Monday, December 12, 2011

Gary Gensler, the WSJ Editorial Page, and Political Competence


The Wall Street Journal editorial page has found a new regulatory villain:  Gary Gensler, chairman of the Commodity Futures Trading Commission (“CFTC”).  In passages that, except for writing style, could have appeared in Rolling Stone, recent editorials imply that Gensler’s supposed friendship with Jon Corzine, a fellow Goldman Sachs alum., led to the CFTC going easy on MF Global and the subsequent bankruptcy and missing customer funds.  (See “Mr. Corzine and His Regulator: MF Global and the new era of crony capitalism regulation” and “The Talented Mr. Gensler: Jon Corzine’s regulator wants you to know he’s been very busy.” )

Rolling Stone, of course, would have concluded that the cure to regulatory laxity is more regulation and purging the government of former Goldman Sachs employees.  The WSJ editorial page naturally draws the opposite conclusion with respect to regulation, while the editorsopinion about former Goldman Sachs employees taking government jobs is left unexpressed.  According to the WSJ editorial page, because regulators failed, they should not be entrusted with more power.  In today’s editorial about the “talented Mr. Gensler, the editors write:  “In classic Washington fashion, Mr. Gensler is nonetheless using his agency's regulatory failure in MF Global to impose still more rules and argue for still more power.  A better response would be to acknowledge that the political system has already entrusted too much power to regulators, who can never be all-knowing and all-seeing but are often vulnerable to political influence from executives or firms they know and like.  Investor beware:  Regulators cannot protect you.”
The New York Times Dealbook section effectively rebuts some of the factual basis for the WSJ editorials in an article dated November 8, i.e., some weeks before the Journal’s editorials.  The article states:

“A few days before MF Globals collapse, regulators stationed at the firm were assured its books were in order.
“Their boss, Gary Gensler, was not convinced.  A former Goldman Sachs partner who once passed the test for certified public accountants, he bore into the numbers himself and grew uneasy with the firms finances.

“‘Keep pressing them,’ he told his regulators, according to people with direct knowledge of the conversation.”
The article also notes that, while Gensler and Corzine have known each other for years, they “have seen each other just a handful of times since Mr. Gensler left Goldman Sachs in 1997.  Mr. Gensler did not attend Mr. Corzine’s 2010 wedding.  And Mr. Corzine did not attend the funeral of Mr. Gensler’s wife, a noted artist who died of breast cancer in 2006.”  Moreover, personal relationships have at least sometime not inhibited Gary Gensler; after he left the Treasury at the end of the Clinton Administration, he wrote a book, The Great Mutual Fund Trap, with another former Treasury political appointee, Greg Baer.  The book is critical of actively managed mutual funds.  Gary Gensler’s identical twin brother, Robert Gensler, is a mutual fund manager at T. Rowe Price.

As for the investment practices and apparently shoddy books and records and inadequate segregation of customer funds in commodity accounts at MF Global, it would seem that something is amiss at the Chicago Mercantile Exchange and the Financial Industry Regulatory Authority, which are the self-regulatory organizations (“SROs”) which had the front-line responsibility to examine MF Global for regulatory compliance.  While one might also look at the adequacy of the oversight of the CFTC and the SEC of the SROs, it is unreasonable to expect that the Chairman of the CFTC would be involved with regulatory compliance at a particular firm until there was a clear problem that staff deemed needed his attention.
This leads one to wonder what is behind the Journal’s vendetta against Mr. Gensler, with little mention of the SEC, which also had regulatory oversight of MF Global.  The reason is likely not that Mr. Gensler has been too lax a regulator but that his regulatory initiatives and aggressive negotiation style have made him some enemies.  It is hard to imagine that his former colleagues at Goldman Sachs like what he has been trying to do.

The liberals in Congress who had put holds or otherwise spoke against his nomination because of his Goldman Sachs ties and his activities on behalf of the Commodity Futures Modernization Act when he was an Under Secretary of the Treasury in the Clinton Administration have been pleased by the positions he has taken since he was confirmed as CFTC chairman.  But Mr. Gensler has run into problems which may undermine his effectiveness.
I argued in one of my more controversial posts that former CFTC Chair Brooksley Born’s lack of political ability hurt the CFTC in its quest to regulate OTC derivatives.  Gensler is not making the same mistakes as Born.  He was, after all, successful in obtaining for the CFTC a great deal of regulatory authority over the OTC derivatives market in the Dodd-Frank legislation.  However, he has not been able so far to obtain from Congress the funding the CFTC believes it needs to carry out these responsibilities.

Gensler also runs the danger of getting into substantive and turf battles with the bank regulators.   He is vulnerable, because he is prone at times to exaggerate his case.  For example, as I pointed out in another post, his argument in a WSJ op-ed (!) that the dangerous interconnectedness of financial firms because of OTC derivatives could be addressed by clearinghouses did not make sense.  Also, Gensler has used volatility in oil prices, by which he usually means sudden increases, not decreases, in prices, for arguing for more regulation, such as speculative position limits, without much factual support that the volatility stemmed from the futures markets.  In fact, the CFTC’s economic staff led an interagency study that said, if anything, speculative positions in the futures markets may have had a stabilizing influence on prices.
While the Journal’s editorial page attacks on Gensler make little sense, they indicate that he has a political problem.  He cannot even mollify Congress by recusing himself from MF Global matters.  He has been attacked for that by Republicans, even though it was a Republican Senator, Charles Grassley, who suggested that Gensler recuse himself.  If he had not recused himself, he would have been attacked for his conflict of interest because of his long association with Corzine.

As a small agency charged with legislative authority that can be interpreted quite broadly, the CFTC has since its creation been the subject of controversy when it comes to financial instruments.  Whether Gensler can manage the relationships he must maintain with various constituency groups in order to remain effective, now that the CFTC’s authority has been unambiguously broadened, is now in question. The Times’ Dealbook article frames his political challenge with the Wall Street community accurately when it states:
“Mr. Gensler has been Washingtons most aggressive ambassador to Wall Street, introducing sweeping new rules to crack down on excessive risk taking.

“Even industry groups acknowledge his influence, though they are not fond of his aggressive tactics.  He can be difficult, colleagues said.  And his unshakeable faith in regulation has left some fearful the agency will jeopardize Wall Streets anemic recovery and broader economic growth.
“‘It may be useful for Chairman Gensler in the short run to be viewed as an opponent of the financial industry, but to be successful in the long run, the C.F.T.C. will have to produce workable regulations that do not damage the economy too much,’ said Steven Lofchie, a partner at Cadwalader, Wickersham & Taft.  ‘The jury is still out on whether the C.F.T.C. can do that.’”

So far, while it is to be expected that Gensler’s substantive positions are opposed by Wall Street interests, his political style may undercut his effectiveness.  The Journal’s editorials are evidence that this may be the case.   


Disclosure:  I worked for Gary Gensler when he was a senior political appointee at the Treasury Department during the Clinton Administration.  With respect to Jon Corzine, I remember attending a couple of meetings, one in New York at Goldman Sachs and one in Washington, DC, at which he was a participant, but other than that I don't know him personally.

Wednesday, October 26, 2011

Republican Tax Proposals – Some Quick Observations


The Republicans contending to be the candidate of their party for President have put tax reform on the national agenda. The plans proffered by Herman Cain and Rick Perry have garnered the most attention.

Both these plans are bold in conception and bereft of detail. For most people, they are not really worth serious study, since they are unlikely ever to become law. Here, though, are some quick observations.

Neither plan addresses transition issues. In other words, can you get there from here? For example, many people have considered, with much encouragement, tax issues when saving for retirement. However, if the government decides not to tax dividends or capital gains, then Roth IRAs no longer make much sense and traditional IRAs would be much less attractive. I do not think Perry or Cain has been clear what the tax treatment would be for distributions from traditional IRAs and 401(k)s under their plans.

Also, the plans seem to hit moderate income people fairly hard, while giving a tax cut for the wealthy. For example, as some commenters have noted, the Cain's 9-9-9 plan consists of a 9 percent tax on wages and salaries, a 9 percent national sales tax, and the equivalent of a 9 percent value added tax. Those who devote a greater percentage of their economic income for consumption get hit harder than those who have room to save and those whose income include a significant amount of capital gains and dividends. Perry's optional 20 percent flat tax confers no benefit on those whose average tax rate is less, even though their marginal rate may be higher. Those in the highest income brackets might find it to their advantage, even after forsaking some deductions.

Neither plan is simple. There is deliberately created confusion here. A flat tax is not necessarily simple. Having different marginal rates is not what makes the current tax code complicated. Determining such things as the character, timing, source, and amount of income, as well as the eligibility for and valuation of deductions and credits are what make taxes complicated.

The Democrats would have an easy time picking apart the Cain and Perry plans, if either were the nominee.   Republicans would yell "class warfare," but I think Democrats would successfully counter that those who propose lowering taxes on the rich and raising them on moderate income workers are the ones engaging in class warfare.

Mitt Romney is apparently being more circumspect. He is making proposals that, while not likely to be enacted in their entirety and about which there can be strong disagreement, are nevertheless less ambitious and probably harder to ridicule.

Another thing that deserves mentioning is that many of those who lean Republican, including those who write the Wall Street Journal editorials, like to praise President Reagan and the Tax Reform Act of 1986. I agree that the Tax Reform Act of 1986 was a major accomplishment. But those on the right who praise this major piece of legislation forget that it eliminated the preference for long-term capital gains and taxed these gains at a maximum rate of 28 percent. I remember Charles McLure, who was the politically appointed Treasury Deputy Assistant Secretary for Tax Analysis from 1983 to 1985 and headed up much of the work that culminated in the Tax Reform Act, saying in speeches that income should be taxed the same whatever its character. Among other things, this would eliminate tax strategies aimed at recharacterizing income and losses because of tax treatment. In other words, the Treasury's position was that, borrowing from Gertrude Stein, income is income is income. Of course, the lack of preferential tax treatment for long-term capital gains was a provision which did not endure.

The case for broadening the base and lowering the rates has merit. I am all for sensible tax reform. We currently use the tax code for too many policy objectives in addition to raising revenue, though I believe that the tax code should be progressive and not have a flat rate. But why make this a priority now, when the unemployment rate is at 9.1 percent? After all, as the history since the enactment of the Tax Reform Act of 1986 demonstrates, the Congress will always be making changes to the Code and undoing even good ideas.

As for the Cain and Perry plans, they are not thought through. Again, borrowing from Gertrude Stein, "there is no there there." 

Tuesday, October 25, 2011

The Misery Index and GDP Growth – Then and Now

There is plenty of reason to be despondent about the economy.  Unemployment remains stubbornly high at 9.1 percent, the real estate market continues to be distressed, and a Eurozone crisis threatens to spill over into the U.S.

But it is not as if the U.S. has not suffered through bad economic times before.  Yes, there was the Depression in the 30s, but the latter half of the 1970s and early 1980s were also pretty bad.  For some reason, this seems to have been erased from our collective memory.
Some charts might help jog the memories of those who were old enough then to be cognizant of the situation and remind others of what their parents experienced during the earlier period.

The first chart starting in 1965 is the monthly unemployment rate.  As can be seen, we did reach current levels and higher in the early 80s.

The second chart is the inflation rate (monthly CPIs compared to a year ago).

Inflation was a real problem in the late 1970s and early 1980s.  It is currently creeping up, but it is nowhere near the level it was back then.
This brings us to the “misery index,” which is the sum of the unemployment rate and the inflation rate.  This is an index attributed to Arthur Okun as a quick way of summarizing how bad economic conditions are, though limiting it to these two statistics and giving them equal weight seems more due to convenience than the result of any thorough analysis.


Because of the stagflation in the late 70s and early 80s, the misery index was then much higher than it is now.
Finally, here is one more graph – the annualized growth rate of quarterly real GDP.


GDP growth went further into negative territory in 2008 than it did in 1980.  Note that there was a “double dip” in the 1980s, as the Fed squeezed the inflation out of the economy.
All this is not to minimize the severity of the current situation, but the earlier rough times should not be forgotten.  We should also recall the significant economic policy changes that took place in the 1970s.  For example, among other developments, the last meaningful link of the dollar to gold was broken when President Nixon closed the gold window to foreign countries, the Bretton Woods system of fixed exchange rates ended, and there was a failed experiment with wage and price controls.  Finally, we went through a recession essentially engineered by the Fed, which finally ended the high inflation and paved the way for better economic times. 

Friday, October 21, 2011

Realpolitik and Economic Policy

In thinking about the debate about the correct government policy to follow in an economic environment characterized by high unemployment, large budget deficits, slow growth, and economic and financial problems in the Eurozone which, if not adequately addressed by European officials, could aggravate problems in the U.S., the school of international relations known as “Realpolitik” came to mind. As a way of conducting international relations based on a country’s national interests, Realpolitik can be viewed as cynical, but an important point is that, in order to conduct a foreign policy based on its tenets, one must correctly understand what the national interest is.

I wonder if those who are currently advocating shrinking government and, even in some cases, reducing taxes, correctly understand where their interest lie. After all, a reduction in joblessness and a return of economic growth as quickly as possible will benefit everyone, including the rich and businesses.

There are some who believe that any attempt to increase economic growth through budget stimulus is doomed to failure, because of the hangover the economy will suffer when the stimulus comes to an end. According to this view, there seems nothing the government can do but to shrink and let the private market solve the problem. The trouble with this view is that it may be a very long wait before the economy resumes adequate growth to reduce unemployment, and the wait may prove to be politically intolerable.

Also, those who hold this view need to address why the deficit spending accompanying World War II., which resulted in a public debt in excess of GDP, put an end to the Depression once and for all, and the debt as a percentage of GDP fell markedly in the years after the war. In other words, sustained stimulus can work.

Perhaps those who oppose further stimulus know this but either believe that a sustained federal effort is not politically possible or fear that a multi-year spending program not the result of a war would be difficult to end. If that is what they believe, then there could be a healthy debate about the issue and what the government should do. The prerequisite is that thoughtful conservatives admit that this is what they think.

For liberals, the stimulus enacted under the Obama Administration demonstrates that to get out of the current slump there needs to be larger effort of longer duration with less reliance on tax cuts. The conservative view, which may be correct, is that this is not politically possible, though the political difficulty may in fact be due to conservatives. They may also be right that federal spending may be difficult to stop, though infrastructure projects do have obvious termination points.

Conservatives, though, may need to reassess their contingency plans if the economy worsens or the current slump shows no sign of ending. It may not be in their interest, correctly understood, nor in the national interest for the government to be seen standing idly by while the economy struggles.

The Success of Occupy Wall Street

It is not surprising that those on the right first tried to dismiss the Occupy Wall Street (“OWS”) movement with ridicule, which some cable news outlets, including CNN (here or here) joining in. To an extent, ridicule was inevitable since this is a protest movement with grievances but no proffered solutions.

The OWS lasting power and engendering of similar demonstrations in cities across the U.S. and in Europe has effectively silenced the ridicule. Now the attempt by some GOP politicians is to characterize the OWS as a “dangerous mob.” That’s not flying too well either.

While the lasting power of OWS throughout the winter may be in doubt, it has already been successful in one respect. For all its incoherence, OWS has focused national attention on unemployment and the increasing wealth and income disparities in the U.S. It was not that long ago that most of the attention was on the debt and budget deficits of the federal government. This is an important, and welcome, change. And for those whose chief concerns are the debt and deficit, they should realize that economic growth and a reduction in joblessness would help pave the way to address those issues. In fact, many, if not most, economists think that further stimulus measures (even if you do not want to call it that) are the necessary accompaniment to longer term efforts to reduce the deficit.

The G-20 Communiqué

International communiqués usually make for extremely boring reading. In this regard, they compete with Financial Accounting Standard Board statements, though the latter actually make sense if you take the time to study them, and they can be quite important. International communiqués, though, often make less sense the more one pores over them, and, while sometimes they are signaling something important, at other times, they seem to be produced even if there is nothing new to say, because that is what is expected.

The acronym laden “Communiqué of Finance Ministers and Central Bank Governors of the G-20:  Paris, France, 14-15 October 2011” is a case in point.  On the first page of this document there is the following sentence: “Advanced economies, taking into account different national circumstances, will adopt policies to build confidence and support growth, and implement clear, credible and specific measures to achieve fiscal consolidation.”  The more one thinks about this sentence, the more it becomes clear that the finance ministers and central bank governors did not agree to anything here, except that each country would do what it thinks best. The communiqué goes on to say:  “Those with large current account surpluses will also implement policies to shift to growth based more on domestic demand. Those with large current account deficits will implement policies to increase national savings…”  I suppose it is left as an exercise to the reader to divine what these policies are.

With respect to emerging market countries, the communiqué starts off with this informative declaration: “Emerging market economies will adjust macroeconomic policies, where needed, to maintain growth momentum in the face of downside risks, contain inflationary pressures and endeavor to enhance resilience in the face of volatile capital flows…”  Perhaps someone thinks this means that a significant agreement has been reached.

To be fair, in some badly written prose, there are some more specific statements later on in the document mostly reaffirming what the G-20 has said in the past.  As for the U.S., the agreement by the Fed and the Treasury on regulatory matters may not mean much unless the various bank regulators, the CFTC, and the SEC agree.

What is dismaying is that this mushy, poorly drafted document must have consumed many hours of staff time in all the countries of the G-20 as staffers participated in numerous meetings and conference calls to negotiate this document, which hardly anyone reads but whose absence would have been noted. Its vagueness about economic policy, though, does serve to signal that there is no real agreement in the G-20 about what the appropriate policies should be.  That is probably not what the drafters intended.

Wednesday, September 21, 2011

Operation Twist and Treasury Debt Management


As expected, the FOMC announced today that it will lengthen the maturity of its portfolio holdings of Treasury securities in an attempt to lower long-term interest rates.  No one is sure whether this will work.

One question that naturally arises is whether the Treasury Department will alter its debt management policy.  Under the current Administration, the Treasury has been lengthening the average maturity of the debt held by the public (which includes Federal Reserve Bank holdings).  Will Treasury continue that policy?  Probably the answer is yes, but, at the same time, Treasury will probably not make things more difficult for the Fed by taking advantage of its new initiative by selling more long-term debt than it would have otherwise.  The Financial Times published an article about this last week, misleadingly headlined “Treasury to accommodate Fed on ‘Twist.’”  In fact, the article only states that “the Treasury would be unlikely to respond to falling long-term interest rates with a sudden shift in the pattern of debt issuance, even though one of the Treasury’s strategic goals is to increase the average term of the US national debt.”  The article does not state that the Treasury would try to shorten the average maturity of the debt.

As for the original Operation Twist in the 1960s, one little remarked fact is that during this program, which was a joint Treasury/Fed initiative, the average maturity of the public debt increased from 1960 to 1963 (fiscal years). (See the table from the 1968 Report of the Secretary of the Treasury on page 74.)   In a short history of U.S. monetary policy posted on the New York Fed’s website, Treasury’s contribution is summarized as follows: “For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.”  As for the Federal Reserve, it “participated with some reluctance and skepticism, but it did not see any great danger in experimenting with the new procedure.  It attempted to flatten the yield curve by purchasing Treasury notes and bonds while selling short-term Treasury securities.” (See page 39 of this document.)
While there have been some attempts to quantify the effect of the original Operation Twist, not much can be inferred from this experience, since Treasury’s contribution was minimal and eventually at cross purposes with the program.  Also, as Modigliani and Sutch in their much referenced article on Operation Twist point out, to the extent that there was a change in the term structure, the reason for this may have been attributable to increases in the interest rates that could be paid on time deposits at banks under the Federal Reserve’s Regulation Q which led to the creation of certificates of deposit (Franco Modigliani and Richard Sutch, “Innovations in Interest Rate Policy,” The American Economic Review, Vol. 56, March 1966, pp. 178-197.)  The effect on the yield curve of altering the supply of Treasury securities at various maturities is an unanswered question.  Assuming the Treasury does not undermine the Fed by its debt management decisions, the Fed is embarking on an experiment which will provide more data for those wishing to study this question.

Friday, September 16, 2011

A Note on Treasury Debt Management – Opportunistic vs. Regular and Predictable



At the August quarterly refunding, the Treasury asked its advisory committee on debt management, the Treasury Borrowing Advisory Committee (“TBAC”) to discuss the cost and benefits of extending the average maturity of the public debt and to provide a way to quantify those costs and benefits.  In its report to the Secretary, TBAC’s discussion of the maturity question was not particularly helpful:


“The presenters considered the total interest expense over time, the volatility of interest expense through time, as well as roll-over and liquidity risks.  The presentation highlights that longer dated term premiums appear elevated relative to the past.  That said, today there are uncertainties surrounding the long-term fiscal outlook, inflation expectations, and future borrowing needs.  A healthy discussion ensued amongst members as to whether or not the current long end premium was warranted.  While no definitive answer was reached, members felt that the current term structure of yields should not deter normal long-end issuance.  However, the Committee agreed that further analysis would be undertaken.”


More instructive, though, was the attached presentation (which can be found after the Treasury charts here).  The analysis seems to lean in favor of floating rate notes, which do not have rollover risk but are based on short-term rates.  The presentation also suggests that Treasury should issue more long-term debt when it thinks that there is a good chance that interest rates will rise more than the “term premium” embedded in long-term rates.  The presentation concludes that the term premium is relatively high but absolute rates are low.  The first bullet on the concluding slide states:  “The benefits of extension do not come for free.  Historical analysis suggests that shorter term funding has at many times been both cheaper and the volatility costs have not been high.”  They balance this statement with the following: 

“It is possible, however, that ‘this time is different’ because

o Nominal rates are much closer to the zero bound than previous periods

o Deficits are very  high historically and rising interest expense less acceptable

o Concentrated foreign ownership creates less reliable demand

o The benefits of funding attributable to being the reserve currency may be fading”

TBAC seems not to want to take a firm view on the maturity question.  This may be because the committee members have different views or because they do not want to say something with which senior Treasury officials may disagree.  What is interesting, though, is that the analysis focuses on current market conditions as the basis for deciding what maturities to issue.  This is a change from a long-term TBAC and Treasury view that debt management should be regular and predictable, and that Treasury should tap all maturity sectors regardless of current interest rates. The thinking was that the benefits to the Treasury of regularity and predictability outweighed any potential gain from trying to outsmart the market.  Treasury, it was thought, was just too big a borrower to do that successfully and consistently.  As one Assistant Secretary for Domestic Finance in the George H.W. Bush Administration put it: “It’s tough for an elephant to dance” (or something very close to that).

But the leadership of Treasury and the membership of TBAC have changed.  Treasury had been shortening the average maturity in the previous Administration; it is now lengthening it.  Part of the reason for this inconsistency is no doubt due to a weakening of the influence of the career staff on these types of issues.  During the late 1970s and until the mid 1980s, the key person making debt management decisions was a long-term career Treasury official, Francis X. Cavanaugh, who was adamant on regularity and predictability and a staunch believer in issuing 30-year bonds on a quarterly basis.  After he left Treasury, those views gradually became less accepted by a succession of political appointees.  Also, political appointees, who have a shorter-time horizon than most career staff, want to leave their mark on Treasury in the relatively short time they have to do it.  (I have, perhaps somewhat unfairly, in this regard remarked that political appointees just want to have fun.)  For those in charge of debt management, making changes is something they can do within the constraints of what the market will accept.

I am in the regular and predictable camp, but I do give the current Treasury credit for not surprising the market.  There is no clearly correct answer to the maturity question, and I am inclined to think that, within some reasonable and fairly broad parameters, it is not that important as long as the Treasury does not do something clearly stupid or rapid.  I do think the Treasury’s reputation took a hit in both the decision and the botched announcement of discontinuing the sale of 30-year bonds in the George W. Bush Administration.  However, while some people faced legal trouble because of their actions when they was a selective leak of the embargoed announcement [see clarification below], the decision was relatively quietly reversed after Peter Fisher left the Treasury, and  the memories of that episode have faded. 

Another interesting aspect of the maturity issue is the potential for Treasury and the Federal Reserve to be at odds.  The Federal Reserve apparently is considering a strategy of getting long-term rates down by reducing the supply of longer-term Treasuries in the market.  Rather than another quantitative easing program, the Fed is thinking of doing this by selling short-term Treasuries in its portfolio and using the proceeds to purchase long-term Treasuries.  Obviously, the Treasury could accomplish the same thing by selling more short-term Treasury securities and less long-term securities.  The Treasury, though, does not view debt management as a way to try to manipulate the term structure of interest rates but is focused on keeping its interest costs as low as possible “over time.” 

(There is an interesting recent blog post by someone using the name “Bond Girl” about this:  “Leave Operation Twist in the past.”  The author is not favor of the Fed trying to change the shape of the yield curve.)


Clarification:  With regard to the announcement of the cessation of 30-year bond issuance, the Treasury did not leak the news.  A consultant present at the press conference told a senior economist at a major investment banking firm about the announcement while the news was still embargoed.  The Treasury also broke its own embargo by posting the announcement on its website prior to the lifting of the embargo but after the consultant had told his client the news.  This was not one of Treasury's better days. 

Thursday, September 15, 2011

Solyndra, Interest Rates, and the Treasury’s Federal Financing Bank


The bankruptcy of Solyndra has drawn attention to a little known financing arm of the U.S. Treasury Department – the Federal Financing Bank or "FFB" – and the interest it charges to borrowers. The Treasury's Inspector General is reportedly investigating the role of the FFB in making this loan. I do not have any personal knowledge about the particular facts of the Solyndra loan, but, as way of background, here is some information about the FFB and how it sets its rates.

The FFB was established by the Federal Financing Bank Act of 1973. (I have been told that Paul Volcker, who was the Treasury's Under Secretary for Monetary Affairs at the time, is particularly proud of helping to create the FFB.) The purpose of the bank is to make more efficient the financing of loans which are 100 percent guaranteed by the federal government. Treasury securities carry cheaper interest rates than other paper sold in the market with 100 percent federal government backing, because they have greater liquidity and do not need to be explained to potential purchasers. Accordingly, the FFB advances the funds for 100% guaranteed loans and obtains the financing for this by borrowing from the Treasury. The Treasury in turn issues more securities than it otherwise would in order to fund FFB loans, though there is no attempt by Treasury to match any particular security with the FFB's borrowings.

The FFB used to charge a 12.5 basis point spread between its cost of borrowing from Treasury and the interest rate set on the loans it makes. According to the FFB's latest financial statements, any spread that is charged now for most loans goes to the agency which guaranteed the loans, not to the FFB, except if the FFB is not able to fund its administrative expenses associated with the loans. In that case, it "may require reimbursement from loan guarantors." The FFB does impose charges for the ability of borrowers to prepay loans and for forward interest rate commitments.

The methodology for setting interest rates on loans, both those at which the Treasury lends to the FFB and those at which the FFB lends to borrowers, is complicated. It does not involve simply reading the rate for a particular maturity off the Treasury yield curve, because Treasury securities provide a different stream of payments than most loans typically do. A Treasury note or bond pays interest semiannually and the entire principal amount at maturity. A typical loan is usually a series of level payments at specific intervals, each of which can be apportioned between interest and partial principal repayment.

The technical aspects of how these loans are priced are too involved to describe here precisely. I will endeavor here to provide a general explanation, which is unavoidably somewhat technical.

The FFB utilizes a model which effectively transforms the Treasury yield curve into a "theoretical spot rate" or zero-coupon curve. In other words, the assumption behind the Treasury yield curve is that the Treasury could sell a security at a given maturity at par with a coupon rate read off the curve for that maturity. A theoretical spot rate curve is a mathematical transformation of the Treasury yield curve to give the rates on zero-coupon notes or bonds that are consistent with the Treasury yield curve. For example, if Treasury can sell a note or bond at par with a 3% coupon, one could discount each coupon payment and the principal payment at maturity by the appropriate zero-coupon rates read off the theoretical spot rate curve in order to determine their present values. The sum of the present values of all the payments would equal the par value of the note or bond.

If a FFB borrower wants to make level payments for a fixed period at periodic intervals in order to obtain a loan for a specific amount, the FFB's model will determine the necessary size of those payments so that when discounted by theoretical zero-coupon rates, the present value equals the amount of the loan. The model will also calculate a "single equivalent rate" for the loan, which, using standard formulas, are used to determine the portions of each payment which constitute principal repayment and interest.

As for Solyndra, the latest FFB press release (July 2011) indicates that it had borrowed about $2.36 million from the FFB at a rate of 1.025%. This is the lowest rate of all the loans made by the FFB in June 2011 guaranteed by Department of Energy. However, the Solyndra loan matures in August 2016, while the other loans, except for one made to Solar Partners I, are for much longer terms and carry higher interest rates, which one would expect, given that long-term rates are higher than short-term rates. The Solar I loan, which matures in June 2014 carries an interest rate of 1.126%. Part of the difference between the rates on this loan and the Solyndra loan are no doubt due to the different pricing dates and the different payment frequencies for the loans – Solyndra is quarterly and Solar Partners I is semiannually. There may have been other details in the terms and conditions of the loans, but they cannot be ascertained from the press release.

It should be emphasized that for most of the loans it makes, the FFB is relying on the government guarantee. If the borrower defaults, it is the other agency which is on the hook to make the FFB whole, which has budget implications for that agency. The FFB, though, does face credit risk on the loans it has made to the U.S. Postal Service, and the financial troubles of that agency have been receiving some attention recently.

Also, investment bankers have not liked the FFB particularly, because its use means that they do not receive underwriting fees for non-Treasury securities that are 100% backed by the U.S. government. Of course, that is the point. Sometimes there are disagreements among various government agencies about the proper role of the FFB and its implications, and some 100% guaranteed loans are financed in the market.

In the Solyndra case, journalists and Congressional committees will no doubt continue to investigate. The role of the FFB may be interesting, but any investigation of why the loan was guaranteed and what analysis of the company's financial conditions was undertaken will need to focus elsewhere.


Update:  The press reports that the Department of Energy granted Solyndra a $535 million loan guarantee.   Bloomberg reports that the FFB made loans totaling $527 million to Solyndra.  I have no reason to doubt this, but it would be helpful if they had indicated from where this information came.  At its website, the FFB does not have information about its current portfolio itemized by borrower.  It does have information about its activity with specific borrowers for the month of June.  Consequently, it is not clear how much of the $535 million DOE guarantee was used to back FFB loans and what the interest rates were, except for the $2.36 million loan in June.  It may be somewhere on the web, but I have not been able to find it.  No doubt, further information will become available as investigations and bankruptcy court proceedings continue.  Since the FFB is something new for most of the press to cover, some news reports may be unclear, but perhaps the original source material will be available to those interested in this issue.

Monday, September 12, 2011

A Quick Note on the American Jobs Act and Entitlements


Liberals in general appeared to be pleasantly surprised by President Obama's speech to Congress last Thursday in which he proposed a $447 billion package of tax cuts and spending increases designed to spur job creation. For example, while Paul Krugman had some reservations about the President's proposal (mostly concerning the effectiveness of tax cuts), he wrote in his column that he "was favorably surprised by the new Obama jobs plan, which is significantly bolder and better than I expected." Liberals, however, may be less happy about how the political need "to pay" for this package may impact long-term deficit reduction proposals that will be produced by the new super committee created by the debt limit legislation.

According to media reports, the White House has outlined some tax proposals to cover the $447 billion package. However, effectively the $447 billion will be added to the amount the super committee has to find in order to prevent automatic spending cuts. This implies that entitlement programs, such as Medicare, Medicaid, and Social Security are likely to be even more inviting prospects for spending cuts, given the larger amount of deficit reduction measures that need to be found in order "to pay for" whatever jobs legislation eventually is enacted.

The American Jobs Act proposal seems to have a dual purpose, to jump start the economy and to achieve entitlement reform. In other words, it is an attempt by the Administration to reach an elusive "grand bargain" that was not achievable during the debt limit negotiations.

Some conservatives, donning the mantle of being "responsible," are saying that this is all to the good and the Republicans should take a deal of short-term stimulus for "serious" entitlement reform. (For example, see this column by David Brooks.) When it becomes clearer that President Obama is trading temporary spending increases and payroll tax cuts for permanent reductions in key New Deal and Great Society programs, liberals are likely to feel disappointed once again. While some elements of the Republican Party have implausibly attempted to paint Obama as some kind of socialist, liberal Democrats are realizing that the President is not as liberal as they once thought.

Federal Reserve Options and Treasury Debt Management


Last Wednesday (September 7), the Washington Post reported that one of the options the Federal Reserve was considering to bolster economic growth involved selling shorter-term Treasury securities in its portfolio and purchasing longer-term Treasuries. This is in contrast to its QE2 program, in which the Fed created bank reserves to pay for long-term Treasuries.

Last October, I wrote about the potential conflict between the Fed and the Treasury on attempts to manipulate the shape of the yield curve ("Monetary Policy and Treasury Debt Management -- A New Operation Twist?"). What I said then is relevant now. Moreover, the policy reportedly under consideration at the Fed could potentially change the maturity structure of the public debt held outside of the federal government trust funds and the Fed even more than QE2, because the new proposal entails the Fed adding to the supply of short-term debt.

During the George W. Bush Administration, the Treasury shortened the average maturity of the public debt, which culminated in a badly introduced policy of stopping the sale of 30-year bonds, which was reversed after the Treasury official responsible for this decision, Peter Fisher, left the Bush Administration. During the Obama Administration, the Treasury has been lengthening the average maturity.

For reasons that are not entirely clear, the Fed has for a long time argued that the Treasury should sell less long-term debt. For many years, the Treasury ignored this advice, but began heeding it in the Clinton Administration by reducing the amount of 30-year bonds, which used to provide the benchmark long-term interest rate to the market but has been supplanted in this role by the 10-year note. Peter Fisher of the Bush Administration came from the New York Fed and was unusually solicitous of debt management advice from the staff of the Federal Reserve Board. While Secretary Geithner was President of the New York Fed, the Treasury has reversed course on the debt maturity issue. Since Fed officials do not usually speak publicly about this type of Treasury debt management issue, there is no direct evidence about what they think of Treasury debt management policy. However, the idea of altering the maturity structure of the public debt in the market would seem to indicate that they believe that Treasury has been issuing too much long-term debt.

The Treasury, if it wanted to, could overwhelm the Fed through its enormous financing operations. One should recall in this respect that the supply of new debt is not only that due to financing the deficit but also to refinancing debt that comes due. The Treasury would be unlikely to issue more long-term debt in order to undo the Fed's policy, should it be implemented. The responsible Treasury officials would probably view the Treasury's liability portfolio to include Fed holdings, even though the interest Treasury pays on that debt is returned to the Treasury after subtracting Fed operational expenses (including the 25 basis points of interest paid on both required and excess reserves).

This highlights a gray area between the Treasury's and the Fed's responsibilities. It is not clear how much discussion between Treasury and Fed officials there has been over this issue. I would guess that there has been some and that the Treasury has indicted that it would not object if the Federal Reserve Open Market Committee decides to alter the maturity structure of the debt in the market. Given the Treasury's responsibility for debt management and its ability to work at cross purposes to the Fed through its debt management operations, I would hope that the Fed does not feel it can do whatever it wants on an issue like this without consulting the Treasury.

Monday, August 29, 2011

More on the Fed and “Printing Money”


As discussed in the previous post, the ratio of the money supply to bank reserves, the supply of which is under the control of the Fed, has been increasing. This does not mean, though, that the Fed has not been able to increase the money supply. Using monthly, non-seasonally adjusted data, this graph shows that reserve balances held at the Fed increased dramatically beginning around September 2008, as did the M2 money supply. (The graph shows dollar amount changes from a year previously, for each month.)



Month to month changes show the same story:




And this is what a graph of the levels of M2 and reserve balances looks like:




In other words, the Fed can increase the money supply and it has been doing it. The data suggests, though, that in order to get the banking system to create an increase in M2, the Fed has had to increase reserves substantially. The increase in the money supply and the huge creation of bank reserves is what worries inflation hawks. Even many of those who believe that the Fed should continue to be expansionary probably worry about the Fed's ability to time correctly the withdrawal of reserves at such time as it risks an unwanted increase in the inflation rate, and to do this without causing an economic downturn.

However, as for the current situation, the ratio of nominal GDP to M2 (velocity), has decreased sharply:



All this suggests that, in order to increase nominal GDP, the Fed has to expand its balance sheet more than it has in the past, since the money multiplier has been increasing while the velocity of money has been falling. To the extent that the Fed does succeed in increasing nominal GDP, this can be due to either inflation or an increase in real activity. 

The current political situation means that fiscal policy cannot be used to help increase the economy's growth rate, at least for the time being.  At the same time, the Fed's ability to use monetary policy as much as some policymakers and some economists might want is hampered both by internal dissents by some Fed Bank presidents on the Federal Open Market Committee and by criticism coming from politicians. (David Leonhardt wrote an interesting article about the political pressures on the Fed in yesterday's New York Times.)

Those who believe that the federal government needs to do something to get the economy back on track are worrying. This is not limited to liberals, such as Paul Krugman. As mentioned in the previous post, Ken Rogoff suggests that the Fed target explicitly an inflation rate. Bruce Bartlett, whom I knew when he was a Treasury Deputy Assistant Secretary (Economic Policy) in the George H.W. Bush Administration, is hardly a liberal, but he has probably angered some conservatives by writing what he believes the facts dictate about the economic situation. He has been prominent in a number of venues arguing that the current economic situation is due to weak aggregate demand. (A recent example is on the New York Times' website: "It's the Aggregate Demand, Stupid.")

Wednesday, August 24, 2011

The Federal Reserve and “Printing Money”


I cringe a little every time someone comments on the Federal Reserve printing money. This is used as a metaphor, but taking it literally, as many do, leads to the belief that the Fed has more precise control over the money supply than it actually has.

The Fed, of course, does not literally print money. That is done by the Treasury Department's Bureau of Engraving and Printing. Paper currency is now in the form of Federal Reserve notes, which are liabilities of the Federal Reserve Banks. The Bureau charges the Fed for the printing cost. Coins are minted by the Treasury's Bureau of the Mint. These are sold to the Fed at face value. Coins are not liabilities of the Fed. The difference in the cost of minting a coin (including the cost of the metal) and the face value is called seigniorage. Seigniorage enters into government accounts as a means of financing, not as an outlay or a receipt. Other means of financing include the sale and redemption of Treasury securities and, as a legacy of its historical monetary role, the purchase and sale of gold. (Some seigniorage can be negative; for example, it costs more than a penny to mint a penny).

The amount of currency in circulation is determined by public demand. When a Federal Reserve member bank needs more currency to meet the demands of its customers, it gets it from its Federal Reserve Bank, which deducts the dollar amount from the bank's account at the Fed. (A significant amount of U.S. currency, especially $100 bills, is held abroad.)

But of course currency in circulation is not what we mean by the money supply. The narrowest measure of the money supply, M1, is defined by the Fed as "(1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions." The other commonly used measure of the money supply, M2, is M1 plus "(1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds."

The banking system essentially "creates" money by making loans and accepting deposits, most of which are lent out and reappearing as additional deposits in banks. (This is called fractional-reserve banking.)

Note that reserve balances at the Fed are not included in M1 or M2. However, when people talk about the Fed "printing money," what they mean is that the Fed is adding to the reserve balances of the banking system, accomplished by buying securities or making loans.

The relationship between the money supply and the monetary base (deposits held by depository institutions at the Fed and paper currency and coins in circulation) is not constant. The Federal Reserve Bank of St. Louis produces a data series, the M1 multiplier, which is seasonally adjusted M1 divided by the monetary base adjusted for changes in reserve requirements and seasonality. This chart shows that the multiplier has been trending downward, then plummeted, and is currently less than one.






We can also divide reserve balances held at the Fed by M2 (in this case not adjusted for changes in reserve requirements or seasonality) to get another picture of how the Fed's ability to increase the money supply has gotten more difficult in recent years:


 


There is concern, especially from those who believe that monetary policy has been much too loose, that inflation is a serious risk. The CPI has increased by 3.6% from a year ago, according to the latest figures for July. Those who are less concerned about inflation point out that the core CPI has only risen by 1.8% over the past year. (This post by Felix Salmon gives a good feel about the confusion surrounding the current inflation numbers.)
While there can be a debate about whether the "stagflation" we experienced in the 1970s is coming back, the data show that the Fed's ability to do much about the stagnant economy has declined significantly. Fears about the Fed "printing money" are overblown in the current environment, though the Fed, without much historical guidance, will have the difficult task of timing the withdrawal and the rate of withdrawal of reserves whenever it is that the economy begins to show some life.

Nevertheless, since, due to the political situation, additional fiscal stimulus is not a policy option, at least for now, everyone is looking for the Fed to do something to help the economy. Ken Rogoff even suggests that both the Fed and the European Central Bank target an inflation rate of "4 to 6 percent for several years." In a column sympathetic to Rogoff's view, Floyd Norris of The New York Times reports on Paul Volcker's reaction to this:

"'I don't think it's a good idea,' was one of the milder comments I got from the most celebrated veteran of those wars [against inflation in the 1970s and 80s], Paul A. Volcker, the former Fed chairman.

"And anyway, he added, 'Right now they probably could not get inflation if they wanted to.' People are not spending the money they have, he said, adding that the situation reminded him of an era he studied in college — the Great Depression."

Friday, August 19, 2011

Why Does the Federal Reserve Pay Interest on Required and Excess Reserves?


When the Federal Reserve announced earlier this month that it would in all likelihood keep it fed funds rate target between 0 and 0.25% for the next two years, there was some comment that the Fed might not have any more very powerful tools left with which to jumpstart the current sluggish economy, which may be headed for another recession. One tool that is mentioned (for example, here by Alan Blinder) is for the Fed to lower the interest it pays banks on excess reserves. The mention of this possibility, though, raises the question of why the Fed is currently paying interest on both required and excess reserves on deposit at the Fed.

Prior to October 2008, the Fed did not pay interest on reserve balances. Prior to this, the Fed did not have the authority to pay interest on reserves. The Fed explains: "The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008."

The topic of paying interest on reserves came up from time to time when I was at Treasury. I and others at Treasury expressed some skepticism about this. Looking out for the Treasury (and, of course, the taxpayer), we pointed out that any interest the Fed paid would reduce its earnings and hence the amount of money the Fed pays to the Treasury. As far as the monetary policy arguments were concerned, they were never convincing. Looking at more recent Fed explanations, they still aren't.

In a Fed October 6 press release announcing that it would use its authority to pay interest on reserves, it justified paying interest on required reserves by stating: "Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector." This more or less says giving money to banks that we were not able to in the past is a good thing. You could argue that not paying interest on reserves was a tax, though banks got a lot of privileges for paying that tax. The Fed statement hardly justifies repealing this tax, and it certainly does not justify paying them an above market rate, as the Fed is arguably currently doing.

Part of the Fed's case for excess reserves is somewhat more credible: "Paying interest on excess balances should help to establish a lower bound on the federal funds rate." Currently, though, it is not doing that since the fed funds rate is currently below the interest the Fed is paying on both required and excess reserves – 0.25%. It is not clear why any banks are lending at rates below the 25 basis points they can receive from the Fed, but that is what the Fed is reporting.

The second part of the Fed's case makes little sense: "The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability." No more explanation is given.

The President's Working Group on Financial Markets ("PWG") issued a statement on October 6 about the passage of the Economic Emergency Stabilization Act ("ESSA") which included a sentence reiterating the Fed's justification for paying interest on reserves: "… the authority to pay interest on reserves that was provided by EESA is essential, because it allows the Federal Reserve to expand its balance sheet as necessary to support financial stability while conducting a monetary policy that promotes the Federal Reserve's macroeconomic objectives of maximum employment and stable prices." On October 8, Treasury Secretary Henry Paulson issued statement on financial markets which included this on interest on reserves: "The EESA granted the Fed permanent authority to pay interest on depository institutions' required and excess reserve balances held at the Federal Reserve. This will allow the Fed to expand its balance sheet to support financial stability while maintaining its monetary policy priorities."

Since the Federal Reserve can expand its balance sheet at will by either buying securities or making loans, why paying interest on reserves is a necessary tool for expansion of its balance sheet is unexplained.  Paying interest on excess reserves does save the Fed from criticism from the banks of having imposed a burden on the banks. Also, it might encourage banks from holding reserves in the form of vault cash beyond their needs, but that would seem to be a minor factor. The PWG and Paulson statements indicate an unquestioning deference to the Fed, particularly by Treasury, which is troubling. While some have argued that the Treasury has too much influence over the Fed, I would argue that, based on my experience and current observations, it has in recent times been the other way round.

It is hard to know how much of a factor interest on reserves has been in encouraging banks to sit on them. In a poor economy, there may not be that much of a demand for loans from creditworthy borrowers. But given that banks are earning more on their reserves than they could by, for example, buying three-month Treasury bills, it is hard to justify this payment to the banks. After one clears the smoke about the Federal Reserve Banks being private institutions in a legal sense, this is essentially taxpayer money. Given the current level of reserve balances held at the Federal Reserve Banks of more than $1.6 trillion dollars, an annual interest rate of 25 basis points amounts to more than $4 billion a year.

Finally, here is a picture that shows what has been happening to required and excess reserves since 2008:



Monday, August 8, 2011

The Administration and the Debt Limit Crisis


There is plenty of deserved criticism aimed at the Tea Party for its part in the debt limit fiasco. This post will make a few comments about the Administration.

The Administration made a mistake by abandoning its insistence on a clean debt limit bill. This validated the Republicans' linkage of the need for a debt limit increase to future budget cuts. It enabled Speaker Boehner to say that the Congress would not give the Administration a credit card with no restrictions. Of course, this is nonsense. The need to increase the debt limit was due to past decisions of Congress and the performance of the economy. The debt limit does not control government spending or receipts; the need to increase it is the result of other decisions.

Not only did the Administration embrace the linkage of the debt limit to budget decisions going forward, President Obama appeared to welcome it. Partly, this seems to have been viewed as a way to pressure Democrats to make concessions on programs they hold dear, such as Social Security, Medicare, and Medicaid. The President and his chief economic adviser, Treasury Secretary Geithner, apparently want as part of their legacy the reform of these programs. However one feels about that, this negotiating strategy was an attempt to be clever, and it did not work. What it did do is enable the President's critics to charge that he was threatening default in his negotiations with the Republicans, just as the Administration was charging the Tea Party as doing. At a minimum, the Administration should have said that a clean debt limit bill would have been acceptable.

Not only did the "grand bargain" the President wanted not materialize, this episode has caused many liberals to have serious reservations about the President. He is more conservative than many liberals thought when they voted for him in the primaries and the general election, and his leadership ability is now in question.

On that last point, the New York Times published yesterday a well-written article by a psychologist who is a political liberal, "What Happened to Obama?" It is well worth reading.

A Few Comments about that Ratings Downgrade


There is not much to say about the S&P action in addition to what has already been said, but here are a few comments for whatever they are worth.

In one sense, the downgrade is ridiculous. Does anyone believe that the U.S. Treasury is a worse credit risk than Microsoft, Automated Data Processing, Exxon, or Johnson & Johnson, all still rated AAA? If somehow one can imagine a scenario in which the U.S., borrowing in its own currency, cannot pay interest on its debt or roll it over, how good would the debt of any U.S.-based companies be in that scenario? Nevertheless, S&P has said it is not currently considering a downgrade to these AAA-rated companies.

In another sense, the threat of default on the debt for political reasons does give one pause. I did not think that would happen, and neither did the market, based on bond prices. Brad DeLong summed it up well, when he wrote that "default was never in the cards, at least not with lawyers at the president's disposal 10% as inventive as those who claim that we are not engaged in 'hostilities' in Libya." That is apparently what most market participants believed.

But if default on the debt was unlikely, or extremely unlikely, to happen, the apparent willingness of some politicians, luckily a minority of the House majority, to cause the U.S. to default on its debt should cause an observer wonder about U.S. politics. Yesterday, the Washington Post quoted Representative Jason Chaffetz (R-Utah) on this point: "'We weren't kidding around, either,' [Chaffetz] said. 'We would have taken it down.'"

There is something deeply wrong with the current state of our politics when people in a position of responsibility make statements like that.

With respect to market movements as I write this midday (Eastern Time), the U.S. and world stock markets have fallen, as one might expect given the uncertainties about the European situation, the economic outlook, as well as the downgrade. However, yields on Treasury securities have been falling, which indicates that they are still viewed as a safe asset to run to when the global economy is shaky.

As for S&P, its record is being examined and roundly criticized, and its action may serve to accelerate a movement, already underway, among regulators to stop relying on credit ratings of "nationally recognized statistical rating organizations." The other two major rating agencies cannot be pleased.

Thursday, August 4, 2011

Geithner: Terrible Process, Good Result


Whatever else you may think about Tim Geithner, public relations is clearly not one of his strengths. A recent example of this appeared yesterday on the Washington Post op-ed page in an article under Geithner's byline. The article begins: "It was a terrible process, but a good result."

What is the point of making this argument? Hardly anyone, except maybe some of those directly involved, think the debt limit agreement was a good result. Liberals think that cutting current spending in a terrible economy, which shows signs of getting worse, is a horrendous idea. They would do the opposite. They also believe that programs that benefit the poor and the elderly may be threatened. Conservatives believe that the cuts over ten years are too small and do not make the fundamental changes they advocate to programs such as Social Security, Medicare, and Medicaid. They also know that the cuts mandated by this law over a 10-year period could prove illusory; future Congresses can always change the law.

Geithner claims that "[t]he agreement removes the threat of default and lowers the prospect of using the debt limit as an instrument of coercion. It should not be possible for a small minority to threaten catastrophe if the rest of the government decided not to embrace an extreme agenda of austerity and the dismantling of programs for the elderly and the less fortunate." Actually, using the debt limit as a political tool to try to enact one's agenda is only removed for the rest of the current Presidential term under the probably safe assumption that any recession that may be coming in the next year is not so precipitous as to make current budget projections wildly off the mark. But this recent experience makes it more likely, not less, that we will have to suffer through bitter debt limit fights once again, waged by whatever party is not in control of the Executive branch. As I have discussed in a previous posts, this is not the first time we have witnessed bitter debt limit fights, but this one was worse than normal, and the President's opponents can claim some political success. Present and future politicians have noticed.

Moreover, while debt limit fights are not on the agenda for the rest of this presidential term, other cliffhangers are coming. First up are the appropriation bills for the 2012 fiscal year, which begins in October. The political fight over this will take center stage next month. If agreements are not reached, there may be a government shutdown, or at least a partial one. That the Federal Aviation Administration is already in shutdown mode does not augur well.

For those who like these kinds of battles, there is a sequel to the appropriation battles of September. The super committee, created by the debt limit agreement Secretary Geithner praises, is due in late November to come up with proposals to reduce the deficit further. If they deadlock, or if Congress does not pass or the President vetoes whatever the super committee proposes, then mandatory cuts take place. Geithner lauds this as "a powerful mechanism for agreement on tax reforms to strengthen growth, and entitlement reforms to strengthen programs such as Medicare." I guess he thinks policymaking is enhanced if, from time to time, there is the threat of the abyss.

It is likely Congress will be in session until close to Christmas. Even if the super committee deadlocks or the Congress cannot pass its proposal, I suspect that the cuts mandated in the legislation just passed will not happen. Too many constituency groups from across the political spectrum will object. The process is likely to be messy, but Congress in that case will change the law. Perhaps it will create another committee, another deadline, and another threat of the abyss.

I don't see what Geithner thought he was accomplishing with his article. Perhaps it made political appointees at Treasury feel good; if so, they talk too much to each other and have no idea how things look for those following developments but are not part of the process. The argument he makes is not persuasive.

Tuesday, August 2, 2011

The Debt Limit – What if there had been no agreement?


While most private analysts who follow Treasury's cash position did not believe that tomorrow was the day everything would have fallen apart if the debt limit had not passed, at some point there would have been a major problem with Treasury either having run out of cash or close to it. The Administration is very unlikely to say what its contingency plans or options were.

It is interesting that there is some dispute about what Vice President Biden said to congressmen recently about the 14th Amendment. According to some press reports, such as the one on the Los Angeles Times website, "Rep. Peter DeFazio (D-Ore.) told reporters that Biden said President Obama 'was willing to invoke the 14th Amendment' if the parties could not reach a debt deal by Tuesday's deadline." However, a CNN blog post about this meeting, says: "The Vice President said the 14th amendment was NOT an option for the President."

There were other ideas floating around. The most amusing, and clever, idea was to use a little known provision of law which apparently allows Treasury to reap unlimited amount of seignorage by minting platinum coins. Jack M. Balkin, a Yale law school professor, argued that this would be a legal way to keep the government funded if the debt limit were not increased in an article on the CNN website. Brad Delong, a former Treasury Deputy Assistant Secretary for Economic Policy during the Clinton Administration and now an economics professor at the U.C. Berkeley, seemed to like the idea, and somebody even posted a hilarious design for this potential coin.

Perhaps Treasury would have started prioritizing payments, starting on August 3, even though its legal authority to do this is questionable. This would have served to make sure that there was enough cash to make the August 15 interest payment, and it would have put pressure on Congress to resolve the issue as they heard from the many people affected by this.

It's worth pointing out, though, that, if Treasury had withheld Social Security payments, it would have been criticized for going beyond its authority. When Social Security payments are made, non-marketable Treasury securities in the trust fund are redeemed. This serves to lower the debt subject to limit, which would allow Treasury to borrow the necessary amount of money by issuing marketable securities. Apparently, some Treasury officials have questioned the practicality of this because they are not sure they can redeem securities before benefit payments are made. It seems likely, though, that, if all the transactions took place on the same day, which admittedly would be expensive for Treasury, no one would raise a serious objection. There may also be other provisions in the law governing Social Security trust funds which would allow some timing gap between the redemption of securities and payments if necessary to ensure that payments go out.

As for the general problem of Treasury running out of cash, there would have been no good options, and that is why the Administration had to keep the pressure on to get the issue resolved. Even if Congressional leaders suspected that the August 2 deadline might not be entirely real, they wanted this to end too. But it seems that Congress thinks playing with the debt politically is so much fun that they will not entertain putting an end to this by tying the size of the debt to whatever is necessary given their spending and tax decisions and economic conditions affecting expenditures and receipts.

If the debt limit had not passed before the measures already taken were not sufficient to prevent Treasury from running out of cash, no one really knows what the Treasury would have done, perhaps not even the relevant Treasury officials and the President. The fixed income markets clearly did not believe there would be a default on the debt. They most certainly agreed with Brad Delong who wrote that "default was never in the cards, at least not with lawyers at the president's disposal 10% as inventive as those who claim that we are not engaged in 'hostilities' in Libya." But no one knows for sure what would have happened, and the risk was not worth taking. That is why there was eventually an agreement, bad as it is.