Tag: debt

Econ 101: SVB and bank runs

What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.

It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).

The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.

The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)?  “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”

Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset.  When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).

The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.

The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years.  See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”

Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits.  Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.  

The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?

Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”

When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available.  The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”

Econ 101: Inflation –Temporary or Longer Lasting?

Prices of many goods and services have increased in recent months. Are these increases permanent or temporary or will they continue rising in the future? Before exploring those questions, it is important to understand the measures of inflation we are considering. What is the current rate of inflation in the United States? U.S. inflation in September was 3.0% (Compound annual rate of change for Consumer Price Index without food and energy prices over the month of September), or 4.0% (percent change from a year ago) or 5.4% (percent change from a year ago including food and energy prices). What does it mean if this is temporary or long lasting?

If prices remain where they are today after the 5.4% increase from a year ago, inflation going forward would be zero even though the cost of living would be permanently higher. If inflation is long lasting it means that prices will continue to rise for some time (years). What are the factors that influence the future behavior of prices? What should we expect in the U.S.?

The price of a good or service increases when its demand exceeds its supply and similarly for prices in general (when aggregate demand exceeds aggregate supply). As prices are measured in a country’s currency, supplying too much of the currency (generally when the money supply grows more rapidly than the supply of goods and services) causes its value to fall (i.e., prices in the country’s currency to rise).

On the cost side, firms will hire workers and pay them a particular wage (and related benefits) when it adds more to the company’s income than it costs, which includes the cost of the tools they use (capital). Workers will accept a job when its benefits (pecuniary and nonpecuniary) are the best they can find. The inflation expected by the employer and the employee over the period of the wage contract is an important factor in determining what will be offered and what will be accepted.

Because of changes in consumer demands, worker preferences, halving of work visas for immigrants, and supply chain disruptions, labor markets are temporarily in turmoil. September unemployment in the U.S. was 7.674 million while there were 10.4 million job vacancies. Employers are raising wages in an effort to fill those vacancies. As reported by Scott Lincicome: “Goldman Sachs analysts saw a ‘perfect storm of factors that have significantly reduced the supply of workers who are currently looking for jobs at the same time that labor demand—as measured by job openings—has risen to an all-time high.’ This includes… state and federal benefits, early retirements, severely restricted immigration, a switch to self-employment, fear of COVID, and a geographic mismatch between unemployed workers and available jobs. Combined, these factors account for most of the missing workers out there.”  “What if the labor shortage isn’t transitory?”

In short, the labor force has shrunk just as the demand for output is increasing. This excess demand for workers is driving up labor costs and thus pushing up output prices. If the 5 or 6 percent price increase experienced over the present year is expected to be temporary, i.e., if prices are expected to return to their level a year ago, because the supply of labor returns to its pre-pandemic level, wage increases should be temporary as well, falling back to their pre pandemic level and growing thereafter on average with labor productivity plus the 2% inflation target of the central bank once there is full employment and better labor market balance.

More likely, if the inflation is expected to be temporary, i.e., the current 5 to 6 percent inflation stops but prices remain at their increased level, wages will remain at the increased level, but their real (inflation adjusted) value will fall back to their original level. In other words, if these higher prices are expected to be “permanent,” the nominal wage increases now being experienced will not result in any increase in real wages and the worker short fall might remain.

While some of those who withdrew from the labor force will probably return, it is not likely to fully satisfy the demand for various reasons (early retirement, fall in immigration, etc.). Filling (or attempting to fill) the remaining labor shortage will require additional wage increases (unless the public’s demand for goods and services falls–see below). In that case, firms will plan to pass on their higher cost of labor to their customers. If we, the customers, can continue to pay the higher prices, the inflation will continue. Expectations of higher prices and or inflation will be realized.

The Covid-19 pandemic caused a sharp fall in output and thus to most people’s incomes. The government provided extraordinary financial support to temporarily fill the resulting income gap. Such support did not increase the output of goods and services or even prevent their decline but rather temporarily redistributed income from those saving it to avoid hunger and defaults on rents, mortgages, and other financial obligations by those who lost it.  “The new covid-19 support bill”  Because personal incomes were substantially maintained while actual output fell, personal savings rates increased dramatically and continue to be well above pre pandemic levels.

The Federal Reserve pitched in by buying up huge amounts of the resulting government debt increasing its balance sheet from $3.5 trillion in February 2020 to $6.3 trillion in August 2021 (measured by the monetary base, M0). This fueled an increase in board money (M3–M0 plus bank deposits and similar liquid assets of the public) from $15.5.0 trillion in February 2020 to $20.8 trillion in August 2021. This increase, though substantial, was significantly less than the increase in M0 (which almost doubled) because the Fed paid interest to banks for keeping the new base money with the Fed (excess reserves) rather than lending it to the public, by paying banks interest on all bank reserves kept with the central bank.

Historical experience is that the public will not be willing to hold these larger amounts of money for ever. They will eventually attempt to spend them down to their traditional (normal) levels, thus adding to aggregate demand for goods and services (and inflationary pressure).

Eventually, the demand for goods and services (aggregate demand) must fall to match real output, or output must rise to match demand. But if the Federal Reserve continues to print money faster than its real value is being inflated away, the inflationary process will continue or accelerate. Similarly, if the government continues to redistribute income from those with a lower propensity to consume (generally higher income families with a higher savings rate) to those with a higher propensity to consume (generally lower income families that save little), aggregate demand will remain excessive perpetuating inflation.

Historically, hyperinflation episodes invariably exploded in the collapse of the currency.  “Hyperinflation in Zimbabwe”  Turkey has come closest to a high inflation “equilibrium.” From the mid 1980s to the end of the 1990s Turkey’s inflation rate varied between 80 and a 120 percent. A high inflation “equilibrium” would be characterized by nominal interest rates and wage rates that fully incorporate the ongoing expected rate of inflation in order to preserve the appropriate real (inflation adjusted) rates. Interest rates in Turkey in this period generally exceeded 100%, as did wage growth.

In its most recent World Economic Outlook, the International Monetary Fund stated that: “In settings where inflation is rising amid still-subdued employment rates and risks of expectations de-anchoring are becoming concrete, monetary policy may need to be tightened to get ahead of price pressures, even if that delays the employment recovery.” “World Economic Outlook-October 2021”

As stands out clearly from the increasingly but unevenly rising inflation in the 1970, the process of increasing inflation is not linear (see the chart above).  As inflation increased, the Federal Reserve tightened monetary policy (raised interest rates to slow monetary growth) to slow inflation, causing real output to slow or decline. Policy then eased prematurely, and inflation and the expectation of higher inflation took off again, each time reaching a higher peak (until Paul Volcker stepped on the breaks and ended the game in 1979-80–the exciting year I worked at the Federal Reserve Board).

The Federal Reserve is smarter today than it was in the 1970s and has the tools to prevent the acceleration of inflation and the unhinging of inflation expectation. But the excess money balances and personal saving are very large and the government’s seeming willingness to run up unprecedented deficits create a powerful inflationary head wind. The tightening of monetary policy that will be needed (sooner rather than later in my view) will reduce the Fed’s purchases of Treasury debt and increase interest rates. Higher interest rates will increase government spending for debt service on its very large stock of debt, which will further increase government borrowing and debt or require cuts in spending for other programs. This must be added to the economic challenges of confronting climate change, the continuing recovery and adjustments from the Covid-19 pandemic, the deepening and destructive partisan divide that is stifling Congress, and the growing lack of public trust that drives it.

Whether our current inflation is temporary or longer lasting depends on how quickly and decisively the Federal Reserve tightens monetary policy and how quickly people go back to work. Whether the U.S. economy and the government’s large stock of debt continue to enjoy safe haven status around the world depends heavily on whether our government brings its spending and tax policies under better control.

Econ 201: CARES Act–Who pays for it?

April 11, 2010

Congress has authorized over 2 trillion dollars (so far) to help those harmed by the partial shutdown of the economy undertaken to slow the spread of the SARS-CoV-2 virus, and to facilitate its rapid recovery when it is safe for people to return to work. The idea is that as the government has requested/mandated non-essential workers to stay home, and non-essential companies (restaurants, theaters, bars, hotels, etc.) have chosen to close temporarily or have been forced to by risk averse customers or government mandates, the government has an obligation to compensate them for their lost income. Above and beyond the requirements of fairness, such financial assistance should help prevent permanent damage to the economy from something that is meant to be a temporary interruption in its operation. No good economic purpose would be served, for example, by lenders foreclosing on mortgage and other loans to workers sheltered in place at home with no income with which to service them. Some of the increased spending quite rightly will go to improve our ability to deal with covid-19 directly (expanded hospital capacity, virus testing capacity, vaccine research and development, etc.)

Obviously, it will be impossible to prevent some amount of waste and corruption from such a huge increase in expenditures. Every rent seeker on the planet has been lobbying Congress to get a piece of the action. In the design of these support programs every effort should be made to carefully target them on the people and activities appropriate to the “above objectives, to remove them and their associated distortions of economic resource allocation when the crisis has passed (i.e., keep them temporary), and to provide watchdog oversight of their implementation. Unfortunately, President Trump is already undermining such oversight. “How-trump-is-sabotaging-the-coronavirus-rescue-plan”  Nonetheless, the objective of minimizing the economic damage of a temporary forced shutdown of a significant part of the economy is appropriate.

The question explored here is who will pay for it and how.  The entertainment output of the economy (restaurants, movie theaters, hotels, vacation travel) is to a large extent non-essential, at least for a few months. If those are shuttered, about 20 percent (my guess for purposes of this analysis) of our economic output and the incomes of those producing them will be lost for the duration of the shutdown. A central goal of the “Coronavirus Aid, Relief, and. Economic Security Act” (CARES Act) is to prevent this necessary shutdown from killing that part of the economy and from spilling over into others. The goal is to enable it to restart as quickly and easily as health conditions permit. Thus, idled workers who would not be able to pay their rent/mortgage, or electric bill, or buy food without help should not be evicted for temporary nonpayment etc. The government might pay them for their lost income directly (unemployment insurance) or it might pay their employer to continue paying their wages for non-work under one program or another, thus continuing their health insurance and other benefits. These details are important but not the subject of this note.  The simplest assumption is that they all receive cash payments sufficient to see them through the shutdown (universal basic income, guaranteed minimum income or whatever you want to call it).

The starting fact/assumption is that the economy’s output and thus income is 20 percent or so lower for the next few months than it was a few months ago. Everyone on average has 20 percent less income, but that average consists of those who continue working as before and those sitting at home earning nothing.  If those unemployed are to receive income support (UBI), those still working and those clipping investment coupons must pay for it.  Paying an income subsidy to the unemployed does not create income, it redistributes it.

The $2 trillion plus authorized by Congress for these purposes will be debt financed, i.e. the government will borrow the money (adding to its deficit of $1 trillion for 2020 already budgeted).  So, to examine who pays for this program we must start by asking who will buy this additional debt?  In the past the Chinese and Germans funded an important part of our debts (via their trade surpluses with the US.  “Who-pays-uncle-sam’s-deficits”  China’s current account surplus with the U.S. is now negligible and it and most every other country in the world will have the financing of their own covid-19 expenditures to worry about. Those purchasing the additional Treasury bonds will thus be largely Americans who must shift their spending from other things (other investments or consumption) to the bonds and thus to the incomes of the unemployed these programs are supposed to be helping.  To the extent that new bond buyers are diverting their spending on other financial instruments interest rates on such instruments will tend to rise.

At this point very little money has been disbursed under CARES and no new government bonds to finance it have been issued. As individuals and firms miss rent and debt service payments, their lenders are being squeezed for the funds with which they must service those financing them (this is why we call banks financial intermediaries). Utility companies faced with nonpayments by their customers must borrow to continue paying their own employees, etc.  Scrambling for such funds would drive up interest rates in funding markets where it not for the Federal Reserve’s willingness to provide the needed liquidity. Similarly, with regard to the supply of funds to financial markets (the other side of bank’s balance sheets), normal investors are interrupting or even withdrawing funding in order to cover their own income shortfalls. This again squeezes financial sector liquidity and the flow of funds from lenders to borrowers needed to finance the remaining economic activity.

Enter the Federal Reserve.  In order to supply the missing funds–the missing rent and debt service payments–needed to keep the financial system flowing and in balance–the Fed has supplied almost $2 trillion to banks over the last 6 weeks, largely by outright purchases of treasury securities, though it has also opened a number of lending facilities. Bank reserve deposits at the Fed increased about $1 trillion over this period and M2 grew by about the same amount. On April 9, the Fed announced that it was opening or expanding facilities to support CARES Act objectives with up to another $2.3 trillion (leveraged by Treasury financial support to cover losses on any Fed loans provided in support of the CARES Act).  Federal Reserve Press Releases  This includes support for lending by the Small Business Administration (refinancing of SBA loans), the Main Street Lending Program administered by banks, Primary and Secondary Market Corporate Credit Facilities, and the Municipal Liquidity Facility. These are dramatic expansions of Fed credit operations and the details of eligibility of borrowers and of the facilities’ administration are critically important. Ensuring that this massive government intervention in the economy creates the right incentives for a quick rebound in the economy when it can reopen and that these interventions are indeed temporary will be difficult and is very important. But the question I want to address here is whether this monetary financing on such a huge scale will be inflationary.

Simplifying and reviewing, if economic output/income falls by, say 20 percent, and the loss is shared by those working with those temporarily laid off (or idle) by workers lending money to those idled, the Fed need not be involved. However, as is often the case with fiscal policy, it is simply beyond the administrative capacity of the government to launch and coordinate such a redistribution of income quickly and smoothly enough to avoid the disruptions of credit flows described above. Instead, the Fed has printed the money paid to those idled by shuttering 20 percent of the economy. As a result, the idled workers have their regular income (more or less) from newly printed money, and the rest have their regular incomes, but the economy is producing 80 less for them to buy. The “excess” income constitutes the inflationary potential. If this income is voluntarily saved (i.e. a temporary increase in the demand for money), the increased saving would be indirectly financing the spending of the unemployed. It is not unreasonable to expect this to reflect actual behavior for a shutdown of a month or two. But should it drag on for many months the extra saving held in anticipation of a reopening of restaurants and theaters, etc. will seek other consumption outlets and prices will begin to rise.

With luck, the economy will begin to return to “normal” after a few months and the Fed will begin to withdraw its monetary injection as loans and payment delinquencies are paid off from increased output/income. The artificially preserved incomes will increasingly be spent on restored output without significant inflationary consequences.

But the CARES Act provides for the forgiveness of loans by firms that kept or that rehire their workers promptly. As the Fed sells its treasuries back to the public (or allows them to mature without replacing them), the Treasury will be issuing the additional debt needed to fund the $2 trillion plus of CARES Act expenditures, including the forgiveness of debt described above. In short, to avoid the inflationary consequences that would normally flow from the Fed’s massive increase in the money supply, the monetary financing must be replaced with fiscal debt financing.  It is hard to see where the money will come from to buy such a large increase debt (some, but not much, will probably come from the foreign financing implicit in an increase in our balance of payments deficits, but the rest of the world is now being saturated with its own debt) without an increase in market interest rates, potentially a significant increase in such interest rates. To the extent that financing remains monetary and pushes up prices, the rising inflation rate will be added to nominal market interest rates compounding the pressure of expanding real debt.  The long looming US fiscal debt problem may be near.

Feeding the Swamp

During his filibuster leading to last week’s brief government shutdown, Sen. Rand Paul (R-Ky.) stated that: “When Republicans are in power, it seems there is no conservative party…. The hypocrisy hangs in the air and chokes anyone with a sense of decency or intellectual honesty.” He was protesting the compromise two-year budget just passed by the Senate and awaiting passage in the House. This budget, now signed into law by President Trump, adds over $300 billion in additional government spending this year alone on top of the $1 trillion dollar deficit created by the recently passed tax cut. “Why-did-the-GOP-vote-for-a-budget-busting-spending-bill-because-voters-dont-seem-to-care”

A few congressmen reacted with more principle. “’I’m not only a ‘no.’ I’m a ‘hell no,’ ” quipped Rep. Mo Brooks (R-Ala.), one of many members of the Tea Party-aligned Freedom Caucus who left a closed-door meeting of Republicans saying they would vote against the deal.

“It’s a “Christmas tree on steroids,” lamented one of the Freedom Caucus leaders, Rep. Dave Brat (R-Va.).” “Right-revolts-on-budget-deal”

Why should we worry about adding to the public debt? The “deficit” is the shortfall of tax revenue below expenditures in one year. This is now forecast to average about one trillion dollars in each of the next two years. “Bipartisan-budget-act-cements-return-trillion-dollar-deficits”. Each year these annual deficits add to the outstanding U.S. national “debt” currently at $20.6 trillion dollars. Even before the recent tax cuts and last week’s expenditure increases, the Congressional Budget Office projected Federal debt held by the public at $25.5 trillion or 91.5% of GDP by 2027. But that figure omits debt held by the Federal Reserve, Social Security “trust” fund, and other government entities, which must also be serviced and repaid. When these are included as they should be, gross federal debt is projected to be $30.7 trillion or 110% of GDP by 2027 and 150% of GDP in thirty years and climbing. And to repeat, this is before the recent tax cuts and budget increases.

As our economy grows so does the government’s capacity to carry and service (pay the interest on) the debt. But on the basis of existing laws and policies our debt will grow faster than the economy forever. But of course that is impossible. At some point taxes must be increased or expenditures cut, or the government defaults on its debt. In fact the problem is worse than these figures suggest because they fail to include the future taxes or borrowing needed to cover unfunded government liabilities. These are commitments, such as future Social Security pension payments, for which existing financing falls short. For example, Social Security payments already exceed its annual revenue from the wage taxes of current workers and the so-called trust fund will run dry in fifteen years. That will add still more to the deficit and the debt.

Indeed, there are times when deficits are ok and even helpful. When the economy goes into recession the government should allow the deficit that naturally results from falling tax revenue and increasing safety net spending. These are referred to as automatic stabilizers. However, we are currently not now in that phase of the business cycle. We are now at its peak and if the government is to achieve fiscal balance over the cycle it must run budget surpluses at the peak to pay for the deficits during the slumps. The U.S. should now have a budget surplus and not the huge deficit presently experienced and projected. The White House’s announcement today (Monday) that it is giving up on the traditional Republican goal of a balanced budget in ten years is hardly a surprise when we are starting with a large deficit at the peak of the business cycle. https://www.washingtonpost.com/business/economy/white-house-budget-proposes-increase-to-defense-spending-and-cuts-to-safety-net-but-federal-deficit-would-remain/2018/02/12/f2eb00e6-100e-11e8-8ea1-c1d91fcec3fe_story.html?utm_term=.514757e9c8de&wpisrc=al_news__alert-politics–alert-national&wpmk=1

Senator Paul was rightly angry that not only was the need to face and correct this untenable future kicked down the road yet again, but the process of doing so was corrupt. Votes were bought by sticking in special tax and spending breaks for the constituents and friends of individual congressmen—the old earmarks by another name. “Budget-deal-retroactively-extend-several-expired-tax-provisions”. While it is true that the bipartisan budget deal wouldn’t have passed without these bribes, it shouldn’t have passed. Instead of draining the swamp the Republicans have joined with the Democrats to feed it. “In-big-reversal-new-trump-budget-will-give-up-on-longtime-republican-goal-of-eliminating-deficit”. And more repulsive is the fact that these are the same Republicans who rallied against spending during the Obama years. This is the hypocrisy Senator Paul lamented.

Congress has failed yet again to prioritize it’s spending to match the resources that taxpayers are willing to pay. The moral corruption of this way of doing business was reestablished and reinforced. As another example of blatant corruption, Presidents have rewarded (paid off) large contributors with Ambassadorships to nice places like London, Paris, and Rome (to name a few) for decades. This is pure corruption for which the country pays with lower quality representation and diplomacy than would be provided by Foreign Service professionals. Unfortunately we have grown used to it and barely notice it. This is dangerous.

All individual government expenditures and programs look worthwhile to at least some people, but at the expense of what? What do taxpayers or investors or other government programs give up to finance them. These are not easy choices and decisions but it is the job of our representatives to make these judgments in the best interests of the country as a whole. That is probably expecting more than they are capable of delivering, but it is their job. Those of you of Generation X, Y and Z will have to pay for this so you are the ones with an incentive to do something about it. We need more Rand Pauls. “The-5-biggest-losers-from-the-2018-budget-deal-are…”

SALT—More press nonsense on tax reform

The elimination of State and Local Tax (SALT) deductions from the proposed tax reforms working their way through Congress has become a hot topic. Fine, but please keep the discussion honest. Sadly my local newspaper, The Washington Post, is not setting a good example: “In-towns-and-cities-nationwide-fears-of-trickle-down-effects-of-federal-tax-legislation”

First a word about tax reform vs tax reduction. We are now in the 9th year of economic recovery, one of the longest on record. It won’t go on forever. Ideally the Federal government’s budget should balance its expenditures and revenue over the business cycle. That allows for aggregate demand stimulating deficits during business downturns. These deficits result from so called automatic stabilizers—the fall in tax revenue from the fall in taxable income plus increased transfer payments to the unemployed. But a cyclically balanced budget also requires budget surpluses during the business expansion phase. The U.S. economy is now fully employed (in fact, unfilled vacancies exceed those looking for work). The Federal Reserve has finally increased inflation to its target rate of 2%. We should now have budget surpluses to make room for the deficits that will follow during the upcoming downturn.

But our fiscal situation is much worse than that. The large increase in “entitlement” expenditures for my greedy generation as we retire (greatly increasing unfunded social security and health benefits) will push our fiscal debt held by the public, now at 77% of our Gross Domestic Product (GDP), to over 150% of GDP within 30 years if current laws remain unchanged. See the figure below.

Taxes will either need to be increased (not reduced) or entitlement expenditures reduced (which means increased less than current law provides). My point is that reducing tax revenue at this time is irresponsible without at least matching expenditure cuts. The proposed tax reforms now in congress would increase the debt by $1,500 billion dollars over the next ten years on a static forecast basis, meaning without taking into account the increased growth and thus tax revenue that might result from the tax reforms, which no one expects to wipe out all of the static forecast of $1,500 billion.

Fed debt      Congressional Budget Office forecasts

While it is irresponsible to cut tax revenue at this time, it is highly desirable to reform how that revenue is raised. The existing taxes distort the economy and thus reduce our incomes in a number of ways. They grant favors to many special interest groups via allowing them to deduct specific expenditures from their taxable incomes (i.e. from the tax base). These so called tax subsidies encourage activities over what the private economy would otherwise under take. One very damaging example is the deduction of interest payments by businesses and individuals, which has encouraged excessive borrowing and indebtedness. The most popular of these is the mortgage interest deduction by homeowners. This tax subsidy benefits homeowners relative to renters, i.e. it benefits the wealthier at the expense of the poor. How well meaning middle and upper income American’s can justify this with a straight face is beyond me.

But what about the SALT deductions? By eliminating such deductions, i.e. by broadening the tax base, the same revenue can be raised with a lower tax rate. Other things equal (such as revenue), lower tax rates are good because they influence taxpayer decisions less. For example, companies are more likely to invest in the U.S. rather than abroad if the corporate tax rate is reduced from its current 35%, virtually the highest in the world, to 20%, which is closer to the rate in most developed countries.

Reducing tax subsidies to state and local governments is also good because it reduces an artificial encouragement for larger state and local government expenditures. If Californians are willing to pay more state taxes for larger state expenditures they are welcome to do so. But there can be no justification for transferring federal tax revenue from states with lower expenditures and matching taxes to California and other high spending states. To a large extent the existing SALT deductions transfer income from poorer states to wealthier ones. Who can support that with a straight face?

How information is presented can have a significant effect on how it is understood or viewed. How did Renae Merle and Peter Jamison of The Washington Post (see link above) report the proposed elimination of the SALT deduction? They reported that, “In San Diego County, the elimination of what is commonly called the “SALT” deduction could affect about a third of households, said Greg Cox, a member of the board of supervisors. The average middle-income resident would lose a $16,000 deduction.” They failed to note that the third of households affected are the wealthiest third. According to CNBC: “More than half of taxpayers who are earning $75,000 and above claim SALT deductions on their federal income tax returns as do more than 90 percent of taxpayers who make $200,000 or more.”

share of SALT

Furthermore, the figure $16,000 is misleading in two respects. The loss of a $16,000 deduction would increase taxes for a single person earning $200,000 annually by $5,280 at the current tax rate of 33%. However, broadening the tax base by eliminating the SALT and other deductions allows raising the same revenue with a lower tax rate. To measure the actual tax impact both effects must be combined. Current congressional proposals are to reduce the rate for the above person to 25%, which would result in an increased tax of $4,000. None of this would affect the poor directly. I assume that Renae Merle and Peter Jamison were just careless rather than letting their biases get the best of them, but you can make your own judgment.

The SALT deduction cannot be justified on either economic or fairness grounds, but there is sadly a good chance congress will cave in to the pressure from the wealthier states to keep it or at least some of it.

 

 

 

My Political Platform for the Nation – 2017

For me, the ideal American government would deliver its important but limited functions efficiently and effectively and would raise the money to pay for these activities with efficient, minimally distorting (neutral), and fair taxes following a principle of maximum subsidiarity (decisions made and services performed at the most local levels possible). The government should do fewer things than it does now but should do them better and should fully pay for them with taxes and fees (cyclically balanced budgets).

My unrestrained, radical platform will be presented here at a high level of general principles. Details need to be refined by a political process involving public discussion and are likely to evolve somewhat over time. Links to earlier articles provide additional details. In the very broadest terms Americans should be self reliant and free to work and play as hard as they choose with the government supporting their choices by providing security, the legal foundation and framework of private property and contracts, and an efficient safety net when individual undertakings are not feasible or fail.

The limited functions of the Federal government are enumerated in Article 1 section 8 of the U.S. Constitution. Broadly these are to:

  1. Develop and maintain our relations with other countries and international bodies and to maintain an Army, Navy and Air Force for the purposes of defending and promoting the security of the United States;
  2. Establish and enforce the rights to property and contracts and to adjudicate related disputes;
  3. Provide for public safety;
  4. Provide an efficient and effective social safety net (welfare);
  5. “Regulate commerce with foreign Nations, and among the several States;”
  6. “Coin money, regulate the value thereof, and of foreign coin, and fix the Standard of Weights and Measures;”
  7. Arrange for the provision of roads and essential infrastructure; and
  8. Tax, borrow, and levy fees and tariffs to pay for these activities.

Our Social Contract

Sovereignty resides with each individual, who have collectively ceded limited powers to government for the general welfare. Each of us is free, within legal limits on doing harm to others, to lead our own lives and build or work at whatever we choose. Thus the government’s laws apply equally to each of us without regard to our race, religion, sex, or sexual orientation. From this environment of freedom and innovation, America has built the most successful economy in the world.

When building companies or developing products, many will fail and try again. The government provides the legal framework (bankruptcy) for resolving such failures. The implicit agreement between citizens and their government is that government will provide a floor—a safety net—whenever a person’s efforts fail or when, e.g., for health reasons, a person is unable to provide for him or herself. The level of the safety net should reflect the level of the country’s income and social consensus and should be designed to achieve its objective as efficiently as possible with careful consideration of the incentives it creates.

Income redistribution: taxation and a guaranteed minimum income

All income (personal and corporate) taxes should be replaced with a comprehensive, flat, consumption tax (Value Added Tax—VAT) and limited progressivity introduced by paying every legal man, woman and child resident a guaranteed minimum income. US federal tax policy, Cayman Financial Review July 2009 Each recipient of these monthly guaranteed income payments would be required to set aside a minimum amount for health insurance (chosen by each person or family in the competitive market place) and a minimum amount for retirement (invested in qualifying retirement funds in the competitive market place). Saving social security

As the guaranteed minimum income should be at a level sufficient to minimally support life’s basic needs, supplements such as unemployment or disability insurance would not be needed or provided. However, disabilities acquired from military or public safety service should receive additional income support.

Health care

Each person will be responsible for paying for at least part of routine medical care (the copay required by the insurance they have chosen) and will thus care about its cost. The cheapest insurance policies will be limited to major medical expenses (catastrophic health insurance). As everyone will be required to contribute monthly to a health savings account from their guaranteed minimum income, most people will chose to use such funds to buy health insurance, which would not be tied to employment or an employer.

Doctors and hospitals will be required to make medical service costs transparent. On that basis, patients, in consultation with their doctors, will decide the level of care and treatments to receive. These measures will introduce normal market competition into the provision of medical care that is currently absent, which will improve its quality and lower its cost.

Education

Equal access to quality education is a critical element in maximizing opportunity for all and the wealth of our society and each person in it. The public school system has often failed in this objective. While the wealthy can afford to put their children in private schools when the neighborhood school is of poor quality, lower income families generally cannot. Every K-12 aged child will receive a tuition voucher that covers the cost of state provided education. The amount will generally vary from state to state (or school district to school district). The voucher can be used to attend the local neighborhood public school with no additional cost, or any private school the family chooses, which might incur additional costs. Schools eligible to receive such vouchers must meet minimum education standards set by the state and must disclose the performance of their students on state administered achievement tests. This information must be available to the public. The learning progress of each child is more important than the average level of achievement of each school’s students as some schools might well specialize in slow or problem learners and performance data should reflect this distinction. The neighborhood school has the advantage of being easier to get to every day and will normally be chosen by families if it provides a good education. The argument for universal tuition vouchers goes beyond providing a level playing field to all. It also introduces the competition for students that is the basis for good quality, low cost goods and services in every other area of our economy.

Access to higher education raises different issues. Those with the aptitude and desire for a college or postgraduate degree can significantly increase their lifetime incomes as a result. It would hardly be fair to tax the general public to subsidize the higher education of those who will become wealthier as a result. However, the tuition loans that may be needed by those from lower income families to make this investment would be hard to get without insurance against default. Many states also provide community (or Jr.) colleges at public expense that provide training in various trade skills as well as four year college preparatory courses. These seem to have often been successful in leveling the playing field. The optimal structuring of higher education subsidies (e.g. between insurance guarantees and tuition subsidies) needs further examination.

Monetary and Financial Policies

Government policies that affect business should be as rule based and transparent as possible. Monetary policy stands out as a particularly important area in which clearer rules are needed. A currency with stable real value (purchasing power) is an important part of the foundation of efficient free markets. At the very minimum the Federal Reserve’s mandate should be tightened as provided in the very pragmatic Federal Reserve Accountability and Transparency Act of 2014. This act would require the Fed to chose an operational rule, from which it could depart only with an explanation to Congress of its reasons. A deeper review of options is proposed by the Centennial Monetary Commission Act of 2015. I have proposed a more radical reform in the spirit of the gold standard but with tighter rules and an anchor of a large number of goods rather than just gold. The supply of this currency, which ideally would become the global currency, would be regulated by the market using currency board rules and “indirect redeemability.” A hard anchor for the dollar.

The banking and financial sector are currently smothered with detailed regulations the compliance cost of which are driving smaller banks out of business. Under the Dodd Frank law adopted after the financial crisis of 2008, the largest five American banks have grown even larger (in absolute terms and as a share of the banking sector) than they were in 2008. Regulators, despite (or because of) their detailed banking regulations have failed to make banks safer and have slowed the competitive process of producing better and cheaper services. Bank owners and market preferences should regulate risk taking by banks.

Bank regulation by the government should focus on broad principles with strong owner accountability. Bank capital requirements should be raised and the no bail out rules strengthened. Bank owners and investors should absorb any bank losses. The payment services of banks should be isolated from the rest of its lending and investing business by adopting the Chicago Plan of one hundred percent reserve requirements against current account deposits, and virtually all other regulations (other than accounting and reporting standards) should be dropped. Larger banks will develop their own risk weighted capital requirements for their internal use, but the government’s capital requirements should state the minimum required leverage ratio (ratio of core capital to total assets) and set it at a high level. Changing direction on bank regulation, Cayman Financial Review April 2015. A bill now in congress moves in this direction: The Financial Choice Act

Business activities and regulation

The government should only provide services that that private sector can’t. It should provide the legal and regulatory framework for the private economy rather than compete with it. Though the approaches to providing “public goods” such as police, courts, prisons, firemen, parks, highways, airports, etc. have varied over time, they are almost always paid for by the government (i.e. collectively by tax payers) and should be provided efficiently at the level expected by the public. Publicly funded and privately produced goods and services are often sources of hard or soft corruption. Rather than over charging for services or paying bribes to win contracts (hard corruption), soft corruption exploits influence on government to obtain contract terms or regulations favorable to particular firms (“rent seeking”). The government’s purchases of goods and services from the private sector should be governed by transparent rules that promote competition among suppliers. This is easier said than done. Open the Books

While the government is involved in and trying to do far too many things, it doesn’t do many of them very well. Of those services the government needs to provide, states generally perform better than the federal government though performance varies across states. In Maryland, where I live, I was able to register my Limited Liability Company on line in about 30 minutes start to finish. Registering my car and updating my driver’s license is quick and easy. However, it took me months to obtain a statement of my residency from the U.S. Treasury and a personal trip to the State Department to have it certified to provide to the National Bank of Kazakhstan before they could pay me for my services. Getting a passport or green card is more complicated and takes longer than they should. The government should do much less and do it much better.

Those in the government who believe they can judge better than competitive private markets how best to allocate resources (what to invest in and produce) are generally wrong. Moreover, they establish an opportunity and thus incentive for corruption.

The government’s regulation of private businesses in the interest of public safety, environmental protection, and market competition should be limited and subject to very serious cost/benefit tests. Cost/benefit analysis unavoidably reflects subjective judgments but their role should be limited to the extent possible by full transparency of the basis of any assessment. Competitive capitalism vs. the other kinds.

Foreign policy and national security

The purpose of our foreign policy is to serve American security interests and the international rule of law under which American’s can explore the world and American businesses can compete globally on a level playing field. Our security requires a strong military, but it also requires the skillful use of diplomacy. Our military must be structured for defense, not offensive wars of our choosing. Our 2003 war in Iraq and subsequent developments in the Middle East have cost many lives (some American) and treasure, undermined our moral authority, and seriously damaged our security. Our foreign policy should be one of “restraint.”

Our relations with other countries should be based on shared interests consistent with our respect for individual dignity and the rule of law. We should support and, where appropriate, lead international bodies dedicated to developing, promoting, and overseeing compliance with the rule of law internationally. Our international leadership should rest, in addition to our economic and military strength, on our commitment to broadly shared values and standards of behavior. Just as we give up limited amounts of our individual sovereignty to our own government when it serves our individual and collective interests, so should we give up limited amounts of our national sovereignty to international bodies when it serves our national and international interests.

Our economic strength depends in part on providing for a sufficiently strong military in the most economical way possible. Money spent on tanks can be spent on building other businesses and producing goods that we enjoy. The very nature of the relationship between our military and the industries that supply it, what President Eisenhower called “the military industrial complex,” makes achieving this objective very difficult. As argued above, clear rules and transparency are important tools. Our unsupportable empire

Trade

Next to the right to personal property, nothing is as central to our liberty and well being as the right to trade. It is the basis of virtually all of our enormous increase in productivity and thus our standard of living. The government impedes our right to trade with a wide range of often unnecessary or excessive regulations. Restricting our freedom to trade across national borders is also a mistake that reduces our standard of living from its potential.

Trade has destroyed some jobs while creating others. “Since 1900, the portion of the U.S. workforce in agriculture has declined from 41 percent to less than 2 percent. Output per remaining farmer and per acre has soared since millions of agricultural workers made the modernization trek from farms to more productive employment in city factories…. Manufacturing’s postwar share of the labor force peaked at about 30 percent” in 1953 and has since declined to less than 9 percent while manufacturing output continued to climb. “Of the 5.6 million manufacturing jobs lost between 2000 and 2010, trade accounted for 13 percent of job losses and productivity improvements accounted for more than 85 percent.” George Will, Washington Post.

As with domestic, competitive trade, those out-performed in competitive markets suffer, at least temporarily. The safety net for “losers” in the competitive process discussed above is an important feature in our willingness to unleash the benefits of free trade. We must insure that they are adequate. We should support the World Trade Organization (WTO) as well as regional and bilateral agreements that reduce the barriers to trade and promote freer trade. Save trade. Globalization and nationalism-good and/or bad?. Trade and globalization

Conclusion

Our government should assume that each of us is capable of and has the right to make our own decisions and lead our own lives as we see fit. Its role is to protect those rights, in part by protecting us from others, foreign and domestic, who would violate them. We are, however, part of and best flourish within broader communities. Our government should develop legal frameworks to facilitate our interactions and relationships within and across societies both business and personal. Our successful flourishing will also depend greatly on a shared culture of mutual respect and comity.

A Modest Proposal—Helicopter Money and Pension Reform

It is possible to fix the bankrupt Social Security System and the Federal Reserve’s failure to achieve its inflation target painlessly. Yes, really.

The Fed has failed to raise inflation to its 2% target because over regulated banks can’t find over regulated firms wanting to borrow and invest. As a result, the increases in the Fed’s base money from its Quantitative Easing and other efforts to stimulate the economy has piled up as bank excess reserve deposits at the Federal Reserve Banks.[1] If the Fed pushes too hard (e.g., by lowering the interest it pays on these bank reserves, potentially even to negative levels) it feeds asset price bubbles (stock and housing prices), which do great damage when they burst.[2] If the Fed just printed more money and sprinkled it around to the general public—what Milton Friedman called helicopter money—there is no doubt that the public would spend more and drive up prices.

Leaving aside whether it is really a good idea to create a steady 2% rate of inflation, there is an easy way of doing it that would also facilitate badly needed reform of the government’s retirement system. Contrary to the myth that our Social Security pensions reflect what we paid in (saved) to the system, Social Security pension payments are now fully pay as you go. This means that the revenue from payroll taxes approximately matches the outflow for current pensions, i.e. nothing is being saved for the future. As our population continues to age and the number of retired pensioners increases relative to the shrinking number of workers paying into the system, the modest amounts that have been accumulated in the Social Security “Trust Fund” will be drawn down to zero in about 15 years at which time the government will not be able to meet existing promises.[3]

The following proposal combines helicopter money sufficient to bring the inflation rate to its target with badly needed reform of our government pension system. Under this proposal all individuals will receive a minimum government guaranteed pension for life whether they paid in anything or not. This might be implemented as part of a Friedman like negative income tax and other badly needed tax reforms,[4] or stand alone. Before retirement, individuals who are working but with incomes below the poverty level (to be politically established) will not pay a wage tax as they do now. The subsequent pensions of such people will be paid with helicopter money (the Federal Reserve will print the money to buy government bonds sufficient to finance these expenditures). All workers with incomes above the poverty level will be required (as they are now) to set aside the amount of income needed to finance their minimum guaranteed pension on a fully funded basis. They are free to save more if they would like a higher pension. The funds set aside must be invested in government licensed and approved private pension funds chosen by each worker rather than in the almost fictitious Social Security Trust Fund.

This would establish the three pillars of good pension policy proposed by the World Bank in 1998: a means tested minimum pension financed by the government’s general revenue, a mandatory minimum pension paid for and privately invested by all working individuals, and additional, optional, supplemental retirement saving privately invested. Such a model was first adopted in Chile over 35 years ago with great success. Central and Eastern European countries have adopted similar models as part of their transition from centrally planned to market based economies. Financing income subsidies to the poor from general revenues (via printing money), and a user fee approach to mandatory saving (mandatory saving matched to the actuarial value of the pension received), conforms more closely to the principles of good tax policy.[5] The alternative sometimes proposed of raising the income cap on the payroll tax is closer to general revenue financing (if the government guaranteed minimum is only paid to the poor), but leaves out non-wage income and thus fails the good tax criteria.

As new workers would be truly saving for retirement, their savings would not be available to finance those currently retired, as is now the case with our pay as you go system. Thus transitional arrangements will be needed (for several decades) to deal with existing unfunded promises. If the promises remain unchanged, the money to pay for them will have to come from somewhere (higher taxes or reduced defense or other expenditures). Usually, in such cases the government spreads the burden around (burden sharing). Two simple and sensible changes to the current promises would absorb the greater part of the shortfall. The first is to adjust the pensionable retirement age to the fact that the average person lives much longer than when the current retirement ages were fixed. People are living longer and can (and most would like to and do) work longer. The other is to change the index to people’s pensions from a wage index (which generally increases pensions in real terms over time) to the cost of living (CPI), which would preserve their real value against any inflation over time.

For today, this means that the wage tax on the poor would be abolished and paid for with new Fed money that would thus be put in the hands of those who would spend it, increasing employment (though we are really at full employment now) and/or wages and prices. It would both raise inflation a bit and launch a genuine, long over due pension reform.

[1] “US Monetary Policy–QE3” Cayman Financial Review, January 2013

[2] “The D E Fs of the Financial Markets Crisis” CATO Institute, September 26, 2008.

[3] https://wcoats.wordpress.com/2008/08/28/saving-social-security/

[4] http://www.compasscayman.com/cfr/2009/07/07/US-federal-tax-policy/

[5] http://www.compasscayman.com/cfr/2013/07/12/The-principles-of-tax-reform/

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

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”