The long run-up to the sequester began during the summer of 2011, when Congress and the Administration failed to reach a budget deal.  Their “solution” was the Budget Control Act of 2011, which mandated–among other things–that if no agreement was reached by the end of 2012, most agencies would be forced to impose 5% across-the-board budget cuts.

The thinking behind the 2011 law was that our elected leaders would never allow a sequester to happen.  A thoughtful, even surgical cutting of the budget?  Fine.  But wielding a 5% meat axe would be so unpalatable that our elected representatives would never let it happen.

Guess again.  Furloughs are here, and all manner of federal programs are under threat.

Unless, of course, you are well-connected.

As soon as furloughs reached air traffic controllers, leading to several hour airport delays, legislation exempting the Federal Aviation Administration from the worst of the sequester was introduced.

Don’t get me wrong.  Getting air travel moving again is a great idea.  But this latest legislative maneuver is clearly aimed at placating a relatively well-off group–that is, frequent fliers.  This group, of course, includes many members of Congress.

It makes me wonder what other special exceptions our elected representatives will carve out while they are busy not solving the pressing national issues we sent them to Washington to fix.

Agriculture Department meat inspectors have been spared, suggesting that carnivores also constitute an especially powerful lobby. I just hope that scientific and medical research–e.g., the National Institutes of Health, the National Science Foundation–has equally powerful friends! [Disclaimer: My wife and I are recipients and/or prospective recipients of NSF and NIH funding; even if we weren't, I would still place a high priority on curing cancer.]

Program-by-program exceptions will both  circumvent the incentives that the Budget Control Act was supposed to impose on the politicians.  And it will justify a redistribution of federal spending toward programs with a lot of constituents and, even better, well-connected constituents, while others are starved for funding.

This is no way to make budget policy.

Sadly, the proposal does not go far enough.

I have written about Libor on a number of occasions (see here, here, and here, for example) and was interviewed by Law360 on the subject a few days ago.  As currently constituted, Libor is constructed by averaging the estimates of the cost of funds submitted by less than two dozen large financial institutions.  And, as we discovered last year, these estimates have not always been made in good faith.

The incentive to “cheat” in Libor submissions is strong.  So strong, that no matter how effective the regulatory structure or diligent the regulators, cheating will eventually reemerge.

A better solution would be for the new benchmark to be based on a highly visible, market-determined interest rate (there a number of possible candidates), which cannot be altered by any individual participant.  The most important characteristic of the new benchmark is that those who engage in financial transactions that depend on it are confident that the rate is not being manipulated.  If they are not, they will withdraw from those transactions and the economy will be poorer.

The IOSCO committee that issued the report was chaired by Gary Gensler, Chairman of the US Commodity Futures Trading Commission, and Martin Wheatley,  the chief executive of the UK Financial Conduct Authority.  In justifying the report’s conclusions that the benchmark be tied to observable transactions, Gensler said “To promote market integrity, it is critical that benchmark interest rates be anchored in observable transactions and supported by appropriate governance structures.”

Better government oversight would certainly help deter cheating. Wouldn’t it be simpler– and more effective–to make it impossible to cheat by instituting a market-based benchmark?

John Simon Guggenheim Memorial Foundation Press Release, April 11, 2013

John Simon Guggenheim Memorial Foundation Announcement in New York Times, April 11, 2013 (Page A9)

That is how we should all feel about the crises that have rocked the financial world during the past few years.  A bunch of highly paid suits took way too much risk and made the rest of us poorer.   They walked away with pay and bonuses in the millions.

There ought to be a law against it.

There soon will be.  Thanks to European lawmakers, rules will soon limit bankers’ bonuses to no more than their base pay (twice their base pay, if bank shareholders agree).  The law will apply to European banks and their subsidiaries operating in the United States as well as to American bankers working in Europe, including the financial hub of London.

In other words, a banker making a base salary of $1 million per year will “only” be able to collect an additional $1 million in bonuses.  It is not uncommon for bankers to pull down bonuses equal five, ten, or even greater multiples of their base salary, so the law will have a dramatic effect on how bankers are paid.

Reining in bankers’ pay will no doubt be politically popular, particularly among those of us who take home salaries that don’t hit seven or and eight figures.

Ultimately, however, the new law will be both ineffective and self-defeating.

The law’s intent—to rein in bankers’ pay–will be easy to evade.  If a bank wants to pay its CEO $10 million, it can set a base salary of $5 million.  If the bank fails miserably, the banker will still walk away with a cool $5 million.  Hence, it is conceivable that the law will lead to an increase in bank CEO pay—including the pay of ineffective CEOs—which is probably not what European lawmakers intended.   This is already happening.

Contrast that outcome with the consequences of retaining the current system, in which a poorly performing CEO with a base pay of $1 million will earn at most $1 million.  Sure, $1 million seems like a lot to pay a failed banker—but it is a lot less than $5 million.

History provides a better mechanism for holding bankers financially accountable and discouraging the sort of high-risk behavior that got us into this mess in the first place.

During the 19^th century, bank shareholders and managers–who were required to be substantial shareholders–were often subject to double liability, meaning that if they invested $100 in a bank, and the bank failed, creditors could sue them for $200.  Further, the shareholder was often subject to double liability for as long as three years after they had sold their stock in the firm, making managers think beyond their next paycheck and reducing their appetite for risk.

One way for modern corporate boards to replicate this result would be for them to make some portion of a CEO’s annual salary depend on the bank’s future performance.  This could be accomplished by including warrants or stock options that could only be exercised if the share price remained above some target value three years after the CEOs’ departure.

Such a system will be more likely to rein in CEO pay, particularly of ineffective CEOs.  More importantly, it will give CEOs an incentive to focus on the long-term health of their institution and hold them accountable for the consequences—both good and bad—of their leadership.

This would be a lot more effective than legislating limits on pay.

And it will make all of us feel better knowing that bankers, like professional baseball players, will be paid on the basis of performance.

The problem was first diagnosed in Ireland in January, but it very soon became clear that its tentacles extend to Britain, France, the Netherlands, Luxembourg, Sweden, Romania, and Cyprus.

What is this latest catastrophe?  Why, the great European horsemeat scandal of 2013, of course.

News of the scandal first became public when Irish authorities announced that they found horse meat in some beef burger products sold in British supermarket chains.  It was discovered subsequently that horsemeat had found its way into a variety of frozen food products, including moussaka, beef lasagna, and spaghetti Bolognese.

Europeans are up in arms, quite rightly, for having purchased one product and being fed another.

The British are doubly horrified because, in addition to their disgust at being fooled, they are inordinately fond of horses and the notion of consuming them has led to national revulsion.

The explanation most commonly given for the horsemeat scandal is the long and winding supply chain involved in the meat processing business.  Newspaper accounts detail the complex route that the horsemeat took from a slaughterhouse in Romania, via agents in the Netherlands and Cyprus, to a French-owned processing plant in Luxembourg, which produced the finished product for a Swedish-owned company.

These stories frequently highlight the complex networks through which meat travels internationally and the presence—or absence—of government controls over those international transactions.

And they should make us think about another area of commerce in which international transactions take place with insufficient regulatory oversight, namely, finance.

Consider the following excerpt from a recent article in the Wall Street Journal about the horsemeat scandal:

“The furor has raised concerns about the complex network of slaughterhouses and suppliers that handle food on its way to the dinner table and the controls governing food transported across borders.”

Replace “slaughterhouses and suppliers” with “banks” and “food” with “money” and the story could easily be from the financial pages.

Given the complexity of the meat supply chain, the best way to protect the meat supply is with Europe-wide regulation and supervision.

The same can be said for banking.

And, in fact, the Europeans have made a good start toward safeguarding their financial institutions.  In December, the European Union began the process of creating a banking union by making the European Central Bank the main banking supervisor and giving it the authority to enforce a common rule book for European banks.

More needs to be done to shore up European banking, of course.  The common rulebook must be finalized.  Money must be raised to fully fund the European Stability Mechanism, the European Union’s bailout facility.  The proposed Europe-wide deposit insurance fund needs to be firmly established.  And European banks need to raise money so they do not fail in large numbers the next time the economy slows.

Despite this long “to-do” list, the December agreement was a step in the right direction.

The horsemeat scandal reminds us of the importance of effective government regulation—both in the US and in Europe–and in particular of the importance of such regulation when the activity that is being regulated is multinational and complex.

We shouldn’t horse around with financial stability.

It seems to have taken a while–and some distance–for that memo to get through.  In evidence before a the House of Commons Treasury Committee earlier this week, Bank of England Deputy Governor Paul Tucker raised the issue, although stressing that action on this possibility was not imminent.

According to the Financial Times, “…the deputy governor cautioned that this was a “radical idea” that was “not something anyone should clutch on to as the answer to the universe…This would be an extraordinary thing to do and it needs to be thought through very carefully.”

I am glad to see that it is under consideration.

The government’s decision to prosecute a statistician indicates that the upgrade was premature.

According to S&P, the ratings change “balances our view of euro-zone member states’ determination to support Greece’s euro-zone membership and the Greek government’s commitment to a fiscal and structural adjustment against the economic and political challenges of doing so.”

And, indeed, European governments and institutions, particularly the European Central Bank, have made it clear that they are prepared to go to great lengths to save the euro,  including propping up Greece.

For their part, the Greeks are putting up with difficult austerity measures, resignedly, if not stoically, in order to remain in the euro-zone.

According to Greek Finance Minister Yannis Stournaras, “It is a very important decision, but there is no room for complacency. It is a decision which creates a climate of optimism, but we know that the road is still long and uphill.”

Nonetheless, the government’s decision to prosecute the Greek statistical agency’s (Elsat) Andreas Georgiou indicates that Greece still falls well short of “investment grade.”

Georgiou, a long-time international civil servant who was brought in to clean up Elsat, faces life in prison, standing accused of having overstated Greece’s deficit.  An NPR Planet Money podcast suggests Georgiou is resented within Elsat because of his efforts to introduce modern, internationally accepted standards.   An editorial in yesterday’s Financial Times cites senior Greek officials who state that Georgiou is being made a scapegoat in a political battle over who should bear the blame for the country’s austerity.

The Financial Times concludes: “Shooting the messenger will not make that truth disappear.”

The reality is far worse.  Shooting the messenger means that we can’t trust the data coming out of Athens.  That should make investors, governments, and ratings agencies nervous.

The news puts these elite universities in the company of financial giants Barclays Bank, the Royal Bank of Scotland, and UBS, which have also been busted for cheating of a different sort.

Barclays, RBS, and UBS have all been implicated in the Libor scandal.  Recall that Libor, a widely used benchmark interest rate, is determined by averaging the self-reported borrowing costs of several large financial institutions.  Reporting artificially high interest rates earned the cheaters increased profits on loans tied to Libor; reporting artificially low rates made them seem as if they were awash with funds when financial markets froze up the appearance of security suited them.

Given the huge amounts of money involved—about $800 trillion in financial transactions are tied to Libor—the incentive to cheat is pretty obvious.  But universities?  Surely, these non-profit bastions of enlightenment wouldn’t stoop so low.  After all, where is the profit?

It turns out that by inflating the average test scores and class ranks of their incoming students, university administrators hoped to boost their standing in the all important US News and World Report annual scorecard of US colleges and universities.

Universities have been gaming the USN&WR ranking for some time.  For example, schools are given higher marks for having more courses with fewer than 20 students.  Many universities—my own included–offer a number of courses with enrollment caps of 19 or less, which I suspect they do for purposes of bolstering their rankings.

This sort of gaming is widespread, well-known, within the rules, and harmless.  But falsifying scores to achieve a higher ranking is fraud.  And universities, banks, and professional athletes will continue to commit fraud, as long as we live in an “it’s OK because everybody is doing it” society.  No wonder Americans have less faith in their institutions than they did 10 years ago.

There are no easy answers to these cheating problems.  The most effective response is to increase transparency and enforcement, and to change the incentives for the cheaters.

To address university cheating, USN&WR ought to make clear what data are provided by the universities themselves and which are gathered from independent sources.  They could also create a second set of rankings, based on the independently reported data only, to provide skeptical consumers with a completely unbiased measure.  Because student data is typically private, there is no simple way of mandating truthfulness when it comes to reporting test scores or class ranks.

To attack cheating among financial firms, a much greater public policy concern, the authorities must take decisive action, first and foremost by changing rules and regulations that rely on bank self-reporting.

Libor should be based on publically available market-determined rates, rather than on unverified data reported by banks.  Current rules which give banks a large say over how much of a capital reserve they need to hold, should be modified.

Bank examination should be made even more rigorous.  The stress tests recently instituted for large US financial institutions are a good start in that direction.

Finally, banks—and managers—must have more “skin in the game.”  A bank official who leaves his bank in a mess—and society with substantial clean-up costs—should not be able to ride off into the sunset with his bonus intact.

Cheaters frequently do prosper.  But we can and should make it harder for them to do so.

Happy reading!

“A Tale of Two Coins”

Until the Administration publicly nixed the idea a few days ago, speculation had run rampant that the Treasury would mint a $1 trillion platinum coin to bypass Republican opposition in Congress during the upcoming fight over the debt ceiling.

Although avoiding a divisive political battle was no doubt tempting, the Administration was wise pass up this particular opportunity to make history.

The idea behind the platinum coin frenzy was simple.  Current law gives the Secretary of the Treasury permission to mint coins.  For small change and commemorative gold and silver coins, the statute law defines the dimensions, weight, and face value in excruciating detail.  The law also allows the Secretary to issue platinum coins, but does not specify which denominations are permitted.

Hence, it appears that there was no legal obstacle to the Secretary issuing a $1 trillion platinum coin.

Because the coin would be legal tender, the Secretary could have deposited it at the Federal Reserve, used the proceeds to pay down the government’s debt, and avoid our collision with the debt ceiling.

Although minting a single coin could have prevented us from repeating the embarrassing spectacle of our elected leaders demonstrating that are more interested in getting their way than in governing.

Minting a $1 trillion coin was clearly not the right thing to do.  History provides many examples of the havoc that can result from playing fast and loose with the currency.

A government that issues a $10 gold coin produced with $6 worth of gold can make a profit of $4 on every coin.  With an incentive like that, it is not surprising that medieval rulers periodically swamped their countries with coins that had a lot less gold in them than advertised on their faces.  This debasement, in turn, led to severe inflation.

Owing huge reparations payments to the Allies after their defeat in World War I, the German government printed so much money that before the inflation ended a 100 trillion mark note had been issued.  Prices rose so quickly during the German hyperinflation that bar patrons ordered two beers at once, since by the time they had finished the first the cost of the second had already increased.

Other twentieth century examples of hyperinflation brought about by reckless monetary policy, from Argentina to Zimbabwe, abound.

A policy adopted by King Gustavus II Adolphus of Sweden in the early 1600s led to one of the strangest monetary phenomena ever.  Sweden was Europe’s preeminent copper producer at the time and the king, hoping to increase the demand for—and price of—copper, decided to make copper legal tender alongside silver.

The law soon led to the widespread use of copper in transactions, while silver disappeared from circulation.  This is an example of Gresham’s famous law, under which “bad” (cheap) money drives out “good” (expensive) money.  Because silver was nearly 100 times as valuable, the copper coins used place of silver had to be massive.  The 10 daler piece weighed 43 pounds.  Large scale transactions became impossible without the assistance of a horse and cart.

No wonder the Swedes were the first Europeans to make extensive use of paper money!

Issuing a $1 trillion coin would not have not forced Americans to bring truckloads of copper money on routine shopping trips.

Issuing a $1 trillion coin would not have led to hyperinflation, at least not initially.  Had the procedure been repeated, it could have.

Issuing a $1 trillion coin would have demonstrated—yet again—that our politicians are unable to do the job for which they have been elected.  In the long run, it would have further weakened the credibility of the US government by marking it as willing to substitute gimmicks for fundamental reforms.

The country remains on a collision course with the debt ceiling.  As it draws closer, politicians of both parties will be tempted to resort to various tricks to get around the debt ceiling, the other side, or both.

Instead of issuing a magic coin or resorting to other gimmicks, Congress and the Administration need to reform the tax system, make some hard choices about entitlements, and set clear spending priorities.  It’s not as flashy as a $1 trillion coin, but it will put us firmly on the path to solvency.  And be less likely to get lost in the washing machine.