A Primer on the National Debt

On May 8, 2012, in credit, economic theory, insurance regulation, tax policy, by admin

Simon Johnson and James Kwak. White Housing Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Pantheon Books, 2012, pp. 352, $26.95 The two constants in the upcoming 2012 general election likely will be an inordinate amount of negative campaigning and vigorous disagreement about how to best foster economic growth. Implicit [...]

Simon Johnson and James Kwak. White Housing Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Pantheon Books, 2012, pp. 352, $26.95

The two constants in the upcoming 2012 general election likely will be an inordinate amount of negative campaigning and vigorous disagreement about how to best foster economic growth. Implicit in any discussion about the nation’s economic woes is the national debt, which as of May 7, 2012, was $15,671,202,480,642.98. While the political center-left has highlighted the perils of rising consumer and student debt, the Tea Party movement and political libertarians have ensured that the perils of this country’s rising national debt remain in the public consciousness. But what should be done about the country’s debt? Should we enter into an age of austerity in which public spending at the federal level is significantly curtailed and once-cherished safety net programs such as Social Security and Medicare are quasi-privatized? How did we get ourselves into debt to begin with? At a more theoretical level, should we be asking ourselves whether debt is always such a bad thing for a country?

In White House Burning, Simon Johnson (Massachusetts Institute of Technology) and James Kwak (University of Connecticut School of Law)* argue that the debate over the national debt comes down to how Americans want to respond to risk, either on their own volition, or through government-run insurance programs. The same is true for the deficit. “The great deficit debate,” write the authors, “is about how much risk people should bear themselves and how much they should pool with each other via the government.” The authors contend that it is indeed possible to maintain a sustainable level of debt and simultaneously have the federal government continue to play its role as an insurer against risk. Indeed, in chapter seven, they delineate what they believe to be the best method for achieving this goal. While most conservatives would likely not agree with their recommendation that the Bush tax cuts expire, others surely will appreciate their preference that tax expenditures, including the mortgage interest deduction, be eliminated or reduced.

While the direct policy sections of White House Burning are somewhat dry reading and do not break substantially new ground, the book’s earlier chapters do merit attention, particularly by those readers interested in economic history. In their Introduction, they discuss how the country’s fiscal weakness during the War of 1812 led to the burning of the White House by British troops in 1814, “the low point of the war, a moment of national humiliation that remains an iconic image in U.S. history” and, one should note, accounts for the title of the book. The problem during the War of 1812, contend the authors, was that Great Britain had money, while Congress opted for “higher spending without higher taxes.” Today, the approaching fiscal crisis comes not from the threat of a literal land invasion, but by a greying population and rising health care costs.

In Chapter 1, entitled “Immortal Credit,” Johnson and Kwak provide an overview of how the United States dealt with its national debt prior to the end of the gold standard in the Nixon era. Not surprisingly, Alexander Hamilton, America’s first Treasury Secretary, and the man responsible for enacting the country’s earliest fiscal policies, plays an important role. In the book’s second chapter, “End of Gold,” the authors posit that the changing relationship between gold and money over the past three centuries has had important consequences for the national debt. The breakdown of the Bretton Woods system for international finance in the early 1970s, led to a growth of American national indebtedness. “Under the Bretton Woods system, the capacity of the world to buy American bonds was limited by American gold reserves; today it is limited only by market demand, which has turned out to be much more forgiving.” Indeed, international investors still consider Treasury bonds to be safe assets. But, as the authors aptly warn, markets could turn against the United States should the world begin to doubt Washington’s ability to manage the dollar effectively.

In conclusion, White House Burning is a useful primer for those readers interested in learning about the national debt and what drives it. Although not as compelling as the authors’ previous work, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, in which they argued that the close ties between Washington and Wall Street are not healthy for the American economy and polity, this most recent publication is still worth reading. This is particularly true for readers interested in how the federal government acts as an insurer against risk for a large segment of the population. Whether their work will have any impact on the gridlock in Washington remains yet to be seen.

Jon Lewis (c) 2012
* I received my J.D. from the University of Connecticut School of Law prior to Professor Kwak taking the position at the law school.

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The Banking Dead

On January 10, 2012, in banking, Federal Reserve, monetary policy, moral hazard, by Jon Lewis

Zombie Banks: How Broken Banks And Debtor Nations Are Crippling the Global Economy. Yalman Onaran. Bloomberg Press, 2012, pp. 184, $34.95 Over the past several years, both the Tea Party and Occupy Wall Street (OWS) have been at the forefront of criticizing the federal government’s bailout of large financial institutions. While their criticism is generally [...]

Zombie Banks: How Broken Banks And Debtor Nations Are Crippling the Global Economy. Yalman Onaran. Bloomberg Press, 2012, pp. 184, $34.95

Over the past several years, both the Tea Party and Occupy Wall Street (OWS) have been at the forefront of criticizing the federal government’s bailout of large financial institutions. While their criticism is generally merited, it is unclear whether it would have been realistic, not to mention politically viable, to have let the big banks fail. Such a move truly could have had devastating effects on the American economy, dwarfing the Great Recession and its aftereffects.

Letting the banks survive to see another day, however, led to the creation of financial zombies, dead, but still living. Not only do they linger in our midst, zombie banks are also holding back our economic recovery. Such is the thesis of Yalman Onaran’s recently published Zombie Banks: How Broken Banks are Crippling the Global Economy. Onaran, a reporter at Bloomberg News, builds upon the notion of zombie banks, a concept first utilized by finance professor Edward J. Kane in a 1987 academic paper. “In its simplest form,” writes Onaran, “[a] zombie bank refers to an insolvent financial institution whose equity capital has been wiped out so that the value of its obligations is greater than its assets.” In its simplest formulation, these are banks that are, for a lack of a better term, broke, but kept alive through government intervention or, as the case may be, non-intervention.

Onaran’s intention in writing this book was to provide a big picture analysis of the global financial crisis. The author argues that many of the current policies employed by both European and the American polities have resulted in the creation of zombie banks. These financial zombies remain alive due to, among other factors, government backing of bank debt and near-zero interest rates. Onaran contends that, “it’s the taxpayer money that zombie banks eat and that’s where their harm to society is.” In a series of vignettes written in a lively, accessible journalistic style, he is generally successful in showing the interconnectedness of the distressed banking sector, government policies on both sides of the Atlantic, and economic stagnation. Indeed, he boldly contends that, “despite their claims to the contrary, politicians worldwide have not tackled the structural problems in the financial system underlying that crisis.” Temporary fixes, it could be said, are not solutions.

Onaran utilizes a comparative approach, one that is notably lacking in many journalistic accounts of the financial crisis. In detailing the differences in how Iceland, Ireland, and the United States handled their respective countries’ banking difficulties, he provides particular insight into the problem of zombie banks. The United States took somewhat of a middle course between the two aforementioned island nations’ approaches to troubled banks, a trajectory more akin to that taken by Germany, which created its own zombies.

Whereas the Irish government initially guaranteed the liabilities of the country’s national banks in 2008 in response to the credit crunch, the Icelandic government embarked upon a starkly different course, seizing the banks and restructuring them, effectively letting the bad banks die. “So while one island’s banks were kept alive as zombies for two more years before they brought down the whole country with them,” writes Onaran, “the neighboring island’s troubled banks were allowed to die.” He points out that, while Iceland has not had it easy since 2008, the country did two notable things correctly; first, private bank debt was not converted to public debt and second, Reykjavik did not prop up failed banks, allowing them to continue artificial lives as zombies.

The relationship between the private debts of financial institutions and sovereign debt is a significant one. “As is the case with most financial crises,” posits Onaran, “the problems of the banks are closely associated with the debt overhang society faces after a decade or two of binging on cheap credit.” He raises thought-provoking issues regarding central bank policies that keep interest rates at a near-zero level.

Onaran contends that these exceedingly low interest rates designed to keep zombies alive and to aid them in healing their balance sheets has harmful societal effects and terms it “a wealth transfer from pensioners and others relying on fixed returns of their savings to the banks’ coffers.” This results, for a segment of society, in reduced disposable income and reducing spending. He also highlights what he perceives to be the connection between quantitative easing and events abroad, positing that it has led to commodity price increases and bubbles in emerging markets. Cheap money, it would seem, needs a home. One could easily imagine a future study detailing the largely unforeseen effects that quantitative easing had had on the politics of foreign lands.

In conclusion, Zombie Banks is a useful addition to the growing corpus of literature on the global financial crisis. While the author could have devoted more attention to the issue of moral hazard in banking regulation, free market advocates will be heartened by Onaran’s contention that propping up banks that should have died is not fair to competitors. “In a real market economy, those companies that take the wrong risks and lose out are supposed to fail, their customers and market share shifting to the surviving firms that were more prudent.” Onaran’s suggestion that governments need to kill the zombies off so that economies can recover is perhaps theoretically correct, though it is probably politically impossible at this time, at least in the United States. Bailouts may be, for better or worse, the new normal. If that is the case, then zombies will continue to stagger among us.

Jon Lewis (c) 2012

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Federal Government as Financial Institution

On November 8, 2011, in banking, credit, by Jon Lewis

Uncle Sam in Pinstripes: Evaluating U.S. Federal Credit Programs. Douglas J. Elliott. Brookings Institution Press, 2011, pp. 147, $19.95 Of all the demands of the Occupy Wall Street movement, none probably has more resonance to many underemployed young Americans than their call for student debt relief. Indeed, according to The Federal Reserve Bank of New [...]

Uncle Sam in Pinstripes: Evaluating U.S. Federal Credit Programs. Douglas J. Elliott. Brookings Institution Press, 2011, pp. 147, $19.95

Of all the demands of the Occupy Wall Street movement, none probably has more resonance to many underemployed young Americans than their call for student debt relief. Indeed, according to The Federal Reserve Bank of New York, outstanding student loans will soon exceed $1 trillion; for Americans, student loan debt has even managed to surpass credit card debt. Since it is doubtful that Congress will alter the U.S. Bankruptcy Code to allow for discharging government insured or guaranteed student loans through Chapter 7 bankruptcy, the upcoming generation will be indebted for many years to come. This will almost certainly have substantial effects on this generational cohort’s consumer spending habits, personal savings rate, and overall attitude toward government intervention in the economy.

In Uncle Sam in Pinstripes, Douglas J. Elliott (Brookings Institution) provides the reader with a comprehensive overview of the goals and history of federal credit programs, including those dealing with student loans. “The federal government,” writes Elliott at the beginning of this academic monograph, “is the biggest and most influential financial institution in the world, a fact often hidden by the widespread public conception that the American government largely stays out of business activities.”

The author notes that the federal government provides more credit, either directly or indirectly, than any of the country’s private banks. Indeed, as of 2010, federal loans outstanding exceed $8 trillion. This figure encompasses not only what he terms the four traditional loan and guarantee programs in housing, farming, education, and business, but also the additional credit that the federal government extended to respond to the recent financial crisis. While most federal credit is actually channeled through assistance to private lenders, this does not alter how large a role the federal government plays in the provision of credit.

In Uncle Sam in Pinstripes, Elliott discusses the theories behind, and policy rationales for, federal credit programs (Chapter 2); a brief history and overview of the programs (Chapters 3 and 4, respectively); a discussion of the costs and benefits of the programs (Chapter 5); and an analysis of the recent emergency credit programs put into place in response to the financial crisis (Chapters 6 and 7). Although far too brief, the book’s third chapter, a history of federal credit programs, stands out as particularly relevant to aiding our understanding of how the federal government came to be the largest provider of credit. Elliott aptly recounts how, with the creation of the Federal Reserve System in 1913, the federal government became a major lender, but that the first real federal credit programs were designed to help farmers. The Great Depression, however, was the major turning point; before then, the federal government was not nearly the major provider of credit that it has since become.

Many federal credit programs that exist today such as the Federal Housing Administration, Fannie Mae, and the Export-Import Bank, have their roots in government’s response to the Great Depression. A comparison between the federal credit programs run by the United States and those run by other industrialized countries would have made this chapter stronger. While Elliott is correct that, between the Founding and the early twentieth-century, the federal government did not have a prominent role in supplying credit, it would have nevertheless been helpful to learn if the United Kingdom, France, and Germany maintain long-standing national credit programs and, if so, how they have fared.

As to the question are taxpayers getting their money’s worth, Elliott contends that, in all likelihood, they are not. Although his argument is nuanced, he concludes with dismay that, “the evidence suggests that credit programs, as they are run today, do not provide good value for money in the aggregate.” Elliott is, however, more than a mere critic of the status quo. In the work’s final chapter, he provides a set of ten overall thoughtful recommendations for improving the federal credit programs. Some, such as his proposal to utilize risk-based discount rates for federal budget purposes, should be relatively uncontroversial. Others, such as his proposal that the government incorporate more underwriting and risk-based prices, as well as his argument for the creation of a federal bank to administer all federal credit programs, are likely to be greeted with a bit more skepticism.

Elliott’s fifth recommendation, namely that the Fed “should run credit programs only under extremely unusual circumstances, outside of its normal interactions with financial institutions and its function as lender of last resort for regulated financial institutions” is undoubtedly correct. He rightly notes the Federal Reserve’s lack of experience in this area and the troubling political implications of having the country’s central bank running credit programs. Unlike those who would seek to abolish the Federal Reserve System, Elliott’s criticism is constructive, and should be taken into consideration by Congressional staffers and policymakers.

For those readers interested in learning about student loans, Elliott’s work provides a framework in which one can better understand both how, and why, the relevant federal programs were created. Although the author might have devoted an entire separate chapter with student loans as a case study, his discussion of this particular federal credit program is nevertheless quite informative. The federal government got into the student loan business in 1958 and expanded the program in the 1960s. Congress, through the Health Care and Education Reconciliation Act in 2010, got rid of guaranteed student loans, leaving only direct lending through the Department of Education. Elliott skillfully uses student loans to demonstrate why the federal government is the main source of credit in this area. Student loans are one area in which there are positive externalities, where the acquired education will not only benefit the debtor, but also society as a whole. In addition, as Elliott points out, private lenders will hardly ever make long-term uncollateralized loans to individuals who cannot demonstrate an ability to repay. This is why the federal government, now through direct lending only, is the primary source of credit to university students.

The federal government, whether Americans like it or not, is not only a financial institution, albeit a public one, but it is also an institution that is itself too big to fail. Although not the subject matter of Uncle Sam in Pinstripes, the indisputable fact that the United States is simultaneously a creditor to the private sector, and a debtor to China, raises serious questions about the long-term fiscal health of the American economy. For those individuals interested in learning about the federal government’s increasing role in providing credit to individuals and businesses, this recent work is an excellent place to start.

Jon Lewis (c) 2011

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