15:   Random Notes to Help our Government Catch Up with Some Neglected Homework

William Krehm

The problems of the world ever more viciously interacting, have produced a challenge that society is ever less equipped to meet. Its capacities to kill have infinitely outstripped its powers of understanding and healing. That is why we are devoting a considerable part of this issue to these failing resources essential for our society’s survival.

The riots began in impoverished suburbs of Paris, City of Light, with marked racial overtones. You couldn’t overlook their alarming parallels with both Iraq and the breakdown of the New Orleans levees. The destruction of social memory snaps the tie between generations. And that in turn converts lengthening life spans into a curse rather than a blessing. For it raises the question: who is going to look after the ever growing retirement costs of the older generation?

That is why I have seized upon an excellent article in The New York Times Magazine by Roger Lowenstein (30/10, "We regret to Tell You That You No longer Have a Pension") that guides us through "America’s Next Debacle."

"When I caught up with Robert S. Miller, CEO of Delphi Corporation, last summer, he was still pitching the fantasy that his company, a huge auto-parts maker, would be able to cut a deal with the workers and avoid filing for bankruptcy protection. But he acknowledged that Delphi faced one perhaps insuperable hurdle – not the current conditions in the auto business so much as the legacy of pension promises that Delphi had committed to decades ago when it was part of General Motors. And as future auto executives would discover, pension obligations – outside of bankruptcy – are virtually impossible to unload.

"For the United Auto Workers, Miller noted forlornly, ‘30 and Out’ – 30 years to retirement – became a rallying cry. Eventually, the union got what it wanted, and workers who started on the assembly line after high school found they could retire in their early 50s. These pensions were created when we all used to work until age 70 and then ‘poop out,’ [i.e., drop dead] at 72. Now if you live past 80, you’re going to take benefits for longer than you’re working. That social contract is under extreme pressure.’

"Earlier this month, Miller and Delphi sought protection under the bankruptcy code – the largest such filing ever in the automobile industry. It followed by a few weeks the Chapter 11 filings of Delta Air Lines and Northwest Airlines, whose pension promises exceeded the assets in their pension funds by an estimated $16 billions.

The Moral Hazard of Insurance

"The under-funding in corporate pension plans totals a staggering $450 billion. Part of this is attributable to healthy corporations that will most likely in time make good on their obligations. But the plans of the companies that fail will become the responsibility of the government’s pension insurer, the Pension Benefit Guaranty Corporation, the PBGC. This collects premiums from corporations and is supposed to be self-financing, but is deeply in the hole, prompting comparisons with the savings-and-loan fiasco of the 1980s. Just as that era took foolish risks, in part because their deposits were insured, the PBGC’s guarantee encouraged managements and unions to raise benefits ever higher.

"Economists in a glum appraisal of human nature, call it ‘moral hazard.’ Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators found it easier to pay off [with] benefits tomorrow than with wages today – especially, when it seemed that every pension promise could be fulfilled by a rising stock market." [Italics are ours.]

It is important to note that not only pension plans have succumbed to "moral hazard," but our economy as a whole has developed a forward lean that mocks gravity. It extrapolates the "rate of growth" already achieved in fact or fiction into the remote future, and then, turning the process around, discounts such future result to its present value and incorporates that into current stock prices. And, of course, the growth rate assumed into the distant future exceeds by far the discount used to arrive at the current value of distant liabilities. That is the sort of game that high finance never tires of playing. Among much else, on those stock prices hangs the worth of the options of high corporative executives. These must exceed the "strike price" of the shares before the options expire. Failing that, the options become worthless. Moreover, when the options are cashed in to become actual shares, they detract from the company’s net value since they add to the dividends that the company must pay.

For years we have emphasized this frequent discrepancy between the optimism with which corporations extrapolate the rate of growth of stock prices achieved in the past into the unknown future that contrasts with far more modest discount rates at which they arrive at the present values of earnings forecast into the distant future.

Many have dismissed such analysis as "too complicated" for the public to grasp. However, no victim of the sudden disappearance of his pension fund will be dumbed down enough to fail to understand that he has been robbed.

The Wall Street Journal (9/11, page C1, "Pension Inquiry Shines Spotlight on Assumptions" by Deborah Solomon and Lee Hawkins Jr.): "The Securities and Exchange Commission, refers to the financial maneuvers that lead to that result as ‘reverse [financial] engineering.’ when corporations change some of the above financial assumptions. And, more specifically, SEC comes up with the precise analysis of the vastly contrasting specifications that many corporations apply in calculating the discount for present value of the forecast liabilities of the pension plan,’ and the interest used to forecast future earnings.

I quote: "Think of it this way: $1 million dollars in cash 10 years from now is worth less than $1 million in cash today. How much less? Well, that’s where the discount rate comes in. The higher the discount rate, the lower the current value of the future liability – and the better funded a plan would appear." It is like a slide in the old-fashioned playgrounds of my childhood – you walked up a steep stairway and then slid down on a gentler, more enjoyable slope. However, that was not taken as the model by the high finance of the day.

One sure conclusion that the SEC should draw from its excellent analysis is this: it provides another reason against making interest rates the sole "blunt tool" for stabilizing the economy. The US Bank Act of 1935 brought in during the Depression, provided two major policy tools for keeping the economy on an even keel. One was to raise the benchmark interest rate at which banks made overnight loans to each other. The other was to vary the proportion of the short-term deposits the banks receive from the public that they must redeposit with the central bank and on which they are allowed no interest. By varying that "statutory reserve" the central bank could stimulate or restrain the economy without varying its benchmark interest rate. That leaves the banks less leverage in financing economic activities throughout the economy. By varying the amount of lending the banks could do instead of raising the interest rates they charge, the central bank could restrict the playground for these "reverse engineering" games. That would reduce the scope of the "moral hazard."

Interest rates are a killer. They hit everything that moves in the economy. They are also the revenue of a potentially greedy group of operators. The very idea that it be left as the sole blunt instrument for "regulating" the economy is spitting in the eye of the Lord. For usury has been condemned by just about every great religion. Strange that the "conservative religious right" should overlook this detail.

However, the official thinking was that in a pure and perfect market in which all actors are of infinitesimal size, and nothing is controlled, matters will work out for the best. And hence the repeat of the requirement that the banks deposit with the central bank a percent of their deposits from the public to allow the central bank by altering that proportion of the deposits they take in from the public that they have to redeposit with the central bank. Ending such reserves left the banks still able to control "the market" by pushing up interest rates. Each of these measures violated the notion of a self-controlled market as much as the other. But the truth is that there is not one market but many markets. Amongst these markets, the most vulnerable are between lenders and borrowers. For on no other market is the disproportion of power so unequal as between those who have little money and must borrow it and those who can drive up interest rates on the money they lend. Why then would a government-owned central bank concentrate on putting the power to control the entire economy in the hands of those whose revenue provides the financial engineering that runs the entire economy? Clearly what is involved is a power grab.

Twelve years ago, in browsing through the shelves of the Robarts Library of the University of Toronto, I came across a dusty pamphlet, put away in a box and apparently hidden or forgotten. It was written by Henry H. Schloss, a professor at New York University entitled The Bank for International Settlements, published in 1970. It set forth that "The BIS was set up in 1930 to manage the transfer of Germany’s reparation payments to the victors of the First World War. BIS shareholders were to consist entirely of central banks, but because the US Federal Reserve was unwilling to participate, a syndicate of American commercial banks (J.P. Morgan & Company, the First National Bank of New York, and the First National Bank of Chicago) took up the US subscription.

Momentous Goings-on over a Pastry Shop In Basel, Switzerland

"The BIS voting rights are permanently reserved to the original members in proportions to the shares originally subscribed by them, even though they may have sold some of their shares in the interim." BIS seems allergic to anything even remotely smacking of democracy.

In keeping with that bias, wrote Schloss, "The purpose and functions of the IMF are widely known, while those of the BIS remain somewhat clouded and mysterious. To safeguard the ‘independence’ of BIS, a director of BIS shall not be an official of a government or a member of a legislative body, unless he is governor of a central bank."

Like the good Lord in heaven, BIS sought to fashion central banks in its own image – independent of their governments, no matter what their charters might say.

The Bank of Canada was nationalized in 1938 when the government of Mackenzie King bought out 12,000 shareholders for a good profit less than four years after they had acquired their shares. And profits of any sort were as scarce as hens’ teeth during the 1930s. The Bank of Canada’s charter sets forth explicitly how in the event of the government and the Bank of Canada disagreeing on monetary policy, the Minister of Finance may give the BoC Governor instructions and sets forth explicitly that within 30 days "the Bank shall obey them."

Nevertheless it was on the say-so of the BIS that Brian Mulroney, our Prime Minister at the time, wanted to put the independence of the Bank of Canada from the government in our very constitution. That was prevented only by the unanimous vote of the caucuses of all three major parties of the Commons Finance Committee – including his own. That is why we have an anomaly as remarkable as the Leaning Tower of Pisa, of the government ignoring its own rights of ownership of the central bank set forth in its charter in great detail, and pretending non-ownership and having the Bank of Canada follow instructions not only from an outside body that excludes any member of a legislative body attending its sessions. To add further spice to this rotten salad, we might mention that BIS is listed on the Paris stock exchange, and when you hear about its valuable holdings of Basel real estate you might even be tempted to pick up some shares of it. Apparently its shareholders are looked after better than Canada’s government watches over our taxpayers’ investment in the Bank of Canada.

As I shook off the dust from the Schloss pamphlet, more amazing revelations unfolded: "One of the major stigmas attached to the reputation of the Bank in the 1940s was a widespread feeling that it had been pro-German during the interwar period and collaborated and appeased Germany in the 1930s and during the war. In fact, the charge of collaboration with the Axis was an important reason why the BIS was not transformed into the preeminent monetary institution in the early postwar period. The International Monetary Fund was created instead.

"These charges of collaboration by the Bank [with the Nazis] have been investigated in considerable detail by the author. The Bank may have been guilty of appeasement in the late 1930s. But the charges of pro-German conduct by the Bank during the war are essentially unfounded." [Italics ours.]

At the Bretton Woods Conference towards the end of WWII a resolution was passed for the liquidation of the Bank at the earliest possible moment. It was initiated by the Norwegian government-in-exile, and passed without opposition. But by 1951 the dissolution of BIS was a dead issue. By then the banks were well advanced towards retaking the positions surrendered during the Depression. "In March 1951 President Truman assented to a negotiated settlement between the Treasury and the central bank agreeing to slightly higher rates and granting minor flexibility to the Fed." Within two years, however, Fed officials claimed a more sweeping interpretation of the Treasury-Fed agreement. It was, they attested, a declaration of full independence for the central bank. By that point, the Liberal Democrats were gone from the White House. Banks on the comeback trail had need for an international bunker. BIS filled the bill to perfection. Since the peace had brought left-of-center governments to power in all key countries, the banks’ comeback campaign had to be organized outside and to an extent against governments. That created the need for a semi-underground bunker as war-room for the comeback campaign. Resolution Five at Bretton Woods had imposed just such a low-profile posture on BIS. Forbes during this period told of the difficulty of locating BIS on arriving in Basel – some of its offices were actually located over a pastry shop. Fake-Greek columns favoured by banks of the period were avoided. Some very special banking recipes laced with social arsenic were devised and sent out to the world from the offices over that pastry shop. They had more to do with the fate of the world since then than any elected parliament.

When the Supreme Saviour Lost Track of Its Busybodying

In December, 1994, the Mexican monetary system collapsed mostly under the incompatibility of the two prongs of policy imposed by BIS. One launched in 1988 was directed to heading off the imminent bankruptcy of banks throughout the world resulting from the removal of many of the restrictions imposed on them during the depression. Amongst these was the ban on banks acquiring interests in the non-banking financial pillars – stock markets, insurance and mortgages.

In 1988 BIS brought in its Risk-Based Capital Requirements Guidelines that declared the debt of developed countries risk-free and hence requiring no capital reserves for banks to load up with. That permitted them to confine themselves to clipping coupons to make good their capital losses.

From the taxpayers’ point of view the arrangement was less attractive. When the central bank held central government debt, most of the interest paid on it came back to the government as dividends, for government was the BoC’s sole shareholder. At the same time the statutory reserves that banks had to deposit with their central bank as a proportion of the deposits taken in from the public were done away with in lesser lands like Canada and New Zealand, or diminished to insignificance in the US and the UK. Those statutory reserves earned the banks no interest, and they provided the central bank with an alternative to raising the benchmark interest rate to "fight inflation." What the BIS and the central banks overlooked was that if interest rates were pushed up, the market value of the banks’ bond hoards specially designed to rescue them from bankruptcy, would take a disastrous beating and undermine their solvency once more.

As COMER forewarned, the result would be like two powerful trains approaching each other at full speed on the same track head on.

To head off the disaster, President Clinton, without the backing of Congress, got together a $51 billion standby fund with the help of the IMF and Canada. Ripple effects of the crisis did help bring on the East Asian meltdown and the Russian default of 1998.

A no less significant consequence of that crisis, was put in place by Clinton’s Secretary of the Treasurer, Robert Rubin, a savvy alumnus of Wall St. He concluded that the age of high interest rates was over – precisely because of the huge bond reserves that the banks were holding as the instrument of their bailout made them vulnerable to interest rate increases.

The real problem arose from Clinton’s principle of never surrendering the political centre. Up to then, when Washington built a highway bridge, or a building, it treated it as a current expenditure. Like a purchase of floor wax: it was written off in the year when it was built or acquired, though it might last for a half century. That had a chain of consequences. In the year of the purchase or construction it added needlessly to the taxes that had to be raised to balance the budget, and hence added to the growing layer of taxation in price that had nothing to do with an excess of demand over supply. Thirty-five years ago, in a paper published in the leading French economic journal, I had made the neglected point that the price index may go up for very different reasons. There could be an excess of aggregate demand over supply, and that I call "market inflation." But such an increased price level might simply signify that more essential capital investments had been made by government and paid for by increased taxation. This I called the "social lien." It reflected not "inflation": but the development of a mixed economy due to the increased cost of public infrastructures to make possible new technologies, our increased population and rapid urbanization, and many other social changes that had to be accommodated. Raise interest rates and you will increase the layer of taxation since it will increase costs in both the private and public sectors.

For decades royal commissions and auditors-general in Canada had recommended the bringing in of accrual accountancy (also known as capital budgeting). To no effect. Instead the deficit, even when it arose from the mistreatment of investment as a current expense, was taken as an occasion for raising interest rates. Rubin managed to work around the ideological barrier involved. He made the adjustments over several years necessary to retrieve some $1.3 trillion and they first appeared in the statistics of the Department of Labour under the heading of "savings." This they certainly were not. Especially since John Maynard Keynes, "savings" has implied cash reserves, whereas most of the undepreciated physical investments of the government are in roads bridges, buildings, equipment. But the political "centre" that Clinton so desired to keep, holds that government cannot be seen as making investments. But it is a tradition in government when facts cannot be presented in the government’s books in accordance with double-entry bookkeeping, that a wink and a nudge to the bond rating agency does the trick. They understand what must not be uttered in circles that really count. The furtive introduction of accrual accountancy into Washington’s books was enough to bring down interest rates, give Clinton his second term, and Canada the boom that climaxed in the high-tech bust of 2000.

Clinton Practices Virtue Like Thieves in the Night

However in Canada Paul Martin, as Finance Minister in the Chrétien cabinet, resisted the insistence of the then Auditor-General Denis Desautels that Canada, too, depreciate its physical investments over their useful lives. Desautels refused unconditional approval to the government’s balance sheets of two years until this was done. In the weeks of wrangling with Finance Minister Martin in 1999, he went so far as to use the expression "cooking the books." Eventually a compromise was reached demeaning to both parties and to the country as a whole. Accrual accountancy was brought in, and unlike what had happened in the US was actually named; but the Auditor-General was obliged to issue a statement that the improved balance sheet that resulted must not be taken as a justification for increased programs, since no "new money" had been brought into the Treasury. Yet when the banks had been bailed out by shifting $60 billion of government debt to the private banks, plus the end of the statutory reserves by which banks redeposited ("interest-free") 8% to 12% of the public’s deposits made into their chequing accounts, grants to the provinces had been cut. The provinces in turn passed on the courtesy to the municipalities.

In the United States partial capital budgeting has been brought in surreptitiously. Completely forgotten was the widely applauded recognition 25 years earlier that investment in human capital was the most productive investment a country could make. The disappearance of the government deficit was attributed to the prudent financial policy of either government.

That is why surpluses could be used largely for military adventures in the US and for the bailout of our banks from their unsuccessful adventures abroad, in the case of Canada, while vital social programs go underfunded and cut back under the labels of "externalities." Economic faculties have been cleansed of dissenting teaching personnel, tenured and untenured. Even the Keynesian model that helped lift the world out of the Depression, made possible the financing of WWII, and the brilliant achievement of the first quarter of a century of postwar catchup is no longer acceptable. University textbooks and the media have been purged to bring economic theory essentially back to what had been taught and believed until 1929. Without, however, the considerable freedom of discussion that existed in that remote period. Without adequate information and access to our history, democracy is pipe-dream. To remedy the damage done in the course of our banks’ comeback, we need a Royal Commission that will have the authority and will to restore our right to know our own economic history. Without that, society is doomed.

William Krehm

– from Economic Reform, December 2005