Doing God’s Work at Goldman’s

by John Médaille on June 7, 2010 · 26 comments <span>Print this article</span> Print this article

in Economics & Empire


Nothing is quite as boring as reading about a banking crisis, unless it is reading about somebody else’s banking crises. It is hard enough to follow the mind-boggling maneuvers of Wall Street and its complex, ponzi-scheme finance. But when it comes to the banks in Athens, most of us say, “It’s Greek to me.” But we generally assume that the Greeks deserve what they are getting. Besides being Europeans, a category just a cut above being French, with their welfare states and high taxes, they seemed to be overly generous with their government pensions (often starting at age 50—a mere youth by my standards) and have surrendered the economy to the unions and other nefarious interests. And so we treat them like all the other “lesser breeds without the (financial) law.”

Simon Johnson is a man who reads about banking failures for a living, both here and abroad. As an economist with the IMF, it was his job to read about banking failures the world over, and then move in with the IMF’s rather peculiar brand of tough love. And it was very tough indeed, because it was dictated by the so-called “Washington Consensus,” which called for the break up of the offending country’s banks and the removal of their political influence and protection as well as conforming to a strict “free market” regime. The root cause of the failures was a Crony Capitalism that privatized profits and socialized losses, leading to certain collapse.

But when Johnson turned his world banker’s eye on the United States, he found something interesting:

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize the troubled banks and break them up as necessary.

This “break ‘em up” strategy was enthusiastically supported by both the Bush administration and the people who now run the economy in the Obama regime. So you would think that they would apply the same tough lessons to our own economy. You would, of course, be wrong. The failure is bi-partisan; not only did the Reagan and Bush administrations support the tough-love policies, but so did Rubin, who ran the treasury for Clinton, along with Summers and Geithner, who run the world for Obama. But when came to domestic banks, these tough men became rather domesticated.

Professor Johnson (along with James Kwak) has written a book about this crisis, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Johnson also runs an excellent blog of financial commentary, The Baseline Scenario. The authors do an decent job of documenting an industry that had been freed of any meaningful regulation or limitation, and whose outsized rewards went to traders who boasted of “ripping the face” off their customers. Nice fellows, to be sure, but the industry itself was based on engineering financial “products” that had no relationship whatsoever to the productive economy.

There was a near-religious rationale to all of the shenanigans. Regulation, as we all know, was merely a demonic attempt by closet communists to deprive us of our liberties. And the markets, being made of of sophisticated buyers and sellers was self-regulating, so the government could just bug-out. This was an article of religious faith, one which transcended party lines. As Johnson notes:

Defending the huge bonuses in St. Paul’s Cathedral in London in October 2009, Goldman Sachs executive Brian Griffiths went Gordon Gecko one better by invoking Jesus: “The injunction of Jesus to love others as ourselves is a recognition of self-interest…We have to tolerate inequality as a way to achieving greater prosperity and opportunity for all.” Goldman CEO Lloyd Blankfein even claimed to be “doing God’s work” (because the banks raise money for companies who employ people and make things).

Perhaps Jesus should apologize to the money-changers. After all, at least they were dealing in real money, no matter how predatory their exchange rates. But our bankers create money to make “products” that have no meaning in terms of real production. Contrary to Blankfinn’s rationale, the banks became less interested in financing actual production. Lending to an actual productive enterprise is a low-profit business, because it is competitive, and any number of banks are willing to make the same loans. But the creation of financial instruments which were no more than a sophisticated form of gambling, commanded high margins and was a game that could only be played by the big boys. Large banks and large hedge funds became involved in an elaborate Ponzi-scheme in which the banks create money to lend to the hedge funds, which then buy the Ponzi equities from the banks to sell to the soon to be faceless customers.

Of course, at some point there must be at least a tenuous connection to real goods; even the tulip bubble involved real tulips. The tulips in this case were mortgages, credit cards, and commercial properties. All of these could be turned into securities to bank bonds, which then backed CDOs, which were “insured” by CDSs. But there were not enough solvent buyers to pump up these markets, so the banks created the money and lowered the loan standards. Even this did not produce sufficient instruments to satisfy the markets, so they produced “synthetic” versions, which had no actual relation to these markets. So instead of a CDO being backed by real mortgages, they were backed by CDSs which were just bets on the payment rate for a given security. If the rate fell below a certain amount, the seller of the CDS would pay the buyer a certain amount. It was like buying an insurance policy on your neighbor’s home in hopes that it would burn down. If a thousand people do this, and the house does burn down, the insurance company would have to pay 1,000 claims instead of just one. Insurance companies like AIG were willing to do this (at extraordinarily low rates) because even if they did have to pay a 1,000 claims for one fire, they couldn’t imagine more than one fire at a time; they could not foresee the whole neighborhood burning down. (This simplifies the process; the degree of financial engineering (that is, fraud) was staggering. My favorite instrument is the “reverse floater” which caused the bankruptcy of Orange County’s retirement funds. But you get the idea.)

But the very need to make loans of whatever quality practically guaranteed a such a conflagration. As the market deteriorated, the banks lowered their lending standards to get more loans to create more ponzi bonds, a process Johnson calls “force-molting”. The term is from factory farms; when hens slow down egg production, they are starved of food and water to force one final bout of egg laying before they die.

It is really possible that the banks and insurance companies didn’t see the collapse coming? More likely, they didn’t care. The market was so large, the government so captured by the banks, and the banks so critical to the economy that there was an implicit guarantee from the government that the big banks would not be allowed to fail. The six largest banks controlled assets equal to about 60% of GDP (up from less than 20% in 1995). The big banks exercised an economic and political veto. It was a duplicate of the situation in third world dictatorships: political power translated into economic power which translated into further political power. This is the cycle the IMF (at the direction of our Treasury Department) wanted to break.

Johnson’s target is the Too Big To Fail banks, which he says should be nationalized and broken up. The rescue plans have accomplished just the opposite; the big six are bigger than before the crises, having gobbled up their weaker rivals. They now control a bigger share of the economy than before, and they are making the same risky loans that they did before the crises. In other words, the situation is worse than before, not better. And the tepid “reform” does nothing to change the situation, even supposing that the regulators have the knowledge and will to enforce their will on the banks. More likely, we will have the same regulatory capture (where the banks virtually run the agencies that should be regulating them.)

Johnson would have us apply the solution that he himself applied to so many “customers” of the IMF: break ‘em up and sell ‘em off. And then work to keep them small. The arguments for doing so are sound. Banks, after a certain minimum size, do not get more efficient by becoming larger; they just get more difficult to manage. In economic jargon, they exhibit “constant returns to scale,” meaning that they get the same efficiencies regardless of their size. But size does confer political power. The large banks have implicit and explicit guarantees from the government. This gives them a tremendous competitive advantage, since it lowers their cost of funds. The Big Six can borrow at a rate .78% lower than their smaller rivals (down from .29% in 2000). In other words, the bigger they get, the more advantages they receive and the bigger still they get.

The situation we have now just sets up the next collapse, which will come sooner than we think. And with each successive crises, we become less able to handle the next. Under the Bush-Obama bailouts, the government is on the hook for as much as $23.7 trillion, or 150% of GDP. It is unlikely that we will lose that much, but we could. Liabilities have been socialized, while the profits continue to be privatized. No wonder the banks show little willingness to change. After all, they can make money—lots of money—by ripping the faces off their customers. And if that fails, they can rip the faces off the taxpayer. What is their incentive to change?

Johnson points to the obvious (which is always difficult to see), namely, that the country is formally an oligarchy, with a government of the rich, by the rich, for the rich. Partisan fights are beside the point. As Obama amply demonstrates, “change” means more of the same, for the same people fund both sides. As entertaining as our political process is, it is meaningless, full of the sound and the fury, no doubt, but signifying nothing. The real power lay elsewhere. The president and the congress seek office to run the country, only to find that the country runs them. Or rather that part of the country in and around Wall Street.

We are now in a trap from which we cannot escape. As Nouriel Roubini notes, the transferring of private liabilities to the public balance sheet has meant high government debts. To pay the debts, there will have to be higher taxes and/or lower government expenditures. But the government has been, for that last 60 years, since a large part of the economy that lower expenditures (or higher taxes) would lower output and make it impossible to pay off the debt. There is no way out, this side of collapse. The situation is worse in countries like the United States that have dismantled so much of their productive capabilities. Because in the end, countries get prosperous by making things. It is in the fields, farms, factories, fisheries, and mines that wealth is first created, and the rest of us must eat what they produce, must wear what they make. This is where our efforts to rebuild the economy must focus, and hence this is what finance must support, and if it doesn’t support these things, then it can only be a destroyer of the economy, however much it may benefit the bankers and politicians. We can get along without synthetic CDOs, but we do need to eat.

{ 26 comments… read them below or add one }

avatar Siarlys Jenkins June 7, 2010 at 10:53 am

Excellent essay. The only thing I’m wondering about is how this should translate practically into political action by citizens.

Take, for instance, the current debate over financial reform in Congress. Obviously, it doesn’t go far enough. Republicans are demanding ironclad guarantees that there will be no bailouts in the future. However, they are NOT demanding that the big failing banks be broken up, and that regulation be geared to keeping banks small. Democrats are tending toward tighter regulation, but again, they are side stepping the obvious: break up the banks.

I have little doubt that on this point, Barack Obama is constrained by his already cozy ties with Chicago bankers, including Jaime Dimond, who is now head of J.P. Morgan Chase after merging his Bank One (which as a midwesterner, I used to prefer to Chase) into the larger enterprise. (Note: I voted for Obama, and in the absence of any attractive alternatives on the horizon, may well do so again).

The essence of the blackmail in this picture is that these banks really ARE too big to fail without taking the rest of us down with them. The Democrats offer to regulate them a bit more, so hopefully they won’t do so many rash things and fail, while the Republicans want to let them do rash things, but posture about no more bail-outs, which, if they are not broken up, would be a recipe for Depression. Where is the political banner for citizens to rally around? (Don’t tell me Rand Paul, who shows no sign he could read your essay and understand the economics you and Johnson lay out so well).

avatar Hans Noeldner June 7, 2010 at 1:20 pm

Excellent posting, John; thank you.

Labor productivity is a huge complicating factor that is seldom properly considered. As human labor input per unit of output has declined over the decades, fewer and fewer people can find employment and livelihoods associated with providing for real human needs. To compensate, an ever-larger portion of the workforce must depend on luxury consumption that must become every more outrageous and obscene to “soak up” workers displaced by the latest “advance”. Consumption MUST grow – the biophysical limits of Eaarth be damned. No wonder no mainstream economist, business leader, or politician will so much as whisper that growth will kill us.

As for “insourcing”, the fact of the matter is that a great deal of production for real human needs still occurs in the United States. Our domestic output of food, for example, greatly exceeds the appetites of domestic humans; what else explains the push to convert excess corn into automobile food? The problem is that most of the essential work is now done by fossil fuels and powerful machines rather than human sweat and cogitation.

And this comes down to values. We-the-people behave as though we don’t want to need human labor. We seem utterly unable to resist “labor-saving” fossil-fueled gadgets. As consumers we demand more stuff for less – and to hell with employment. As investors we demand the highest rates of return – and to hell with employment. God help any business which fails to pay attention. God help any leader who urges us to put on sweaters and get thrifty.

avatar Art Deco June 7, 2010 at 5:08 pm

But the government has been, for that last 60 years, since a large part of the economy that lower expenditures (or higher taxes) would lower output and make it impossible to pay off the debt.

Can you please explain what is meant by this sentence?

avatar John Médaille June 7, 2010 at 8:47 pm

Art, sure. Before the depression, federal gov’t expenditures were maybe 2-4% of GDP. Since 1942, they have run 18-42%. A decrease in such a large segment of the economy would obviously have negative impacts. Standard theory states that a reduction in demand by the gov’t would be replaced by demand in other sectors, but not only is there no reason to think this is true, but pre-war experience would seem to contradict it. The plain truth of the matter is that capitalism has never been able to balance its books, to achieve a rough parity between supply and demand, without massive help from the gov’t.

Higher taxes would certainly reduce demand, particularly if the new taxes went to pay debts rather then increase investment or demand. Of course, the bond holders could use the money to increase investment, but there are two problems with that theory. People don’t invest just because they have money, but because they think they can make a profit. If people have cut back on buying, they are at the same time reducing investment opportunities, which depend on having an increasing number of solvent consumers. So the economy gets into a “liquidity trap,” meaning people would rather hold money than invest it.

The second problem is that about half of the bonds (excluding those held by the government’s trust funds) are held by foreigners, and repayments are more likely to be invested abroad then here. When we “owe it to ourselves,” repayments likely circulate through the domestic economy; when we become dependent on foreigners, no telling where they will go.

avatar Clare Krishan June 7, 2010 at 9:28 pm

Siarlys, not sure how you rank intellect and use thereof, in social studies
but “Don’t tell me Rand Paul, who shows no sign he could read your essay and understand the economics you and Johnson lay out so well” IMHO sounds a tad ignorant – the story on legal tender and its purchasing power is just a wee bit more convoluted than either John or Simon want you to beleive (both adhere to mercantilist fantasies of fractional reserve banking money multipliers and Keynesian illusions of debt=wealth for the world’s reserve currency, ie the US dollar) for if you had a clue, they’d lose your confidence and you’d be as indignant as Rand Paul and others who smell a rat at the Fed. Read Cobden and Mises for true subsidiarity (and solidarity incidentally) in the social sciences, of which economics is but one expression of human action, not FPR’s resident distributist who would have us return to feudalism in the name of embracing “tradition”.

Those who advocate for central bankers have a vested reason for doing so… they will benefit from the decrease in purchasing power that hyperinflation unleashes because they sit on the overvalued “bubble” assets like real estate. Ordinary savers on the other hand are being exposed to massive harm inflicted on us by our own government.

avatar John Médaille June 7, 2010 at 9:41 pm

FRB being wrong does not make Mises right.

avatar Bruce Smith June 8, 2010 at 8:08 am

Here is another article by Simon Johnston quoting Richard Fisher, president of the Dallas Fed, in support of his argument that not breaking up the large banks is too risky and anti-competitive to boot:-

Personally I think neither the Republican nor the Democratic parties understand that the real root of the financial problems is a deeply flawed society where Means are conflicted with Motives, a sort of United States of Absurdity. In this condition theoretically democracy is used as a tool to achieve the best ethical solutions for a society so that individuals can get as close as possible to implementing the Golden Rule as humanly possible which thereby creates an optimum situation for all human beings to flourish. In reality there are two systems of voting and two systems of ethics. Firstly, capital controlled by an increasing few has more and more “voting say” over the direction of investment such that the ballot box of democracy has increasingly less and less countervailing power particularly now that the controllers of large sums of capital have corrupted the democratic process. Secondly, liberal democracy may be thought of as a system that attempts to reflect the ethical views of society through the electoral assembly process but private capitalism is always in competition and the pressures as such minimize consideration of ethics. For example, human labor is commoditized and becomes just another cost in doing business. If it’s cheaper to manufacture in a low wage economy then close down the factories in the United States and get rid of your American workers as cheaply as possible and employ some migrant Chinese peasant for a tenth of the American’s wage. Don’t worry about the effect of reducing overall demand in the American economy with more and more unemployed American workers, that’s somebody else’s problem, and if you don’t outsource your volume manufacturing your competitor like Steve Jobs will by sub-contracting his latest gizmo to a company like Foxconn in China:-

In this Country of Absurdity one form of voting is pitted against another and one form of ethics is pitted against a virtually non-existent one. Politicians hustle up and down trying to convince the electorate that black is white and that the voters are so lucky to live in such a conflicted society. It’s bull-shit and slowly more and more individuals are realizing it.

avatar Randall B. Smith June 8, 2010 at 10:24 am

This is really a wonderful article, but I am confused by something. In one paragraph, we read about the so-called “Washington Consensus,” that it “called for the break up of the offending country’s banks and the removal of their political influence and protection as well as conforming to a strict ‘free market’ regime.”

Then in a later paragraph (a quote from Simon Johnson’s book “13 Bankers”; a worthwhile read, by the way), we read: “The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize the troubled banks and break them up as necessary.”

Francis Fukuyama has described the “Washington consensus” as “a collection of measures intended to reduce the degree of state intervention in economic affairs” (State-Building, pg. 5). If one’s goal is to “reduce the degree of state intervention in economic affairs,” one can hardly imagine a WORSE strategy than nationalizing the banks. Breaking them up, yes; nationalizing them, no.

The term “Washington Consensus,” for those who are unfamiliar with the term, was coined in 1989. The first written usage was in a paper by John Williamson for a conference that the Institute for International Economics convened in order to (quoting Williamson now) “examine the extent to which the old ideas of development economics that had governed Latin American economic policy since the 1950s were being swept aside by the set of ideas that had long been accepted as appropriate within the OECD. In order to try and ensure that the background papers for that conference dealt with a common set of issues, [Williamson] made a list of ten policies that [he] thought more or less everyone in Washington would agree were needed more or less everywhere in Latin America, and labeled this the “Washington Consensus.” Here is Williamson’s more recent listing (with brief comments) on each of those 10 points. To what extent these represent policies designed to enforce “a strict free market regime” (as is often said), I’ll let the reader decide. (I mean that quite honestly. Some will probably say yes; others will likely say no. But at least they’ll know what “The Washington Consensus” actually was. Others will have to say what applications were made of it after Williamson wrote his paper.)

For good or for ill (be he angel or demon), here is what John Williamson wrote about the 10 points of the so-called “Washington Consensus” in 2004:

1. Fiscal Discipline. This was in the context of a region where almost all countries had run large deficits that led to balance of payments crises and high inflation that hit mainly the poor because the rich could park their money abroad.
2. Reordering Public Expenditure Priorities. This suggested switching
expenditure in a pro-growth and pro-poor way, from things like non-merit subsidies to basic health and education and infrastructure. It did not call for all the burden of achieving fiscal discipline to be placed on expenditure cuts; on the contrary, the intention was to be strictly neutral about the desirable size of the public sector, an
issue on which even a hopeless consensus-seeker like me did not imagine that the battle had been resolved with the end of history that was being promulgated at the time.
3. Tax Reform. The aim was a tax system that would combine a broad tax base with moderate marginal tax rates.
4. Liberalizing Interest Rates. In retrospect I wish I had formulated this in a broader way as financial liberalization, stressed that views differed on how fast it should be achieved, and—especially—recognized the importance of accompanying financial liberalization with prudential supervision.
5. A Competitive Exchange Rate. I fear I indulged in wishful thinking in asserting that there was a consensus in favor of ensuring that the exchange rate would be competitive, which pretty much implies an intermediate regime; in fact Washington was already beginning to edge toward the two-corner doctrine which holds that a country must either fix firmly or else it must float “cleanly”.
6. Trade Liberalization. I acknowledged that there was a difference of view about how fast trade should be liberalized, but everyone agreed that was the appropriate direction in which to move.
7. Liberalization of Inward Foreign Direct Investment. I specifically did not include comprehensive capital account liberalization, because I did not believe that did or should command a consensus in Washington.
8. Privatization. As noted already, this was the one area in which what originated as a neoliberal idea had won broad acceptance. We have since been made very conscious that it matters a lot how privatization is done: it can be a highly corrupt process that transfers assets to a privileged elite for a fraction of their true value, but the evidence is that it brings benefits (especially in terms of improved service coverage) when done properly, and the privatized enterprise either sells into a competitive market or is properly regulated.
9. Deregulation. This focused specifically on easing barriers to entry and exit, not on abolishing regulations designed for safety or environmental reasons, or to govern prices in a non-competitive industry.
10. Property Rights. This was primarily about providing the informal sector with the ability to gain property rights at acceptable cost.

avatar Clare Krishan June 8, 2010 at 11:59 am

John “FRB being wrong does not make Mises right.”
rather than tackle John’s vincible ignorance and repeat myself, please refer to comments under Rod Dreher’s post
on Cameron’s austerity generation ie his warning to the proles at the end of the money multiplier that they are being called to bail out the elites at the top – the MORAL HAZARD Venerable Rosmini predicted if rule-by-revenue replaced classical private ownership aka the serfdom predicted by Hayek aka the Thanatos Syndrome at work – why worry about debts, or the next generation when you have contraceptives and abortion and the comfort-seeking infantilization of Keynesianism is so much more pleasureable.

The Fed’s Richard Fisher suffers the same vincible ignorance, he wants the world clock to stop with the “not-big-enough-yet-to-fail” sized institutions at home, while failing to realize that he — and them — are in competition with the “not-big-enough-yet-to-fail” sized institutions abroad (like the Greeks who skirted EU laws to access German and US capital market).

Germany’s Constitutional courts in a former hometown of mine, Karlsruhe,,1518,698926,00.html
are being asked to consider the legal ramifications – shame our own legal beagles aren’t being asked the same, tho’ not sure they’d be as impartial as we’d like to believe (Kagan was a board member, Research Advisory Council, Goldman Sachs Global Markets Institute: she now knows “the ropes” so to speak on the relationship of legal tender laws, suspension of payments and the public spigot paying her salary)

avatar Clare Krishan June 8, 2010 at 12:09 pm

oops mea culpa missed the blog URL for the “financial dementia” piece:

N.B. Central banking is simply the precursor of central planning of all economic activity aka collectivization of aggregates aka Communism. Natural production of monies is the patent remedy to the dead-end of the world paper money union, for narrative details refer to

avatar Clare Krishan June 8, 2010 at 12:29 pm

Here’s my translation from the German of the classic Austrian school “malinvestment of capital” argument against the too-big-to-fail currency unification of the ECB under the €:

Mr Sinn argues, that the introduction of the Euro has led to a bubble in the southern European States that was financed predominantly with foreign capital “Capital came above all from Germany, withdrawn from private and public investments there. That’s why the German economy went comatose in a mirror image of the blossoming of the southern European States” explained Mr Sinn. The Euro crisis could pave the way to an end to this development, “because German investors no longer know where to turn” and thus more money will again be invested domestically.

The German Historical School (the bedrock political philosophy of most of the liberal economic thinking of the past hundred years) is on its last legs…

John, Mises may not be your cup of religious-experience tea, but his view of the social sciences has been born out by reality… we’re living it…

avatar Clare Krishan June 8, 2010 at 12:41 pm
avatar John Médaille June 8, 2010 at 12:53 pm

I can’t see anything in the current situation which would bear out Mises’s views, or at least nothing which unique to Mises. But perhaps you will tell us what you see that would bear out that view. Nor is there the slightest evidence that the “German Historical School” is the bedrock of liberal economic thinking, unless one means by “liberalism” something other than either historical liberalism (which is more Misean) or the current welfare-state liberalism. What dominates economics is not a cultural-historical approach, but contending schools of theorems that are suspicious of historical tests, even when they claim to be “empirical.”

The problem with the Euro is that you have a single currency trying to express a multitude of diverse economies, which is a recipe for failure, at least for the weaker economies. As painful for Greece, etc., as leaving the monetary union might be, it will be less painful than staying.

avatar John Médaille June 8, 2010 at 1:55 pm

Claire, I still don’t know what your point is–aside from calling everybody who disagrees “ignorant” (which you do three times). If your claim is merely that borrowing and spending cannot continue indefinitely, then you are arguing with a straw man, since nobody maintains that. And we hardly need Mises to tell us that, since the same is a bedrock of Keynesianism. So once again, “what’s your point?”

And just what is “natural production of money”? It sounds like “natural production of computers”. AFAIK, both of these are man-made things, not produced by nature.

avatar Bruce Smith June 8, 2010 at 2:29 pm

Clare. Have you not noticed that the production of money (debt) has been in private hands and produced the latest financial crash? The Federal Reserve is owned by private banks and they did absolutely nothing to stop the massive leverage for property asset inflation and financial gambling based on that inflation.

avatar Art Deco June 8, 2010 at 7:44 pm

The plain truth of the matter is that capitalism has never been able to balance its books, to achieve a rough parity between supply and demand, without massive help from the gov’t.

What do you mean, ‘balance its books’? And you just admitted that prior to 1929 federal expenditure amounted to 3% of domestic product.

Higher taxes would certainly reduce demand, particularly if the new taxes went to pay debts rather then increase investment or demand. Of course, the bond holders could use the money to increase investment, but there are two problems with that theory. People don’t invest just because they have money, but because they think they can make a profit. If people have cut back on buying, they are at the same time reducing investment opportunities, which depend on having an increasing number of solvent consumers. So the economy gets into a “liquidity trap,” meaning people would rather hold money than invest it.

‘Liquidity trap’ is a theoretical construction found in macroeconomics texts, which posits that monetary policy is rendered ineffective because additions to the money stock are absorbed into people’s store of real balances. It was pointed out last year by Arnold Kling (among others, I am sure) that the central bank can evade a liquidity trap by substituting the purchase of any sort of security with a positive interest rate for Treasury issues for which the interest rate is near zero. That is just what the Federal Reserve did, purchasing $1,000 bn of mortgage-backed securities. What do you know, real output and prices stabilized. That is fairly strong evidence that liquidity trap is not a practical problem

The second problem is that about half of the bonds (excluding those held by the government’s trust funds) are held by foreigners,

I believe the figure is closer to 20%

avatar Art Deco June 8, 2010 at 7:46 pm

Those who advocate for central bankers have a vested reason for doing so… they will benefit from the decrease in purchasing power that hyperinflation unleashes because they sit on the overvalued “bubble” assets like real estate. Ordinary savers on the other hand are being exposed to massive harm inflicted on us by our own government.

The most recent figures from the Bureau of Labor Statistics indicate that prices are on a slight downward trajectory at this time.

avatar Bruce Smith June 8, 2010 at 8:32 pm

Matt Taibbi’s latest update on the Vampire Squids’ efforts to kill financial reform:-

avatar John Médaille June 8, 2010 at 10:14 pm

Bruce, it’s a pretty sleazy story and Taibi gives a good account of it: the appearance of reform without the reality, which is what Johnson is saying. Business as usual. However, you can’t continue the game forever, and the day reckoning is fast upon us.

Art, it’s odd, to me at least, that you define capitalism as “balancing its books” when the gov’t spends the least. However, in the time that the Federal gov spent only 3% of GDP, the economy was in recession or depression an astounding 40% of the time. Since the Gov’t increased its spending to 18% (at a minimum), it has been in recession 15% of the time. Oddly enough, most people would define economic “balance” more in terms of having a decent job. When I talk of “balance” I mean achieving a rough balance between supply and demand, without lurching between economic euphoria and depression. This balance capitalism cannot achieve without gov’t help, or at least it never has for any appreciable length of time. But it looks now like it can’t do it even with gov’t help. The capitalists went to the well once too often.

Thanks also for pointing out that we have static or declining prices now, despite the amount of money being conjured up by the Fed. But money isn’t inflationary unless someone actually spends it, a point I can’t seem to get the Austrians to understand. Money in the mattress, or the bank vault, or in non-productive assets like gold, or in speculative instruments, do nothing for the economy.

And you are right about liquidity traps; that is exactly how we avoided one right up through 2008. I’m not sure anyone wants to repeat that experience.

As for the Federal debt owned to foreigners, it is $3.9T, which sound like only 30% of the $13T total (more or less). However, 45% of the debt is held by the Fed Bank or the Gov’t Trust Funds; only $7.15T (give or take a few billion) is public debt, so foreign holdings are more than half of the public debt. Tobin Tax, anyone?

avatar Bruce Smith June 9, 2010 at 7:06 am

Here are Matt Taibbi’s notes on his article “Wall Street’s War”. He explains the mechanics of why America’s political system is utterly corrupt and controlled by the rich. Both his article and notes should be required reading by senior students and professors of economics and politics:-

avatar Bruce Smith June 10, 2010 at 3:52 am

John. The day of reckoning arrived in the fall of 2008 and will finally be confirmed in Congress this year with the deliberate sabotage by the Democratic and Republican parties of financial reform. This reckoning is that a sociopathic and traitorous few see it as legitimate to leverage huge sums of money from the private creation of money and use that money to make vast profits by “deliberately” destroying the economies of countries, including the United States, through the device of “shorting”. This is the reality lying behind the events of the Financial Crash and which most people fail to grasp and continue to vote for the old corrupted parties complicit in this travesty. The future will continue to be highly unstable until this reality is confronted!

avatar Siarlys Jenkins June 11, 2010 at 10:23 am

One of the pitfalls of pointing to recent economic history in order to score points for the prescience of a given economic theory, is that economic theories tend to be like broken clocks. Twice a day, a broken clock tells the correct time. I have heard nothing from either Rand Paul nor his father which suggests bold government action to break up the banks. Somehow, they advocate that if we just embrace the gold standard, and cut back the size of government, everything will work out. (I know, the so-called “Austrian” school, the broken clock du jour, is more wordy and erudite than that, but from the viewpoint of a reasonably informed citizen who is not a specialist in economics, that’s what it all boils down to.)

There are reasons that complex regulatory institutions developed in our government. One recurrent reason is that large “free” institutions grew to such enormous size that they dominated the “freedom” of all the rest of us. In the absence of government intervention, they also ran us through far more boom and bust than we have experienced with regulation.

Massive regulation by experts who are intertwined with the regulated businesses is indeed a significant problem. The solution is not to let large powerful business combinations run amuck unregulated, nor is it to once again “crucify mankind upon a cross of gold.” Accordingly, I find the prescriptions John outlines here quite impressive and likely to be beneficial. They are far from medieval or feudal, although tradition can be a good thing, taken in moderation.

avatar Gene Callahan June 14, 2010 at 4:29 pm

“Nor is there the slightest evidence that the “German Historical School” is the bedrock of liberal economic thinking…”

John, Clare’s knowledge of economics comes from reading 3 or 4 articles at the Mises Institute web site, one of which mentioned the German Historical School as “the enemy.”

avatar Andrew Smith June 19, 2010 at 10:37 pm

What is your beef with the Austrian Economic theory. I myself have not made an opinion about it except to say that money produced from fiat seems to take our liberties. I was taught at school and college about everything else but austrian theory and let me tell you I am beginning to thing that there is something to it. We are a credit addicted nation. We have no fiscal discipline and none is necessary since we can produce more currency. Why do prices have to continually rise? Why can’t they fall?

avatar John Médaille June 20, 2010 at 9:28 pm

Andrew, What do I think of Austrian “economics”?

1. It is based on a flawed methodology, namely deduction from axioms considered beyond dispute. But that is a methodology that applies only to speculative sciences, that is, logic, mathematics, metaphysics. It never applies to the practical sciences, and economics is a practical science.

2. Its “axioms of action” are totally unrelated to the way human beings actually behave, and find no support within psychology, sociology, theology, or any of the humane sciences. The absurdity of the axioms is illustrated by Mises’s quite logical conclusion that if the axioms are correct, then God cannot exist. No, nor man either.

3. It is based on a theory of money which, if not outright bizarre, at the very least has not a single historical instantiation. It is a bit thick to maintain “this is what money is” when money never has been such in the entire history of the human race.

4. Why not lower price levels overall (deflation)? Because deflation inflates the value of debts and hence works a hardship on the young, on the small businessman, the farmer, those just starting a family, anybody who must borrow to get started or keep going. It is a sophisticated form of usury, a transfer of wealth from borrowers to lenders over and above that stipulated in the loan contract. It may be objected that inflation is a transfer in the other direction, except that loan contracts normally anticipate some level of inflation and build it into the interest rate.

There’s more, but that’s a start, I think.

avatar John Médaille June 20, 2010 at 9:40 pm

Oh, one other thing, Andrew. The talk of “fiat money” is nonsense, since money, even gold money, is always by human fiat. Objecting to fiat money is as absurd as objecting to Fiat cars. Neither money nor cars grow on trees, no, nor in mines either. Money is merely the numeraire for exchangeable commodities, and nothing else. The problem with our fiat money is that the fiat is monopolized by the banks, who get to create it from nothing for their own purposes.

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