That’s the headline for a defense of Modern Money Theory by Levy senior scholar L. Randall Wray, who complains that “even deficit doves like Paul Krugman, who favor more stimulus now, are fretting about “structural deficits” in the future.” Wray goes on to say:

There is an alternative view propounded by economists following what has been called “Modern Money Theory”, which emphasizes the difference between a currency-issuing sovereign government and currency users (households, firms, and nonsovereign governments) (See here and here). They insist that the notion of “fiscal sustainability” or “solvency” is not applicable to a sovereign government — which cannot be forced into involuntary default on debts denominated in its own currency. Such a government spends by crediting bank accounts or issuing paper currency. It can never run out of the “keystrokes” it uses to credit bank accounts, and so long as it can find paper and ink, it can issue paper currency. These, we believe, are simple statements that should be completely noncontroversial. And this is not a policy proposal — it is an accurate description of the spending process used by all currency-issuing sovereign governments.

Regular readers of this blog will recall the earlier debate on these issues between Krugman and Levy senior scholar James K. Galbraith.

In this morning’s Wall Street Journal, Princeton’s Alan Blinder suggests a way to increase fiscal stimulus, deliver aid to those who need it most and avoid increasing federal deficits–all at the same time. Here’s his plan, in his own words:

Let the upper-income tax cuts expire on schedule at year end. That would save the government an estimated $75 billion over the next two years. However, it would also diminish aggregate demand a bit. So, instead of using the $75 billion to reduce the deficit, spend it on unemployment benefits, food stamps and the like for two years. That would surely put more spending into the economy than the tax hike takes out, thus creating jobs.

How much more? Getting a numerical estimate requires the use of a quantitative model of the U.S. economy. In recent testimony before the House Budget Committee, Mark Zandi of Moody’s Analytics used his model to estimate that extending unemployment insurance benefits has almost five times as much “bang for the buck” as making the Bush tax cuts permanent.

Based on his estimates, the budgetary trade I just recommended would add almost $100 billion to aggregate demand over the next two years—without adding a dime to the deficit.

Paul Krugman and James K. Galbraith agree that this is a time for fiscal stimulus, not austerity. But they differ on a larger question: do government deficits ever matter? Or is the government so special–by virtue of its ability to create money out of thin air–that its spending can exceed income forever, by any amount?

In an interesting blog post (warning: not safe for the equation-challenged), the New York Times columnist and Nobel laureate Krugman argues that, carried to extremes, deficit spending by government can lead to runaway inflation. But, he adds, “we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.”

Krugman wrote this in response to testimony by Galbraith, a Levy senior scholar, to the federal Commission on Deficit Reduction. Galbraith responds in the comments by asserting that Krugman’s conclusion is the result of a modeling error. But his key graf comes earlier:

If the government spent but declined to “borrow,” what would happen? Nothing much. Banks would hold their reserves as cash rather than bonds, and their earnings would be a bit lower. It is *not* true, as a rule, that people (or banks) move readily to substitute lumps of coal for dollars, unless the price level is already moving up and out of control.

Randall Wray, also a Levy senior scholar, weighs in with this:

f you look at the data on tax revenue growth over the previous two cycles you will observe that in the upswing federal revenue grows at an annual rate above 15%–typically two to three times faster than GDP and government spending. This is why the deficit is reduced. Your scenario in which govt just keeps “pumping” money into the economy even as we reach full employment of resources is not plausible. In any case, your original case against the Modern Money Theory approach adopted by Galbraith had to do with insolvency, not inflation. Insolvency is a matter of inability to meet NOMINAL commitments as they come due. When govt spends by crediting bank accounts, there is no situation in which it cannot make its promised payments. You have tried to shift this to a case of full employment of all resources, when govt cannot move more resources to the public sector. But again that is not plausible–so long as there are any resources for sale for dollars, the federal govt can compete with the private sector for them, and can win by bidding up the price. Note I am not advocating such policy.

A post in the Wall Street Journal’s Real Time Economics blog notes that counting research and development as investment rather than as an expense would have increased gross domestic product by 2.7 percent between 1998 and 2007 (they refer to new numbers from the BEA). If this were standard national accounting practice, then measured GDP would have grown 0.2 percent faster, or an average of 3 percent annually. It makes some sense to treat R&D as an investment, but this item begs the question: would anyone have been better off if we did?

The clock is ticking and right now first-time buyers have to close the deal in six days. The incentive is sweet: up to $8,000 from Uncle Sam. The Internal Revenue Service reported that $12.6 billion was credited to 1.8 million home buyers (the final toll will be higher as transactions in 2010 have not been filed yet, not to mention the inevitable fraud).

Calculated Risk, a highly regarded blog that tracks these matters, suggests that six months of inventory is normal in the housing market. For new homes, in May, the level rose to 8.5 months from 5.8 in April as sales plunged. Things are little better in the market for pre-existing homes; there we find 8.3 months of supply, in part due to the non-stop flow of foreclosures and short sales.

From the data, it seems that the tax credit program has stimulated the market, at least a little, and for awhile. My question to you is, should our uncle in Washington keep the program going?

Pros:

• Propping up shaky home prices may encourage private spending and support aggregate demand.
• Aiding the real estate market in lowering inventories may keep prices from falling further and generate some construction jobs.
• Reaching a “normal” level of inventories may improve everyone’s expectations and thus create a virtuous cycle of self-fulfilling recovery.

Cons:

• The tax credit program may condition potential buyers to wait for another round of subsidies, thus delaying the very purchases we most want to accelerate..
• The temporary subsidy may not be enough to sustain a high volume of transactions, and inventories may rebound (unless higher demand fueled by economic recovery takes place miraculously). Multiplier effects of the subsidy may not be enough to get us to a self-sustaining market.
• The program delivers benefits to people who can afford to buy home, and therefore is regressive. This regressivity implies high opportunity costs.

Levy research scholar Thomas Masterson has co-edited a new book about the Solidarity Economy, a form of economic organization that emphasizes cooperation over competition and communal well-being over individual gain. From the back cover:

“So many of us wish for something more, something different—an economy that we can feel a part of, not that makes us feel like a disposable cog in a mindless, heartless, soulless machine. That something exists and it’s called the Solidarity Economy. It represents new ways of living, of working, of consuming, of banking, of doing business. It represents different ways of doing trade, aid and development between nations. This kind of economy starts from entirely different premises than those of the ruling model of neoliberal capitalism which enshrines individualism, competition, materialism, accumulation, and the maximization of profits and growth. The solidarity economy by contrast seeks the well being of people and planet. It holds at its core these principles: solidarity, equity in all dimensions, sustainability, participatory democracy, and pluralism (meaning that this is not a one-size-fits-all model).”

Levy senior scholar James K. Galbraith argues in the Los Angeles Times this morning that deficit hawks are pursuing the wrong prey. In a nutshell:

The real cause of our deficits and rising public debt is our broken banking system. The debts our economic leaders deplore were largely due to the collapse of private credit, and to the vast giveaways the federal government made to banks to prevent their failure when credit collapsed. Yet those rescues have failed to reanimate private credit markets and job creation, as the latest employment reports show. And so long as that failure persists, public deficits and rising public debt must remain facts of life.

Are broken banks a national security threat? Let’s avoid going that far. But the only way to reduce public deficits eventually is to revive private credit, and the only way to do that is build a new financial system to replace the one that has failed. The “national security” case for cutting Social Security and Medicare is bogus. In economic terms, it’s just a smokescreen for those who would like to transfer the cost of all those bank failures onto the elderly and the sick.

The Economist’s obituary for the late Wynne Godley generated a couple of worthwhile letters. A key passage:

Your obituary of Wynne Godley (May 29th) did an injustice to his considerable intellectual achievements in macroeconomics and his courage in going against the orthodoxy that has ruled the economics profession for the past three decades.

You can read the rest here.

The Squam Lake Report (Princeton University Press) is a set of recommendations by 15 leading economists on reforming the financial system. Considering the magnitude of the recent financial crisis, it is surprising how little change the book proposes.

Certainly, the first step in devising a set of recommendations for reform is to understand what went wrong, something the authors set out to do in their first chapter. They list a number of factors that may have contributed to the crisis but take no stand on their relative importance. They believe that their recommendations will help make the system more stable, although not crisis-proof, even if they don’t completely understand the origins of the current crisis. While a few of the recommendations are intended for guiding the financial system towards stability, most are only useful for when a financial crisis has already erupted.

Perhaps the best recommendation is for a systemic regulator with an explicit mandate of maintaining financial stability. As financial institutions are increasingly involved in activities outside their traditional domain, having a systemic regulator makes sense. But the report recommends that the central bank be that regulator—which is logical, since the Fed’s discount window gives it a good view of financial institution balance sheets. The problem, at least in case of the U.S., is that the Federal Reserve had the authority to regulate key aspects of the financial system when the last meltdown occurred, but chose not to exercise that authority. For instance, the Fed had had the power to regulate all mortgage lenders since 1994.

The question now is whether the culture of deregulation that has prevailed at the Fed for at least the past 25 years will allow it to transform itself into a good regulator. The FDIC has a better track record of being tough on the financial sector, and may well be better suited for the job.

The report is also big on transparency. For instance, it proposes that large financial institutions, including hedge funds, “report information about asset positions and risks to regulators each quarter.” Having better-informed regulators is certainly important but only goes so far. The magnitude of fraud during the last crisis demonstrates the difficulty of relying on information reported by the institutions themselves and underscores the importance of active regulation (The Repo 105 transactions used by Lehman, Citibank and Bank of America were merely the tip of the iceberg in the accounting gimmicks used by these institutions to mask their true positions.) The authors don’t seem to recognize the role of fraud in the financial sector and offer no recommendation on how to deal with it.

A whole chapter of the Squam Lake Report is devoted to regulating retirement savings, which is timely and appropriate considering that pension funds have been among the biggest losers in the current crisis. The crux of the Squam Lake proposal is to require investment products offered in defined contribution plans to have a standardized disclosure of costs and risks, to increase deductions from workers’ pay and to restrict default investment alternatives to low-fee, diversified products. These are sensible ideas but won’t insulate retirement savings from a crisis, because in a crisis asset classes (except for Treasuries) tend to crash in unison. At such times, diversification doesn’t help.

Furthermore, diversification (already required by federal pension law) was a major contributor to the bubble economy of the past decade as pension funds hunted for financial products uncorrelated with stocks. Overall, I don’t see merit in their pension reform proposal. The best solution would be to eliminate tax advantages for pension plans and instead boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. See Nersisyan and Wray (2009) for more on the trouble with the pensions.

The report also calls for higher capital requirements for major institutions, another reasonable idea that wouldn’t have helped much last time around, when the market for asset-backed securities froze and their prices collapsed. Under such circumstances, only impractically high capital requirements would have made any difference. Besides, an institution can face liquidity issues even if it’s highly capitalized. Bear Stearns, before its collapse, had enough capital but couldn’t finance its asset positions for want of willing lenders.

The report also recommends that financial institutions issue long-term debt instruments that convert into equity under specified conditions. This would automatically recapitalize banks if they got into trouble. But again, higher capital levels cannot prevent a crisis. Besides, one of the proposed conversion triggers is the declaration by the systemic regulator that the financial system is in a crisis. But a crisis is not always so easy to spot. When Bear Stearns failed, some people said the problem wouldn’t spread. Later, the consensus was that it wouldn’t go beyond subprime mortgages. If the regulator proclaims at soe point that there is a risk of a systemic crisis, this itself might freeze the markets and make institutions unwilling to lend to each other. Giving the disease a name, in other words, might well kill the patient.

Although a whole chapter of the book is devoted credit default swaps (CDS), there is no recommendation that would make CDS safer for the financial system. The authors oppose limiting CDS trades to entities that hold the underlying security on the basis that this will make derivative markets less liquid, raising costs. They propose merely to encourage financial institutions to clear CDS and other derivative contracts through clearinghouses as well as to trade them in exchanges (rather than making such arrangements mandatory).

Again, the response seems wholly inadequate to the scale of the hazard. Derivatives create counterparty risk out of thin air and vastly magnified the recent crisis. Without CDS the subprime mortgage industry couldn’t have grown to the proportions it did. Getting rid of CDS would make it hard for financial institutions to hide risks from regulators, and make investors more cautious when investing in asset-backed securities.

Despite their deliberations, the Squam Lake economists overlook some important aspects of the financial structure that ought to be reformed. Securitization and off-balance sheet activities that were largely to blame for the current debacle are not even mentioned. It wasn’t until securitization that the shadow banking sector exploded. Securitization creates major incentive problems by separating risk from responsibility. Off-balance sheet activities allow financial institutions to avoid capital requirements and use more leverage. And while the authors seem to recognize the costs associated with having too-big-to-fail institutions that are systematically dangerous, they have no prescriptions for what needs to be done about them.

The authors are acutely conscious that regulation often has unintended consequences, yet as they implicitly recognize (by proposing regulations), this doesn’t mean there shouldn’t be rules. What should these rules look like? continue reading…