The terrible, horrible, no-good very-bad budget bill

JDN 2457005 PST 11:52.

I would have preferred to write about something a bit cheerier (like the fact that by the time I write my next post I expect to be finished with my master’s degree!), but this is obviously the big news in economic policy today. The new House budget bill was unveiled Tuesday, and then passed in the House on Thursday by a narrow vote. It has stalled in the Senate thanks in part to fierce—and entirely justified—opposition by Elizabeth Warren, and so today it has been delayed in the Senate. Obama has actually urged his fellow Democrats to pass it, in order to avoid another government shutdown. Here’s why Warren is right and Obama is wrong.

You know the saying “You can’t negotiate with terrorists!”? Well, in practice that’s not actually true—we negotiate with terrorists all the time; the FBI has special hostage negotiators for this purpose, because sometimes it really is the best option. But the saying has an underlying kernel of truth, which is that once someone is willing to hold hostages and commit murder, they have crossed a line, a Rubicon from which it is impossible to return; negotiations with them can never again be good-faith honest argumentation, but must always be a strategic action to minimize collateral damage. Everyone knows that if you had the chance you’d just as soon put bullets through all their heads—because everyone knows they’d do the same to you.

Well, right now, the Republicans are acting like terrorists. Emotionally a fair comparison would be with two-year-olds throwing tantrums, but two-year-olds do not control policy on which thousands of lives hang in the balance. This budget bill is designed—quite intentionally, I’m sure—in order to ensure that Democrats are left with only two options: Give up on every major policy issue and abandon all the principles they stand for, or fail to pass a budget and allow the government to shut down, canceling vital services and costing billions of dollars. They are holding the American people hostage.

But here is why you must not give in: They’re going to shoot the hostages anyway. This so-called “compromise” would not only add $479 million in spending on fighter jets that don’t work and the Pentagon hasn’t even asked for, not only cut $93 million from WIC, a 3.5% budget cut adjusted for inflation—literally denying food to starving mothers and children—and dramatically increase the amount of money that can be given by individuals in campaign donations (because apparently the unlimited corporate money of Citizens United wasn’t enough!), but would also remove two of the central provisions of Dodd-Frank financial regulation that are the only thing that stands between us and a full reprise of the Great Recession. And even if the Democrats in the Senate cave to the demands just as the spineless cowards in the House already did, there is nothing to stop Republicans from using the same scorched-earth tactics next year.

I wouldn’t literally say we should put bullets through their heads, but we definitely need to get these Republicans out of office immediately at the next election—and that means that all the left-wing people who insist they don’t vote “on principle” need to grow some spines of their own and vote. Vote Green if you want—the benefits of having a substantial Green coalition in Congress would be enormous, because the Greens favor three really good things in particular: Stricter regulation of carbon emissions, nationalization of the financial system, and a basic income. Or vote for some other obscure party that you like even better. But for the love of all that is good in the world, vote.

The two most obscure—and yet most important—measures in the bill are the elimination of the swaps pushout rule and the margin requirements on derivatives. Compared to these, the cuts in WIC are small potatoes (literally, they include a stupid provision about potatoes). They also really aren’t that complicated, once you boil them down to their core principles. This is however something Wall Street desperately wants you to never, ever do, for otherwise their global crime syndicate will be exposed.

The swaps pushout rule says quite simply that if you’re going to place bets on the failure of other companies—these are called credit default swaps, but they are really quite literally a bet that a given company will go bankrupt—you can’t do so with deposits that are insured by the FDIC. This is the absolute bare minimum regulatory standard that any reasonable economist (or for that matter sane human being!) would demand. Honestly I think credit default swaps should be banned outright. If you want insurance, you should have to buy insurance—and yes, deal with the regulations involved in buying insurance, because those regulations are there for a reason. There’s a reason you can’t buy fire insurance on other people’s houses, and that exact same reason applies a thousandfold for why you shouldn’t be able to buy credit default swaps on other people’s companies. Most people are not psychopaths who would burn down their neighbor’s house for the insurance money—but even when their executives aren’t psychopaths (as many are), most companies are specifically structured so as to behave as if they were psychopaths, as if no interests in the world mattered but their own profit.

But the swaps pushout rule does not by any means ban credit default swaps. Honestly, it doesn’t even really regulate them in any real sense. All it does is require that these bets have to be made with the banks’ own money and not with everyone else’s. You see, bank deposits—the regular kind, “commercial banking”, where you have your checking and savings accounts—are secured by government funds in the event a bank should fail. This makes sense, at least insofar as it makes sense to have private banks in the first place (if we’re going to insure with government funds, why not just use government funds?). But if you allow banks to place whatever bets they feel like using that money, they have basically no downside; heads they win, tails we lose. That’s why the swaps pushout rule is absolutely indispensable; without it, you are allowing banks to gamble with other people’s money.

What about margin requirements? This one is even worse. Margin requirements are literally the only thing that keeps banks from printing unlimited money. If there was one single cause of the Great Recession, it was the fact that there were no margin requirements on over-the-counter derivatives. Because there were no margin requirements, there was no limit to how much money banks could print, and so print they did; the result was a still mind-blowing quadrillion dollars in nominal value of outstanding derivatives. Not million, not billion, not even trillion; quadrillion. $1e15. $1,000,000,000,000,000. That’s how much money they printed. The total world money supply is about $70 trillion, which is 1/14 of that. (If you read that blog post, he makes a rather telling statement: “They demonstrate quite clearly that those who have been lending the money that we owe can’t possibly have had the money they lent.” No, of course they didn’t! They created it by lending it. That is what our system allows them to do.)

And yes, at its core, it was printing money. A lot of economists will tell you otherwise, about how that’s not really what’s happening, because it’s only “nominal” value, and nobody ever expects to cash them in—yeah, but what if they do? (These are largely the same people who will tell you that quantitative easing isn’t printing money, because, uh… er… squirrel!) A tiny fraction of these derivatives were cashed in in 2007, and I think you know what happened next. They printed this money and now they are holding onto it; but woe betide us all if they ever decide to spend it. Honestly we should invalidate all of these derivatives and force them to start over with strict margin requirements, but short of that we must at least, again at the bare minimum, have margin requirements.

Why are margin requirements so important? There’s actually a very simple equation that explains it. If the margin requirement is m, meaning that you must retain a portion m between 0 and 1 of the loans you make as reserves, the total amount of money supply that can be created from the current amount of money M is just M/m. So if margin requirements were 100%—full-reserve banking—then the total money supply is M, and therefore in full control of the central bank. This is how it should be, in my opinion. But usually m is set around 10%, so the total money supply is 10M, meaning that 90% of the money in the system was created by banks. But if you ever let that margin requirement go to zero, you end up dividing by zero—and the total amount of money that can be created is infinite.

To see how this works, suppose we start with $1000 and put it in bank A. Bank A then creates a loan; how big they can make the loan depends on the margin requirement. Let’s say it’s 10%. They can make a loan of $900, because they must keep $100 (10% of $1000) in reserve. So they do that, and then it gets placed in bank B. Then bank B can make a loan of $810, keeping $90. The $810 gets deposited in bank C, which can make a loan of $729, and so on. The total amount of money in the system is the sum of all these: $1000 in bank A (remember, that deposit doesn’t disappear when it’s loaned out!), plus the $900 in bank B, plus $810 in bank C, plus $729 in bank D. After 4 steps we are at $3,439. As we go through more and more steps, the money supply gets larger at an exponentially decaying rate and we converge toward the maximum at $10,000.

The original amount is M, and then we add M(1-m), M(1-m)^2, M(1-m)^3, and so on. That produces the following sum up to n terms (below is LaTeX, which I can’t render for you without a plugin, which requires me to pay for a WordPress subscription I cannot presently afford; you can copy-paste and render it yourself here):

\sum_{k=0}^{n} M (1-m)^k = M \frac{1 – (1-m)^{n+1}}{m}

And then as you let the number of terms grow arbitrarily large, it converges toward a limit at infinity:

\sum_{k=0}^{\infty} M (1-m)^k = \frac{M}{m}

To be fair, we never actually go through infinitely many steps, so even with a margin requirement of zero we don’t literally end up with infinite money. Instead, we just end up with n M, the number of steps times the initial money supply. Start with $1000 and go through 4 steps: $4000. Go through 10 steps: $10,000. Go through 100 steps: $100,000. It just keeps getting bigger and bigger, until that money has nowhere to go and the whole house of cards falls down.

Honestly, I’m not even sure why Wall Street banks would want to get rid of margin requirements. It’s basically putting your entire economy on the counterfeiting standard. Fiat money is often accused of this, but the government has both (a) the legitimate authority empowered by the electorate and (b) incentives to maintain macroeconomic stability, neither of which private banks have. There is no reason other than altruism (and we all know how much altruism Citibank and HSBC have—it is approximately equal to the margin requirement they are trying to get passed—and yes, they wrote the bill) that would prevent them from simply printing as much money as they possibly can, thus maximizing their profits; and they can even excuse the behavior by saying that everyone else is doing it, so it’s not like they could prevent the collapse all by themselves. But by lobbying for a regulation to specifically allow this, they no longer have that excuse; no, everyone won’t be doing it, not unless you pass this law to let them. Despite the global economic collapse that was just caused by this sort of behavior only seven years ago, they now want to return to doing it. At this point I’m beginning to wonder if calling them an international crime syndicate is actually unfair to international crime syndicates. These guys are so totally evil it actually goes beyond the bounds of rational behavior; they’re turning into cartoon supervillains. I would honestly not be that surprised if there were a video of one of these CEOs caught on camera cackling maniacally, “Muahahahaha! The world shall burn!” (Then again, I was pleasantly surprised to see the CEO of Goldman Sachs talking about the harms of income inequality, though it’s not clear he appreciated his own contribution to that inequality.)

And that is why Democrats must not give in. The Senate should vote it down. Failing that, Obama should veto. I wish he still had the line-item veto so he could just remove the egregious riders without allowing a government shutdown, but no, the Senate blocked it. And honestly their reasoning makes sense; there is supposed to be a balance of power between Congress and the President. I just wish we had a Congress that would use its power responsibly, instead of holding the American people hostage to the villainous whims of Wall Street banks.

3 thoughts on “The terrible, horrible, no-good very-bad budget bill

  1. Do you take questions from readers?

    Recently there was a story by New York magazine (since revealed to be a hoax) about a high schooler who made millions of dollars in the stock market by trading oil and gold futures.

    Q: What are the different types of trading and how do they add value to economies, i.e. to what extent do traders deserve the money they earn and why?

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    • While there are many different types of strategies used and an ever-growing proliferation of derivatives by which to apply them, trading really boils down to three possibilities:

      1. Investment financing: Traders buy shares of companies that are planning to invest in new equipment, facilities, personnel, etc.; this provides those companies with the necessary funds to make these purchases and expand production. This is the foundation of a capitalist economy; its benefits are enormous, and it is fully justified that investors—in this case the word is apt—be rewarded for their contribution. Typically this is actually done through the bond market, not the stock market, though stock IPOs can also be a major source of real investment financing. The primary difference between stocks and bonds in terms of investment financing is a question of who bears the risk: With bonds, most of the risk lies upon the company, while with stocks most of the risk lies upon the investor. In each case, that higher risk comes with a corresponding chance of a higher return. There’s a famous theorem called the Modigliani-Miller theorem that says it doesn’t matter whether a company uses stocks or bonds for financing, but it should come as no surprise to my readers that this theorem relies upon assumptions that are ludicrous in the real world—no taxes, no bankruptcy costs, perfect information, perfect rationality, and normally-distributed risk. In the real world bonds are almost certainly the better way of financing investment.

      2. Speculation: The classic principle of buy low and sell high, in which thousands of traders clamor for advantage, each hoping that they are smarter than the last and can see trends coming that others cannot. There is a certain temptation of glamour in this, in much the same way that there is glamour in gambling; what if you’re the one in a million who strikes it rich? This is the majority of the stock market and is obviously what that high school student was claiming he did (even though in fact he didn’t). Its impact on the economy is mixed. On the one hand, rational speculation would increase liquidity; the crowd of speculators making trades constantly would ensure that the trades that actually need to happen for real investment can happen on a steady timetable. Moreover, this would tend to stabilize prices, because any deviation from the fundamentals would quickly be speculated away—if the price is too high they’ll sell and lower it, if it’s too low they’ll buy and raise it. On the other hand, the whole point of this blog is that people are not always rational, and large herds of irrational speculation have exactly the opposite effect—they destabilize prices, causing them to swing wildly in every direction as rumors spread or people follow the herd. We can see examples of this as recently as the Tweeter Incident or as far back as the Dutch Tulip Bubble; speculation has been a major problem in real-world markets as long as capitalism has existed. Indeed, it is such a problem that our markets are fat-tailed, meaning that they sometimes have swings so wild that they cannot be captured by a normal distribution. Virtually all of the standard neoclassical risk models—such as the Black-Scholes Model—are based upon the assumption of a normal distribution, which makes them dangerously wrong.

      3. Arbitrage: A handful of traders and hedge funds—the very richest and most powerful—are able to buy low and sell high with little or no risk, because they have access to inside information or tools of market manipulation that are not accessible to outsiders. High-frequency trading is firmly within the arbitrage category—basically the only reason you would ever want to make a thousand trades per second is because you can use this to get in ahead of other people’s trades and thereby shave off a few pennies for yourself at every trade. To get a sense of the figures involve, typical values might be $0.03 per trade times 20,000 trades per second times 86,400 seconds per day = $51.8 million per day. Not a dime of that money has done anything useful for anyone in the world; it’s simply grazed off the top of the economy like cream off of milk, and represents pure loss just as much as if it had been outright stolen. Even worse, the expenditure of expertise and technology involved in maintaining these systems actually represents another loss to the economy, because those people could otherwise have done something useful with their lives. These people should be paying us for the deadweight loss they are causing upon our society.

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