Category: Economics

Teachers of the Poor

The raging debate about income inequality has focused on the growing demand for well-trained workers and the declining quality of American education. The mismatch is contributing to rising incomes for the well-educated and stagnant incomes for the poorly educated. Improving the education of the poor is thus a sensible and promising target for improving the incomes of the poor.

Thus the case getting underway in California attacking teacher tenure as a source of poor teachers being assigned to the poorest schools is timely and important. Teacher tenure goes on trial in Los Angeles courtroom/2014/01/26/

The issue of the unionization of public sector workers more generally is contentious. In the private sector unions can balance the market power of employers and are restrained in their demands by their impact on an employer’s bottom line. If excessive wages make a company uncompetitive and it losses market share or goes out of business, the jobs go with it. In fact, a constructive relationship between unions and their employers can potentially improve wages and the bottom line.

Public sector workers, on the other hand, are not constrained by the government’s bottom line (tax payers). Charles Lane provides a good discussion of this issue in today’s Washington Post: Public Sector Unions Interfere with the Public Interest/2014/01/27/.  Unionized or not, public sector workers have long been protected from political interference by the Civil Service system. These protections were established in order to reduce the role of political favoritism in public sector hiring and promotion. However, the trade-off was the creation of a system in which promotion had much more to do with years of service than performance and in which it was difficult to fire anyone thus sheltering mediocre workers.

These trade offs are not easily resolved. If government supervisors can evaluate performance and reward it appropriately, they can also be easier prey for political interference. If they can’t, the worst performing employees rise to the top over time just as fast as the best performing and we get the civil service that we know and love. The plaintiffs in the California case “are nine students who say they were trapped in classrooms with “grossly ineffective teachers” who could not be fired because of the job protection laws.” (W.Post)

The solution, of course, is to leave as much in the private sector as possible. Private schools, including government funded but privately run charter schools systematically produce better results than public schools, especially for the poor.

In an interesting footnote, the plaintiffs legal team includesformer U.S. solicitor general Ted Olson and Theodore Boutrous, who most recently paired to win a U.S. Supreme Court decision that struck down California’s prohibition against same-sex marriage.  Olson and Boutrous had famously represented opposing sides before the Supreme Court in Bush v. Gore, which halted the Florida vote recount and resulted in Bush capturing the presidency. Olson’s wife Barbara died on September 11, 2001 when American Airlines flight 77 crashed into the Pentagon.

A Hard Anchor for the Dollar

For the last three years with zero interest rates and “quantitative easing” the Federal Reserve has been pushing on a string. It has been trying to stimulate an economy that suffers from problems that are not basically monetary. In the process it is distorting the limping economic recovery and potentially reflating housing and other asset bubbles. The Federal Reserve has jeopardized its revered independence by undertaking quasi-fiscal operations (buying long-term government debt and MBS to push down longer term interest rates in those markets while paying banks interest on their deposits at the Fed to keep them from lending the proceeds). The result has been an explosion of the Fed’s balance sheet (base money—the Fed’s monetary liabilities—jumped from around $800 billion in mid 2008 to over $3,200 billion in July 2013) while the money supply only grew modestly (over the same period M2 increased from about $8,000 billion to about $10,700 billion- about the same increase as over the five year earlier period from mid 2003 to mid 2008).

There is growing sentiment that our fiat currency system should be replaced with a hard anchor, such as the gold or silver standards in place in much of the world over the two centuries preceding gold’s abandonment by the United States in 1971. In order to avoid the weaknesses of the earlier gold standard, which contributed to its ultimate abandonment, three key elements of its operation should be modified. These are: a) the conditions under which currency fixed to a hard anchor is issued and redeemed; b) what the currency is sold or redeemed for; and c) what the anchor is.

Monetary Policy

During the earlier gold standard, the value of one U.S. dollar was fixed at $19.39 per ounce of fine gold from 1792 to 1934 and $35.00 per ounce from 1934 to 1971 when Nixon ended the U.S. commitment to buy and sell gold at its official price because the U.S. no longer had enough gold to honor its commitment.  None-the-less, the official price was raised to $38.00 per ounce in 1971 and to $42.22 in 1972 before President Ford abolished controls on and freed the price of gold in 1974.

Under a strict gold standard, operated under currency board rules, the central bank would issue its currency whenever anyone bought it for gold at the official price of gold and would redeem it at the same price. In fact, however, the Fed engaged in active monetary policy, buying and selling (or lending) its currency for U.S. treasury bills and other assets when it thought appropriate. Thus rather than being fully backed by gold, the Fed’s monetary liabilities (base money) were partially backed by other assets. Moreover the fractional reserve banking system allowed banks to create deposit money, which was also not backed by gold. The market’s ability to redeem dollars for gold kept the market value of gold and hence the dollar close to the official value. Because the Fed could offset the monetary contraction resulting from redeeming dollars, this link was broken and in 1971 President Nixon closed the “gold window” altogether for lack of gold.

A reformed monetary system should be required to adhere strictly to currency board rules. The Federal Reserve should oversee the interbank payment and settlement systems and provide the amount of dollars demanded by the market by passively buying and selling them at the dollar’s officially fixed price for its anchor (gold, in a gold standard system) in response to market demand. Banks should be denied their current privilege to create deposit money by replacing the fractional reserve system with a 100% reserve requirement (a subject for another time).

Indirect redeemability

Historically, gold and silver standards required that the monetary authority buy and sell its currency for actual gold or silver. These precious metals had to be stored and guarded at considerable cost. More importantly, taking large amounts of gold and/or silver off the market distorted their price by creating an artificial demand for them. Under a restored gold standard the relative price of gold would rise over time due to its limited supply, and the increasing cost of discovery and extraction. The fix dollar price of gold would mean that the dollar prices of everything else would have to fall (perpetual deflation). While the predictability of the value of money is one of its most important qualities, stability of its value (approximately zero inflation) is also desirable.

This shortcoming of the traditional gold standard can be easily overcome via indirect redeemability. The market’s regulation of the money supply in line with the official price of money in terms of its anchor does not require transacting in the actual anchor goods or commodities. As long as an asset of equal market value is exchanged by the monetary authority when issuing or redeeming its currency, the market will have an arbitrage profit incentive to keep the supply of money appropriate for its official value. In a future, hard anchor monetary system, the Federal Reserve could issue and redeem its currency for U.S. treasury bills rather than gold or other anchor goods and services. The difference between that and current open market operations by the Fed is that such transactions would be fully at the initiative of the market rather than of the central bank. The storage cost of such assets would be negligible and in fact would generate interest income for the Fed.

The Anchor

The final weakness of the gold standard was that the relative price of the anchor, based on a single commodity, varied relative to the goods and services (and wages) purchase by the public. In short, though the purchasing power of the gold dollar was highly stable historically over long periods of time, gold did not provide a stable anchor over shorter periods relevant to most business decisions.

Expanding the anchor from one commodity to 10 to 30 goods and services carefully chosen for their collective stability relative to the goods and services people actually buy (e.g. the CPI index) would be an important improvement over anchoring the dollar to just one commodity (gold). There have been many such proposals in the past, but the high transaction and storage costs of dealing with all of the goods in the valuation basket doomed them. Replacing such transactions with the indirect convertibility described above eliminates this objection.

A Proposal

The United States could easily amend its monetary policy to incorporate the above features – a government defined value of the dollar as called for in Article 1 Section 8 of the U.S. Constitution and a market determined supply of dollars. First Congress would adopt a valuation basket of 10 to 30 goods and services chosen to give the dollar the most stable value possible in terms of an average family’s consumption (i.e. the Consumer Price Index). The basket would consist of fixed amounts of each of these goods and would define the value of one dollar. As with the gold standard, if the value of the goods in the basket were more in the market than one dollar, anyone could buy them more cheaply by redeeming dollars at the fed for an equivalent value of U.S. treasury bills (indirect redeemability). The resulting contraction of the money supply would reduce prices in the market until a dollar’s value in the market was the same as its official valuation basket value. The money supply would grow with its demand (as the economy grows) in the same way (selling t-bills to the fed for additional dollars). The Federal Reserve would be restricted to passive currency board rules. All active purchases and sales of t-bills by the fed (traditional open market operations) or lending to banks would be forbidden. During a two year transition period the fed would be allowed to lend to banks against good collateral in order to allow banks time to adjust their operations and balance sheets to the new rules.

A global anchor

The gold standard was an international system for regulating the supply of money in each country and between countries and provided a single world currency (fixed exchange rates). This led to a flourishing of trade between countries. This was a highly desirable feature for liberal market economies.

The United States could adopt the hard anchor currency board system described above on its own and others might follow by fixing their currencies to the dollar as in the past. The amendments to the historic gold standard system proposed above would significantly tighten the rules under which it would operate and strengthen the prospects of its survival.

However, there would be significant benefits to developing such a standard internationally as outlined in my Real SDR Currency Board proposal (http://works.bepress.com/warren_coats/25/). One way or the other, replacing the widely fluctuating exchange rates between the dollar and other currencies would be a significant boon to world trade and world prosperity.  Replacing the U.S. dollar as the world’s reserve currency with an international unit would have additional benefits for the smooth functioning of the global trading and payments system.

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.

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.

Our Unsupportable Empire

Most of you are grudgingly aware that the U.S. government has promised us more than we want to or can easily pay for.  China is no longer willing to fill the gap knowing that we will not be capable of repaying it.  This is on top of the existing national debt from past borrowing to cover the government’s current and past spending in excess of its revenue of $16 trillion, about the same as the United States’ total annual output.  These numbers pale in comparison with the government’s unfunded commitments (those not covered by the revenue expected from existing tax laws and user charges) to future retirees and recipients of medical care (social security, medicare and Medicaid). The present value of the revenue short fall to pay for these future commitments (the government’s unfunded liabilities) is currently around $50 trillion for an astonishing total debt of around $66 trillion, which is larger than the total annual output of the world per year.

Naturally, these promises must be pared back because they can’t be paid for. To some extent a healthy, growing economy will also increase our capacity (lighten the burden) to pay for them but by itself growth will not be enough. This is one, but only one, of the reasons that we also need to reconsider our military promises around the world, while reducing and reorienting our military budget and modestly increasing our diplomatic (State Department) expenditures.

Our promise to provide security to most of the world suffers from the same moral hazard as does an overly generous welfare state.  Incentives matter. When access to welfare is easy and the level of support is generous, more people will choose it over taking a job that doesn’t interest them much.  When President Bill Clinton signed “The Personal Responsibility and Work Opportunity Reconciliation Act of 1996” (PRWORA) on August 22, 1996 (with strong Republican support), he fulfilled his campaign pledge to “end welfare as we have come to know it.” The law ended welfare as an entitlement by introducing tighter conditions for receiving it. Welfare costs dropped following adoption of the law. “A broad consensus now holds that welfare reform was certainly not a disaster–and that it may, in fact, have worked much as its designers had hoped.”[1] While some people remain skeptical, Sweden’s welfare reforms of the last two decades have demonstrated very similar results.[2]

The United States spends more on its military than the next 14 largest military spenders combined (China, Russia, UK, France, Japan, Saudi Arabia, India, Germany, Brazil, Italy, South Korea, Australia, Canada, and Turkey). We are policing/protecting most of the world. This has two negative effects. The first, similar to chronic welfare recipients, is that other nations spend less on their own defense, taking a free ride on the United States’ ability to keep the world safe for everyone else. The second is that by diverting so much of our productive resources into the military, we reduce the resources available for developing and strengthening our economy. It is our powerful economy that underlies our influence in the world as much, if not more, than our military power. Moreover, our military might is made possible by our economic power. So we need to get the balance right. I urge you to read David Ignatius’ recent discussion of this issue in The Washington Post, (“The foreign policy debate we should be having”, Oct 21, 2012, page A15)

But there are more reasons that our military adventurism and spending should be reduced and more resources given to diplomacy. Our national security and the freedoms America was founded to establish and protect will be strengthened as a result.

American hegemony rests largely on our economic and military power, but also on widespread respect for the American way of life (our respect for human freedom and dignity and our prosperity). Our efforts to promote democracy via military interventions have generally not gone well.  The talents and spirit of enterprise that have served us so well at home have not generally contributed to success in building new democratic nations where we have militarily intervened. Books like Joseph Heller’s, Catch 22 (about WWII) and movies like Robert Altman’s Mash (about Viet Nam) entertainingly introduced us to the bureaucratic problems of fighting and/or governing in foreign lands. We have the best trained and most well equipped military history has ever known, but it has failed for the last ten years to win in Afghanistan, which is now the longest war in American history. Our powerful military is not good at nation building, nor should we expect it to be. The military is not the right tool for promoting the values we believe in around the world. That is a job for diplomacy (with our powerful military well in the background).

We have been more successful at promoting our values and our economic interests through our promotion of and participation in international organizations like the International Monetary Fund, the World Bank, and the World Trade Organization and a wide range of international agreements and cooperation that facilitate free trade, and capital movements, and that extend the protection of property and human rights internationally. These organizations and agreements have developed the international legal frameworks for telecommunications, patents, financial and product standards, etc. that underlie the explosion of globalization that has dramatically raised the standard of living for much of the world’s population.

Rajiv Chandrasekaran, has written an excellent exposition of our military efforts in Afghanistan, which I urge you to read “Afghan security forces rapid expansion comes at a cost as readiness lags” (The Washington Post, Oct 21, 2012, page 1). Every few years America’s military strategy has changed: from counter terrorism, to counter insurgency, to building and training (and equipping) an Afghan National Army and Afghan National Police. As each approach fails, the Joint Chief’s extract the lessons learned and try a new one until it fails. In recent years, our military commanders have correctly emphasized the fact that “success” cannot be achieved by the military alone (it amazes me that anyone could have thought so – no wonder they are so eager to start wars).

But those are far from the only reasons for reducing our military footprint and budget. I believe in keeping government relatively small and encumbered with the organizational and political checks and balances meant to replace the role of competition in the private sector in bending self-interest to the public good. People are influenced by their self-interest whether they are in government or the private sector. However, in the private sector success comes from serving the needs of others in the market. This exerts a strong incentive on individual behavior. (Dishonesty can exist in either sector and can only be addressed by embracing appropriate moral standards and consistent punishment of breaches of those standards) In place of market discipline (acceptance or rejection), government must rely more on checks and balances to ensure that government officials behave as intended and they can only go so far to keep government honest and impartial in serving the public. The power of the government to coerce, and the expenditure of large sums of money by the government create enormous temptations for personal gain by those in positions of power in the government. The bigger government gets the more difficult it is to prevent some in government from yielding to the temptations to direct its power and money to their own good rather than the general good.

The firms in our large and important military support industry (Lockheed Martin, Boeing, Northrup Grumman, General Dynamics, Raytheon, Halliburton, United Technologies, Computer Sciences, BAE Systems, General Electric, Bechtel, and Honeywell International, to name a few), do not have a disinterested view about the most appropriate and cost-effective military technology the defense budget should provide for. The millions of dollars they spend attempting to influence the choices of the services and congress are, in a sense, “honest” efforts to promote their self-interested view of what best serves our national security. The growing behemoth of the industrial military complex of which Eisenhower warned us over fifty years ago now both defends and threatens our liberties. See my earlier comments on Ike’s famous farewell address: http://dailycaller.com/2011/01/17/ikes-farewell-address-fifty-years-on/

The risks of the misallocation of our resources and waste are directly related to the size of our military (and government more generally). The boundary between honest differences of opinion over the best military equipment and systems and simple cronyism is fuzzy.  Consider, for example, the recent award of a large contract to build 100,000 homes in war-torn Iraq to HillStone International, a newcomer in the business of home building. When its president David Richter was asked how the newcomer swung such a big deal, he replied that it really helps to have “the brother of the vice president as a partner” (James Biden).[3] It would not be fair to disqualify bidders because they are friends or relatives of high government officials (As Afghan President Karzai’s brother Mahmoud said to us with regard to the shares of Kabul Bank given to him by its founders. The Bank is now in receivership as the result of the bank lending 95% of its deposits to its shareholders), but how can you tell what is merit and what is cronyism?

My point is that the defense budget needs to be on the table when our elected officials finally confront the cuts that must be made to the government’s expenditures to save the country. Defense spending needs to be cut not just because we can’t afford it, but also because our oversized military is weakening our economic base on which both our military and our political power in the world rest. And perhaps most important of all, over reliance on military power to the exclusion of diplomacy has actually weakened our security and standing in the world.

[1] The New Republic, editorial September 4, 2006, page 7.

[2] The Economist, “Sweden: The New Model” October 13, 2012.