“Quantitative Easing” Equals “$600 Billion Tax Increase”

Although most economists are loathe to admit it, inflating the currency really serves as a form of stealth taxation. The entire goal of inflation is to allow the issuer of the currency to buy things with the full initial value of the money being inflated while simultaneously reducing the value of the money held by everyone else. In other words, inflation transfers the value represented by monetary tokens (bills, banking computer data, etc.) from the people who hold old tokens (the bills in your wallet) to the people printing the money (in America, the Fed).

Now, toss in this little bit of goodness:

The Fed usually [sic] manages the economy by adjusting short-term interest rates. With those rates already near zero, Fed officials had to dust off a strategy for boosting the economy that debuted during the darkest days of the financial crisis. The Fed plans to create money, essentially out of thin air, and then pump it into the economy by buying Treasury bonds on the open market. These purchases are to be finished by the end of June, the Fed said.

Stop laughing at the “manages the economy” bit and focus on the emphasized text. What is really going on here?

What is really going on is that the Fed is stealing $600 billion dollars of real value from your pocket and using that value to fund the US Federal government through Treasury bonds. The real transfer of real value goes: You–>Fed–>Government.

It’s a damn tax increase craftily carried out using the finance system.

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Food for thought

Though medical education is not inexpensive, academic leaders often ignore the fact that the funds to support it properly are already available, if they choose to use the funds for this purpose. Student tuition, appropriations from state legislature to public schools, and certain portions of endowment income have always been intended for the education of medical students. Traditionally, deans have appropriated these funds for purposes not directly related to education – an animal care facility here, the establishment of a new research program there. Academic leaders bemoan the lack of funds to support faculty teaching time, even as they spend tens of millions of dollars to build new “teaching and learning centers” or expand the administrative bureaucracy.

N. ENGL J MED 351;12 WWW.NEJM.ORG SEPTEMBER 16, 2004 (link to pdf)

I thought of the above when reading the following at Instapundit:

The real problem is that higher education isn’t providing enough of a benefit to its graduates, not that universities aren’t extracting enough money from the students. But read the whole thing. Including this: “And, of course, while professors are expensive, they’re not the main expense. Administrators outnumber faculty at most universities these days. But I suspect that won’t get the scrutiny it deserves.” Speaking of cost centers. Much more on administrative bloat, here.

None of this is exactly new knowledge. The response, however, has been as slow as, well, bureaucratic molasses.

Update: Thanks for the link, Professor Reynolds!

Avoiding the Stalemate State

Get ready for a lot of stories bemoaning the coming period of political gridlock in the federal government. Jacob S Hacker and Paul Pierson offer up a typical sample of the genre in The American Prospect. But it doesn’t have to be that way if the GOP in the House acts in a pro-government/small-government way.

A united GOP in the House could insist on a new paradigm for passing legislation, passing all the good stuff first. Yes, it gets less passed, but isn’t that the point? The House can, legitimately, say that it’s not shutting down the government. It can bang out funding for the essential programs in each department in the spring, pass (or not) the middle tier popularity programs in the summer, and then present the real stinkers in the fall, right before elections.

There would be no government shut down. The Parks people could not shut down Mt. Rushmore and the George Washington Monument because their operations would be funded. Programs that could not get a majority to vote for them would be shut down but that happens every year. It’s how the system is supposed to work.

The political choices for Democrats would be very unattractive. Their attempts to stuff in budget stinkers into the must-pass bill will be turned back with the reasonable explanation that the program is funded in a different bill and that it will get a vote, but not here. Once the early bills pass, government shutdown is averted.

Is the GOP going to be smart enough to create a better way to fund the government? I hope so. What concerns me is that nobody else seems to be talking about appropriation sequence passage reform.

Thanks to Bastiches in the comments who gave a pointer that led me to a September 30 speech by John Boehnor which I had not seen to now. The relevant section:

While the culture of spending stems largely from a lack of political will in both parties to say ‘no,’ it is also the consequence of what I believe to be a structural problem. As Kevin McCarthy often says, structure dictates behavior. Aided by a structure that facilitates spending increases and discourages spending cuts, the inertia in Washington is currently to spend — and spend — and spend. Most spending bills come to the floor prepackaged in a manner that makes it as easy as possible to advance government spending and programs, and as difficult as possible to make cuts.

Again, this is not a new problem. But if we’re serious about confronting the challenges that lie ahead for our nation, it’s totally inadequate.

I propose today a different approach. Let’s do away with the concept of “comprehensive” spending bills. Let’s break them up, to encourage scrutiny, and make spending cuts easier. Rather than pairing agencies and departments together, let them come to the House floor individually, to be judged on their own merit. Members shouldn’t have to vote for big spending increases at the Labor Department in order to fund Health and Human Services. Members shouldn’t have to vote for big increases at the Commerce Department just because they support NASA. Each Department and agency should justify itself each year to the full House and Senate, and be judged on its own.

It isn’t exactly what I’m talking about (the level of granularity is different and the sequencing idea is entirely absent) but it’s a very close cousin and that is much appreciated. This speech helps the tea party because even if Boehnor is not serious about the proposal now (tough to tell without actual reform legislation text), focused public pressure to support this would lead him and the rest of the GOP to run to the front of the parade. And if he is serious? We might end up with an actual small government party again under this kind of leadership. We certainly could use one.

In either case, this remains a good pressure point between now and January for small government activists to press for reform. And now it has the advantage that soon-to-be-speaker Boehner has come out on the right side.

How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

Download the paper (1 MB pdf).

That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act  worsens future systemic risk.

That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake. 

By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

Download the paper (1 MB pdf).


Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.