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Federal Unaccountability Beyond My Wildest Dreams

06 Friday Apr 2018

Posted by pnoetx in Big Government, Federal Budget

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Accounting Adjustments, Black Projects, Catherine Austin Fitts, Congressional Budget Office, Department of Defense, Department of Housing and Urban Development, Forbes, General Accounting Office, Government Waste, Graft, Journal Vouchers, Laurence Kotlikoff, Mark Skidmore, Office of the Inspector General, Special Access Programs, The Solari Report

In December, Laurence Kotlikoff wrote in Forbes about large chunks of federal spending over many years that have not been reconciled with known accounting transactions. (The link is to a cached version of Kotlikoff’s article because Forbes blocks its site to those using adblockers). I first learned of these massive discrepancies at The Solari Report, which covered the issue in February. At first, I was so dumbfounded by the numbers that I thought it might have been a joke, or worse: fake news on Solari? But the story is real and it is shocking: $21 TRILLION of spending that cannot be explained, spanning the years 1998-2015! That’s more than five times the level of federal spending in 2017. It’s also shocking that the gap has gone almost unnoticed by the news media, though a few specifics have garnered attention at different stages of the disgorgement, as demonstrated by the various links provided in the Solari article.

The discrepancies are concentrated mainly in two departments of the federal government: Defense (DOD) and Housing and Urban Development (HUD). Kotlikoff quotes a description of the “accounting adjustments” from the Comptroller General of the General Accounting Office (GAO). These adjustments are akin to the entries people make in their checkbook registers when the balance can’t be reconciled to their bank statement:

“‘Journal vouchers are summary-level accounting adjustments made when balances between systems cannot be reconciled. Often these journal vouchers are unsupported, meaning they lack supporting documentation to justify the adjustment or are not tied to specific accounting transactions…. For an auditor, journal vouchers are a red flag for transactions not being captured, reported, or summarized correctly.'”

The article at Solari makes the following observations:

“There appear to be at least five possibilities: 1-The missing money was spent appropriately, but existing accounting infrastructure is incapable of tracking it. 2-The money was “wasted,” i.e. spent unwisely. 3-The money was directed into black projects and Special Access Programs in massive amounts outside the Constitutional appropriations process, and therefore without the knowledge of Congress and the citizenry, for purposes unknown. 4-The money was used to manipulate markets to maintain the reserve status of the dollar. 5-The money is being stolen by fraud and collusion between government and private interests. Or perhaps a combination of all of these.“

All five explanations represent a form of failure of governance or government administration. Some are more nefarious than others. While #1 might seem fairly innocuous, it nevertheless would demonstrate a slovenly approach to record-keeping and accountability as well as a ripe temptation to anyone seeking opportunities for graft. Furthermore, one cannot trust that #1 is the full explanation. The amounts are so massive that they far exceed the waste in government that even I thought possible. And no one in the federal agencies seems to have an explanation. Mark Skidmore, a Michigan State University economist who has studied the issue and made inquiries with these agencies, describes what sounds like a runaround. In December, however, the DOD announced a positive step: it’s first-ever department-wide independent audit. The Office of the Inspector General (OIG), the Congressional Budget Office, and the General Accounting Office are certainly aware of the discrepancies. Links to supporting documentation at the OIG and DOD web sites appear in both the Solari and Kotlikoff articles.

If these funds have been wasted or misused, taxpayers are the victims, of course. There are a few well-known examples of private and even public companies that have victimized investors to perhaps a similar (proportionate) extent over the years. Bernie Madoff and Exxon come to mind. But in general, public companies cannot escape demands that their books be in order and that they produce value over time. The federal government, however, has received a pass for this fecklessness over many years. Perhaps it’s because the public has such low expectations for the government’s effective use of tax dollars. Federal agencies such as HUD and DOD seem almost as budgetary “black holes” into which tax dollars are sucked, with an apparent lack of scrutiny.

Kotlikoff closes by urging a thorough investigation into the government’s cockeyed accounts:

“Taken together these reports point to a failure to comply with basic Constitutional and legislative requirements for spending and disclosure. We urge the House and Senate Budget Committee to initiate immediate investigations of unaccounted federal expenditures as well as the source of their payment.”

The Solari piece is no less emphatic in demanding a full probe of the causes of the budgetary discrepancies:

“We must recognize the possibility that massive fraud is being perpetrated against the American people. If that is not the case, it would take relatively little effort and expense to put that concern to rest. On the other hand, what malfeasance might investigation reveal, and who might be responsible?

At the very least, we should be asking the secretaries of DOD, HUD, and the Treasury, the chairman of the Federal Reserve, and the President of the NY Fed what they know, and we need independent audits of all those entities plus the Exchange Stabilization Fund. Anything less will be to acquiesce in an ongoing financial coup d’état.“

Bankers, Risk and the Rents of Slippery Skin

12 Monday Mar 2018

Posted by pnoetx in Banking, rent seeking

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Deposit Insurance, Fannie Mae. Freddie Mac, Fat Tails, FDIC, Fractional Reserves, Frank Hollenbeck, GSEs, Guatam Mukunda, Gvernment Sponsored Enterprises, Irving Fisher, It's a Wonderful Life, John Cochrane, Laurence Kotlikoff, Milton Friedman, Nassim Taleb, Ralph Musgrave, rent seeking, Skin in the Game, Too big to fail

Risk taking is important to the economic success of a nation. Creative energy demands it, and it is critical to achieving economic growth and wealth creation. But it’s obviously possible to take too much risk or risks that are ill-considered, and that is all the more likely when risk-takers are absolved of the consequences of their actions. That is, healthy risk-taking and responsibility are inextricably linked. One can’t truly be said to take a risk if the cost of failure is borne by another party. It’s easy to understand why risk-taking becomes excessive or misdirected when that is the case.

Risk Shifting

There are various ways in which a party can parlay risky undertakings into easy gains by shifting the risks to others. For example, any piece of merchandise comes with the risk that it will not perform as advertised. Some traders might be tempted to sell unreliable merchandise and shift risk to the buyer without recourse. This is an area in which we must rely on a bulwark of private governance: caveat emptor. On the other hand, government tends to subsidize risk-taking in various ways: limited liability under the corporate form of business organization, bank deposit insurance, bankruptcy laws, the implicit government guarantee on mortgage assets, and the “too-big-to-fail” mentality of government bailouts.

Whose Skin In the Game?

These are examples of what Nassim Taleb bemoans as the failure to have “skin in the game”. The quoted expression happens to be the title of his new book. I have both praised and castigated Taleb’s work in the past. He made an interesting contribution about the nature and risk of extreme events in his book “Black Swan”, such as his application of so-called “fat tails” in probability distributions, though some have claimed the ideas were anything but original. I was highly critical of Taleb’s alarmist hyperbole on the effects of GMOs. In the present case, however, he considers “the asymmetry of risk bearing” to be a major social problem, and I’m generally in agreement with the point. The most interesting part of the brief discussion at the link is the following:

“In Taleb’s universe, the fieriest circle of hell is reserved for bankers and neoconservatives. ‘The best thing that could happen to society is the bankruptcy of Goldman Sachs,’ he tells me. ‘Banking is rent-seeking of industrial proportions.’ Taleb, who became rich as a derivatives trader, is not a foe of capitalism but of ‘cronyism’. ‘If you’re taking risks, God bless you. This is why I accept inequality. I’ve seen people go from trader to cab driver and back again.’“

Banks are a prominent example of the risk-shifting phenomenon. First of all, banking institutions are not required to hold much capital against their assets. In fact, recently banks have had average equity of less than 6% of assets. That’s much higher than during the financial crisis of ten years ago, but it is still rather thin and hardly represents much “skin in the game”.

Fractional Reserves

It should come as no surprise that a bank’s assets are funded largely by account balances held by depositors (liabilities), and not by equity capital. But your bank balance is not kept as cash in the vault. Instead, it is loaned out to the bank’s credit clients or used to purchase securities. This is facilitated by “fractional reserve banking”, whereby banks need only keep a fraction of their depositors’ money on hand as cash (or in their own reserve deposit accounts with the Federal Reserve). This generally works well on a day-to-day basis because depositors seldom ask to redeem more than a small fraction of their money on a given day.

Reserve requirements are set by the Federal Reserve and range from 0-10%, depending on the size of a banks’ deposit account balances. At the upper figure, a dollar of new cash deposits would allow a bank to extend new loans of up to $0.90. This legal practice divides many in the economics profession. Some believe it represents fraud rather than sound banking. This article by Frank Hollenbeck at the Mises Canada web site states that it is improper for a bank to lend a depositor’s money to others:

“Suppose you lived in the 18th century and had 100 ounces of gold. It’s heavy and you do not live in a safe neighborhood, so you decide to bring it to a goldsmith for safekeeping. In exchange for this gold, the goldsmith gives you ten tickets where eachis clearly marked as claims against 10 ounces. …

… Quickly the goldsmith realizes there is an easy, fraudulent, way to get rich: just lend out the gold to someone else by creating another 10 tickets. Since the tickets are rarelyredeemed, the goldsmith figures he can run this scam for a very long time. Of course, it is not his gold, but since it is in his vault, he can act as though it is his money to use. This is fractional reserve banking with a voluntary reserve requirement of 50%. Today, modern US banks have a reserve requirement of between 0% and 10%. This is also how the banking systemcan create money out of thin air, or basically counterfeit money, and steal the purchasing power from others without actually having to produce real goods and services.”

Another aspect of the argument against fractional reserves is that it creates economic instability, fueling booms and busts as the quantity of money in circulation sometimes exceeds or falls short of the needs of the public. Many authorities have taken a negative view of fractional reserve banking through the years: Irving Fisher, Milton Friedman, John Cochrane, Ralph Musgrave, and Laurence Kotlikoff, to name a few prominent economists (see this recent paper by Musgrave).

In Defense of Fractional Reserves

Others have defended fractional reserves as a practice that has and would again arise in a free market environment. According to this view, depositors would accept the logic of allowing banks to lend a portion of the funds in their accounts in order to generate income, rather than charging larger fees for “storage” and administration. If the depositing public is aware of the risk and has competing choices among banks, then the argument that banks expose depositors to excessive risk via fractional reserves is moot. Fractional reserves can exist in a private money economy in which competitive pressures reward banks (and their privately circulating notes) having sound lending practices. In fact, some would say that the very idea of a 100% reserve requirement is an unacceptable government intrusion into the private relationship between banks and their customers. All of that is true.

Some have compared fractional reserve banking to the sale of insurance. Consumers buy insurance to take advantage of pooled risk, but they have no expectation of a refund unless they incur the kind of insured loss in question. Bank depositors, on the other hand, expect a return of their funds in-full. Yes, low risk is an attribute they desire, and pooling across the withdrawal needs of many depositors is one reason why banks can invest and pass a part of the return on to depositors, both in interest and reduced fees. So, despite the differing needs and expectations of their customers, there is some validity to the comparison of insurers to fractional-reserve bankers.

Amplification of Shifted Risks

Do fractional reserves allow banks to take risks without having skin in the game? Absolutely! With as little as 6% equity at risk, banks have relatively little to lose relative to depositors. Yes, banks pay the FDIC to insure deposits, and premiums are higher for riskier banks. However, not all deposits are insured by the FDIC. More importantly, at the end of 2017, the entire FDIC deposit insurance fund was about 0.7% of commercial bank assets. One big bank failure would wipe it out, or a few hundred small ones. That’s well within the realm of possibility and historical experience. So, where does that leave depositors? Their skin is very much in the game, and the game is about the risks taken by banks in investing depositors’ funds.

We now live in the era of “too-big-to-fail” (TBTF), whereby large banks (and sometimes industrial firms) are viewed as so “systemically important” that they cannot be allowed to fail. Taxpayers must bail them out in the event they become insolvent. Thus, taxpayers have skin in the game. Banks collect rents to the extent that their returns exceed those commensurate with the risks for which they are actually “on the hook”.

Another avenue through which banks off-load risk is the extent to which Fannie Mae and Freddie Mac are still presumed to have the federal government’s implicit guarantee against default on the mortgage debt they purchase from banks. That is beyond the scope of the present discussion, however. And I have not discussed the role of large investment banks in the capital markets. That’s a whole other dimension of the story. This article by Guatam Mukunda in the Harvard Business Review provides a perspective on rent seeking in investment banking.

Conclusion

The combination of deposit insurance, TBTF and other risk-insulating subsidies, layered on top of a fractional reserve banking system, places banks into Taleb’s “fieriest circle of hell”. These factors blunt bank incentives to manage risk effectively as well as consumer incentives to conduct adequate due diligence in their banking relationships. It means that risk is not priced properly, because banks are likely to ignore risks from which they are shielded. Therefore, banks may allocate resources into excessively risky uses. The consequences for depositors and taxpayers can be dramatic.

Fractional reserves are not “fraud” in the sense that the system has unsuspecting victims. Anyone who has watched “It’s a Wonderful Life” knows that banks lend your deposits to others. But fractional reserves magnify the risk-mitigating privileges conferred upon the banking industry by government through various mechanisms. This “risk-cleansing” is converted to rents and collected by banks for their shareholders, but the risks are still borne by society. To the extent that fractional reserves create instability, deposit insurance is viewed as a necessity, but banks should pay a market premium to an insurer to cover the actual risk inherent in the system. Too-big-to-fail should end, as should the implicit subsidy collected by banks through the government-sponsored enterprises.

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