If the Republican Party insists on default by not raising the debt ceiling then President Obama and Secretary of the Treasury Tim Geithner should simply issue Treasuries anyway while Federal Reserve Chairman Ben Bernanke continues paying the bills.

How is this possible?  It’s in the 14th Amendment, section 4.  From Wikipedia:

Section 4 confirmed the legitimacy of all United States public debt legislated by the Congress. It also confirmed that neither the United States nor any state would pay for the loss of slaves or debts that had been incurred by the Confederacy. For example, several English and French banks had lent money to the South during the war.^[47] In Perry v. United States (1935), the Supreme Court ruled that voiding a United States government bond “went beyond the congressional power” on account of Section 4

Berkely economic professor Bradford DeLong addresses the issue with more detail:

The black-letter law:

§3101. Public Debt Limit:

(a) In this section, the current redemption value of an obligation issued on a discount basis and redeemable before maturity at the option of its holder is deemed to be the face amount of the obligation.

(b) The face amount of obligations issued under this chapter and the face amount of obligations whose principal and interest are guaranteed by the United States Government (except guaranteed obligations held by the Secretary of the Treasury) may not be more than $12,394,000,000,000, outstanding at one time, subject to changes periodically made in that amount as provided by law through the congressional budget process described in Rule XLIX [1] of the Rules of the House of Representatives or otherwise.

(c) For purposes of this section, the face amount, for any month, of any obligation issued on a discount basis that is not redeemable before maturity at the option of the holder of the obligation is an amount equal to the sum of—

(1) the original issue price of the obligation, plus

(2) the portion of the discount on the obligation attributable to periods before the beginning of such month (as determined under the principles of section 1272(a) of the Internal Revenue Code of 1986 without regard to any exceptions contained in paragraph (2) of such section).

§3102. Bonds:

With the approval of the President, the Secretary of the Treasury may borrow on the credit of the United States Government amounts necessary for expenditures authorized by law and may issue bonds of the Government for the amounts borrowed and may buy, redeem, and make refunds under section 3111 of this title. The Secretary may issue bonds authorized by this section to the public and to Government accounts at any annual interest rate and prescribe conditions under section 3121 of this title…

The Treasury Secretary’s argument would be that the debt in excess of limit issued is required in order for him to faithfully execute the appropriations bills, and that the 14th Amendment makes the debt in excess of limit full faith and credit obligations of the U.S. government in spite of the limit in §3101(b). The excess bonds are not authorized by §3101 and §3102. But they are authorized by the 14th Amendment.

Beezer here.  In a press conference today President Obama made a point of saying that most of the spending has already been appropriated by Congress, and much of it already spent.  Was he thinking of the 14th amendment here?

Republican Senators have already said they won’t support any legislation creating a Consumer Finance Protection Agency.

Which is consistent with the GOPs ideology.  Anything that hampers private corporate interests in making a buck is bad.  Even if the buck is made off the backs of working people by using incredibly hard to understand contracts. 

Obama says he supports having an agency focused on making consumer financial products easily understandable.  So does Treasury Secy. Tim Geithner.

So does Harvard professor Elizabeth Warren, who literally wrote the book on the need for protecting the consumer from the legaleeze and other shenanigans that have been used to pull the wool over unsuspecting consumers who use credit cards or sign tricky mortgage contracts.

Warren, who now chairs the Congressional Oversight Panel created to investigate the US Banking bailout, would be an excellent first chairman for the proposed consumer protection agency.  She and her daughter, Amelia Tyagi, have co-authored two best selling books:  “All Your Worth: The Ultimate Lifetime Money Plan,” and “The Two Income Trap:  Why Middle Class Mothers and Fathers Are Going Broke.”

The second book pointed out that a fully employed worker today earns less money, adjusted for inflation, than did a worker 30 years ago.   The growing gap between the wealthy and the rest of us (called income inequality) is thought by many to be a main cause of our current financial woes.

Warren also played an important role in discovering that the majority of personal bankruptcies came from overwhelming medical bills. 

From Wikipedia:

“In 2005, Dr. David Himmelstein and Warren published a study on bankruptcy and medical bills,^[6] which claimed that half of all families filing for bankruptcy did so in the aftermath of a serious medical problem. The finding was particularly noteworthy because 75% of those who fit that description had medical insurance.^[7] This study was widely cited, although critics from the insurance industry argued that the criteria used were too loose.^[8]. In 2007, the team repeated the study, using more robust criteria. They concluded that the proportion of medical bankruptcies had increased to 62% of personal bankruptcies and that, once again, about three-quarters of those families had health insurance at the onset of their medical problems..”

Warren is not intimidated by large corporation powers.  She regularly lambasts them for using shady practices against consumers and is a popular guest on television when the subject of protecting consumers comes up.

But the GOP knows the drill and knows where the easy money always is:  With large trans-national corporations.  Protecting consumers doesn’t get one dollar into the campaign till.  So among Republicans it won’t get one vote either.

James K. Galbraith’s white paper account of a Paris meeting of a collection of economists and bankers earlier this year provides a strong rationale for basic reform of the globe’s monetary and financial systems.  My previous post dealt with one part of that white paper which provided a means to acheive full employment  without fearing inflation.

This post describes as clearly as I’ve seen written, an explanation of our problems with rising income inequality and the power of oligopolies and their control over our government.

“American participants were almost equally skeptical of the effectiveness of the U.S. approach to date.  As one put it “Diabetes is a metabolic disease.”  Elements of a metabolic disease can be treated (here, stimulus plays the role of insulin), but the key to success is to deal with the underlying metabolic problem.  In the economic sphere that problem lies essentially with the transfer of resources and power to the top and the dismantling of effective taxing power over those at the top of the system.  (The speaker noted the effective corporate tax rate of the top 20 firms in the U.S. is under 2 percent.)  The effect of this is to create a “trained professional class of retainers” who devote themselves to preserving the existing (unstable) system.  Further there were massive frauds in the origination of mortgages, in the ratings process that led to securitization, and in the credit default swaps that were supposed to insure against loss.  In the policy approach so far there is a consistent failure to address, analyze, remedy and prosecute these frauds.

“Fundamental reform and “bottom up” recovery strategies based on social insurance and public investment are therefore blocked from the outset.  President Obama has his equivalents of Lewis Douglas, the conservative budget director under FDR, but no one to play the role of Harry Hopkins, Harold Ickes and Frances Perkins–the architects of the New Deal employment policy, of public works and improved labor conditions.  Meanwhile major legislation from health care to bank reform continues to be written in consultation with the lobbies; as one speaker noted, legislation on credit default swaps was being prepared by “Jamie Dimon and his lobbyists.”

“One of the gravest dangers to economic recovery, finally,  lies precisely in the crisis-fatigue of the political classes, in their lack of patience with a deep and intractable problem, and their inflexible commitment to the preceding economic order.  ”

In another brief section, Prof. Galbraith invokes the Kondratieff cycle (Beezer here, this is interesting but not a unanimously agreed upon concept); the long waves of technical change that generally underlie major economic depression. 

“In the slump governments come under pressure to save faded or dying industries, such as automobiles–and industry based on a 19th century combustion engine and the eternal promise of cheap oil. (Beezer again.  The new drive trains are evolving away from oil and the combusion engine).  Meanwhile they fail to put adequate resources behind the sectors whose growth is most promising–notably sustainable energy, greenhouse gas reductions, and public health.  In these matters organized politics and rational foresight stand at cross purposes, and the cause of economic recovery is not served.”

The white paper discusses liberal and neoliberal philosophies.  Liberal being the classic liberalism, but neo liberalism being a transformation where the marketplace totally dominates and crowds out the concepts of public good and social improvement.

“The slippage from liberal to neoliberal thinking occurs in every domain of economic discourse, and it is especially clear in banking.  Banks are institutions, chartered by public authority, to serve public purpose.  It is clearly understood, in law and in practice, that banks have responsibilities as well as rights, and that the state has power over the conduct of banks, including the power and the duty to take them over and run them when they are troubled enough to threaten the public guarantee that lies behind bank deposits.

“Financial Markets,” on the other hand, and especially the “shadow banking” of modern times, are neoliberal creations:  They exist to place in the domain of private market transactions what previously existed in a clearly defined relationship to public purpose.  They escape both regulation and insurance.  The result has been to vitiate the concept of public purpose, creating in banks privileged and powerful market-oriented institutions that use and largely control the state rather than respond to it.

“The Geithner-Summers plan recognizes the deficiencies of the financial market system, including the shadow banking system.  It strongly acknoweldges the need for comprehensive reform.  Certain of the specific proposals in the plan, that for a “Consumer Financial Safety Commission” with broad powers to oversee the financial products offered to consumers, are promising.  Equally promising is the push to bring over-the-counter derivatives under control and institute clearinghouses, implying obligatory standardization of contracts.

“The fact that these proposals are engendering opposition from the bank lobbies is a marker of their merit.  Nevertheless, the U.S. administration’s approach remains anchored in a neoliberal version of financial markets and not in the older, liberal version of banking institutions.  In this respect it does not depart from the Basel II emphasis on capital requirements and transparency, as formulae to provide a margin of safety and assurance of honesty–in what is otherwise accepted as properly a sphere for the market rather than for the state.  This remains substantially (though not entirely) the approach of the European regulatory authorities. 

“The difficulty and deficiences of this way of thinking are twofold.  First, one cannot escape institutional history.  Banks are creatures of the state, subject to state deposit insurance and prudential regulation.  This reality cannot be overturned or neglected without exposing the state to uncontrollable financial losses.  The attempt in the neoliberal era to escape from deposit insurance by allowing it to wither away (by declining to increase insurance limits as the economy grew) proved completely unworkable, as British authorities discovered with Northern Rock, and the Paulson Treasury realized with the enactiment of TARP (troubled asset relief program), and as the Irish and, later, all the European authorities realized as the crisis spread.  Deposit insurance is the one proven antidote to panic, and it entails a need for in-depth prudential regulation, not just of the markets but of the institutions themselves.

“Second, even if one accepted the neoliberal version of market discipline, the doctrine of “Too Big To Fail” completely perverts it.  An institution that is too big to fail has the implicit support of the state, and therefore a crushing weight of market power, compared to all competing institutions.  The result of combining too big to fail with neoliberalism is perverse in every way, facilitating and even encouraging dysfunctional risk taking and excessive compensation–incentives for fraud.  And when the system crumbles, the perversity redoubles, as in the panic ordinary bank depositors flee from institutions that are not too big to fail to those that are.  No principal of market discipline can work under these conditions; on the contrary, destabilizing and dangerous behaviour is actually rewarded.”

Beezer here.  There you have it; a concise, historically informed perspective, of our problems.  One can only hope Galbraith’s paper is being read thoroughly down in Washington.

Sometimes stepping back, taking a big breath, and looking at the basic picture reveals more important insight than anything else.

Such appears to be the case right now with the world convulsing over the partial collapse of it’s financial system(s).  Articles and ideas are flying around the world.  Major central bankers and an army of academics are calling for international reform under the overarching theme of “Macro Prudential Regulation.” 

Large, multinational finance holding companies became hopelessly intertwined to the point where the failure of one or more staggered the entire system.  Tremendous amounts of private and public capital was lost.  Financial innovations, it turned out, contained severe flaws among which included an inability to be accurately priced as economic circumstances changed.   This problem, among others, came close to shutting down the critical allocation of funds to enterprises of all kinds, in all places.

That initial crisis appears to have been averted in its worst form.   But what remains is still a damaged and poorly functioning world financial system that is vulnerable to any further shocks.  Common sense repairs are needed, and they must be implemented with all deliberate speed.

So let’s step back and make some basic observations.

Finance is an enabling business.  It’s primary job is to efficiently allocate money (liquidity) to business, both public and private.  Capital investment cycles are seldom steady.  There’s an ebb and flow, with peaks and valleys.  And in our modern world these cycles can be focused on one or more countries.  One part of the world may have a tremendous need for capital investments, while another part of the world may languish.

Some history. The United States went through a tremendous capital investment cycle that began prior to WWI and continued after the war into the 1920s.  It was a “golden age” where wage rates increased among labor as manufacturing innovations came one after the other.

But inevitably the cycle relented.  Capital investments declined because little more was needed.  In-place manufacturing just kept turning out product without much additional investment.   Labor stopped gaining but the wealth for ownership continued to rise unabated.  There appeared a widening “gap” between classes of wealth.  A gap that, at the time, was little noted or understood.

The dearth of capital investment in the face of rising wealth creates problems, it’s now realized.  Lacking enough productive investment opportunities, money searches for alternatives.  In the 1920s it was the burgeoning stock market.  Prices of these paper assets rose and rose creating a bubble that burst in the crash of 1929.  Fortunes evaporated then, just as they have now.

It took a couple years, but the stock market crash eventually led to bank failures and a collapse of industry and global trade.  The Great Depression ensued.  Newly elected Franklin Delano Roosevelt declared a bank holiday and put the government on a path of radical change.  With the unemployment rate in the mid-20s, the government became the employer of first resort.  National programs of construction, from bridges and roads to parks and dams to art were government funded. 

It was socialism on a massive scale.  Just as is being done today, government back then stepped up and provided capital investments to a market where such investment had disappeared.  Included in that investment were investments in labor and wages.   One aspect of the programs was to push some of what was left of wealth down to the lower rungs of the income ladder, and therefore provide some life support for a wide range of industries, including those involved in consumer consumption.

While economic times remained hard compared to the 1920s, the efforts had dramatic effect.  One was on unemployment, which dropped by more than 10% because of the government induced programs.  The economy stabilized until 1937 when, under pressure from fiscal conservatives worried about government debt, FDR pulled in the spending causing the still fragile economy to plunge back into a severe recession. 

The economy again began to recover as FDR took his foot off the economic brakes, but it wasn’t until the ultimate fiscal stimulus program (a totally socialist endeavor) of WWII that the economy truly recovered.

Fast forward to today.  It has been documented that income inequality in the United States has been increasing for the greater part of two decades and accelerated after 2000.  The top one percent of wealth went from roughtly 7% to more than 14%.  And instead of a robust capital investment market the United States began shipping much of its manufacturing industries overseas in search of cheaper labor.

While capital investment in the United States languished in relative terms, the developing countries of the Far East, primarily China and India, were in the throes of a massive capital investment cycle. 

But there are limitations in these countries on foreign capital investment.  By tightly controlling this investment and manipulating currencies, China primarily but also India and other emerging Far East  countries, dynamically pulled their economies forward with strong export industry growth.  This wasn’t the advertised “free trade” but a solid example of the much older method of mercantilism.  Importantly, the primary buyers of these products were Americans.

But in the United States, wealth was still being created and income was flowing up, not down the income ladder.  Outside of one industry, that of finance, there was a lack of productive capital investment opportunities.  And just as in the 1920s, this wealth searched wide and far for someplace to go, for alternatives.

Enter financial innovation created by the one industry growing strongly in the United States:  Finance (at its height, this industry comprised more than 30% of GDP as opposed to a normal 7-8%).  Using property as the underlying “asset,” both commercial and housing, but primarily housing, Wall Street designed securities, called derivatives, comprised of these assets.  They were designed to mimic more traditional bond investments that normally provide a significant source of money for productive capital investment.

As in the 1920s, for a long while these underlying assets went up in price.  There was a boom in liquidity as wealth from around the world rushed into these bond-like securities that promised the manna of all wealth preservation: Steady income and a safe return of principal.  During the boom, as with all paper asset booms, leverage became common and the prudent boundaries on leverage use were discarded.

The inevitable happened.  The underlying property stopped increasing in price and rolled over.  A heavily indebted populace whose incomes had not kept pace with inflation found themselves unable to support debt that had become greater than their property asset.   The derivatives market boom collapsed.  Buyers disappeared.  Within months trillions of dollars in what had been thought were safe investments evaporated.

International finance holding companies, the princes of the derivatives boom, teetered on the brink of collapse.  Governments around the world, but primarily in the United States and in Europe, quickly moved to shore up the balance sheets of their biggest banks.  It’s still going on and the process is being severely hampered because many of the derivatives are almost impossible to price.  It turns out much of them become illiquid in extremis and, as a result, stubbornly weigh down bank balance sheets.

Mark Twain is famously credited with the observation that “History never repeats itself, but it ryhmes a lot.”

With FDR’s stimulus spending as a guide, the current administration of President Obama quickly received from Congress a $780 billion stimulus package, which is now just beginning to flow into the general economy.  At the same time, Federal Reserve Chairman Ben Bernanke, often in concert with Treasury Secretary Tim Geithner, pumped liquidity into the markets, particularly into markets that service the business communities (such as commercial paper markets) and the property markets.  Wherever the staggering banks withdrew their support, the government stepped in.

What is needed are more productive capital investment opportunities.  Private industry is staggered.  And much of what it has invested in capital, has been and continues to be, in foreign countries.  Which leaves the government, just as in the days of FDR.

Fortunately, there are many areas where the government can invest.  Unfortunately they exist because for the past 30 years the government has not been investing in the United States.  The lack of productive capital investment opportunities arose, in no small part, because the US government ceased investing in badly needed projects such as energy reformation, public transportation, universal health care or pure research and development.

At days end, it is this investing which will lay the groundwork for real recovery.  Private capital, once it recovers its balance, will join in this next cycle of capital investment.  And like all such past cycles, part of that investment capital will benefit labor, which will help the recovery from the bottom up.

So what’s the take away?  One, governments need to have steady, forward looking, capital investment programs.  A strong government must continuously direct investment, public and private, into the nation. 

Two, investment securities must have strong contractual relationships to underlying assets.  As long as these direct relationships are uniformly maintained then pricing can be determined even in extremis, making a financial liquidity crisis less likely.

Three, large financial institutions probably need to be broken up into smaller, independent businesses.  And a solid, impenetrable regulatory wall must be re-imposed between commercial bank deposits which are insured by government and all other financial services which should not gain any type of government guarantee, implied or otherwise.  Without this change finance will continue to hold government hostage (regulatory capture).

Four, trade imbalances must be better controlled.  In hindsight, the idea that the US economy could continue at the level of 75% of GDP coming from consumption is ridiculous.   Warren Buffett has recommended an import certificate regime be imposed where trade balances between nations are kept in check.  One thing is clear, the US can no longer afford to ship “mission critical” jobs and skill sets overseas.  Fair trade between nation’s must replace what we have today.

Five, leverage must be strictly limited, particularly regarding commercial bank functions.  And these limits should be imposed globally.

The devil’s in the details, of course.  But an understanding of fundamentals, basics which in truth haven’t changed for centuries, is necessary.  Otherwise, we’ll just be back here again.

Steve Waldman writes a blog, Interfluidity, which is often on point and well written.  He’s got a new post explaining what he thinks needs to be accomplished along the way of fixing our banking system.

It’s a fairly common theme amongst those, and there are many, who won’t be satisfied if the banking system isn’t reformed to avoid future financial meltdowns caused by excessive risk taking.

He writes about one aspect of the current problem which we believe doesn’t get enough attention:  That investors failed to reign in excessive risk taking and, as a result, not only damaged their own investments but damaged the investments of many others.  

“I am a true believer in American-style capitalism. So I would like to see people who earned profits lending to banks in good times bear the high costs of failing to monitor the organizations they funded. Investor fear is what is supposed to prevent the indiscriminate misuse of capital. To the degree that creditors have leaned upon “implicit” government guarantees, I think it would both be just and set a useful precedent if they were reminded that investors have to take responsibility for where they place the precious capital they steward….” Waldman writes in this essay.

Meanwhile, today’s news was that Treasury informed Bank of America and Citi that they needed to raise more capital.  Also, FDIC Chief Sheila Bair said yesterday the too big to fail bank concept needs to be tossed into the “dustbin,” and called for giving the FDIC, and other regulators, more power to wind down large companies that are systemically important.

The future path of the bank resolution is not certain, of course, but what is certain is that federal regulators from Treasury, to the Federal Reserve, to the FDIC are setting the table for taking out one or more of the TBTF institutions.  They may not want to do this, but the option is obviously still “on the table.”

We’ve noticed recently that Treasury Secretary Tim Geithner has begun to point out that he is not a banker.  Never has been one.  That he is putting some distance between who he is, and who bankers are, is no doubt intentional.  The huge subsidies made to the TBTF group raises the fear that Geithner has been “captured” by the very industry he regulates.  In effect, Geithner is signaling he hasn’t forgotten he has responsibilities to the public and not just to banks.

Waldman’s essay is featured today at Economist’s View, Prof. Thoma’s site.  There is a strong comment discussion on Waldman’s essay there, as well as at Waldman’s site itself.

For those inclined to follow this part of the Great Recession, today’s essay and comments are interesting contributions to what we believe will be a story with many twists and turns to come.

There’s a growing sense that Washington is in fact captive to Wall Street.  Despite the Obama administrations protestations about “responsibility,” and Secretary Tim Geithner’s remarks that government should act forcefully “and do what government is supposed to do,” the sense increases that this isn’t true when it comes to Wall Street.

“Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.”  This from former International Monetary (IMF) Fund Chief Economist Simon Johnson, now a professor at MIT’s Sloan School of Management.  Johnson, who authors the blog baselinescenario.com, writes this in a terrific article in the Atlantic magazine here.

Later Johnson says what the IMF would do, and has done many times in the past.  “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 troubled banks and break them up as necessary.”  Today that would cost taxpayers, Johnson estimates, about $1.5 trillion.

But even that is not enough.  There’s a deeper problem Johnson sees in the US, and one he saw many times in other countries in financial distress when they had to come to the IMF for help.

“This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.

“Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

“Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.”

This is basically the same prescription being offered by a number of powerful economic voices, including Nobel prize winners Paul Krugman and Joseph Stiglitz as well as economist Nouriel Roubini, who loudly and accurately predicted our current problems.   And many, many others, including Mark Thoma of economist’s view, have deep misgivings about the Obama’s administration’s clear attachment to preserving Wall Street’s status quo. 

For our part, we still hold some hope that Treasury Secy. Geithner will somehow see the wisdom of dismantling the old Wall Street, and re-making it into a smaller and no doubt less dangerous banking financial system. 

Not doing so, warns Johnson, will only prolong the recession, limit recovery–and still leave the U.S. with an unchanged financial Oligopoly that guarantees further collapses.