One of the oft-heard criticisms of Modern Monetary Theory (MMT) is that the original developers (including myself) say one thing but know another. We say – there are no financial constraints on a currency issuing government but then, as if as an afterthought, admit that in the real world there are lots of constraints on government spending. On Christmas Day 2009 I wrote the following blog – On voluntary constraints that undermine public purpose. It renders such criticisms redundant. But in the light of the Cyprus schemozzle (putting it mildly), it is interesting to reflect on what could have been done to avoid the ugly consequences that will follow the “Bail-in” package. Even within the constraint of keeping Cyprus in the Eurozone, the authorities (in particular, the ECB) has the capacity to save that nation’s banking system and avoid destroying the nation’s economy. The fact they chose not to use that capacity is telling given the consequences that will now follow. They might have followed their American counterparts who in 2011 clearly knew how to reduce the damage of the crisis and operate as a central bank rather than as part of a vicious syndicate of unelected and unaccountable socio-paths (aka the Troika).
As a warm-up, there is an interesting technical and legal debate going on in Sweden at present that illustrates how rigid administrative constraints can easily be circumvented. You can find background to this discussion provided by the Swedish National Debt Office (Riksgälden) (January 22, 2013) – Borrowing to satisfy the Riksbank’s need for foreign exchange reserves.
The issue arose in 2008-2009 when the central bank (Riksbank) sought foreign currency to bolster their diminishing reserves so that it could maintain financial stability by providing the domestic banks’ foreign currency funding needs. The Debt Office is constrained by the Budget Act, given that all its dealings show up one way or another in the national budget.
The Debt Office concluded that while it was not explicitly detailed, the request from the central bank was “implied in the assignment we have under the Budget Act.” However, they soon realised that the wording of the Act in this relation was ambiguous. There was a discussion about how to interpret the word “may” in terms of the criteria for borrowing.
The Budget Act specifies the purposes for which the Debt Office may borrow. One of those purposes is to “satisfy the Riksbank’s need for foreign exchange reserves”.
But the Debt Office concluded that:
it is not evident that the Debt Office has a duty – or even a right – to borrow unlimited large amounts in order to increase the foreign exchange reserves at the request of the Riksbank. Such borrowing is not necessary for the state’s on-going activities in the same way as borrowing to finance budget deficits. At the same time, it is unclear on what grounds the Riksbank’s need for foreign exchange reserves should be determined.
A ruling was sought from the Government’s Committee on the Constitution, which said that the Riksbank should not expect unlimited funding. But the generality of the Budget Act, that the Debt Office will “meet the Riksbank’s need for foreign exchange reserves” means that:
In practice, this grants the Riksbank extensive discretion in specifying the size of the foreign exchange reserves.
I could cite many examples like this.
Further, in many countries (Sweden included) laws were changed during the crisis to ensure that previously constrained governmental institutions (such as central banks) could act more freely to get cash where it was needed.
Now what did the US Federal Reserve Bank do in 2011 that is relevant to this story? On January 6, 2011, they issued this very opaque statement – Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.
I say opaque because only those in the know would have a clue what it meant. At the time, hardly any financial journalists picked it up and when they did the Austrian schoolers (gold bugs) went crazy – for they thought it confirmed all their worst fears. The fact is that the decision did confirm their worst fears but then advanced paranoia is a state that can be treated with appropriate care so things will turn out alright for them once the sedatives take over and the counselling begins.
The financial journalists, who also didn’t really have a clue what the press release meant, didn’t really respond for nigh on 2 weeks. This was the first response I recorded at the time – Accounting tweak could save Fed from losses – which came out on my Reuters feed on January 21, 2011. Then all hell broke loose in the financial press, for a day or two, until the next big impending (apparent) meltdown occupied their typewriters and blogs.
The “accounting change” was also mentioned in the – Monthly Report on Credit and Liquidity Programs and the Balance Sheet – under “recent developments” (page 1) – the relevant paragraph being:
Effective January 1, 2011, as a result of an accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the Treasury.
What did this January 6, 2011 Statistical Release mean? Start with this: negative capital.
Ring a bell? Try Cyprus and think about the ECB. The whole Cyprus mess could have been solved with an accounting change or two and some legal changes.
Back to the US to clarify.
The Release began with this statement:
The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has been modified to reflect an accounting policy change that will result in a more transparent presentation of each Federal Reserve Bank’s capital accounts and distribution of residual earnings to the U.S. Treasury.
In other words, they didn’t think there was much in it. A meagre accounting change to make things clearer.
This accounting change “does not affect the amount of residual earnings that the Federal Reserve Banks distribute to the U.S. Treasury” (under the Federal Reserve Act), the Release tells us that “it may affect the timing of the distributions”.
That is, the change allows the parties to manipulate when things occur.
Prior to the change, the Bank gave the Treasury any earnings that exceeded the sum of its operational costs, dividend payments and “the amount necessary to equate surplus with capital paid-in”. That last quoted reference refers to maintaining its capital, which in an accounting sense defines solvency.
For a private firm, of-course, negative capital means it is insolvent. For a central bank in a currency-issuing nation it means accounting insolvency but nothing other than that. Maintaining bank capital for a central bank is just a charade. The comparison with private balance sheet practices fails. There is no relevant meaning to “negative capital” for an institution that has the monopoly capacity to create its own liabilities at will (that is, issue currency).
The January 6, 2011 accounting change amounts to a sleight of hand – another layer of the voluntary smokescreen designed to obfuscate the fact that there is no intrinsic financial constraints faced by the consolidated US government. Any constraints that exist are voluntary and can be manipulated in one way or another at will. In this case, by some accounting changes.
That means, where the accountant puts numbers in accounts. Smoke and Mirrors sort of stuff. The underlying substance remains – the imagery changes.
So, after the January 6, 2011 accounting change, as noted in the quote above, the Federal Reserve would consolidate the member bank accounts and place any losses as a liability to the Treasury in some account – “Interest on Federal Reserve notes due to U.S. Treasury” – and not write the losses against its capital held on the balance sheet.
At some future time – recall “may affect the timing” – it would then write residual earnings (over the costs etc) off against this liability.
It is more transparent because it tells the public: (a) that it can make losses in the financial markets if it purchases assets at one price and sells them lower or cannot sell them at all; and (b) that it can never go broke because ultimately it is the US consolidated government that issues the US dollar currency.
So if it was to lose amounts equivalent to all or more than its current paid-up capital nothing would happen. Liabilities would get some bigger numbers recorded and life would go on as usual.
It also means that the Federal Reserve is under no compunction to transfer cash to the Treasury on a regular basis. It can put that on hold until the accounting profits improve to wipe out any past losses.
A private company could not do this because it doesn’t issue the currency.
As it happened the Federal Reserve Governor told the – US Senate Committee on the Budget the day after the accounting change was announced during his regular testimony that it could not go broke.
The former Chairperson of that Committee – Kent Conrad – asked the Governor whether there would be losses incurred by the Federal Reserves as part of the “extension of credit that was made during the downturn”.
Dr Bernanke replied:
As a practical matter, what matters is not losses, because those are paper losses. What matters is the amount of funds, remittances we send back to the Treasury. Under most scenarios, because our cost of funding is so low, we will continue to remit back to the Treasury significant amounts of money. Under a scenario in which short-term interest rates rise very significantly, it is possible that there might come a period where we do not remit anything to the Treasury for a couple of years. That would be, I think, the worst-case scenario.
That should have been the end of the story. But the gold bugs know no bounds – they clearly have no reason or, for that matter, comprehension. So the accounting change was seen as a diabolically heinous act of sabotage of US freedom and would send the nation broke with hyperinflation being recorded just moments before the entire staff of the US Bureau of Labor Statistics, which assembles the inflation data in the US, was sacked because the US had run out of money. Its a fun world out there in the denizons!
The Reuters story, that I linked to above, claimed that many financial market commentators were:
… at once surprised that the Fed can set its own guidelines, and also relieved that the remote but dangerous possibility that the world’s most powerful central bank might need to ask the U.S. Treasury or its member banks for money is now more likely to be averted.
Which is amusing in itself. On both counts there is total ignorance. First, of-course governments and the related institutions such as the central bank can alter laws and regulations to suit the current need. Governments are not always stupid and place a fair majority of the operational detail of their institutions in rules and regulations or by-laws, which can be changed, by stealth, without the need to go back to the legislature for approval.
Otherwise, the operation of the government sector would become more cumbersome. This practice does raise questions about the transparency of the democracy. But the reality is that there are a lot of wriggle-room rules that are codified and can be easily changed.
Second, anyone who for a second thinks that the Federal Reserve Bank or, for that matter, any central bank (in a currency-issuing nation) can go broke hasn’t understood the basis of the monetary system they are commenting about.
Please read my blogs – The US Federal Reserve is on the brink of insolvency (not!) and The ECB cannot go broke – get over it – for more discussion on this point.
Why did we just take this little historical diversion?
Think about the options for Cyprus. I am clearly not in favour of the Eurozone continuing. It cannot operate as an effective monetary system under its current structure and there is no political will to change the structure to make the single currency work.
But assume that issue away for the moment.
The Troika’s response was captured in the leaked document I mentioned yesterday, which was published in the Cypriot press on Monday (April 1, 2013) – Memorandum of Understanding on Specific Economic Policy Conditionality.
It is a staggering document. The Troika’s demands amount to a full-scale frontal attack on the well-being of the Cypriot people by a body who are unelected by those people and are not accountable to those people.
The extent of the attack on the well-being of Cyprus, and the fact that the Bail-In will effectively force the nation to endure a Depression for the extended future suggests to me that the decision-makers are socio-paths.
They could not possibly be interested in promoting prosperity in that little nation.
What was the alternative within the Euro structure? Think Federal Reserve accounting rules. The ECB is just a creature of laws and regulations as well. Its intrinsic monetary capacity is that it can never go broke because it issues the currency.
However, its outlook is dominated by the Bundesbank mentality. It is obsessed with the 1920s and fails to even understand that the 1930s wiped what happened in the 1920s away. It also doesn’t seem to understand that it can create Euro liabilities on its balance sheet to whatever size it might choose. That is, in unlimited quantity (please don’t write in and tell me that money cannot be infinite. I understand calculus).
The alternative ECB action which could have avoided the Bail-In would have be as follows:
1. Declare the private Cypriot banks insolvent.
2. Nationalise them under Cypriot law.
3. Guarantee all deposits held by the new state banks.
4. Issue enough Euros to itself and the new state bank(s) to ensure they satisfy the capital adequacy
5. If they are worried about having negative capital themselves, then manipulate some accounting rule or another. As I explained in these blogs – The US Federal Reserve is on the brink of insolvency (not!) and The ECB cannot go broke – get over it – negative capital for a central bank is a meaningless concept. It only has meaning if the institution cannot issue its own liabilities in the currency being used.
Relatedly, the comic book for this week is the latest edition of the Time Magazine which has a headline story “Can this Woman Save Europe?” – the focus being Ms Lagarde. The same Ms just – told Cyprus – that they have to:
… achieve a 4 percent of GDP primary surplus by 2018, which is required to put debt on a firmly downward path.
… and push the real economy on a very sharp downward path and unemployment on a very sharp upward path. The priorities of the socio-paths are all based on anti-people measures – they design policy interventions that they know will cause harm to people over long periods of time (5 years in this case).
They take massive salaries themselves and flit around the place staying at the best hotels, eating the finest cuisine and scoffing the finest wines. Then when the blood is dripping of their hands, they retire on massive superannuation benefits.
I get a lot of E-mails asking me about these so-called fiscal consolidation formulas. The full paragraph that the previous quote is taken from in the latest IMF statement says:
In addition to the fiscal consolidation already underway—estimated at about 5 percent of GDP— an additional 2 percent of GDP in measures will be implemented during the program period, including by raising the corporate income tax rate from 10 to 12 ½ percent and the tax rate on interest income from 15 to 30 percent. An additional 4½ percent of GDP in measures will be needed over the medium term to achieve a 4 percent of GDP primary surplus by 2018, which is required to put debt on a firmly downward path.
The comprehension gap appears to be what does, for example, cutting net spending “at about 5 per cent of GDP” mean. It is very simple.
Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. It is also equal to total spending and total income over the same period.
Cutting government spending by 5 per cent of GDP means initially that GDP falls by 5 per cent. But the multipliers will ensure that the overall contraction is more than 5 per cent.
Add all the “equivalent of X per cent of GDPs” in the program that has been forced on the Cypriot people and you will find they are going to contract the economy by some amount more than 15 odd percent.
Why the hell is that necessary when the simple solution was to nationalise the banks and the ECB to manipulate the accounting to ensure the new state banks had enough capital to satisfy the Basel capital adequacy rules?
And recall that a significant component of the Cypriot banks’ problems were there exposure to Greek government debt, the value of which was reduced because the Troika, themselves engineered an unconscionable “hair cut” as part of their destructive Greek bail out.
Pretty depressing really.
But the point is that these voluntary constraints allow socio-paths and conservatives (both of whom might be in the same set) to fool the public into believing there are no alternatives but to inflict massive damage on the economy and the citizens (avoiding any collateral damage being borne by themselves of-course).
They can typically be changed with a stroke of a pen (an “accounting change”). Sometimes they need a change in the relevant legislation.
They should all be scrapped and replaced with clear statements of the role of government in terms of achieving and sustaining full employment and price stability. The two are not trade-offs in a properly constructed policy mix.
I also thought I was being positively generous in not concluding that all conservatives were socio-paths! Just most of them.
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.