Steve Keen, on his way to Mt. Kosciuszko, outlines threat to Australia's housing bubble

Growing like Topsy
by Steve Keen
Debtwatch
March 31, 2010

My Walk to Mt Kosciuszko is no longer a solitary affair: at last count, I will have a dozen companions for the entire distance, and another 16 joining me for at least one day.

One of those coming for the entire trip is the Commentary Editor from Business Spectator, Rob Burgess. Rob will report from and on the Walk on a daily basis, covering it both as a news story, and as the basis for a discussion of the wider issues facing business and economics in the uncharted terrain of the supposedly ‘post-GFC’ world.

The others joining me on the trek are doing so not just for the scenery, but because they too believe that Australia’s economic policy has become beholden to maintaining house prices at unsustainable levels. Despite government rhetoric (and some action) about improving home affordability, the First Home Vendors Boost did far more to make houses more unaffordable than the government’s minor actions in the opposite direction. The other walkers are joining me to bring attention to the absurdity of managing the Australian economy by making it impossible for people to afford houses in their own country.

But though The Walk will have a political protest at its core, it is not party partisan: our call here is “A Plague on Both Your Houses”. Whatever else might change if Tony replaces Kevin, one thing that won’t change is a sky-high house price policy, since both sides of politics in Canberra (not to mention the commercial Banks and their economists) have become convinced that the major reason the GFC occurred was that house prices fell.

This is true in the same sense that jumping off a cliff is painless—it’s hitting the ground at its bottom that hurts. The real cause of the GFC wasn’t falling house prices per se, but the mortgage debt that drove them higher as households took part in a speculative bubble. The rising debt level was, in effect, climbing the mountain in the first place: deleveraging was jumping off it.

The only way to prevent a financial crisis is not to climb the mountain in the first place: to stop debt being taken on for speculative reasons. But instead politicians the world over encouraged households to do precisely that, in the misguided belief that financial engineering was a road to wealth. Instead, it was the road to debt penury.

Once that debt has been accumulated, trying to stop house prices falling is like keeping Wily Coyote stationary in midair after he’s fallen off a cliff with an anvil attached to his legs: he’ll stay there for a moment, but after a while, it’s “Hello Terra Firma”.

House prices rose in America and the rest of the OECD because households took on bucketloads of mortgage debt, and they fell because households stopped taking on more debt. The fall in house prices was a symptom of households ending the leveraging game: it was coincident with the crisis, it made it worse because the collapse in house prices and the rise in insolvencies made banks insolvent, but the real problem was that households had got into too much debt.

So how does Australia keep house prices high? By encouraging households to get into yet more debt. The next chart shows what happened to the household debt ratios (both to disposable income and to GDP) before and after the First Home Vendors Boost.




The rise against GDP is far more dramatic than against household disposable income because other government policies—the stimulus package itself and the RBA’s 4% cut in interest rates—boosted disposable income dramatically last year (but even so, mortgage debt is now a higher proportion of household disposable income than before the GFC). The Boost-inspired house price bubble was financed by households adding another 6% of GDP to their already unprecedented debt burden, when prior to The Boost they were on track to reduce mortgage debt by about 3% of GDP in 2009.

We’ve avoided hitting the ground of deleveraging by climbing to a higher cliff.

L. Randall Wray asks, "Is the Health Insurers Bailout Bill is better than nothing?".

Health Reform.Gov
By L. Randall Wray
Economic Perspectives from Kansas City
March 24, 2010

Many who supported health care reform are celebrating passage of the Health Insurers Bail Out Bill (HIBOB) and the argument that something--no matter how fundamentally flawed--is better than nothing. Fine. That is a point that Michael Moore as well as Dennis Kucinich make--and they are far more politically astute than I am. How can I criticize them?

A lot of my friends do not want to hear any criticism about the flaws. They ask for a few days to bask in the glorious victory. They think my critiques of the HIBOB are "annoying". I take that as my job description.

Oh, alright, celebrate. But don't you think that someone ought to point out what the flaws are, so that we might move forward? Even if the bill were a marginal improvement over what we have, and even if it allows the Dems to claim a victory, no one should be fooled into thinking this was healthcare reform. Health insurance reform? OK, maybe a bit-—but more on that below.

I think that any legislation that forces people against their will to turn over their paychecks to the FIRE (finance, insurance and real estate) sector is a mistake--it does not take too much thought to foresee the kinds of problems this will generate down the road. Also note that the government is going to start taxing and reducing Medicare funding BEFORE anyone gets the "benefits" of the legislation. What a great policy to introduce in the midst of this great depression! (Sound like 1937 deja vu all over again—when government started collecting payroll taxes before Social Security payments started, throwing the economy back into the Great Depression? You betcha.)

There is very little in the bill that requires health insurers to actually pay for the provision of any additional services--and most of the small improvements in that area do not kick in until 2014 or 2018. Read the fine print. Existing insurers are not subject to new requirements--only new insurance providers. The "legacy" firms get grandfathered--business as usual for them, and time to fight the provisions to ensure they never take effect.

Yes more people will get INSURANCE. Will they actually get more CARE PAID FOR? Not necessarily. They will get hit with deductions, co-pays, annual limits (for several more years), exclusions, out of pocket expenses. This will ensure that health CARE remains too expensive to actually take advantage of their new INSURANCE. And many currently insured people are going to get higher taxes. Premiums will rise. Government is going to shovel more of the costs to you. Wall Street needs your money.

There will be revolts of uninsured who do not like the mandates. We might need more riot police and prisons. More costs to bear to keep Wall Street insurers flush.

Exactly how it all turns out will take years to determine. I expect that insurer abuses will increase significantly; there will then be a regulatory reaction--as in Massachusetts. We will try to impose regulations, restrictions, fees, fines, taxes, and what-have-you on the insurers to force them to do what they do not want to do. Indeed, we will try to force them to do what no insurance company ought to do. That is because health insurance is fundamentally at odds with healthcare. Always has been, always will be. It is a crazy way to pay for healthcare.

So ultimately, that is what the problem with the HIBOB really comes down to: the insanity of running healthcare through the for-profit private health insurance industry, and thus an attempt to increase the insanity by running more healthcare through the insurers. This is a pro-Wall Street bill, by design. That is why the focus of the HIBOB was mostly on finance/insurance and not really on any (mostly minor and unintended) healthcare benefits that come out of the bill. And if we had actually had a HEALTHCARE bill, it would have been mathematically impossible to have one with fewer benefits than the HIBOB that passed—which by design was just a bail-out for Wall Street.

Many supporters say that this bill was the best we could do under the circumstances, and that in coming years we will make improvements to it. So, we will take the small benefits now and work for bigger ones incrementally. I am sorry but I do not buy the "incrementalist" defense of the HIBOB.

This is not incrementalism. It is a huge and unprecedented mandate to benefit private insurers. Fifty million people are being told they must turn over their paychecks to private companies. Protests and lawsuits have already begun. States are trying to change their constitutions. here If we had wanted incremental improvements to HEALTHCARE there are infinite combinations of small policy changes we could have pursued—without involving insurers at all. And celebrations by Dems of this great victory by Wall Street are laughable. I think Robert Prasch is right—it is the biggest giveaway to the GOP the Dems could have managed. here (But hold on, they are now preparing to turn Social Security over to Wall Street—the debates are just now getting underway.)

Here is what the whole HIBOB "reform" was all about (and Prasch suggests this was candidate Obama's plan from the beginning; I have no strong reason to doubt him): health insurers were losing premiums because employers were dropping coverage (in part because they could not compete since no comparable country uses private insurance to provide health care); healthy individuals were dropping because no reasonable calculation could show insurance to be good value for the money. And it is not just the healthy young people who were dropping coverage. If you are single and have no chronic conditions, you are far better to pay out-of-pocket (UNLESS your employer pays most of the premiums and will not give you wages instead). 80% of healthcare costs are due to the 20% of the population that is unhealthy and perhaps unlucky. If you can make it to age 65 without chronic conditions (you don't smoke, are not obese, were not born with too many preexisting conditions, and so on) it is quite rational to avoid health insurance. And if you get extremely unlucky, you do not have to have health insurance to get some kind of health care. Sure it is probably going to be inferior—but it could well be adequate. And in any case, you might not have that much faith in traditional medical approaches, anyway.

But the insurers were terrified. They could see the writing on the wall--they were losing the healthiest members from their pool, forced to raise rates, and that pushed more healthy people out in a vicious cycle. Hence, they went after Hillary Clinton and later Obama to get a HIBOB to force healthy people back into the pools so they would pay premiums. Yes, insurers knew there would be a trade-off because they'd have to take some unhealthy people. But giving them insurance IS NOT THE SAME THING AS paying for their care. So insurers agreed to accept some pre-existing conditions but never agreed to actually pay for treatments for those conditions. And they won't.

I hope that those who are interested in this topic will actually read the Policy Brief I wrote with Marshall Auerback. here The point is that healthcare is not insurable. There is a fundamental conflict between provision of healthcare and insurance.

Compare it to auto insurance. When I was young and poor and perhaps somewhat foolish and irresponsible I drove without car insurance (it was not mandated at the time). I managed to drive for about two decades with only 2 accidents—both caused by drunk drivers who ran over me. Their insurers were more than happy to pay me to avoid a law suit. Actually these were not accidents (random Acts of God)—they were criminal infractions. The perps lost their insurance and licenses (and I believe one went to jail because he had already lost his license—he was driving his firm's car, and it was his firm's insurer that paid me). Later I started buying insurance. Last fall while driving home from OK at a rather high rate of speed (but within the limit, I hasten to add!), I was struck by an Act of God. She had a large buck leap in front of my car. $10k and 4 months later my car was almost repaired. I paid $1k deductible and my fellow insurance premium payers paid the other $9k (thanks guys!).

Now, we do not know why God did it. Maybe the deer blasphemied, or God hated my car, or she wanted me to stop begrudging the thousands I have paid over the years to car insurers; or she wanted a bit of stimulus for the local body shop. In any case, we do not know her Plan and for all intents and purposes it appears random to us. So we insure against Acts of God. On average of course, car insurance is a very bad deal. But for those of us targeted by God it is a good deal; and none of us really knows who will be chosen next. Further, by basing premiums on individual behavior and by charging large deductibles, we induce safer driving. I avoid speeding—mostly not due to fear of the fine but rather to the higher premiums to be paid for years. Ditto safer driving in parking lots (given that I made the decision—actually now mandated—to purchase insurance). And speaking of mandates, of course you can always avoid paying premiums by not driving. No one is mandated to hand over a paycheck to auto insurers.

Ok, turn to health "insurance". For reasons discussed in detail in our Brief, health is not insurable. Every infant is a bundle of pre-existing conditions. You cannot provide insurance against a house already afire. After you hit a deer, you cannot go buy insurance. NOR WOULD YOU WANT TO BUY IT! Because the actuarially sound premium would exceed the cost of repairing your car. You cannot insure a pre-existing condition—and would only insure it if you could hide it from the insurer (that is of course called fraud). God already acted. She chose you, and nobody would even think about insurance: you don't want to pay for it, the insurer doesn't want to provide it, and your potential pool of fellow premium payers do not want you to be added to their pool.

An insurer cannot sell insurance against diabetes to a person who has diabetes; nor would that person want to buy the insurance; nor does any pool want that person included.

So what we do is pool the people with diabetes with people who do not have it and who are extremely unlikely to get it, then we have the healthy people subsidize the diabetes care. That is not insurance—it is an expensive way to take money away from the healthy and give it to the sick. You could make the argument that from the vantage point of society as a whole, these Acts of God are sort of random (not really, since obesity results from individual behavior as well as public policy) so if we get everyone into the pool we have got insurable risks. OK, sort of. But for the aggregate, it is always a bad deal—we have to pay the costs of running the insurer, plus profits. But there is no way you can run this through competing private insurers because each one has strong incentives to exclude the expensive cases—and so do all of their relatively healthy premium payers. So the only way to do this is to have mandatory insurance, everything covered, and either only one insurer or multiple insurers operating with identical pools and coverage. That ain't going to happen. And it ain't incrementalism.

And, of course, most of the healthcare that most of us receive has nothing to do with Acts of God. We need well-child care. We get pregnant. We get old. We need our teeth cleaned. We want Botox and Tummy Tucks. Nothing random about it. Not insurable risks.

We don't need more health insurance. We need less. We need health provision; and we need to get it out of the hands of Wall Street.

Simon Johnson sees financial reform emerging as no reform

Financial Reform: Will We Even Have A Debate?
Simon Johnson
The Baseline Scenario
March 25, 2010

The New York Times reports that financial reform is the next top priority for Democrats. Barney Frank, fresh from meeting with the president, sends a promising signal,

“There are going to be death panels enacted by the Congress this year — but they’re death panels for large financial institutions that can’t make it,” he said. “We’re going to put them to death and we’re not going to do very much for their heirs. We will do the minimum that’s needed to keep this from spiraling into a broader problem.”

But there is another, much less positive interpretation regarding what is now developing in the Senate. The indications are that some version of the Dodd bill will be presented to Democrats and Republicans alike as a fait accompli – this is what we are going to do, so are you with us or against us in the final recorded vote? And, whatever you do – they say to the Democrats – don’t rock the boat with any strengthening amendments.

Chris Dodd, master of the parliamentary maneuver, and the White House seem to have in mind curtailing debate and moving directly to decision. Republicans, such as Judd Gregg and Bob Corker, may be getting on board with exactly this.

Prominent Democratic Senators have indicated they would like something different. But it’s not clear whether and how Senators Cantwell, Merkley, Levin, Brown, Feingold, Kaufman, and perhaps others will stop the Dodd juggernaut (or is it a handcart?)

This matters, because there is more than a small problem with the Dodd-White House strategy: the bill makes no sense.

Of course, officials are lining up to solemnly confirm that “too big to fail” will be history once the Dodd bill passes.

But this is simply incorrect. Focus on this: How can any approach based on a US resolution authority end the issues around large complex cross-border financial institutions? It cannot.

The resolution authority, you recall, is the ability of the government to apply a form of FDIC-type intervention (or modified bankruptcy procedure) to all financial institutions, rather than just banks with federally-insured deposits as is the case today. The notion is fine for purely US entities, but there is no cross-border agreement on resolution process and procedure – and no prospect of the same in sight.

This is not a left-wing view or a right-wing view, although there are people from both ends of the political spectrum who agree on this point (look at the endorsements for 13 Bankers). This is simply the technocratic assessment – ask your favorite lawyer, financial markets expert, finance professor, economist, or anyone else who has worked on these issues and does not have skin in this particular legislative game.

Why exactly do you think big banks, such as JP Morgan Chase and Goldman Sachs, have been so outspoken in support of a “resolution authority”? They know it would allow them to continue not just at their current size – but actually to get bigger. Nothing could be better for them than this kind of regulatory smokescreen. This is exactly the kind of game that they have played well over the past 20 years – in fact, it’s from the same playbook that brought them great power and us great danger in the run-up to 2008.

When a major bank fails, in the years after the Dodd bill passes, we will face the exact same potential chaos as after the collapse of Lehman. And we know what our policy elite will do in such a situation – because Messrs. Paulson, Geithner, Bernanke, and Summers swear up and down there was no alternative, and people like them will always be in power. If you must choose between collapse and rescue, US policymakers will choose rescue every time – and probably they feel compelled again to concede most generous terms “to limit the ultimate cost to the taxpayer” (or words to that effect).

The banks know all this and will act accordingly. You do the math.

Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.

On reflection, perhaps this is exactly why the sponsors of this bill are afraid to have any kind of open and serious debate. The emperor simply has no clothes.

Collapse in demand, not protectionism, caused the collapse in trade

Had you been listening to the podcast or reading this blog fourteen months ago, you would know that the collapse in trade resulting from the financial meltdown was a collapse in demand. Here is some confirmation.

Trade collapse or trade crisis?

Kristian Behrens   Gregory Corcos   Giordano Mion Vox EU

21 March 2010

World trade fell dramatically during 2009, as widely documented on this site and elsewhere. But there has been little econometric analysis of the different explanations put forward. This column uses data from Belgium to argue that a fall in demand was the main culprit. It is not a trade crisis – it is a trade collapse.

World trade in manufactures fell by about 30% between the first half of 2008 and the first half of 2009 (WTO 2009), with remarkable synchronisation within the OECD (Araújo and Martins 2009). This trade collapse exceeded the fall in GDP as well as the trade fall predicted by computable general equilibrium models (e.g. Benassy-Quéré et al., 2009) or international real business cycle models (as in Levchenko et al. 2009).
Explanations abound, as illustrated by the comprehensive discussion in Baldwin (2009). Some emphasise a crisis of the supply-side of trade citing such causes as a shortage of trade finance, disruption of global value chains, and increased trade barriers. For others, this fall is simply the flip-side of a fall in the demand for manufactures, postponed purchases of intermediates, and the drawing down of inventories.

Plugging the gap with data

Who is right? Aggregate and broad product categories level analyses are not well suited to provide a clear answer because the different effects and margins of adjustment cannot be separately identified. Econometric analysis of firm-level data is therefore critical to discriminate between these explanations. Yet despite a wealth of statistical analysis, econometric work on firm-level data is scarce.¹ Our recent research (Behrens et al., 2010) tries to fill this gap, using data on firm-product-country level Belgian exports and imports as well as a wealth of balance sheet information. We compare the first half of 2008 and the first half of 2009 as the Belgian trade collapse started in November 2008.
Three key findings stand out.

• First, the fall in trade overwhelmingly occurred at the intensive margin, i.e., prices charged and quantities sold.
• Second, the absence of composition effects suggests that the drying-up of trade finance, the breaking-up of global value chains, or the drawing-down of inventories were not the main drivers of the fall in trade.
• Third, changes in exports and imports did not systematically deviate from changes in turnover and intermediate consumption respectively.

We conclude that the trade collapse did not result from a crisis of trade itself. We can presume that, although exports and imports in Belgium are still suffering to recover, as Schott (2009) puts it: “trade will bounce back relatively quickly once conditions improve”.

A fall at the intensive margin of trade

Which margins mattered most for the trade collapse, firm entry or exit? Adding or dropping products and markets? Price adjustments? Or output scaling? The answer to this question is important. Changes at the intensive margin (price and quantity adjustments) are likely to be less durable and less costly than changes at the extensive margin (i.e., changes in the number of trading firms, products sold, and markets served). This is because the latter entail high irreversible costs, such as those of creating a trading network across different countries.

Table 1 shows that virtually all of the trade collapse during the 2008-2009 crisis was driven by changes in the prices quoted and the quantities shipped. Though both exports and imports fell by about 24%, almost all trading firms remained active, with hardly any change in the average number of countries they traded with, and in the average number of products shipped to or sourced from each country. On the one hand, this result echoes findings on the 1997 Asian crisis and confirms evidence on comparable French data on the current crisis (see Bernard et al. 2009 and Bricongne et al. 2009). On the other hand it highlights the extreme flexibility of business relationships across firms, their input suppliers, and their clients. This is reassuring. A massive reduction in the number of trading firms, countries or products would likely make recovery more costly and sluggish.
Table 1. Changes in the margins of Belgian trade, first semesters of 2008 and 2009
 

Hardly any systematic differences within or between industries

We decompose the fall in trade into firm, country and product components, and relate each component to observable firm, industry, country and product characteristics. If trade falls more for certain firms, products or countries, the “composition effects” inform us on the likely determinants.

Firm characteristics include size and productivity, export and import shares, a vertical specialisation index, variables linked to financial structure, ownership indicators, as well as a proxy for inventory capacity. Country characteristics include exchange rate movements, the trading partner's growth rate, as well as EU and OECD dummies.
Product variables follow a product classification as well as Rauch's (1999) measure of product differentiation (see Behrens et al. 2010 for a discussion of the methodology and data).

Our econometric analysis provides a number of striking results. The intensive margin fall has been extremely evenly spread across products, including consumer durables and capital goods. The same applies to destination and origin markets, though the fall has been slightly less pronounced for EU partners and/or higher-growth countries.
Finally, no firm composition effects appear on the export side. On the import side, larger and/or more indebted firms (especially with trade credit as opposed to financial credit), and firms relying on a larger share of imported intermediate inputs, reduced imports a bit more. Yet even then firm characteristics explain less than 25% of the change in imports. Furthermore, cross-industry heterogeneity is hardly relevant for exports and completely irrelevant for imports.

A comparable fall in domestic operations

Finally, we consider changes in exports-to-turnover and imports-to-intermediates ratios at the firm level. This allows us to compare the magnitude of the fall in domestic activity with that of the fall in international trade. On aggregate, the ratios of exports and importer over production did not fall during the period we consider (as can be seen from Figures 1 and 2) so confirming the evidence provided in Eaton et al. (2009) for most OECD countries. Crucially, our micro analysis reveals no cross-industry pattern, while firm characteristics have almost no explanatory power. The exports-to-turnover ratio falls more among firms with higher vertical specialisation indices, but by less than 2 percentage points.

Figure1. Monthly export over production value ratio from January 2005 to June 2009

Figure 2. Monthly import over production value ratio from January 2005 to June 2009

Conclusion

Detailed micro trade data from Belgium allow for a sharp analysis of the trade collapse. Our econometric study shows that the 25% trade fall was very evenly spread across industries, across firms within industries and across products and countries. Finally, domestic sales and purchases fell equally fast with no systematic variation across firms. We conclude that trade is not in crisis per se and so it would be better to talk about a trade collapse rather than a trade crisis. Further investigation of the fall in demand is certainly needed. Sector biases in fiscal stimuli, a fall in commodity prices, or substitution patterns among consumers may be among the suspects.

References

Araújo, Sónia and Joaquim O Martins (2009), “The Great Synchronisation: tracking the trade collapse with high-frequency data”, in Richard Baldwin (ed.), “The Great Trade Collapse: Causes, Consequences and Prospects”, VoxEU.org.
Baldwin, Richard (ed.) (2009), “The Great Trade Collapse: Causes, Consequences and Prospects”, CEPR.
Behrens, Kristian, Gregory Corcos and Giodarno Mion (2010), “Trade Crisis? What Trade Crisis?”, mimeo LSE.
Bénassy-Quéré Agnès, Yvan Decreux, Lionel Fontagné, and David Koudour-Casteras (2009), “Economic Crisis and Global Supply Chains”, Document de travail CEPII, 2009-15.
Bernard, Andrew, Jensen J Bradford, Stephen Redding and Peter K Schott (2009), “The Margins of US Trade”, American Economic Review Papers and Proceedings
Bricongne, Jean-Charles, Lionel Fontagné, Guillaume Gaulier, Daria Taglioni, and Vincent Vicard (2009), “Firms and the global crisis: French exports in the turmoil”, mimeo CEPII.
Eaton, Jonathan, Sam Kortum, Brent Neiman, and John Romalis (2009), “Trade and the Global Recession”, mimeo.
Levchenko, Andrei, Logan Logan and Linda Tesar (2009), “The collapse of US trade: In search of the smoking gun”, VoxEU.org, 27 November.
Schott, Peter K (2009), “US trade margins during the 2008 crisis”, in Richard Baldwin (ed.), “The Great Trade Collapse: Causes, Consequences and Prospects”, CEPR.

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1 To the best of our knowledge, only Bricongne et al. (2009) make use of some firm-level data. They examine the fall in French trade among various classes of exporter size, and various sectors which depend to different degrees on external finance. They do not, however, exploit individual firm characteristics to discriminate between the above-mentioned explanations.

Meager proposal to return to progressive taxation from Robert H. Frank

The belief that lower taxes lead to a stronger economy is deeply rooted in the American psyche. It is not rooted in evidence of any sort. High tax nations are the prosperous nations. In the U.S., tax cuts have not led to stability or prosperity. We have cited the 2008 tax cuts that were George W. Bush's glance at stimulus. But there were the huge tax cuts in 2001 and 2003 and the Reagan tax cuts that led nowhere.

Taken together, federal, state and local taxes are not progressive. They are, at best, flat. Part of this has to do with the sales taxes of many states, but more has to do with the patently regressive payroll taxes, not collected on incomes over about $90,000. Simply ending this cap would return the tax structure to some form of progressivity.

Combine this with the increasing evidence that lower taxes on high incomes increase incentives for fraud and waste, not innovation and harder work, and you have what we think is compelling logic for something big.

Yet here is the best we can get. A doofus idea to stimulate rich people's spending in down times by enacting an easily circumvented, convoluted consumption tax. And a second, better piece by Senator Jim Webb on getting back some of the bonuses big banks paid from the taxpayer bailout.

Hey, Big Spender: You Need a Surtax
Robert H. Frank
New York Times
March 19, 2010

LAST year’s stimulus spending is running out, yet unemployment stays stubbornly near 10 percent. And as state and local governments keep cutting their budgets, the economy desperately needs an additional spending boost. Concerned about growing federal deficits, however, many in Congress appear reluctant to act.

Their worries are misguided. Yes, deficits are bad, but protracted unemployment is far worse. Still, it seems unlikely that additional stimulus legislation can attract the supermajority now required to clear the Senate. And even without such legislation, huge budget deficits loom for years. In the long run, these deficits will impoverish our grandchildren, just as the deficit hawks assert.

But an effective remedy is at hand. A simple revision to current tax policy could spur an immediate burst of nongovernment spending that would help restore full employment without adding to the deficit. And this same revision would simultaneously create a relatively painless new revenue stream that would help balance future budgets.

What I have in mind is a surtax on extremely high levels of consumption. It would be enacted right away, but not take effect until unemployment again fell below 6 percent.

More than 99 percent of households would be exempt from this tax, which would be levied only on families earning more than $1 million who consume more than $500,000 annually.

These families would continue to report their incomes to the I.R.S., but also their annual savings, much as they now document contributions to tax-sheltered retirement accounts. Consumption would then be calculated as the difference between reported income and savings.

Once consumption topped $500,000, the families would be subject to the surtax. Rates would start low but rise as consumption grew.

(Here are a few more details: Loan repayments would be added to the savings total, thereby reducing potential tax liability. New borrowing, meanwhile, would be subtracted from savings, increasing the potential tax. For homeowners, annual housing consumption would be counted as the implicit rental value of their house, so a $500,000 purchase would not set off the tax.)

A progressive consumption surtax would produce immediate, off-budget economic stimulus by giving wealthy families powerful incentives to accelerate future spending. For example, a family that had been planning to build a new wing onto its mansion, or buy a yacht, would want to make those purchases now rather than be taxed on them later.

Stimulating a new luxury spending spree may not seem an ideal way to stimulate the economy. Far better, perhaps, would be for the government to repair dilapidated bridges and build high-speed trains. But unless someone can persuade 60 senators to support a huge new stimulus bill, this second option is foreclosed. Given our choices, it would be much better to provoke an additional burst of luxury spending than to let high unemployment linger for years.

Once it took effect, of course, a progressive consumption surtax would discourage luxury spending. Would that cause job losses down the road? No, because employment depends on total spending, not just consumption spending.

If the surtax were phased in gradually, it would shift spending from consumption toward additional savings and investment. In the long run, higher investment would increase economic growth and boost earnings across the income spectrum.

Is a progressive consumption surtax politically feasible? As we know, voters never respond warmly to any new taxes. But the looming retirements of the baby boomers will make it impossible to eliminate huge budget deficits by cutting government spending. We need more revenue.

And there is broad agreement among economists that if additional taxes are needed, consumption taxation is the way to go.

A progressive consumption surtax embodies important advantages over higher income tax rates or a national sales tax — other widely proposed sources of new revenue. Many economists warn that higher income tax rates would weaken incentives to save and invest. But because a progressive consumption tax would shelter savings from tax, it would have precisely the opposite effect. The problem with a national sales tax — or its close cousin, a value-added tax — is that it’s extremely regressive because the poor save at much lower rates than the rich .

More than a decade ago, shortly after the publication of my article advocating replacement of the income tax with a progressive consumption tax, I received a warm letter from Milton Friedman, the late Nobel laureate, who was the patron saint of small-government conservatism. Mr. Friedman began by disagreeing with my contention that additional public investment would yield high returns.

He quickly added, however, that if the government did need additional revenue, a progressive consumption tax would be the best way to raise it. He enclosed a reprint of a 1943 article from the American Economic Review in which he had advocated a progressive consumption tax to pay for the war effort.

THE University of Delaware economists Larry Seidman and Ken Lewis estimate that a progressive consumption tax could generate $50 billion or more in additional revenue annually. Such a tax would not cause painful sacrifices because, beyond a certain point, additional consumption serves needs that are almost completely socially determined.

When all C.E.O.’s build bigger mansions, for example, they are simply raising the bar that defines how big of a mansion a C.E.O. needs. If a progressive consumption surtax induced all of them to postpone those additions, nothing important would be sacrificed. And if top earners spent less on mansions, so would people just below them, and so on, all the way down the earnings ladder.

If that’s not creating money out of thin air, it’s pretty close.

Robert H. Frank is an economics professor at the Johnson Graduate School of Management at Cornell University.

How to reward taxpayers who bailed out Wall Street
Senator Jim Webb
Washington Post
March 21, 2010

On Sept. 19, 2008, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke convened a conference call with the Democratic caucus of the U.S. Senate. We were starkly told that the liquidity of our financial system was frozen by a plethora of toxic assets and that if we did not immediately appropriate $700 billion the world economy would, within weeks, descend into a cataclysmic free-fall.

Ten days of frantic briefings and negotiations followed. I talked with people across the philosophical spectrum and heard conflicting advice, but the bottom line was: The crisis is real. On Oct. 1, 2008, the Senate voted to fund the Troubled Assets Relief Program (TARP).

I decided to vote favorably after being reassured by Senate Democratic leaders that we would examine excessive executive compensation, work to reregulate the financial sector and include the American taxpayer on the upside of any recovery.

The financial sector recovered rather quickly, but not without a vast amount of help.

The time has come to include taxpayers in the rewards of a recovery that would never have happened without their money.

Billions of dollars in bonuses paid recently to financial-sector executives are a direct result of the TARP bailout and generous Federal Reserve policies constructed during the crisis. These firms have had toxic assets removed from their balance sheets and have benefited from interest rates near zero as the Federal Reserve opened its "discount window." A July 2009 report to Congress indicated that the guarantee of support from the Fed was in the neighborhood of $6.8 trillion. In short, the top-tier managers in these companies had enormous backup from taxpayers.
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As we are all painfully aware, this economic crisis wiped out jobs, assets and retirement accounts. It is not fair, as we pick up the pieces, that our middle class is the last to be made whole.

Recognizing this, I offered a one-shot amendment to recent "tax extenders" legislation, designed to give taxpayers a place on the upside of the recovery of the financial system that they so clearly enabled. This amendment, which Sen. Barbara Boxer principally co-sponsored, provided for a one-time 50 percent tax on bonuses in excess of $400,000 paid to executives of Fannie Mae, Freddie Mac and any other financial institution that received at least $5 billion through TARP. The tax would apply only for the excess amount of the bonuses (and not on basic income) of monies earned in 2009 and compensated in 2010. At a time of huge deficit spending, this "fairness tax" would recover $3.5 billion to $10 billion.

After predictable lobbying by the financial sector, the amendment was not even allowed a vote on the Senate floor. Why? Because this issue, like others involving true economic fairness, is political poison. Voting in favor of a "windfall profits" tax, however narrowly defined, incurs the wrath of key political donors. But voting against it would increase the anger of working people who know they are not being fairly treated. And so, after a bit of political hand-wringing, the issue disappeared from view.

I do not favor recurring taxes on windfall profits. They are usually difficult to define in a rough-and-tumble economic culture designed to reward inventiveness and the willingness to take risks. But this situation is different. The risks were mitigated, if not eliminated. There is no risk or inventiveness to reward. These executives got lucky, to the exact degree that our middle-class taxpayers got the shaft.

Entrepreneurial risk-taking is an engine for growth in our economy and should be justly rewarded. But our middle class, which seldom has direct access to power, deserves the full protection of our leaders. In this case, bailed-out executives should be eternally grateful that they are receiving not only full compensation but also extremely generous bonuses. And our political leaders should have the fortitude to require that bonuses in excess of $400,000 be shared with American workers who may not even own stock but who were required to invest their tax dollars into TARP to stabilize the economy.

The writer is a Democratic senator from Virginia.

Robert Reich puts the health care vote in perspective

The health care reform passed by Congress is a bigger political event than it is an economic event, according to Robert Reich. It had better be, because it's not much of an economic improvement when compared to where we need to go.

The Final Health Care Vote and What it Really Means
Robert Reich
March 21, 2010

It’s not nearly as momentous as the passage of Medicare in 1965 and won’t fundamentally alter how Americans think about social safety nets. But the likely passage of Obama’s health care reform bill is the biggest thing Congress has done in decades, and has enormous political significance for the future.

Medicare directly changed the life of every senior in America, giving them health security and dramatically reducing their rates of poverty. By contrast, most Americans won’t be affected by Obama’s health care legislation. Most of us will continue to receive health insurance through our employers. (Only a comparatively small minority will be required to buy insurance who don’t want it, or be subsidized in order to afford it. Only a relatively few companies will be required to provide it who don’t now.)

Medicare built on Franklin D. Roosevelt’s New Deal notion of government as insurer, with citizens making payments to government, and government paying out benefits. That was the central idea of Social Security, and Medicare piggybacked on Social Security.

Obama’s legislation comes from an alternative idea, begun under the Eisenhower administration and developed under Nixon, of a market for health care based on private insurers and employers. Eisenhower locked in the tax break for employee health benefits; Nixon pushed prepaid, competing health plans, and urged a requirement that employers cover their employees. Obama applies Nixon’s idea and takes it a step further by requiring all Americans to carry health insurance, and giving subsidies to those who need it.

So don’t believe anyone who says Obama’s health care legislation marks a swing of the pendulum back toward the Great Society and the New Deal. Obama’s health bill is a very conservative piece of legislation, building on a Republican rather than a New Deal foundation. The New Deal foundation would have offered Medicare to all Americans or, at the very least, featured a public insurance option.

The significance of Obama’s health legislation is more political than substantive. For the first time since Ronald Reagan told America government is the problem, Obama’s health bill reasserts that government can provide a major solution. In political terms, that’s a very big deal.

Most Americans continue to be suspicious of government. That distrust is deeply etched in our culture and traditions. Our system of government was devised by people who distrusted government and intentionally created checks and balances, three separate branches, and almost insuperable odds against getting big things done. The period extending from 1933 to 1965 — the New Deal and the Great Society — was an historical aberration from that long tradition, animated by the unique crises of the Great Depression and World War II, and the social cohesion that flowed from them for another generation. Ronald Reagan merely picked up where Calvin Coolidge and Herbert Hoover left off.

But Reagan’s view of government as the problem is increasingly at odds with a nation whose system of health care relies on large for-profit entities designed to make money rather than improve health; whose economy is dependent on global capital and on global corporations and financial institutions with no particular loyalty to America; and much of whose fuel comes from unstable and dangerous areas of the world. Under these conditions, government is the only entity that can look out for our interests.

We will not return to the New Deal or the Great Society, but nor will we continue to wallow in the increasingly obsolete Reagan view that we don’t need a strong and competent government. Today’s vote confirms our hope that we can have both strength and competence in Washington. It is an audacious hope, but we have no choice.

Nouriel Roubini points at private debt as the millstone carrying the economy down

As clear as you can be, Nouriel Roubini begins, "The Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies." He ends, "Unsustainable private-debt problems must be resolved by defaults, debt reductions, and conversion of debt into equity. If, instead, private debts are excessively socialized, the advanced economies will face a grim future: serious sustainability problems with their public, private, and foreign debt, together with crippled prospects for economic growth."

What are we doing? Excessively socializing the private debts of the big banks. Without a change in this policy, we will be going nowhere fast.

States of Risk
Nouriel Roubini
Project Syndicate
March 15, 2010

The Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies. While there is much talk about de-leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized at very high levels.

By contrast, as a consequence of fiscal stimulus and socialization of part of the private sector’s losses, there is now a massive re-leveraging of the public sector. Deficits in excess of 10% of GDP can be found in many advanced economies, and debt-to-GDP ratios are expected to rise sharply – in some cases doubling in the next few years.

As Carmen Reinhart and Ken Rogoff’s new book This Time is Different demonstrates, such balance-sheet crises have historically led to economic recoveries that are slow, anemic, and below-trend for many years. Sovereign-debt problems are another strong possibility, given the massive re-leveraging of the public sector.

In countries that cannot issue debt in their own currency (traditionally emerging-market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public-debt restructuring.

In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to high inflation. And inflation is – like default – a capital levy on holders of public debt, as it reduces the real value of nominal liabilities at fixed interest rates.

Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in many advanced economies (and a smaller number of emerging markets). Bond-market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher. Eventually they may take aim at other countries – even Japan and the United States – where fiscal policy is on an unsustainable path.

In most advanced economies, aging populations – a serious problem in Europe and Japan –exacerbate the problem of fiscal sustainability, as falling population levels increase the burden of unfunded public-sector liabilities, particularly social-security and health-care systems. Low or negative population growth also implies lower potential economic growth and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the sustainability of public-sector debt.

The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable increase in the spread on sovereign bonds, the short-run effects of raising taxes and cutting government spending tend to be contractionary. This, too, complicates the public-debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated recession and eventually led to default.

In countries like the euro-zone members, a loss of external competitiveness, caused by tight monetary policy and a strong currency, erosion of long-term comparative advantage relative to emerging markets, and wage growth in excess of productivity growth, impose further constraints on the resumption of growth. If growth does not recover, the fiscal problems will worsen while making it more politically difficult to enact the painful reforms needed to restore competitiveness.

A vicious circle of public-finance deficits, current-account gaps, worsening external-debt dynamics, and stagnating growth can then set in. Eventually, this can lead to default on euro-zone members’ public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough.

Provision of liquidity by an international lender of last resort – the European Central Bank, the International Monetary Fund, or even a new European Monetary Fund – could prevent an illiquidity problem from turning into an insolvency problem. But if a country is effectively insolvent rather than just illiquid, such “bailouts” cannot prevent eventual default and devaluation (or exit from a monetary union) because the international lender of last resort eventually will stop financing an unsustainable debt dynamic, as occurred Argentina (and in Russia in 1998).

Cleaning up high private-sector debt and lowering public-debt ratios by growth alone is particularly hard if a balance-sheet crisis leads to an anemic recovery. And reducing debt ratios by saving more leads to the paradox of thrift: too fast an increase in savings deepens the recession and makes debt ratios even worse.

At the end of the day, resolving private-sector leverage problems by fully socializing private losses and re-leveraging the public sector is risky. At best, taxes will eventually be raised and spending cut, with a negative effect on growth; at worst, the outcome may be direct capital levies (default) or indirect ones (inflation).

Unsustainable private-debt problems must be resolved by defaults, debt reductions, and conversion of debt into equity. If, instead, private debts are excessively socialized, the advanced economies will face a grim future: serious sustainability problems with their public, private, and foreign debt, together with crippled prospects for economic growth.

Copyright: Project Syndicate, 2010.

Robert Kuttner sees Obama reborn as a fighter

The health care bill passed through Congress is far short of the common sense single-payer system, but to Robert Kuttner it signals a turn back toward the populism that was the mark of the Obama candidacy. Does the milquetoast financial reform legislation and the coddling of banks -- no, the wholesale subsidy to banks -- have a sunset here. We think not. It will be a long time before events force policy back toward what will work. Still, Kuttner is often very right

Defining Moment
Robert Kuttner
March 22, 2010

We have just witnessed what could be a turning point in the Obama presidency. In many respects we can thank Scott Brown. For it took the humiliating loss of Ted Kennedy's senate seat, and the even deeper incipient humiliation of lost health reform, for Obama to be reborn as a fighter. It remains to be seen whether he will match the resolve that he finally summoned on health reform with comparable leadership on all of the other challenges he yet faces.

But even those of us who were lukewarm on this bill should savor the moment and honor Obama's odyssey. His Saturday speech was simply the greatest of his presidency. It reminded us of the inspirational figure in whom so many of us invested such hopes last summer and fall. If you have been on Jupiter and somehow missed the speech, you owe it to yourself to watch it.

At long last, we saw this president leading, as only a president can. And we saw him leading as a progressive Democrat, finally admitting that no common ground with today's Republicans is possible, narrating stories we all can recognize about the human tragedy that is our current health care system.

We saw him reminding Democratic congressmen and women why progress on health reform is good politics. We saw him using gentle ridicule on the Republicans, who have suddenly become oddly solicitous of the Democrats' congressional majority.

I noticed that there's been a lot of friendly advice offered all across town. (Laughter.) Mitch McConnell, John Boehner, Karl Rove -- they're all warning you of the horrendous impact if you support this legislation. Now, it could be that they are suddenly having a change of heart and they are deeply concerned about their Democratic friends. (Laughter.) They are giving you the best possible advice in order to assure that Nancy Pelosi remains Speaker and Harry Reid remains Leader and that all of you keep your seats. That's a possibility. (Laughter.)


But it may also be possible that they realize after health reform passes and I sign that legislation into law, that it's going to be a little harder to mischaracterize what this effort has been all about.



We watched Obama master the mechanics of legislative politics, cobbling together a majority one vote at a time. And we observed the Republican right reduced to sputtering frustration.

What a splendid shift from the Obama who less than a month ago went imploringly to reason with the House Republican Caucus.

Until very recently, the press treated this battle as a symmetrical stand-off. Now, with the president at last regaining control of the narrative, the Republicans are revealed as pure obstructionists. As the bill takes effect and citizens actually experience benefits (and as Obama said, "Lo and behold, nobody is pulling the plug on Grandma,") the Republicans will lose both as the party of No, and as a party that tried and failed to block a beneficial reform that citizens will come to value.

It has taken more than fourteen months for Obama to vindicate as president the leadership potential that we saw on the campaign trail; fourteen months to give up on the fantasy of bipartisanship; fourteen months to start truly inspiring ordinary people as he did as a candidate.

House Speaker Nancy Pelosi deserves to share this moment. She never gave up on this legislation, and she kept after Obama and his aides to be tougher, smarter, and unapologetically partisan. She as much as Obama did the hard work of pulling together a majority, and kept Obama from caving in to Rahm Emanuel's advice to seek a puny bill that the Republicans might support.

The media is notorious for exaggerating the ups and downs of a president. A few weeks ago, Obama and health reform were doomed and Obama was not up to the job. In the coming days, we will see a jubilant Obama on the cover of newsmagazines. He will be lionized as a giant-killer. His approval ratings will rise, both because more Americans are paying attention to the beneficial features of the bill as opposed to the Republican caricatures and because Americans love a winner.

Whether he continues to earn these accolades depends on what he does next, now that the long distraction of health reform is finally behind us. For this come-from behind victory is only the first step in a long road back to the presidency we thought we were getting when we voted for Barack Obama.

The financial system is setting itself up for a second collapse, as new speculative maneuvers make insiders rich and add risks to the rest of the system. The bill working its way through the Senate is far too weak to fix what is broken. We are inviting new scandals, even before we get to the bottom of what really happened at Lehman Brothers and at AIG.

Mortgage foreclosures continue to increase far faster than the Administration's feeble program of subsidizing the banks can provide relief to homeowners. Credit is still very tight because of the administration's strategy of putting Wall Street bank balance sheets ahead of recovery on Main Street.

Last week's signing ceremony in the Rose Garden for a pitifully small jobs bill was enough to wilt the roses. It was a relic of what we get when we strive for bipartisanship. With the economy short at least eleven million jobs, Obama himself has appointed a bipartisan deficit-reduction commission stacked with members who are almost certain to call for massive cuts in social investment that America needs.

And the health bill itself only begins the long task of wresting control of the health care system from callous insurance and drug companies. We still have to fight for a real public option that is the first step towards national health insurance.

But in the springtime of March 2010, we have seen a president who evidently has learned how to lead, who relishes winning, and who is primed to become a more effective progressive. For that we should be grateful. It should whet his appetite as a fighter -- and ours.

Anti-deficit fever has unintended consequences

The IMF and its John Lipsky have called for increasing public sector savings in the wealthy countries.

The global economic crisis has left “deep scars” in the fiscal balances of the world’s advanced economies, which should begin to rein in spending next year as the recovery continues, the No.2 official at the International Monetary Fund said Sunday.
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For the United States, “a higher public savings rate will be required to ensure long-term fiscal sustainability,” Mr. Lipsky said.
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“Addressing this fiscal challenge is a key near-term priority, as concerns about fiscal sustainability could undermine confidence in the economic recovery,” Mr. Lipsky said. ... While it makes sense for the world’s largest economies to continue stimulus spending through the end of this year, “fiscal consolidation should begin in 2011, if the recovery occurs at the projected pace,” Mr. Lipsky said.

This is a continuation of the Neoliberal fallacies and will create grief in exact proportion to the amount it is applied. Minsky correctly expanded the work of the great economist Michal Kalecki and showed with elegant algebra that the profits of private sector businesses in a downturn are directly dependent on public sector deficits.

With that extended introduction, below is a heavy lift, but another way of looking at the same problem, from Robert Parenteau.

Will the Quest for Fiscal Sustainability Destabilize Private Debt?
Robert Parenteau
Economic Perspectives from Kansas City
March 3, 2010

The question of fiscal sustainability looms large at the moment – not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt to GDP ratios, and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.

However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities (see here and here). Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere - unless an offsetting increase in current account balances can be accomplished in tandem.

To make the interconnectedness of sector financial balances clearer, proposed fiscal trajectories need to be considered in the context of what we call the financial balances map. Only then can tradeoffs between fiscal sustainability efforts and the issue of financial stability for the economy as a whole be made visible. Absent consideration of the interrelated nature of sector financial balances, unnecessarily damaging choices may soon be made to the detriment of citizens and firms in many nations.

Navigating the Financial Balances Map

For the economy as a whole, in any accounting period, total income must equal total expenditures. There are, after all, two sides to every transaction: a spender of money and a receiver of money income. Similarly, total saving out of income flows must equal total investment in tangible capital during any accounting period.

For individual sectors of the economy, these equalities need not hold. The financial balance of any one sector can be in surplus, in balance, or in deficit. The only requirement is, regardless of how many sectors we choose to divide the whole economy into, the sum of the sectoral financial balances must equal zero.

For example, if we divide the economy into three sectors – the domestic private (households and firms), government, and foreign sectors, the following identity must hold true:

Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0

Note that it is impossible for all three sectors to net save – that is, to run a financial surplus – at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time – some sector has to be issuing liabilities.

Since foreigners earn a surplus by selling more exports to their trading partners than they buy in imports, the last term can be replaced by the inverse of the trade or current account balance. This reveals the cunning core of the Asian neo-mercantilist strategy. If a current account surplus can be sustained, then both the private sector and the government can maintain a financial surplus as well. Domestic debt burdens, be they public or private, need not build up over time on household, business, or government balance sheets.

Domestic Private Sector Financial Balance + Fiscal Balance - Current Account Balance = 0

Again, keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong. To make these relationships between sectors even clearer, we can visually represent this accounting identity in the following financial balances map as displayed below.

On the vertical axis we track the fiscal balance, and on the horizontal axis we track the current account balance. If we rearrange the financial balance identity as follows, we can also introduce the domestic private sector financial balance to the map:

Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance

That means at every point on this map where the current account balance is equal to the fiscal balance, we know the domestic private sector financial balance must equal zero. In other words, the income of households and businesses just matches their expenditures (or alternatively, if you prefer, the saving out of income flows by the domestic private sector just matches the investment expenditures of the sector). The dotted line that passes through the origin at a 45 degree angle marks off the range of possible combinations where the domestic private sector is neither net issuing financial liabilities to other sectors, nor is it net accumulating financial assets from other sectors.

Once we mark this range of combinations where the domestic private sector is in financial balance, we also have determined two distinct zones in the financial balance map. To the left of the dotted line, the current account balance is less than the fiscal balance: the domestic private sector is deficit spending. To the right of the dotted line, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus or net saving position.

This follows from the recognition that a current account surplus presents a net inflow to the domestic private sector (as export income for the domestic private sector exceeds their import spending), while a fiscal surplus presents a net outflow for the domestic private sector (as tax payments by the private sector exceed the government spending they receive).

Accordingly, the further we move up and to the left of the origin (toward the northwest corner of the map), the larger the deficit spending of households and firms as a share of GDP, and the faster the domestic private sector is either increasing its debt to income ratio, or reducing its net worth to income ratio (absent an asset bubble). Moving to the southeast corner from the origin takes us into larger domestic private surpluses.

The financial balance map forces us to recognize that changes in one sector’s financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode.

When sustained over time, this negative cash flow position for the domestic private sector will eventually increase the financial fragility of the economy, if not insure the proliferation of household and business bankruptcies. Mimicking the military planner logic of “we must bomb the village in order to save the village”, the blind pursuit of fiscal sustainability may simply induce more financial instability in the private sector.

Leading the PIIGS to an (as yet) Unrecognized Slaughter

The rules of the eurozone are designed to reduce the room for policy maneuver of any one member country, and thereby force private markets to act as the primary adjustment mechanism. Each country is subject to a single monetary policy set by the European Central Bank (ECB). One policy rate must fit the needs of all the member nations in the Eurozone. Each country has relinquished its own currency in favor of the euro. One exchange rate must fit the needs of all member nations in the Eurozone. The fiscal balance of member countries is also, under the provisions of the Stability and Growth Path, supposed to be limited to a deficit of 3% of GDP. The principle here is one of stabilizing or reducing government debt to GDP ratios. Assuming economies in the Eurozone have the potential to grow at 3% of GDP in nominal terms, only fiscal deficits greater than 3% of GDP will increase the public debt ratio.

In other words, to join the European Monetary Union, nations have substantially diluted their policy autonomy. Markets mechanisms must achieve more of the necessary adjustments – policy measures are circumscribed. Policy responses are constrained by design, and experience suggests relative price adjustments in the marketplace have a difficult time at best of automatically inducing private investment levels consistent with desired private saving at a level of full employment income.

Now let’s layer on top of this structure three complicating developments of late. First, current account balances in a number of the peripheral nations have fallen, in part due to the prior strength in the euro. Second, fiscal shenanigans along with a very sharp global recession have led to very large fiscal deficits in a number of peripheral nations. Third, following the Dubai World debt restructuring, global investors have become increasingly alarmed about the sustainability of fiscal trajectories, and there is mounting pressure for governments to commit to tangible plans to reduce fiscal deficits over the next three years, with Ireland and Greece facing the first wave of demands for fiscal retrenchment.

We can apply the financial balances approach to make the current predicament plain. If, for example, Spain is expected to reduce it's fiscal deficit from roughly 10% of GDP to 3% of GDP in three years time, then the foreign and private domestic sectors must be together willing and able to reduce their financial balances by 7% of GDP. Spain is estimated to be running a 4.5% of GDP current account deficit this year. If Spain cannot improve its current account balance (in part because it relinquished its control over its nominal exchange rate the day it joined EMU), the arithmetic of sector financial balances is clear. Spain’s households and businesses would, accordingly, need to reduce their current net saving position by 7% of GDP over the next three years. Since they are currently estimated to be net saving 5.5% of GDP, Spain’s domestic private sector would move to a 1.5% of GDP deficit, and thereby enter a path of increasing leverage.

Spain already is running one of the higher private debt to GDP ratios in the region. In addition, Spain had one of the more dramatic housing busts in the region, which Spanish banks are still trying to dig themselves out from (mostly, it is alleged, by issuing new loans to keep the prior bad loans serviced, in what appears to be a Ponzi scheme fashion). It is highly unlikely Spanish businesses and households will voluntarily raise their indebtedness in an environment of 20% plus unemployment rates, combined with the prospect of rising tax rates and reduced government expenditures as fiscal retrenchment is pursued.

Alternatively, if we assume Spain’s private sector will attempt to preserve its estimated 5.5% of GDP financial balance, or perhaps even attempt to run a larger net saving or surplus position so it can reduce its private debt faster, Spain’s trade balance will need to improve by more than 7% of GDP over the next three years. Barring a major surge in tradable goods demand in the rest of the world, or a rogue wave of rapid product innovation from Spanish entrepreneurs, there is an additional way for Spain to accomplish such a significant reversal in its current account balance.

Prices and wages in Spain’s tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the Eurozone members). Arguably, the slack resulting from the fiscal retrenchment is just what the doctor might order to raise the odds of accomplishing such a large wage and price deflation in Spain. But how, we must wonder, will Spain’s private debt continue to be serviced during the transition as Spanish household wages and business revenues are falling under higher taxes or lower government spending?

Part II Spain Ensnared in the EMU Trap


As evident from the financial balances map, there are a whole range of possible combinations of current account and domestic private sector financial balances which could be consistent with the 7% of GDP reduction in Spain’s fiscal deficit. But the simple yet still widely unrecognized reality is as follows: both the public sector and the domestic private sector cannot deleverage at the same time unless Spain produces a nearly unimaginable trade surplus - unimaginable especially since Spain will not be the only country in Europe trying to pull this transition off.

As an admittedly rough exercise, we can assume each of the peripheral nations will be constrained to achieving a fiscal deficit that does not exceed 3% of GDP in three years time. In addition, we will assume each nation finds some way to improve its current account imbalances by 2% of GDP over the same interval. What, then, are the upper limits implied for domestic private sector financial balances as a share of GDP for each nation?

Greece and Portugal appear most at risk of facing deeper private sector deficit spending under the above scenario, while Spain comes very close to joining them. But that obscures another point which is worth emphasizing. With the exception of Italy, this scenario implies declines in private sector balances as a share of GDP ranging from 3% in Portugal to nearly 9% in Ireland.

Private sectors agents only tend to voluntarily target lower financial balances in the midst of asset bubbles, when, for example home prices boom and gross personal saving rates fall. Alternatively, during profit booms, firms issue debt and reinvest well in excess of their retained earnings in order take advantage of an unusually large gap between the cost of capital and the expected return on capital. We have no compelling reasons to believe either of these conditions is immediately on the horizon.

The above conclusion regarding the need for a substantial trade balance swing flows in a straightforward fashion from the financial balance approach, and yet it is obviously being widely ignored, because the issue of fiscal retrenchment is being discussed as if it had no influence on the other sector financial balances. This is unmitigated nonsense. It is even more retrograde than primitive tales of "twin deficits" (fiscal deficits are nearly guaranteed to produce offsetting current account deficits) or Ricardian Equivalence stories (fiscal deficits are nearly guaranteed to produce offsetting domestic private sector surpluses) mainstream economists have been force feeing us for the past three decades. Both of these stories reveal an incomplete understanding of the financial balance framework – or at best, one requiring highly restrictive (and therefore highly unrealistic) assumptions.

The EMU Triangle
This observation is especially relevant in the Eurozone, as the combination of the policy constraints that were designed into the EMU, plus the weak trade positions many peripheral nations have managed to achieve, have literally backed these countries into a corner. To illustrate the nature of their conundrum, consider the following application of the financial balances map.

First, a constraint on fiscal deficits to 3% of GDP can be represented as a line running parallel to and below the horizontal axis. Under Stability and Growth Pact rules, we must define all combinations of sector financial balance in the region below this line as inadmissible. Second, since current account deficits as a share of GDP in the peripheral nations are running anywhere from near 2% in Ireland to over 10% in Portugal, and changes in nominal exchange rates are ruled out by virtue of the currency union, we can provisionally assume a return to current account surpluses in these nations is at best a bit of a stretch. This eliminates the financial balance combinations available in the right hand half of the map.

If peripheral European nations wish to avoid higher private sector deficit spending – and realistically, for most of the peripheral countries, the question is whether private sectors can be induced to take on more debt anytime soon, and whether banks and other creditors will be willing to lend more to the private sector following a rash of burst housing bubbles, and a severe recession that is not quite over – then there is a very small triangle that captures the range of feasible solutions for these nations on the financial balance map.

It is the height of folly to expect peripheral Eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative), the peripheral nations in the Eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will run up their debt to income ratios.

Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.

As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. European economic growth will prove extremely difficult to achieve if the current fiscal “sustainability” plans are carried out. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability.

Summary and Conclusions

These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path – the very outcome policy makers were frantically attempting to prevent but a year ago.

There may be ways to thread the needle – Domingo Cavallo’s recent proposal to pursue a “fiscal devaluation” by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation. Cavallo’s claims to the contrary, however, it was not the IMF that tripped him up. Fiscal cuts begat lower domestic income flows, which led to tax shortfalls, missed fiscal balance targets, and another round of fiscal retrenchment, in a vicious spiral fashion. But more innovative solutions than these, where financial stability, not just fiscal sustainability, is the primary objective, will not even be brought to light unless policy makers and investors begin to think coherently about how financial balances interact.

Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher's paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue.

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. We remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s tradable products, but it is also said that necessity is the mother of all invention (and desperation, its father?). Pray there is life on Mars that consumes olives, red wine, and Guinness beer.

Rob Parenteau, CFA
MacroStrategy Edge
February 22, 2010

Kaufman provides leadership in the U.S. Senate

The people in the Senate know what is going on with the financial sector and what to do about it. It is outright corruption not to do the people's business in a case like this. How do we know they know what is going on? Ted Kaufman told them in a speech. Here.

The Rule of Law and Wall Street
Speech by Senator Ted Kaufman
March 15, 2010

Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis. Now that we’re beginning to learn many of the facts, at least with respect to the activities at Lehman Brothers, the country has every right to be outraged. Lehman was cooking its books, hiding $50 billion in toxic assets by temporarily shifting them off its balance sheet in time to produce rosier quarter-end reports. According to the bankruptcy examiner's report, Lehman Brothers’ financial statements were "materially misleading" and its executives had engaged in "actionable balance sheet manipulation." Only further investigation will determine whether the individuals involved can be indicted and convicted of criminal wrongdoing.

According to the examiner’s report, Lehman used accounting tricks to hide billions in debt from its investors and the public. Starting in 2001, that firm began abusing financial transactions called repurchase agreements, or “repos.” Repos are basically short-term loans that exchange collateral for cash in trades that may be unwound as soon as the next day. While investment banks have come to over-rely upon repos to finance their operations, they are neither illegal nor questionable; assuming, of course, they are clearly accounted for.

Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received – hence, the name “Repo 105.” As explained by the New York Times' DealBook, “That meant that for a few days – and by the fourth quarter of 2007 that meant end-of-quarter – Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.”

Even worse, Lehman’s management trumpeted how the firm was decreasing its leverage so that investors would not flee from the firm. But inside Lehman, according to the report, someone described the Repo 105 transactions as “window dressing,” a nice way of saying they were designed to mislead the public.

Ernst & Young, Lehman's outside auditor, apparently became “comfortable” with, and never objected to, the Repo 105 transactions. And while Lehman never could find a U.S. law firm to provide an opinion that treating the Repo 105s as a sale for accounting purposes was legal, the British law firm Linklaters provided an opinion letter under British law that they were sales and not mere financing arrangements. And so Lehman ran the transactions through its London subsidiary and used several different foreign bank counterparties.

Mr. President, the SEC and Justice Department should pursue a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet – and that means everyone from the Lehman executives, to its board of directors, to its accounting firm, Ernst & Young. Moreover, if the foreign bank counterparties who purchased the now infamous "Repo 105s" were complicit in the scheme, they should be held accountable as well.

Returning the Rule of Law to Wall Street

Mr. President, it is high time that we return the rule of law to Wall Street, which has been seriously eroded by the deregulatory mindset that captured our regulatory agencies over the past 30 years, a process I described at length in my speech on the floor last Thursday. We became enamored of the view that self-regulation was adequate, that “rational” self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people. Transparency and vigorous oversight by outside accountants were supposed to keep our financial system credible and sound.

The allure of deregulation, instead, led to the biggest financial crisis since 1929. And now we’re learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well. Since the fall of 2008, Congress, the Federal Reserve and the American taxpayer have had to step into the breach – at a direct cost of more than $2.5 trillion – because, as so many experts have said: "We had to save the system."

But what exactly did we save?

First, a system of overwhelming and concentrated financial power that has become dangerous. It caused the crisis of 2008-2009 and threatens to cause another major crisis if we do not enact fundamental reforms. Only six U.S. banks control assets equal to 63 percent of the nation’s gross domestic product, while oversight is splintered among various regulators who are often overmatched in assessing weaknesses at these firms.

Second, a system in which the rule of law has broken yet again. Big banks can get away with extraordinarily bad behavior – conduct that would not be tolerated in the rest of society, such as the blatant gimmicks used by Lehman, despite the massive cost to the rest of us.

The Lessons of Lehman Brothers and Other Examples

Mr. President, what lessons should we take from the bankruptcy examiner’s report on Lehman, and from other recent examples of misleading conduct on Wall Street? I see three.

First, we must undo the damage done by decades of deregulation. That damage includes financial institutions that are “too big to manage and too big to regulate” (as former FDIC Chairman Bill Isaac has called them), a “wild west” attitude on Wall Street, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on manageably-sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients.

Second, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.

Third, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable “rules of the road” wherever possible. That includes studying conduct that may not be illegal now, but that we should nonetheless consider banning or curtailing because it provides too ready a cover for financial wrongdoing.

The bottom line is that we need financial regulatory reform that is tough, far-reaching, and untainted by discredited claims about the efficacy of self-regulation.

The Fraud Enforcement and Recovery Act

When Senators Leahy, Grassley and I introduced the Fraud Enforcement and Recovery Act (FERA) last year, our central objective was restoring the rule of law to Wall Street. We wanted to make certain that the Department of Justice and other law enforcement authorities had the resources necessary to investigate and prosecute precisely the sort of fraudulent behavior allegedly engaged in by Lehman Brothers.

We all understood that to restore the public's faith in our financial markets and the rule of law, we must identify, prosecute, and send to prison the participants in those markets who broke the law. Their fraudulent conduct has severely damaged our economy, caused devastating and sustained harm to countless hard-working Americans, and contributed to the widespread view that Wall Street does not play by the same rules as Main Street.

FERA, signed into law in May, ensures that additional tools and resources will be provided to those charged with enforcement of our nation's laws against financial fraud. Since its passage, progress has been made, including the President’s creation of an interagency Financial Fraud Enforcement Task Force, but much more needs to be done.

Many have said we should not seek to "punish" anyone, as all of Wall Street was in a delirium of profit-making and almost no one foresaw the sub-prime crisis caused by the dramatic decline in housing values. But this is not about retribution. This is about addressing the continuum of behavior that took place – some of it fraudulent and illegal -- and in the process addressing what Wall Street and the legal and regulatory system underlying its behavior have become.

As part of that effort, we must ensure that the legal system tackles financial crimes with the same gravity as other crimes. When crimes happened in the past (as in the case of Enron, when aided and abetted by, among others, Merrill Lynch, and not prevented by the supposed gatekeepers at Arthur Andersen), there were criminal convictions. If individuals and entities broke the law in the lead up to the 2008 financial crisis (such as at Lehman Brothers, which allegedly deceived everyone, including the New York Fed and the SEC), there should be civil and criminal cases that hold them accountable.

If we uncover bad behavior that was nonetheless lawful, or that we cannot prove to be unlawful (as may be exemplified by the recent reports of actions by Goldman Sachs with respect to the debt of Greece), then we should review our legal rules in the US and perhaps change them so that certain misleading behavior cannot go unpunished again. This will not be easy. As the Wall Street Journal’s “Heard on the Street” noted last week, “Give Wall Street a rule and it will find a loophole.”

Systemic issues in Uncovering and Prosecuting Fraud

This confirms what I heard On December 9 of last year, when I convened an oversight hearing on FERA. As that hearing made clear, unraveling sophisticated financial fraud is an enormously complicated and resource-intensive undertaking, because of the nature of both the conduct and the perpetrators.

Rob Khuzami, head of the SEC’s enforcement division, put it this way during the hearing:

“White-collar area cases, I think, are distinguishable from terrorism or drug crimes, for the primary reason that, often, people are plotting their defense at the same time they're committing their crime. They are smart people who understand that they are crossing the line, and so they are papering the record or having veiled or coded conversations that make it difficult to establish a wrongdoing.”

In other words, Wall Street criminals not only possess enormous resources but also are sophisticated enough to cover their tracks as they go along, often with the help, perhaps unwitting, of their lawyers and accountants.

Assistant Attorney General Lanny Breuer and Khuzami, along with Assistant FBI Director Kevin Perkins, all emphasized at the hearing the difficulty of proving these cases from the historical record alone. The strongest cases come with the help of insiders, those who have first-hand knowledge of not only conduct but also motive and intent. That’s why I’ve applauded the efforts of the SEC and DOJ to use both carrots and sticks to encourage those with knowledge to come forward.

At the conclusion of that hearing in December, I was confident that our law enforcement agencies were intensely focused on bringing to justice those wrongdoers who brought our economy to the brink of collapse.

Going forward, we need to make sure that those agencies have the resources and tools they need to complete the job. But we are fooling ourselves if we believe that our law enforcement efforts, no matter how vigorous or well funded, are enough by themselves to prevent the types of destructive behavior perpetrated by today’s too-big, too-powerful financial institutions on Wall Street.

Is Lehman Brothers an Isolated Example?

Mr. President, I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg. We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel. Enron engaged in similar deceit with some of its assets. And while we don’t have the benefit of an examiner’s report for other firms with a business model like Lehman’s, law enforcement authorities should be well on their way in conducting investigations of whether others used similar “accounting gimmicks” to hide dangerous risk from investors and the public.

The Case of Greece

At the same time, there are reports that raise questions about whether Goldman Sachs and other firms may have failed to disclose material information about swaps with Greece that allowed the country to effectively mask the full extent of its debt just as it was joining the European Monetary Union (EMU). We simply do not know whether fraud was involved, but these actions have kicked off a continent-wide controversy, with ramifications for U.S. investors as well.

In Greece, the main transactions in question were called cross-currency swaps that exchange cash flows denominated in one currency for cash flows denominated in another. In Greece’s case, these swaps were priced “off-market,” meaning that they didn’t use prevailing market exchange rates. Instead, these highly unorthodox transactions provided Greece with a large upfront payment (and an apparent reduction in debt), which they then paid off through periodic interest payments and finally a large “balloon” payment at the contract’s maturity. In other words, Goldman Sachs allegedly provided Greece with a loan by another name.

The story, however, does not end there. Following these transactions, Goldman Sachs and other investment banks underwrote billions of Euros in bonds for Greece. The questions being raised include whether some of these bond offering documents disclosed the true nature of these swaps to investors, and, if not, whether the failure to do so was material.

These bonds were issued under Greek law, and there is nothing necessarily illegal about not disclosing this information to bond investors in Europe. At least some of these bonds, however, were likely sold to American investors, so they may therefore still be subject to applicable U.S. securities law. While “qualified institutional buyers” (QIBs) in the U.S. are able to purchase bonds (like the ones issued by Greece) and other securities not registered with the SEC under Securities Act of 1933, the sale of these bonds would still be governed by other requirements of U.S. law. Specifically, they presumably would be subject to the prohibition against the sale of securities to U.S. investors while deliberately withholding material adverse information.

The point may be not so much what happened in Greece, but yet again the broader point that financial transactions must be transparent to the investing public and verified as such by outside auditors. AIG fell in large part due to its credit default swap exposure, but no one knew until it was too late how much risk AIG had taken upon itself. Why do some on Wall Street resist transparency so? Lehman shows the answer: everyone will flee a listing ship, so the less investors know, the better off are the firms which find themselves in a downward spiral. At least until the final reckoning.

Who’s Responsible? The Role of Congress, Regulators, Accountants and Lawyers

Who’s to blame for this state of affairs, where major Wall Street firms conclude that hiding the truth is okay? Well, there’s plenty of blame to go around. As I said previously, both Congress and the regulators came to believe that self-interest was regulation enough. In the now-immortal words of Alan Greenspan, “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity -- myself especially -- are in a state of shocked disbelief.” The time has come to get over the shock and get on with the work.

What about the professions? Accountants and lawyers are supposed to help insure that their clients obey the law. Indeed, they often claim that simply by giving good advice to their clients, they’re responsible for far more compliance with the law than are government investigators. That claim rings hollow, however, when these professionals now seem too often focused on helping their clients get around the law.

Experts like Professor Peter Henning of Wayne State University Law School, looking at the Lehman examiner’s report on the Repo 105 transactions, are stunned that the accountant Ernst & Young never seemed to be troubled in the least about it. Of course, the fact that a Lehman executive was blowing a whistle on the practice in May 2008 did not change anything, other than to cause some discomfort in the ranks. While saying he was confident he could clear up the whistleblower’s concerns, the lead partner for Lehman at Ernst & Young wrote that the letter and off-balance sheet accounting issues were "adding stress to everyone."

As Professor Henning notes, one of the supposed major effects of the Sarbanes-Oxley Act was to empower the accountants to challenge management and ensure that transactions were accounted for properly. Indeed, it was my predecessor, then-Senator Biden, who was the lead author of the provision requiring the CEO and CFO to attest to the accuracy of financial statements, under penalty of criminal sanction if they knowingly or willfully certified materially false statements. I don't believe this is a failure of Sarbanes-Oxley. A law is not a failure simply because some people subsequently violate it.

I am deeply disturbed at the apparent failure of some in the accounting profession to change their ways and truly undertake the profession's role as the first line of defense (the gatekeeper) against accounting fraud. In just a few years time since the Enron-related death of the accounting firm Arthur Andersen, one might have hoped that "technically correct" was no longer a defensible standard if the cumulative impression left by the action is grossly misleading. But apparently that standard as a singular defense is creeping back into the profession.

The accountants and lawyers weren't the only gatekeepers. If Lehman was hiding balance sheet risks from investors, it was also hiding them from rating agencies and regulators, thereby allowing it to delay possible ratings downgrades that would increase its capital requirements. The Repo 105 transactions allowed Lehman to lower its reported net leverage ratio from 17.3 to 15.4 for the first quarter of 2008, according to the examiner's report. It was bad enough that the SEC focused on a misguided metric like net leverage when Lehman's gross leverage ratio was much higher and more indicative of its risks. The SEC's failure to uncover such aggressive and possibly fraudulent accounting, as was employed on the Repo 105 transactions, provides a clear indication of the lack of rigor of its supervision of Lehman and other investment banks.

The SEC in years past allowed the investment banks to increase their leverage ratios by permitting them to determine their own risk level. When that approach was taken, it should have been coupled with absolute transparency on the level of risk. What the Lehman example shows is that increased leverage without the accountants and regulators and credit rating agencies insisting on transparency is yet another recipe for disaster.

Conclusion

Mr. President, last week’s revelations about Lehman Brothers reinforce what I’ve been saying for some time. The folly of radical deregulation has given us financial institutions that are too big to fail, too big to manage, and too big to regulate. If we have any hope of returning the rule of law to Wall Street, we need regulatory reform that addresses this central reality.

As I said more than a year ago: "At the end of the day, this is a test of whether we have one justice system in this country or two. If we don’t treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law? For our economy to work for all Americans, investors must have confidence in the honest and open functioning of our financial markets. Our markets can only flourish when Americans again trust that they are fair, transparent, and accountable to the laws."

The American people deserve no less.