forces killed Awlaki’s 16 year old son Abdulrahman two weeks later. The government has never explained whether his death was another of their many accidents or had been deliberate and if so why. He was also an American, born in Denver Colorado on August 26, 1995 (https://www.facebook.com/abdulrahman.14.10.2011). Soon thereafter Robert Gibbs, Obama’s former White House press secretary, was asked: ‘“It’s an American citizen that is being targeted without due process of law, without trial. And, he’s underage. He’s a minor,” reporter Sierra Adamson told Gibbs. Gibbs shot back: “I would suggest that you should have a far more responsible father if they are truly concerned about the well-being of their children. I don’t think becoming an al Qaeda jihadist terrorist is the best way to go about doing your business.”’ (Dirty Wars)  Gibbs should be publicly whipped (if we did that sort of thing) or at least banished from polite society. How disgusting.

I am proud of the principles of individual dignity and rights upon which my country is based. I am proud of what many of my countrymen have accomplished and contributed to the world. I am tired of being ashamed of many of the self-destructive things my government has increasingly been doing in the misguided name of my security.  Why do you think Muslims in Yemen, Somalia, Iraq, Afghanistan, Saudi Arabia and elsewhere wish to attack the United States rather than (or in addition to) fighting each other for one reason or another? Because many of them have been killed or injured by our global campaign of assassinations and/or outright wars, which they see as an American attack on Islam. They are fighting to defend themselves just as we would (or say that we are). We need to leave them alone. They will have no interest in attacking us if we stay out of their homelands.

I am hoping the current revelations of some of our government’s abuses of its powers and our liberties will bring them to an end.  It is, as I have noted so many times before, the nature of government to want to grow in scope and power. As we all know, eternal vigilance is the price of liberty. The pendulum of potentially coercive government power has swung too far in the false name of defending our safety against foreign (and now domestic) enemies. I hope that the current revelations will shock us into sending the pendulum back the other way.

Several weeks ago, on Memorial Day, my friend Lou Cordia sent the following from President Reagan’s Memorial Day Proclamation for May 25, 1981 as a reminder of what we properly aspire to:

Over one hundred years ago, Memorial Day was established to commemorate those who died in the defense of our national ideals. Our ideals of freedom, justice, and equal rights for all have been challenged many times since then, and thousands of Americans have given their lives in many parts of the world to secure those same ideals and insure for their children a lasting peace. Their sacrifice demands that we, the living, continue to promote the cause of peace and the ideals for which they so valiantly gave of themselves.

Today, the United States stands as a beacon of liberty and democratic strength before the community of nations. We are resolved to stand firm against those who would destroy the freedoms we cherish. We are determined to achieve an enduring peace — a peace with liberty and with honor. This determination, this resolve, is the highest tribute we can pay to the many who have fallen in the service of our Nation.

Life and Death in Boston

We will all die and can hope that our passing and the passing of our loved ones will be peaceful and painless. It is sad when anyone dies prematurely. It is very disturbing when someone’s death is the result of a deliberate act. And is seems worse yet, when the targets of murder are random. How should we react to each of these?

I am struck by how differently we have reacted to the terrorist attack at the Boston Marathon that killed (initially) 3 innocent soles and injured over 180, the Texas fertilizer plant blast two days later that killed 14 (at the time of this writing) and injured about 200, and the 88 deaths on American highways on average every day (down from the high of 150 per day in 1972). No one would think to propose closing all of the highways, yet much of the area around Boston and Cambridge has been locked down (a term I know very well from my many trips to Iraq and Afghanistan) for over a day.

There is of course an important difference between the dangers of driving and a 19-year-old killer on the loose. However, Ed Crane’s comment (in a private email) introduces what I wish to reflect on: “Since when does the government shut down half of Massachusetts (stay in your house!) to catch one 19-yr-old?  If everyone in Boston had a gun there would be no shut down.  Just a dead 19-yr-old.” Ed is the founder and until last month the President of the Cato Institute here in Washington D.C.

Where it is possible and/or necessary to take precautionary measures to protect the public safety, it is prudent to do so. However, zero risk is not the standard we live by or automobiles and much else would be banned. Were we safer or did we feel safer a few years ago when signs and laud speakers kept announce that the city was code orange so be on alert?  At best such measures were silly and at worst they were part of a pernicious campaign to make us all feel more dependent on the government.

Public safety is a legitimate concern, but needs to be pursued sensibly. But what about the impact of our reactions on those wishing to terrorize us? We do not yet know what motivated the Chechnyan brothers Tamerlan, 26, and Dzhokhar, 19, Tsarnaev to blow up some joggers. Young Dzhokhar lived in the United States most of his life. What was his point? If it was to terrorize us, for whatever reason, our reactions have fulfilled that goal beyond his wildest dreams.

This brings to mind another recent case where our reaction to intimidation has surely rewarded the intimidator, another near child, beyond any reasonable expectation. I am speaking of (probably) 29 year old man child Kim Jong Un, the ruler of North Korea.  It is only prudent for the U.S. government to take defensive measures in response to the daily threats coming from young Kim. But why reward his behavior so loudly with such importance and publicity.

Consider the comments by Professor Andrei Lankov from Seoul’s Kookmin University: “The North Koreans are very, very rational. … Why do the foreign media, why do people overseas consider Kim Jong Un to be suicidal? … If he attacks he will be dead in 10 or 15 minutes and he knows it perfectly well. He is not suicidal. He is a young boy who is madly in love with his wife, who loves fast cars and a slice of pizza. And the people around him are not suicidal. They are hard-nosed, cynical Machiavellians who survived decades in the cutthroat world of a Stalinist palace. … They are not ideological zealots. They are just brilliant manipulators.” “Threats and crises are just normal North Korean diplomacy”

I am not suggesting that it is easy or obvious what measures should be taken to keep the risks of living in balance with its joys. But life has always been a risky undertaking. If our big brother government insists on trying to reduce its risks to near zero, which is not possible anyway, it will not be worth living.

Printing Money

Isn’t that just printing money?  Here is a quick, and hopefully simple, primer on what central banks do.

Central banks print money. They are responsible for issuing a country’s legal tender (banknotes and bank deposits with the central bank) and regulating its value. Most of what we call money is actually privately produced (deposits at commercial banks, credit and debit cards, paypal, etc.) but tied to the money printed by each country’s central bank by the public’s demand that it be redeemable for the central bank’s money. There are a few exceptions to this demand by the market, such as bitcoin (see: the-rise-of-the-bitcoin-virtual-gold-or-cyber-bubble), but they shall ever remain unimportant fads. There is never a question about whether central banks print monetary or not. It is their responsibility to do so. This is as true for a pure gold standard or other fixed exchange rate monetary regimes, as for the variety of fiat money regimes (from monetary targets to inflation targets to flying by the seat of their pants day-to-day).

The important and proper question about a central bank’s behavior is what guides its decisions about when and how much money to print. A secondary question is what does it buy when it issues money (there are no helicopters that drop it from the sky)?

The gold standard: Under a gold standard the central bank buys gold with the money it prints and is legally bound to buy that money back with gold at the same price whenever anyone holding its money wants to redeem it. While this is still printing money, the supply is determined by the preferences of the market (each and every one of us) to hold and use that money. Such central banks have no monetary “policy” in the usual sense. They passively supply whatever amount of money the public demands.

Fiat money: If the central bank issues money with no obligation to redeem it for anything in particular nor at a particular price, its value is determined in the market by its supply and demand. The amount supplied by the central bank relative to the market’s demand for it will determine is value (the price level). Monetary policy consists of the decisions made by central banks that determine the amount of the money they supply and manner in which they supply it.

The public’s demand for money reflects its convenience for making payments, its expected value when exchanged for goods and services, and the opportunity cost of holding it (inventory costs, i.e., the interest rate that could have been earned on holding wealth in other forms). Rapidly changing payment technology (debit/credit cards, Paypal, e-money, etc.) has a profound impact on this demand. There is a vast academic literature on this subject. Unlike any other good or service money’s value derives solely from what it can be exchanged for or more specifically from the economy it brings to exchange/trade.  Fiat currency is always useable and thus “redeemable” for the payment of taxes and other obligations to the government that issued it. These obligations are denominated (valued) in the same units as the currency. These guaranteed uses of fiat money anchor its demand and thus value in the same way that the demand for gold for jewelry and other non-monetary uses anchors its value. Bitcoin has no alternative use and thus has no anchor to its value.

Central banks have learned the value of establishing clear rules for issuing money, such as targeting the rate at which the money supply (by one definition or another) grows, or targeting nominal income, or inflation. These rules guide how much money they “print.” They also influence the public’s demand for money by informing its expectations of the central banks actions. The policy regime adopted—rule—determines the behavior of the money supply and thus its value (or visa versa). The supply of bitcoin also follows a well-defined rule, but its demand is unanchored. The fact that the central bank is printing money is irrelevant by itself.

A secondary consideration is what it is that the central bank buys with the money it prints. Under a gold standard it buys gold. Under a fiat money standard central banks generally buy government securities because these securities are generally of unquestioned safety and in most countries have the deepest and most liquid secondary markets. Central banks also traditionally adhere to a “bills only” policy, i.e., they buy short-term government security, in order not to interfere with the market’s determination of the term structure of interest rates, i.e. the relationship of interest rates on securities with longer maturities relative to those with shorter maturities. In a free market, rates on longer maturities are determined by the expected value of overnight rates over the period in question plus a risk premium for the uncertainty over the behavior of overnight rates.

Whatever the ultimate or intermediate targets of monetary policy, most central banks in recent decades have pursued them by targeting a short-term interest rate, their so-called “operating target.” The Federal Reserve targets the overnight interbank rate, the so-called “federal funds rate,” as its approach to targeting the money supply, nominal income, or inflation. Given all other market factors, a particular fed funds rate target will result from and result in a particular rate of growth in the money supply.

Because most money and related means of payment are privately produced by banks or is ultimately settled through banks, and because banks only keep a small amount of the money produced by their central banks for which bank deposits are redeemable (the so-called “fractional reserve banking system”), central banks have also been given the role of insuring that banks have sufficient liquidity to function smoothly. They are mandated to lend to solvent but illiquid banks when banks need to convert loans into cash to accommodate deposit withdrawals (the so-called “lender of last resort” function).

As more and more central banks successfully adopted the techniques of inflation targeting and most of the rest fixed the exchange rate of their currencies to an inflation targeting currencies such as the U.S. dollar or the Euro, the world entered a long period dubbed “the great moderation.” However, the long period of very low interest rates following the bursting of the “dot com” bubble produced the housing price bubble in many locations in the U.S. and Europe. Its collapse in 2007-8 plunged much of the Western world into the long, Great Contraction.

Monetary Policy Plus (MP+):  In the last few years the Federal Reserve, the European Central Bank (ECB) and other central banks have undertaken many non-traditional actions in an effort to help lift their respective economies out of recession. In the early days of the serious liquidity crunch following the collapse of Lehman Brothers in September 2008, the Fed, ECB, Bank of England and a few other central banks very successfully pumped needed liquidity into their financial systems by expanding the number of counterparties they would lend to, increasing the eligible collateral, and entering into currency swap arrangements to supply dollar liquidity to foreign banks.

However, after unblocking the flow of funds between banks and other financial firms, the Fed’s concern shifted to fighting deflation, then to reviving economic activity. After driving its operating target to almost zero, the Fed continued increasing monetary growth beyond the rate resulting from a zero fed funds target and dubbed it quantitative easing. However, the channels through which monetary policy is traditionally transmitted to the economy (interest rate, credit, asset price, portfolio/wealth effects, exchange rate channels) seemed ineffective. Thus, the Fed began to purchase non-traditional, financial instruments, such as Mortgage Backed Securities (MBSs) and longer-term government securities, in an effort to keep mortgage interest rates low and to encourage the flow of funds into the mortgage market and stimulating investment more generally. These quasi-fiscal policy measures do not square easily with the Fed’s legal mandates of price stability and employment.

With the Fed’s third program of quantitative easing it is now pushing on a string  (QE3: http://works.bepress.com/warren_coats/28/). It is attempting to stimulate an economy that lacks a clear policy environment that would encourage more investment rather than one suffering from inadequate liquidity. While market measures of inflation expectations remain very low, long periods of very low interest rates influence the capitalized value of income streams. A given monthly mortgage payment will purchase a more expensive house when interest rates are lower. What people and firms invest in is distorted toward more capital-intensive projects than are economically efficient and justified at normal rates of interest.  Pension funds and other endowments lose income that must be made up somehow (often by moving into riskier investments). Asset price bubbles emerge. On top of these economic risks, the Fed’s need to unwind its huge portfolio of securities (purchased by printing money) when the economy recovers more fully is becoming more and more challenging.

Moreover, the policies of one central bank can affect the exchange rate of its currency if its policies are not coordinated with those of other central banks. This can either improve or worsen the balance of payments between countries (balance of imports and exports). The very wide swings over the last decade in the exchange rate of the US dollar with the Euro, for example, cannot be justified by economic fundamentals and is very disruptive to trade and international capital movements. Recent monetary policy initiatives by the Bank of Japan raise such concerns.

In short, the problem is not that the Fed and other central banks are printing money. The problem is the amount they print and their conceit that they can do more to help the real economy than they really can, thus adding to the market’s uncertainty over the economic, policy, and financial environment in which their decisions to spend and invest must be made. The solution is to reestablish a hard anchor for monetary policy that allows the supply of money to be market determined (as proposed in my: Real SDR Currency Board, paper).

The fantasy of a purely private money that would overcome the weaknesses of government money, remains for the foreseeable future a utopian fantasy: “The Future of Money”. But those of you who enjoy fantasy, might enjoy the following story by Neal Stephenson: “The Great Simoleon Caper”.

Cyprus: Bailing in and capital controls

Three European countries with oversized banking sectors have suffered major bank failures. Two of them are in the Euro Zone (Ireland and Cyprus) and one has its own currency (Iceland). Iceland and Cyprus imposed temporary capital controls, while Ireland did not. Iceland imposed losses on the foreign depositors in its large, failed banks while Ireland, under EU pressure bailed out everyone (even bond holders) except the shareholders.

The jargon used to describe much of this—“bail outs,” “bail ins,” “haircuts,” “good bank bad bank splits,” etc.—can be confusing. In this note I attempt to clarify the key concepts and their importance via the examples of Iceland, Ireland and Cyprus.

Market discipline vs. supervision and regulation

Incentives always matter. Banks, like any other business, are in business to make money. But the amount of risk they take (more risk more return—ON AVERAGE) depends on who regulates their behavior. Fundamentally, the market can regulate bank risk taking—by the willingness of investors to lend to banks and of depositors to place their money there—or the government can.

The last century has seen a steady shift away from market regulation toward government regulation. Deposit insurance is an important factor contributing to that shift by removing any concern by smaller depositors of the condition of their bank. Thus deposit insurance requires a substitution of the due diligence that used to be performed by small depositors with increased government regulation of bank risk taking. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides much of that supervision and regulation.

However, increasingly countries became unwilling to allow banks to fail. While shareholders might be wiped out when a bank became insolvent (i.e., when the value of its assets fell below that of its deposits and other liabilities), country after country have “bailed out” all other bank creditors, including uninsured depositors. Bailing out depositors and other creditors means giving taxpayers’ money to the bank to make up for its losses and thus cover its liabilities (other than shareholders).  For large, “systemically important” banks (meaning banks whose failure could cause fatal losses in other banks or firms), most countries are not willing to let them fail at all, thus bailing out shareholders as well in order to allow the banks to continue to operate. Hence the problem of banks that are “too big to fail.” Bailing out uninsured depositors made deposit insurance redundant and pointless. Market discipline was pushed aside all together. The safety and soundness of banks came to rest almost completely on the adequacy of regulations and the skills of supervisors. Bank owners, the only ones who care any more, now have a financial incentive to take big risks for potential big gains. If they lose, as they do from time to time, the government, i.e., tax payer, will pick up the bill.

It is desirable to shift more of the discipline of bank risk taking back to the market by convincingly putting bondholders and large, uninsured depositors at risk of loss if their bank becomes insolvent. They have a financial incentive to get it right that supervisors do not.

Resolution of insolvent banks

Best practice when a bank becomes insolvent is to resolve it quickly and fully and to put a large part of the cost of its losses on uninsured creditors (shareholders, bond holders and uninsured depositors in that order).  Normal company bankruptcy can take the form of shutting down, locking the doors, and selling off anything of value (normally taking a few years) and distributing the proceeds to the creditors in the order of the legal priority of their claims. It is a transparent and objective, but slow process. In many instances the highest value for a failing company is obtained by selling it whole or in part to another company that is able to run it more efficiently. The recent bankruptcy of Sara Lee and sale of its best products to other companies is an example.

The bankruptcy and resolution of an insolvent bank is more challenging because of the ease with which depositors can run when they sense trouble. Thus the weekend sale of such banks in whole or in part to another bank is the norm for small or medium-sized banks in the U.S.  The good bank bad bank split, as occurred recently in Cyprus, is a recent example. Laiki became the bad bank that was closed and is being liquidated and the Bank of Cyprus became the good bank. After wiping out its shareholders and bondholders and administering a large haircut to the uninsured depositors, it acquired the insured deposits of Laiki and an equivalent value of good Laiki assets. Such bank resolutions, which freeze depositors’ funds only for very short periods (a few days), require special bankruptcy laws for tailored for banks. As the surviving good bank must continue to operate with little to no interruption, more judgment and uncertainty is involved in valuing the assets that it acquires from the bad bank.

It is instructive to look more closely at the resolution process used in Cyprus. First, the two major banks in Cyprus, Laiki and Bank of Cyprus, incurred large losses on their holdings of Greek sovereign debt when all banks were required to “voluntarily” write off about 75% of its value. The magnitude of this loss was clear and well-known from October 2011. The only issue was who would pay for it, the Cypriot government, the EU, or the creditors (depositors) of these banks. Depositor’s obviously thought that they would be bailed out (i.e. that the Cypriot government or the EU would pay for the losses of Laiki and Bank of Cyprus) as had been all depositors in Europe before them, though the deposit liabilities of the Bank of Cyprus fell from 37.1 billion Euros at the end of 2010 to 32.1 billion at the end of 2011 to 28 billion at the end of September 2012 (the latest available).

After a terrible false start in which the Cyprus government attempted to pay for the losses by levying a wealth tax on all depositors (of good and bad banks), Cyprus choose to impose the entire loss on the respective banks’ owners and creditors, and to undertake the good bank bad bank split briefly described above (see my earlier blog on the subject: https://wcoats.wordpress.com/2013/03/27/the-cyprus-game-changer/). This was a dramatic change in approach that shifted the risk of bank behavior back to uninsured depositors. Many were shocked.

This approach is relatively easy for known losses and should have been undertaken a year and a half earlier when the Greek debt write off occurred. But many of the losses a bank has or is incurring are less clear. Of the currently delinquent mortgage loans, for example, how many will actually default and what will be the market value of the mortgage collateral. The recapitalization of insolvent Irish banks suffered from underestimation of the ultimate losses resulting in three separate injections of state money to recapitalize them, which weakened market confidence in the process. In part to deal with this uncertainty but to restore market confidence in the solvency of the surviving good bank (Bank of Cyprus), known losses were totally written off while the additional but uncertain further losses were covered by replacing an equivalent amount of deposits with equity claims on the BOC (shares). If losses turn out to be smaller than was provided for, these claims will have value and will thus reduce the size of the initial haircuts to deposits.

So “bailing out” a bank refers to covering its losses with someone else’s money (tax payers somewhere) and “bailing in” a bank’s creditors refers to covering its losses (after its capital is used up) with bondholders and uninsured depositors’ money via “haircuts” (writing off part of their value). The former “socializes” losses while leaving any gains from successful bets to the private owners and creates a serious moral hazard leading to excessive risk taking by banks. The latter makes depositors financially responsible for excessive bank losses and restores the market’s discipline of bank risk taking. This is very desirable as market discipline is more effective than regulatory discipline, but the dramatic change in the implicit rules in Cyprus was very large and abrupt.

Capital controls

As part of their respective bank resolutions, both Iceland and Cyprus imposed temporary capital controls, which, however, served very different purposes. Iceland has its own currency while Cyprus is part of the Euro zone.

At the time of Iceland’s banking crisis in 2008 its three largest banks had assets 11 times the total annual output of the economy. About half of their assets (largely loans) and their funding were outside of Iceland. Landsbanki, for example, funding its lending with roughly the same amount of borrowing and deposits (a highly risky strategy). When the borrowed funding of these three banks dried up, their size made it impossible for the Icelandic Central Bank (ICB) to provide their needed liquidity (much of which was in the Euro, a foreign currency), resulting in the failure of all three banks in the second week of October 2008.

Iceland honored all insured deposits domestically and abroad but moved all domestic deposits into newly established “good” banks from the three now bad banks, while leaving their overseas, uninsured deposits in these three banks in receivership. To the extent that these banks failed because of illiquidity (the cut off of their borrowed funding), the receivership should be able to recover all losses to depositors from the liquidation of the banks’ remaining assets.

The UK and Netherland’s objected to the unequal treatment of the uninsured deposits of Icelanders and of foreigners. While Iceland’s decision to bail out all of its domestic depositors may be questioned because of the moral hazard it perpetuated, they had no legal obligation to do the same for Euro deposits by foreigners. The UK and the Netherlands stepped in and followed the same policy adopted by Iceland by guaranteeing the deposits of their citizens. They then tried to collect the cost of these guarantees from Iceland, a very questionable claim.

As the three new “good” banks were fully capitalized, they should have been able to withstand any level of deposit withdrawal as long as the ICB was able to provide any liquidity needed against the good but illiquid assets of these banks. The return of depositor confidence to the banks invariably takes time and some depositors wanted to withdraw their funds. However, because Iceland has its own currency, nervous Icelandic depositors wanting to move their bank deposits abroad, would need first to convert them into Euros or U.S. dollars, which would have depreciated the international value (exchange rate) of the Icelandic króna, and depleted ICB’s international reserves. A depreciation of the króna would raise the cost of imports and reduce the standard of living in Iceland. To protect the exchange rate from excessive devaluation, the ICB imposed temporary limits on the amount of money its residents could move out of the country. These capital controls are still in effect.

Lucky Cyprus is in the Euro zone.  After recapitalizing its banks, in part by writing down their deposit liabilities, they should have sufficient assets to cover all of their deposit liabilities and thus to cover any deposit withdrawals. The only issue would be whether the BOC’s assets were sufficiently liquid to cover the withdrawals. Within the Euro zone payments outside the country are made via the Target Payment System. A transfer of deposits from the BOC in Cyprus to a bank in any other Euro zone country is made by debiting the BOC’s clearing balance with the Central Bank of Cyprus (CBC) and crediting the recipient bank’s clearing account with its central bank via Target. If the BOC does not have sufficient funds in its clearing account with the CBC and is unable to sell sufficient assets to increase that balance, it can borrow the funds from the CBC using its good but illiquid assets as collateral. The CBC is able to do the same by borrowing from the European Central Bank (ECB), which is prepared to lend unlimited amounts against good collateral now that Cyprus has undertaken the measures required for the troika’s financial support (i.e., from the EU/ECB/IMF). There is no exchange rate issue or concern. It is purely a matter of the solvency and liquidity of Cypriot banks.

However, establishing sufficient liquidity to fund large deposit withdrawals may take a few weeks or months and thus Cyprus has imposed temporary capital controls that limit the amount of money that may be withdrawn each day as cash or by transfer. If the arrangements enjoy sufficient public confidence in the soundness and viability of the surviving Bank of Cyprus, the deposit withdrawals should be modest. The period of limits on withdrawals should be measured in weeks rather than months or years.

Conclusion

The resolution of Cyprus’s insolvent banks ultimately, after a false start, was achieved by bailing in its creditors. The resolution was relatively quick and seems complete. While Cyprus’s economy is likely to suffer its abrupt adjustment for some time, its banks should now be sound. The dramatic shift of the responsibility of regulating the risk taking of banks to their uninsured depositors, should, if it is maintained throughout Europe despite nervous claims that it is one-off and not a model, restrain excessive risk taking by banks and lead over time to a stronger banking system. In the interim, there may be some disruptive deposit shifts as previously reckless banks are forced by the market to clean up their acts.

The Cyprus Game Changer

Early banks were established by wealthy men that depositors could trust to return their money when they wanted it. Bank owners had unlimited liability for the trust placed in them. Any losses that exceeded what the bank owed its creditors (primarily depositors) had to be made up from the personal wealth of their owners.

With the introduction of limited liability banks, bank owners invested in significant amounts of capital (the difference between the value of the bank’s assets and liabilities) to reassure depositors that the bank was safe. They also advertised the conservatism with which they lent and invested depositor money. Some countries granted bank owners a liability limited to double the capital they paid into the bank in order to increase depositor protection without tying as much money up in capital.  In the much of the nineteenth century in the United States banks held capital well above 50% of their loans.

These early experiences with banking without any deposit insurance or any expectation by depositors that someone would bail them out (repay their deposits) if the bank failed (failure was the result of the bank not having enough money to repay depositors), maximized the market’s discipline of bank risk taking. Depositors paid close attention to the safety and soundness of the bank they put their money in.

During the great depression, the U.S. and most other countries introduced limited deposit insurance for small depositors thought to be too unsophisticated to evaluate the soundness of their banks. Such deposit insurance pretty much eliminated bank runs by panicked depositors. The level of deposits covered by insurance has risen considerably in most places (in the U.S. it is $250,000 and in Europe €100,000) thus reducing market discipline to some degree.

But outside of the United States, where the Federal Deposit Insurance Corporation (FDIC) has broad intervention and resolution powers to take over insolvent banks and to keep them going (if that is the least cost resolution) by reducing shareholder, bondholder, and uninsured depositor claims, almost no country allows its banks to fail (though this has begun to change in the last decade or two). If a bank experienced large enough losses that it became unable to pay off its depositors (i.e. became insolvent), governments would almost always bail it out one way or another. Depositors never lost anything. This practice and the market expectation it created made a joke of limited deposit insurance (because ALL deposits were implicitly guaranteed) and significantly reduced market discipline of bank behavior. This required more active supervision and regulation of banks to take the place of market regulation.

After a very bad start in Cyprus last week (see my blog from last week: https://wcoats.wordpress.com/2013/03/23/cyprus-and-the-euro/) the resolution of Cyprus’ two largest banks, Cyprus Popular Bank and the Bank of Cyprus, is taking the form intended by the banking law. Rather than bailing out the bank (the Cyprus government doesn’t have the money to do so, hence its need to turn to external help –EU/IMF/ECB and to accept the conditions attached), the shareholders, bondholders, and uninsured depositors (in that order) are being bailed in to cover the losses. The insured deposits of the Cyprus Popular Bank, aka Laiki, will be transferred to the Bank of Cyprus along with good assets of equivalent value. Laiki, the “bad bank”, will be put into receivership and its uninsured depositors will receive whatever value can be realized from the sale of its remaining assets (they are expected to lose about 80% of the value of their deposits). The Bank of Cyprus, the “good bank”, will continue to operate but will be recapitalized by wiping out the shareholders, bondholders and about 40% of the value of uninsured deposits. Depositor risk and the market discipline it provides to banks has returned with a vengeance. Hopefully this will be the practice throughout Europe going forward, which could then stop ignoring its no bailout rule.

In a Financial Times interview Jeroen Dijsselbloem, the Dutch finance minister and Eurogroup chairman stated that: “If we want to have a healthy, sound financial sector, the only way is to say, ‘Look, where you take the risks, you must deal with them, and if you can’t deal with them you shouldn’t have taken them on….’ That’s an approach that I think we, now that we are out of the heat of the crisis, should consequently take.”

This is a very promising change in European attitudes. Sadly it shocked so many EU officials that Mr. Dijsselbloem had to back track by saying: “Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday. Macro-economic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.” (quoted in the March 26 WSJ “Shocked about Cyprus”) The big unknown is whether this was too rapid a restoration of market discipline. Changing the rules is always problematic and government explanations to their publics of the situation and their policies for dealing with it have been poor to date. The coming days will be interesting indeed.

Cyprus and the Euro

Does the Euro need to be supported by closer European fiscal integration? Many countries do just fine without their own currency and no fiscal coordination with their currency’s issuer. Panama has used the U.S. dollar for well over a century with good success. Ecuador and El Salvador have used the dollar as their own currency for a much shorter time and are doing better for it. Etc.

The major failing of the Euro, along with its considerable benefits for the Euro zone countries and those doing business or traveling among them, has been the failure of lenders to properly price the risk of lending to the Greece’s and Italy’s of the world. The spread between Greek government bonds over German government bonds collapsed to near parity after Greece replaced its inflation prone currency with the low inflation Euro. Greeks, both private and public, responded by borrowing with abandon. Greece has many other structural problems that keep its productivity lower than its neighbors, but credit markets indulged its borrowing binge on the assumption that there was little to no risk that the Greek government would be allowed to default on its debt.  This gave Greece the illusion of a higher standard of living for a while. Richer brothers to the north would surely step in and bail it out if it couldn’t repay its debts. And so it was for a while.

Against German resistance, Greece finally defaulted on much of its debt (the so-called voluntary haircut – write down — of its debt held by banks to about 30% of its full value). This was an important restoration of market risk and hence market discipline of Greek and other EU periphery countries’ borrowing. It will potentially help save the Euro. Most banks were able to absorb their resulting loss, but some big Cyprus banks apparently were not.

The EU/ECB/IMF (the troika) have offered conditional financial assistance to Cyprus but not to cover the cost of recapitalizing Cyprus’s underwater banks. Cyprus is required to raise those funds themselves. At least this is my assumption. Press reports on what the external support covers are almost totally lacking and the conditions for the deal are not yet final anyway. There is a relatively straightforward approach to resolving these banks, though the details would depend on the particulars of its banking and bankruptcy laws. I do not know the details of these laws nor of the conditions of these banks (Laiki and Bank of Cyprus), but I assume that they are viable if recapitalized and worth more as going concerns than from liquidating them.

The insolvent banks should be put into receivership and instantly split into a good, fully capitalized, bank and a bad bank (i.e. what ever is left) to be liquidated. The good banks would be fully capitalized by leaving some of their liabilities with the bad bank, starting with its shareholders, then bondholders (of which there are not many), then uninsured depositors. These creditors would, in effect, be written off. This would enable the new good banks to continue operating without serious interruption. The only real debate should be about how far to cut into depositors (so-called bailing creditors in) to rebalance assets and liabilities. The Economist argues that the write-offs should stop with shareholders and bondholders and all depositors should be made good via bailout funds from the European Stability Mechanism.

Depending on the particulars of the banking law, an insolvent but otherwise viable bank is put into receivership. This removes the shareholders from any control over the bank. Immediately the good assets of the bank, including its branch network and equipment, and staff would be sold to a new bank, which would assume all insured deposits and a proportionate amount of the uninsured deposit sufficient to match the value of the assets purchased. Ideally the new bank would be sold immediately to new private owners. But if more time is needed to organize its sell, it would be sold temporarily to the government for one Euro. What remains of the old bank would be liquidated and the proceeds would be apportioned in accordance with the priorities provided in the law to the credits (deposits that were not transferred to the new bank). As all of the good assets were transferred to the good bank, there would be virtually no further assets in the bad bank to recover and the remaining creditors would receive little to nothing.  The overall loss to depositors will depend on the losses incurred by the bank on its assets that made it insolvent in the first place. The orderly resolution described above almost always result it much smaller losses to creditors than a disorderly default in which the bank closes its doors totally.

Market discipline would clearly be more strengthened if uninsured depositors were also at risk of losing money. But increasing that risk unexpectedly and to too large an extent could cause deposit runs throughout Euro (and the world). Ultimately, but maybe not at the moment, this would be a good thing for the banking sector. Banks would have to behave more prudently or run the risk of losing deposits. Such market discipline is more effective in limited excessive risk taking by banks than is tighter supervision; though required capital and senior convertible bonds should be significantly increased in the future. In my view, the full recapitalization of all insolvent banks should be financed by bailing in as many uninsured depositors as needed to cover their capital deficiency. The IMF’s position, opposed by the EU, was that a good bank should assume only the insured depositors and receive sufficient good assets to cover them. This would leave all uninsured deposits in the bad bank, which were expected to suffer losses of 20 to 40 percent of their value.

The Cypriote officials originally proposed something quite different. They proposed a one-time levy on all depositors with a lower tax rate on smaller insured deposits. Thus both insured and uninsured depositors in good banks as well as bad ones would be paying to cover the losses of insolvent ones. Not exactly a boost to market discipline of banks. Depositors everywhere and especially in the Euro zone were shocked and the Cyprus Parliament rejected the proposal.

It will be interesting to know what motivated this crazy idea. For one thing it protects the shareholders from the loss of their shares and control of their banks, which is not a good idea from the point of view of the health of the banking system, though it may have been a deliberate goal of the plan (the shareholders are likely to be influential people in Cyprus). Antonis Samaras, the President of Cyprus, suggested that he wished to diminish the loss to large depositors (which include many wealthy Russians, some of whom have dealings with his law firm). Steve Hanke states that about half of Cyprus banks’ deposits are owed to Russians (including those of Russian subsidiaries established in Cyprus).

Whether lightening the burden of large depositors (sharing the burden more equitably according to the President) involved murky deals with Russians or the mistaken belief that it might save the large offshore deposit business Cyprus had developed (the deposit liabilities of its banks were eight time Cyprus’s GDP) only time will tell (maybe). Cyprus’s banking business is more like that of Iceland or Ireland before they crashed and burned several years ago, than the typical off shore financial centers like Cayman. The deposits in Cyprus are with Cyprus banks. If they become insolvent, depositors (or tax payers somewhere) lose. Foreign depositors in Cayman banks are actually depositing in branches of international banks with headquarters and assets elsewhere. Loses incurred by Cayman branches would be a small fraction of the total assets of the global bank and more easily absorbed.

Cyprus’s misguided attempt to spare large depositors at the expense of depositors in general, even if rejected in the end, greatly unnerved depositors everywhere and is likely to weaken rather than strengthen market discipline of bank risk taking.  By making the depositor haircut a levy/tax, Cyprus intended to bypass the bankruptcy/resolution provisions of the banking law and deposit insurance provisions. They created a mess.

The Sequester

Everyone agrees that the sequester, an $85 billion cut from the planned increase for this fiscal year, applied across the board within the broad categories of Defense ($42.5 billion) and non defense discretionary ($42.5 billion) is the worst way to allocate cuts. This is apparently why President Obama proposed it as a sort of poison pill. (See Bob Woodward: bob-woodward-obamas-sequester-deal-changer/).   Indeed it is. Little else is clear about the sequester. It is worth clarifying the facts and context of the size of the cuts and their distribution after a quick review of how we got here.

Background

Republicans want to bring federal government spending down to traditional levels, which can be fully financed with existing taxes, while Democrats want to raise taxes to finance a larger government (currently at 24.3 percent of GDP reflecting, in part, great recession related factors, and averaging 19.8 percent from 1960 to 2007).  Many efforts have been made to forge a compromise package that would be accepted by both the Republic majority House and the Democrat majority Senate. So far, none has succeeded.

Three years ago President Obama established a bipartisan budget reform commission—Bowles-Simpson commission, which in December 2010 recommended spending cuts and tax increases that would slow down the ballooning of debt over the next ten years by 4 trillion dollars, 3 trillion in spending cuts and 1 trillion in tax increases (largely from closing tax loopholes). As the base line projected increase over that period was $10 trillion, the Bowles-Simpson proposals would hold the increase in the debt to $6 trillion. Sorting out what Bowles-Simpson actually proposed became so complicated (e.g., they actually used an eight year period rather than ten and for incomes over $250,000 assumed a return to pre-Bush tax cuts rates) that even President Obama ignored the report. http://www.cbpp.org/cms/index.cfm?fa=view&id=3844

Soon thereafter (January 2011) three Republican and three Democrat Senators, the so-called gang of six, began discussions to find an acceptable compromise, eventually announcing failure in May of that year. Later that same year the Bipartisan Policy Center’s Debt Reduction Task Force co-chaired by Pete V. Domenici, former Republican U.S. Senator from New Mexico, and Alice M. Rivlin, founding director of CBO, former OMB director, and former Vice Chairman of the Board of Governors of the Federal Reserve, made similar recommendations.

On several occasions President Obama and Speaker of the House, Republican John Boehner, were close to a “grand bargain” that included some tax revenue increase and entitlement cuts. Efforts failed when Boehner concluded that he could not obtain enough Republican votes in the House. The President may have had the same problem with his party in the Senate if he had tried to present it to them. Other efforts, such as one led by Vice President Biden, met similar fates.

To avoid the sharp curtailment of government spending that would result from hitting the debt ceiling, preventing any further government borrowing in late 2011, the Budget Control Act of 2011 increased the authorized debt ceiling by $2.3 trillion and cut $841 billion from the projected deficit increase over the next ten years by capping the annual increases in discretionary spending over that period. The caps do not constrain increases in war related expenditures (Afghanistan), natural disasters, or entitlements. It also established as special joint committee of Congress charged with agreeing on an additional $1.2 trillion in deficit reduction over the next ten years with everything on the table (entitlements and defense cuts, tax increases, etc). If this so-called Super Committee was unable to reach an agreement or Congress did not approve it, the same amount would be cut according to the now infamous sequester. (Super Committee Sequestration) The sequester provision was deliberately meant by all sides to be so unpalatable that the Super Committee could not possibly fail to reach a compromise.

However, on November 20, 2011, the co-chairs of the Super Committee stated that “after months of hard work and intense deliberations, we have come to the conclusion today that it will not be possible to make any bipartisan agreement available to the public before the committee’s deadline.”

Two things were scheduled to happen if nothing changed. First, $1.2 trillion of automatic across-the-board spending cuts would kick-in on Oct 1, 2012. Second, the Bush tax cuts would expire for everyone at the end of that year. In addition, the temporary cuts in the payroll tax and the extension of unemployment benefits might not be continued. These three items constituted the infamous fiscal cliff, which was averted at the last-minute by making the Bush tax cuts permanent for everyone except those with incomes above $400,000, indexing the Alternative Minimum Tax and a few other things. The start of the sequester was delayed until January 1, 2013 and then again until March 1. This is a very simplified summary (trust me) of how we got to the sequester.

The Sequester

The sequester does not reduce total spending. Total Federal government’s spending in 2012 was $3,538 billion and planned spending (no actual budget has been approved for three years) for 2013 (which ends September 30) was (before the sequester) $3,796 billion. Reducing this amount by the $85 billion as required by the sequester still leaves an increase of $173 billion, which even after adjusting for inflation is a real increase. http://www.usfederalbudget.us/federal_budget_estimate_vs_actual

The often misleading practice in Washington of referring to reductions in increases as “cuts” is illustrated by the following statement by Sen. Bernard Sanders (I-Vt.), a member of the Budget Committee: “Some of us believe very strongly that it would be absolutely wrong to cut Social Security benefits.” He was referring to the proposal offered by President Obama to John Boehner to shift the index used to increase Social Security benefits over time to one that would increase them more slowly (the chain CPI index, which would preserve the real value of benefits).  Senate-democrats-budget-challenges-obama-on-medicare-social-security-cuts

While the sequester does not cut total spending, the way in which it is allocated does cut spending in some areas. Half of the cut comes from Defense, which was already being cut (cuts that actually reduce spending below the previous year) before the sequester. The other half of the cut falls on discretionary spending (sparing the entitlements – social security, Medicaid, etc, and the Department of Veteran’s Affairs). As such non-military discretionary spending is only about 15% of total spending, taking half of the total cut from items that are only 15% of the total is about an 8% cut. These figures apply to this year only. Like this year’s “cuts,” the sequestered spending over the next ten years are to be taken from the ever-increasing base line amounts and thus just slows down the previously planned increases.

The Budget Control Act of 2011 also specified that within the categories identified above, the cuts must be applied across-the-board (i.e. proportionally) to each Budget Account (BA), of which there are 1200, and each of which consolidates a number of programs, projects and activities (PPA).  Within each Budget Account, the executive branch of government is responsible for prioritizing the cuts, i.e. for cutting those things least valuable (most wasteful). The government rarely spends money on things that have no value at all (some of my friends will challenge me on this statement), but that is not the correct standard of judgment. The correct standard (in part) is whether the money spent on a valuable project would have produced even more value if spent on something else (whether by the government or the taxpayer).

To review, the President proposed the cross the board cuts to defense and non-defense discretionary spending and Congress accepted the idea in the Budget Control Act of 2011 believing, with the President, that it would never need to be applied. However, we are now there and the cuts must be made. But within the cuts required for each Budget Account, it is the Administration that is responsible for what to cut. Like the CEO of any company faced with limited resources, Department heads are responsible for cutting those activities of least value and preserving those of greatest value.

Smoke

Any cut hurts someone even if it benefits the economy over all. Consider, for example, the loss of four air traffic controllers at the Garden City, Kansas airport. “THE $85 BILLION in across-the-board budget cuts known as sequestration have begun to affect places like Garden City, the Kansas county seat (pop. 26,880) whose airport will lose $318,756 in Federal Aviation Administration funds that pay for four air traffic controllers. As The Post’s Stephanie McCrummen reported, Garden City Regional Airport’s control tower is one of 238 affected by sequestration, which will reduce total FAA spending in fiscal 2013 from about $16.7 billion to $16.1 billion. Small towns are lamenting the potential impact on air safety and local economies.” A Washington Post editorial on March 8 notes that of the two commercial flights that take off and land there each day one already does so when the control tower is closed (Small-town-airports-propped-up-with-200-million). The Post concludes that the $200 million a year the federal government spends to subsidize commercial flights to small lightly used airports is a waste that deserves to end.

A considerable fuss was raised about the Administration’s cutting the White house tours. Was this the least costly cut from the White House or Secret Service budget? I have no idea.  The Washington Post editorialized that: “THE DECISION to drop White House tours always had a whiff of what’s known as Washington Monument syndrome. The ham-handed tactic is employed when government is faced with budget cuts and officials go after the services that are most visible and appreciated by the public.” (Reopen-the-white-house-to-tourists) The government could not threaten to close the Washington Monument because it has already been closed for several years for repairs from earthquake damage.

On the other side of the ledger, the Administration’s release of non dangerous illegal immigrants held in federal prisons is more likely a case of doing what the Administration and many others consider the right thing to do anyway and using sequestration as an excuse (the release was weeks before the sequestration). Wasting-money-lives-through-the-detention-of-immigrants

The proposal to cut back on Congressional junkets abroad was made by a columnist, not the administration for obvious reasons. Everyone can find their own favorite wasteful spending. Budget decisions are never easy and resources are always limited so careful prioritization is a normal and essential part of the management of any organization.

Lies

Then there were the claims of cuts that never occurred. Education Secretary Arne Duncan’s false claim of pink slips for teachers earned him 4 Pinocchios (big lie) from The Washington Post’s Fact Checker. And Duncan is one of the good guys:  4-pinocchios-for-arne-duncans-false-claim-of-pink-slips-for-teachers

On March 1 at his press conference President Obama stated: “Starting tomorrow everybody here, all the folks who are cleaning the floors at the Capitol. Now that Congress has left, somebody’s going to be vacuuming and cleaning those floors and throwing out the garbage. They’re going to have less pay. The janitors, the security guards, they just got a pay cut, and they’ve got to figure out how to manage that. That’s real.” But it wasn’t. It also received 4 Pinocchios from the Fact Checker.  sequester-spin-obamas-incorrect-claim-of-capitol-janitors-receiving-a-pay-cut

The Congressional janitors seemed to be a particular concern of the administration. Gene Sperling, director of the White House economic council, on ABC News’ “This Week,” March 3, 2013 observed: “You know, those Capitol janitors will not get as much overtime. I’m sure they think less pay, that they’re taking home, does hurt.”

On March 4, White House spokesman Jay Carney observed at his news briefing: “On the issue of the janitors, if you work for an hourly wage and you earn overtime, and you depend on that overtime to make ends meet, it is simply a fact that a reduction in overtime is a reduction in your pay.”  But none of this was true and drew 4 more Pinocchios from the Post Fact Checker. Capitol-janitors-making-ends-meet-with-overtime-nope

Though the President already has the responsibility of deciding where to cut within Budget Accounts, Republicans have offered to broaden the range of his discretion to determine what to cut and what to keep. Senator Toomey (R-Penn) reported this to us at the Heritage Foundation the day after his dinner with the President at the Jefferson Hotel. He and Sen. James Inhofe (R-Okla) have introduced a bill in the Senate to this effect. The President said no thanks. If you believe that the president has the best interests of the nation at heart, this is a shocking revelation. The President seems to prefer to blame the Republicans for forcing harmful cuts on the nation because after having accepted tax increases on the wealthy they refuse to raise taxes more without some cuts in entitlement programs. This was confirmed in a revealing article by Ezra Klein How-to-fix-sequestration-without-raising-taxes

The way forward

The Budget Act of 1974 requires the president to submit a budget request to Congress on the first Monday in February. He has yet to do so (written March 14th). His recent step into the leadership role normally played by Presidents on major budget matters is welcomed and will be essential if compromise is to be achieved.

White-house-delay-budget-proposal-infuriates-republicans. For the first time in three years the Senate is on the way to adopting a budget as well. Given the budget already passed by the House (the Ryan budget), for the first time in several years the two chambers will have written proposals to negotiate, and hopefully reconcile, with each other.

Most Republicans don’t want to raise taxes or cut defense. Most Democrats don’t want to touch entitlements. Most everyone accepts that the current path is not sustainable. “Sen. Mark R. Warner (D-Va.) argued — to the “consternation” of people “on my side,” he said — that Democrats will have to do more to prevent Social Security and Medicare from bankrupting the nation as the population ages. I share the belief of even my most progressive colleagues that Medicare and Social Security are among the greatest programs ever implemented. But I also believe that the basic math around them doesn’t work anymore,” Warner said. The longer we put off this inevitable math problem,” he said, “the longer we fail to come up with a way to make sure that the promise of Medicare and Social Security is not just there for current seniors but for those 30 years out.” (in the previously cited Post article). Demographics alone will dramatically increase Social Security, Medicaid and Medicare spending even if benefits for each person are not increased as the ratio of old and retire people to working people increases dramatically over the next thirty. Increasing immigration, reducing benefits and increasing tax revenue are the only things that can help. Both sides will need to compromise.

My preference is to cut the Defense department a bit more and “cut” entitlements a lot (which would have little to no effect for a number of years but is critical for the future), and modestly increase the State Department and infrastructure repair spending. Medicare and Medicaid will be more difficult because they require structural changes that actually reduce the cost of medical care, not just arbitrary cuts that must be made up by paying customers picking up other peoples’ bills. Social Security is much easer to fix: Saving Social Security

There are many reasons for reducing the size of our government. Keep-it-lean, How-to-measure-the-size-of-government.

Whether it increases tax revenue or not our tax system needs major overhaul: “US Federal Tax Policy”. At a minimum personal income tax loopholes (deductions) should all be closed and if the corporate income tax can’t be eliminated yet, its rate should be lowered to the levels found in Europe.

But Obama won the last election. I will not get what I want. Republicans will also have to compromise. The battle should be fought over spending. The question should be what government programs and at what level are we willing to pay for with our tax revenue. Some tax increases and spending cuts have already been adopted. More are needed.  It is time for Congress and the Executive to get back to their jobs of evaluating priorities and trade offs and develop and adopt a real budget. Hopefully this time they will succeed. Much depends on it.

Protecting our Civil Liberties

Richard Nixon reminded us of the great dangers to our cherished liberties inflicted by the powers available to our government. Remember his “enemies list.” Or if you are too young to remember it real-time, hopefully you have read about it (Watergate!! Remember?). Nixon was forced to resign because of it.  It was a victory of our free press.

Or if you want something more recent, what about “Filegate.” According to Wikipedia: “The White House FBI files controversy of the Clinton Administration, often referred to as Filegate, arose in June 1996 around improper access in 1993 and 1994 to Federal Bureau of Investigation security-clearance documents. Craig Livingstone, director of the White House‘s Office of Personnel Security, improperly requested, and received from the FBI, background reports concerning several hundred individuals without asking permission. The revelations provoked a strong political and press reaction because many of the files covered White House employees from previous Republican administrations, including top presidential advisors. Under criticism, Livingstone resigned from his position. Allegations were made that senior White House figures, including First Lady Hillary Rodham Clinton, may have requested and read the files for political purposes, and that the First Lady had authorized the hiring of the underqualified Livingstone.”

I feel bad using the above example after Bill Clinton’s wonderful article in today’s Washington Post calling for the repeal of DOMA, which he had signed into law in an earlier time.

Any power that government has can potentially be abused, so our Constitution strictly limited them and required checks and balances on their use. When I was in college – U of C Berkeley in the mid 1960s—George Orwell’s 1984 was still several decades in the distant future. Big Brother (an all-powerful government that looked after our safety and its own), with its ability to spy on our every activity to ensure that we behaved in the country’s (i.e. the government’s) interest, was a fictional nightmare that we couldn’t imagine happening in America.

Then came 9/11 and the Patriot Act. The American Civil Liberties Union flagged three powers in the Act, even after it was renewed in May 2011, that go too far:

“The three expiring provisions of the Patriot Act give the government sweeping authority to spy on individuals inside the United States, and in some cases, without any suspicion of wrongdoing. All three should be allowed to expire if they are not amended to include privacy protections to protect personal information from government overreach.

                  Section 215 of the Patriot Act authorizes the government to obtain “any tangible thing” relevant to a terrorism investigation, even if there is no showing that the “thing” pertains to suspected terrorists or terrorist activities. This provision is contrary to traditional notions of search and seizure, which require the government to show reasonable suspicion or probable cause before undertaking an investigation that infringes upon a person’s privacy. Congress must ensure that things collected with this power have a meaningful nexus to suspected terrorist activity or it should be allowed to expire.

                  Section 206 of the Patriot Act, also known as “roving John Doe wiretap” provision, permits the government to obtain intelligence surveillance orders that identify neither the person nor the facility to be tapped. This provision is contrary to traditional notions of search and seizure, which require government to state with particularity what it seeks to search or seize. Section 206 should be amended to mirror similar and longstanding criminal laws that permit roving wiretaps, but require the naming of a specific target. Otherwise, it should expire.

                        Section 6001 of the Intelligence Reform and Terrorism Prevention Act of 2004, or the so-called “Lone Wolf” provision, permits secret intelligence surveillance of non-US persons who are not affiliated with a foreign organization. Such an authorization, granted only in secret courts is subject to abuse and threatens our longtime understandings of the limits of the government’s investigatory powers within the borders of the United States. This provision has never been used and should be allowed to expire outright.”

Now our government has hinted that it might have the power to undertake extra judicial killing of Americans on American soil via drone attacks. I have been stunned in recent years at the relatively quiet acquiescence of many Americans to these dangerous extensions of unchecked or under-checked government powers. They happily send their neighbors’ sons and daughters to far off lands to fight “our” enemies and to sometimes die there, while not having the courage to tell our government here at home to back off.

Today’s “The New Yorker” headlined “The Borowitz Report” with: “Poll: Majority of Americans Opposed to being Killed by Drone.” This is meant to be satirical, of course. But until Rand Paul filibustered in the U.S. Senate against the confirmation of John Brennan unless the government would state clearly that it would not target Americans in the U.S. without due process, you might have thought that Americans didn’t care much. Earlier this week Attorney General Eric Holder “wouldn’t rule out the possibility of a drone strike against Americans on U.S. soil. But he said the administration wasn’t planning on such a strike and would use the option only under extreme circumstances.” (CNN: http://www.cnn.com/2013/03/07/us/drones-five-things/index.html)

Following Senator Paul’s filibuster the Attorney General sent a new letter to the Senator stating:

“It has come to my attention that you have now asked an additional question: ‘Does the President have the authority to use a weaponized drone to kill an American not engaged in combat on American soil?’ ” Holder wrote. “The answer to that question is no.” (CNN)  This is a small but important victory for restraining Leviathan and protecting our liberties and it has taken a long time. I wrote on this same subject almost exactly one year ago: https://wcoats.wordpress.com/2012/03/22/extra-judicial-killing/

Thank you Rand Paul.

I have spoken out in defense of our constitutional liberties on a number of occasions as well, including: https://wcoats.wordpress.com/2012/09/15/further-thoughts-on-free-speech/,   https://wcoats.wordpress.com/2012/09/29/freedom-of-speech-final-thoughts-for-a-while-at-least/

“The price of liberty is eternal vigilance”