Greece: What should its creditors do now?

Following Sunday’s NO vote in Greece, what ever that might have meant, it is tempting to tell Greece to get lost and be done with them. Aside from the unseemly lack of compassion for our suffering fellow man, the further collapse of the Greek economy and society that would likely follow Grexit (the Greek exit from the Euro and introduction of its own currency) would open unknown and potentially very dangerous risks to the rest of Europe from its southern periphery. However, any new deal between Greece and its creditors should be mutually beneficial for Greece and the EU in the long run and achievable and practical in the short run. What are the key elements needed for such an agreement?

Greece’s second bailout program with its creditors (the EU, ECB, and IMF) expired June 30 after a four-month extension without disbursing the final installment of around $8 billion dollars. It cannot be resurrected. Thus any further discussions between Greece and its creditors will concern a third bailout program.

Greece’s recently replaced and unmissed Finance Minister, Yanis Varoufakis’, stock speech said basically that Greece does not need or want more loans because it is bankrupt rather than illiquid. In short, it wants debt forgiveness. In fact, many European officials have acknowledged the possible need to write off (reduce the present value one way or another of) existing Greek debt but insisted that any such consideration be put off for a new program. Discussion of a new program has now arrived.

The foundation of any financial assistance program with the IMF is its assessment that the borrowing country can repay the loan. This assessment is contained in the IMF’s “Debt Sustainability Analysis.” This analysis imbeds the agreed (or assumed) level of government spending and estimated tax and other government revenue and of the level of economic activity (GDP growth) upon which it depends in a forecasting model of the deficit and debt/GDP ratios expected from implementation of the agreed policies. The IMF was badly embarrassed by its acceptance of overly optimistic assumptions about income growth government revenue in its first bailout program in 2010 with the EU and ECB. Under political pressure from the EU and ECB, these assumptions allowed the IMF to conclude that Greece’s debt would be sustainable thus avoiding the need for some debt write off favored by the IMF but opposed by Germany and France, whose banks held large amounts of that debt. The second bailout program included a write off of about 70% of the privately held Greek debt. However, this came too late and the adjustment in the Greek government’s annual deficits required by the first program proved too severe causing a much larger and longer lasting contraction in the Greek economy than expected and assumed in the IMF Debt Sustainability Analysis at that time.

On June 26, 2015 (i.e. prior to Greece’s default on its $1.7 billion payment to the IMF and to the July 5 referendum) the IMF released a draft Debt Sustainability Analysis based on the information available at that time. It concluded that “If the program had been implemented as assumed, no further debt relief would have been needed under the agreed November 2012 framework…. At the last review in May 2014, Greece’s public debt was assessed to be getting back on a path toward sustainability, though it remained highly vulnerable to shocks. By late summer 2014, with interest rates having declined further, it appeared that no further debt relief would have been needed under the November 2012 framework, if the program were to have been implemented as agreed. But significant changes in policies since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs. Coming on top of the very high existing debt, these new financing needs render the debt dynamics unsustainable…. But if the package of reforms under consideration is weakened further—in particular, through a further lowering of primary surplus targets and even weaker structural reforms—haircuts on debt will become necessary.”

In short, the Greek economy was finally beginning to recover by the end of 2014 but the reversals by the new Syriza government of some of the policies contributing to that gain and the loss of market confidence in the muddled and amateurish behavior of the new government reversed the recovery and further increased Greek deficits. In addition, increasing capital flight has been financed by short-term emergency liquidity loans from the ECB, thus adding to Greece’s over all indebtedness. Capital flight per se should not reduce banks’ capital, as they lose the same amount of assets and liabilities, as long as they are able to liquidate sufficient assets by selling them or by using them as collateral for loans from the ECB or other banks. These loans and the process of transferring Euros abroad are described in the paper I presented in Athens May 19 at the Emergency Economic Summit for Greece: http://works.bepress.com/warren_coats/32/.

Under these circumstances it would be desirable (i.e. consistent with and/or required by a European desire to keep Greece in the Euro Zone while returning it to fiscal balance and sustainability over a reasonable, if somewhat longer, period of time) for Greece’s creditors to forgive some of the debt held by the ECB and IMF and to lower the structural fiscal surpluses initially required in a follow on program for the next few years (this latter element had already been offered by the creditors before the referendum). In short, by reducing Greece’s debt service payments and lowering its primary fiscal surplus, it would endure less “austerity.” Former Finance Minister Varoufakis actually proposed a sensible risk sharing form of refinanced Greek debt indexed to the economy’s economic performance. Creditors would do better than expected on their concessional loans if the economy performed better than forecast and would suffer losses if it did worse. This would give both sides a financial incentive to get the pace and balance of fiscal adjustment right (growth maximizing). While Europe’s political leaders sort out the details, the ECB should continue to provide liquidity credit to the extent that, and as long as, Greek banks can provide realistically valued collateral.

The purpose of these adjustments by the creditors should not and must not be to throw more good money after bad allowing a continuation of decades of corruption, rent seeking and government inefficiency. Long before it joined the Euro Zone, Greece suffered poor government services by a bureaucracy overstaffed by friends and supporters of the government in power at the time. Not receiving expected government services, many Greeks have decided not to pay for what they are not getting. Hence tax evasion and a large underground economy added to Greece’s deficits. Quoting from Bret Stephens’ July 6 column: “Greeks retire earlier and live longer than most of their eurozone peers, which means they spend close to 18% of GDP on public pensions, compared with about 7% in Ireland and 5% in the U.S…. As of 2010, Greek labor costs were 25% higher than in Germany. [As a result of internal devaluation since then, this is no longer true.] A liter of milk in Greece costs 30% more than elsewhere in Europe, thanks to regulations that allow it to remain on the shelf for no more than a week. Pharmaceuticals are also more expensive, thanks to the cartelization of the economy…. Greece wanted to be prosperous without being competitive. It wanted to run a five-star welfare state with a two-star economy. It wanted modernity without efficiency or transparency, and wealth without work. It wanted control over its own destiny—while someone else picked up the check.”

Changing this behavior by Greek governments and the Greek public will not be easy if it is possible at all. The still very strong support by the Greek public for keeping the Euro suggests a strong awareness of the need for some restraints and discipline of its government’s spending. But is the desire for a truly better deal (from their own government) strong enough to overcome the resistance of the entrenched and favored interests, who would lose from liberalizing the economy and cleaning up the patronage mess and tax non compliance, etc.? The best hope is the formation of a unity government that strongly endorses a well balance program of gradual further fiscal adjustment and the continuation of the structural reforms so badly needed. Close monitoring by the creditors of Greek compliance with its promises and the phasing of financial assistance tied to such performance benchmarks, is the IMF’s standard approach to enforcing compliance with the measures the government agrees to. There are risks in agreeing to a third program and risks in not doing so and thus Grexit.

Grexit, even with total default on all external debt, will surely force more austerity on Greece than would any program now contemplated, even before taking account of the almost certain collapse of all of Greece’s already “temporarily” closed banks. The Greek government will hardly be in a position to bailout its banks suffering a surge of non-performing loans. Depositor bail-ins will need to cut all the way into “insured” deposits. The pain will be largely felt only in Greece, and unfortunately mostly by the ordinary Greek citizen.

Greece—how could they?

Today Greece is voting whether its government should accept the conditions required by the “Institutions” (EU/ECB/IMF) for the final installment of its second “bailout” package—a yes vote, or to reject them—a no vote. No one is quite sure what it all means. The program to which these conditions and the final installment of $8 billion applied expired on June 30 and those funds are no longer on offer. A yes vote would presumably indicate support by the majority of Greek voters for accepting the conditions (a modest primary budget surplus by the Greek government in coming years and structural reforms to improve the quality of government services and the productivity of Greece’s economy) likely to be offered for a third bailout program. The alternative—no more financial assistance from the Institutions—would force even greater “austerity” on the Greek government even after repudiating all of its external debt and thus saving the funds that it would otherwise needed to pay to service it. If Greek tax payers won’t cover the cost of the government’s promises and the market will no longer lend the shortfall, the government is likely to resort to augmenting its Euro tax income with IOU claims on Euros, i.e. introducing and inflating its own currency.

What were the Greek government and the Greek people thinking when they borrowed all that money in the first place, and it must be added, enjoyed spending it on an inflated, unsustainable lifestyle rather than investing it in a more productive future? But Greek politicians (and public) are hardly the only ones in the world to ignore future costs when making current promises they have no way to keep.

Take the United States, for example. For decades, the U.S. Congressional Budget Office has forecast ever-increasing deficits from American entitlement programs (Medicare, Medicaid, and Social Security) as expenditures increasingly outstripped revenue. This reflects both the growth in the generosity of these programs and demographics (increasing life expectancy and the baby boomer bulge in retired people relative to those working to pay for them—anyone who still thinks that the retired are receiving what they paid in while working just hasn’t been paying attention). I have written about this from time to time such as four years ago in: https://wcoats.wordpress.com/2011/04/23/thinking-about-the-public-debt/

The future unsustainability of Social Security promises has been the subject of public debate for at least fifty years. The “future” retirement of the WWII baby boomers and their pension expectations has been known since the end of WWII. But one congress after the other has kicked the ball down the road. Seven years ago I outlined the issues and the relatively simple solutions to Social Security deficits in: https://wcoats.wordpress.com/2008/08/28/saving-social-security/ Since then Medicare and Medicaid promises have only increased.

President Obama established the National Commission on Fiscal Responsibility and Reform (the so called Simpson-Bowles Commission) in early 2010 to develop bipartisan proposals for reducing future entitlement driven deficits. He ignored their modest proposals made in the Commission’s final report on December 1, 2010.

The Economist magazine last week reported that the assets available to cover U.S. public sector pensions covered only 75% of their obligations. In fact, the short fall is much greater than that because they are computed assuming a 7.6% return on their assets, which greatly overstates the actual experience of recent years. Private pensions are in much better shape. “But if public plans used the same discount rate as private ones, the deficit would increase to $3.9 trillion and the funding ratio fall to 45%.”

So what are our elected representatives thinking? “Deficits have eventually to be closed. That means lower benefits for the retired, bigger contributions from existing employees (a pay cut) or higher contributions from the employer—which means tax increases for state or city residents, or cuts to other services.

Why is it that our political representatives have such shorter policy horizons than does the public in general? The Economist provides a reasonable summary for the U.S..

“No wonder that no one is getting to grips with the problem. Unions do not like to draw attention to the deficits, for fear benefits will be cut. Politicians do not want to pick a fight with the unions, or increase taxes and annoy voters. Instead, states and cities tend to hope that rising markets will make the problem disappear.”

http://www.economist.com/news/finance-and-economics/21656202-betting-equities-has-not-eliminated-americas-pension-deficit-wishful-thinking?frsc=dg%7Ca

The All Volunteer Military: Unintended consequences and a modest proposal

America’s war in Vietnam, its longest before Afghanistan, relied on the obligatory military service of its young men if drafted. When we turned 18, we were required to enroll with the Selective Service System and those of us who did not volunteer lived in terror for about ten years of eligibility that we would be “called up.” To protect the education of our more talented youth, deferments from the draft were given to those of us in college. Not surprisingly this did not go down well with those who could not or chose not to go to college and the fairness of the system was challenged. Thus, college deferments for anyone older than I was (lucky me) were ended and replaced with a lottery at the beginning of each year based on the selective service numbers we received when we first enrolled. Those whose numbers where at the top of the list were sure to be drafted and those closer to the bottom were sure not to be.

Because of the draft the majority of American families with sons were emotionally involved and connected to the war and as it became more and more unpopular this broad connection helped finally bring it to an end.

In 1967, a group of libertarian University of Chicago students and I founded the Council for a Volunteer Military to publicize the inequities of the draft and the benefits of an all volunteer military. We were not subject to the draft ourselves as our college deferments were grandfathered, and thus we were purely motivated by our sense of fairness and believe in the superior effectiveness of a volunteer Army. The Council’ directors were Jim Powell, Henry Regnery, myself as Executive Secretary, Danny Boggs, and David Levy (the one who is now a Professor of Economics at George Mason U). Our Sponsors included my teacher, Milton Friedman, as well as Yale Brozen, Richard Cornuelle, David Franke, James Farmer, Karl Hess and socialist Norman Thomas.

President Richard Nixon appointed Professor Friedman to a commission to study the viability of an all volunteer military headed by Thomas S. Gates, Jr. This led to Nixon’s replacement of the draft with higher pay and other employment conditions that made it possible to man our military with hired professionals. The result was a more expensive (the draft was effectively a tax on those drafted, who tended to be poorer to begin with) but significantly more effective military. After some years adjusting to the new approach, even the Generals praised the great success of our all-volunteer force.

As our military adventurism of recent decades has resulted in more and more American troops fighting and dying abroad, some observers have noted that the volunteer force left most American families unaffected directly by these wars thus undercutting the opposition they might otherwise express. This was obviously an unintended and negative aspect of the All-Volunteer Force (AVF). If there were no way to compensate for this negative consequence, the AVF would still be the best and fairest approach to manning our military. However, there is a simple way to help mitigate this negative feature, which has much merit in its own right.

Since 2001 our wars have cost us $1.6 trillion dollars ($10.5 million dollars per hour). This is just the direct budgetary cost and does not take account of the lives lost and other indirect costs and distortions to the economy, worsened relations abroad, etc. While the top 20-30 percent of income earners in the United States provide almost none of their sons and now daughters to fight these wars and thus might be more inclined to support them, they do provide almost one hundred percent of the taxes raised to finance our government. (In 2012, the latest income tax data available, about half of American families reported taxable income of which the top 50% paid 97.2% of all income tax revenue in that year. The top 5% of tax payers earned 36.8% of total adjusted gross income reported that year and paid 58.9% of total income taxes received.) None of the costs of these wars have been paid for by raising taxes or cutting other spending (except within the Defense Department, where equipment and weapons development expenditures suffered). The funds were borrowed from those buying U.S. treasury securities, adding to our debt that will have to be paid by our children.

My modest proposal, echoing one made a few years ago by U.S. Congressman David Obey, D-Wis., who on Nov. 19, 2010 introduced H.R. 4130, the “Share the Sacrifice Act of 2010,” is that any budget supplemental appropriations to cover the costs of fighting abroad must be paid for fully by an income tax surcharge. See Bruce Bartlett’s discussion of this issue: http://www.forbes.com/2009/11/25/shared-sacrifice-war-taxes-opinions-columnists-bruce-bartlett.html. By explicitly putting the cost on income taxes, any war and its financing will get the attention it deserves from the wealthier members of society who pay that tax. Taxing to pay for wars has the double benefit of adhering to principles of sound finance (properly paying for whatever the government spends), and of bringing the costs (at least the budgetary costs) of war to the pocket books of American voters.

Can Washington Still Govern?

October 11, 2013

The popularity of the government is at an all time low. Different people want different things, thus none of us can have everything we want. What to do? Congress enacts laws and if they later decide that they enacted a bad one they can vote to amend or repeal it. The voting public can vote out representatives who don’t properly represent them and vote in new ones who will adopt the laws they want.  But at the end of the day compromise is required to satisfy the largest number of people.

Refusing to authorize government expenditures for existing laws and thus shutting down the government (sort of) is better described, according to Andrew Reinbach, as sedition:

“The definition of sedition says among other things that ‘If two or more persons in any State or Territory, or in any place subject to the jurisdiction of the United States, conspire… by force to prevent, hinder, or delay the execution of any law of the United States… they shall each be fined or imprisoned not more than 20 years, or both.’”

The best overview of the outrageous behavior by both the Republicans and the Democrats remains, in my judgment, the article by Charles Krauthammer that I posted earlier. “Who Shut Down Yellowstone? /2013/10/03/”.  This all came back to my mind as I drove down Clara Barton Parkway toward the District yesterday morning for an 8:30 am meeting with the Afghan delegation here for the IMF/World Bank Annual Meetings. There are a number of parking areas along the parkway. People park there to take their canoes down to the Potomac or to walk along the river. You might have thought that closing the government would have no consequences for such pullovers. At most it might leave the trash deposited in the trash cans there uncollected. Instead, the government spent the money to place concrete barriers beside the road preventing anyone from pulling off and parking there.  I am told that the same was done across the river on the Virginia side along the George Washington Memorial Parkway and no doubt in many other places as well employing the well-known government trick of making the cuts as painful as possible to the public.  This is the government we have now. The moron who made those decisions should be fired (the gentlest penalty that passed through my mind).

I have always believed that one of the things that makes America great is that it has managed to create a system in which people of different cultures and faiths, but common core values, live peaceably together. This gives our country the enriching benefits of the creative power of diverse ideas from diverse cultures without the costs of social strife. A major source of this success comes from a constitution and system of government that has limited the power of the government and does not overly interfere in the private activities of its citizens. No ones religious beliefs are imposed on anyone else, etc.

These days our political class seems to have lost the capacity of compromise, an essential aspect of living together peaceably. Many of our politicians no longer see compromise as a virtue (the fools). The problem is not a new one, of course. When farmers from the Near East moved into Central Europe 7,500 years ago they were not assimilated by the hunters-gatherers who lived there. Rather they coexisted in parallel cultures, forced by necessity to get alone.  “Stone-age Farmers-Hunters Kept Their Distance /2013/10/10/”

Fortunately, the dysfunction of our government is not reflective of our broader society, though I know there are many ugly exceptions. I was happy to read in today’s Washington Post that a heart wrenching dispute between the natural father of a four year old girl and her adopted parents who actually loved and cared for and raised her has been resolved and a mutually sensible way, keeping hope for civilization alive: “Cherokee Nation and Father of adopted 4 year old girl drop court battle for custody /2013/10/11” Veronica’s adopted parents will retain custody of her but will cooperate in making ways for her natural, Cherokee father to be involved in her life.

Using an increase in the debt ceiling as leverage to reduce the government’s deficit to sustainable rates is quite a different matter.  It has been recognized for many years by both political parties that government spending commitments in the future, given the aging of the population (i.e., the fall in the working age population relative to the retired population), could not be met. The Congressional Budget Office’s current long-term, baseline forecasts, which assume current tax and spending laws (including the reduced spending growth required by the sequester) are for the debt to grow more rapidly than income, i.e., to rise as a percent of GDP without end. One bipartisan effort after another (Bowles-Simpson commission, the Senate Gang of Six, Bipartisan Policy Center’s Debt Reduction Task Force, the Super Committee, etc.) tried to reach tax and spending compromises and failed. Yes, even with the sequester (across the board cuts in planned spending increases) the growth in debt is not sustainable. Something must change. A compromise must be agreed. Using approval of an increase in the debt ceiling as leverage to achieve such a compromise is a reasonable tactic. If not now the market will force it later (significant increases in the interest rates demanded by the market to lend to an increasingly over indebted government). Better and cheaper sooner than later. “The-sequester”  “Thinking About the Public Debt”

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.

Our Government, or Lack There Of

Some of you thought my recent complaints against uncompromising Republicans toward the fiscal cliff were somewhat one sided. It takes two to tango in the compromise game, of course. I would like to suggest a structural change in the U.S. budgetary rules that I think will help reduce our deficits and our debt while at the same time making government more effective. It shifts the focus of the debt reduction discussion from taxation to expenditures, which is the side of the equation on which the Democrats have been irresponsible and uncompromising. The Democrat controlled Senate has not even passed our government’s budget for the last three years.

The subject of taxation divides into its structure (what is taxed and how the burden is shared among the population—these are issues of fairness and the economic consequences), and its level (how much revenue is raised). Getting the structure right is very important for economic growth and for public acceptance of and cooperation with paying the taxes chosen. My views on taxation were reviewed four years ago: https://wcoats.wordpress.com/2008/09/06/how-to-measure-the-size-of-government/ and more extensively almost 40 years ago: http://works.bepress.com/warren_coats/29/.

My proposal, which is really a bit of left over unfinished business from the Reagan administration, is that the level of tax revenue should be set to pay for all of government’s expenditures over the business cycle. Deficits would be allowed during recessions (the so called automatic stabilizers), which would have to be paid for with surpluses during booms. I would like to see a constitutional amendment that imposes this requirement in place of legislated debt ceilings. If the public really wants more government spending, taxes will need to be raised to pay for it.

The focus on taxation, and the refusal of many Republicans to raise them, has been very counterproductive. The Republicans have done a terrible job of making the case for smaller government and I blame a lot of that on their emphasis on taxes rather than spending. If we insist that Obama’s spending programs must be financed by tax revenue rather than borrowing (except for automatic stabilizers during recessions – e.g., increases in unemployment insurance and the natural fall in tax revenue when incomes fall), people would start focusing on the fact that they will have to pay for these expenditures. It would make fighting for more restrained spending easier.

The government (federal, state and local) should be involved in some areas of our lives, but we should make the case for such involvements carefully because the nature of government, if not firmly and continuously resisted, is to keep growing. The defense industry in the United States is large and powerful. It has an obvious profit interest in seeing the government’s defense expenditures increase and it has the economic means to help influence such an outcome. The taxpayers’ representatives in government need the counter pressure those taxpayers can provide to evaluate defense spending and all other government programs carefully and to apply rigorous cost benefit analysis to every proposal.

Even then, it is well known in public choice literature that it is difficult for the diverse and defused public interest of taxpayers to dominate over the individual special interests of bankers, pharmaceuticals, farmers, teachers unions, etc. If these special interests are able to gain special favors from the government (e.g., farm subsidies) they benefit greatly but the cost is spread widely over all taxpayers. These forces push government to grow into activities that can harm the economic efficiency and growth that benefits us all. But they also invariably push and ultimately cross the boundaries of honest advocacy into blatant corruption. I expounded on this dangers in (at least) two earlier blogs:

https://wcoats.wordpress.com/2009/12/23/keep-it-lean/ and http://dailycaller.com/2011/01/17/ikes-farewell-address-fifty-years-on/

Liberal (in the classical meaning defined by John Stewart Mill) and democratic societies are the exception in history. They are not easily defended.

“The price of liberty is eternal vigilance.”

Happy New Year.

Republicans and the Fiscal Cliff: What are they thinking?

Our government, whether headed by a Republican or a Democrat, governs for all of us. The Republicans lost this time around, though they still control the House of Representatives. They are in the minority. The Democrats, who control the Senate and the Executive branch, rightly expect to introduce and oversee policies that are more aligned with their view of what is best for the country than the views of the party that lost. But if they are wise and have the best interests of the country at heart they will take into account the views of the rest of the country as well. Compromise is part of the art of governing a diverse people successfully. Limiting the scope of government is another. See my comments on this theme over four years ago: “The Death of the Right?”

Many Republicans, however, are behaving as if they think they should force their views on the majority.  Not only is this unwillingness to compromise unacceptable in our democracy, it is producing worse outcomes for those of us who would like to keep government smaller. These republicans rejected a deal last year tentatively agreed between House Speaker John A. Boehner (R-Ohio) and President Obama that would have increased tax revenue by $800 billion over the next ten years in exchange for spending cuts three times that.  Without some sort of agreement by the end of this week, falling over the “fiscal cliff” will increase tax revenue by around $5,000 billion over the same period. That won’t happen, of course, as both parties want to restore the existing income tax rates for all but the wealthy. The Democrat controlled Senate has already passed such a bill, which would increase tax revenue by $700 billion over the next ten years. That would become the base line from which Obama would bargain for more tax revenue in exchange for budget cuts.

I assume that some minimalist agreement will be reached in the next week that will eliminate the worst tax effects from going over the cliff, but that will only perpetuate and prolong uncertainty over how our currently unsustainable future spending commitments will be rained in and/or financed. This uncertainty is a major factor contributing to the slow recovery of investment and the economy in general. The current impasse will continue to do great damage to the county.

According to Ezra Klein: “If Boehner had taken the White House’s deal in 2011, he could’ve stopped the tax increase at $800 billion. If he took their most recent deal, he could stop it at $1.2 trillion. But if he insists on adding another round to the negotiations — one that will likely come after the White House pockets $700 billion in tax increases — then any deal in which he gets the entitlement cuts he wants is going to mean a deal in which he accepts even more tax increases than the White House is currently demanding.

“Today, Boehner wishes he’d taken the deal the president offered him in 2011. A year from now, he might wish he’d taken the deal the president offered him in 2012.”[1] See also: “The GOPs worst cliff myth”[2]

For the sake of the country and for the sake of the principles in which many Republicans believe, they must recover (with the cooperation of Democrats) the art of governing.


[1] Ezra Klein, “Obamas small deal could lead to bigger tax increases” The Washington Post, Dec 22, 2012

[2] Ezra Klein, The Washington Post, Dec 24, 2012.