TOPICS IN POLITICAL ECONOMY

THE BITCOIN BUZZ

Digital money is clearly the techie infatuation of the moment. In the guise of 'bitcoins' it has been taken up by libertarians and most everyone who thinks that central banks are inherently incompetent.  Just Google 'bitcoin' and scan the vast number of web sites explaining, discussing or dealing with the subject.

The vast bulk of most developed countries’ money supply is digital - it consists of electronic notations on financial institutions’ computers.  In the U.S., paper currency in circulation (excluding the $400 billion held outside the country) makes up only 7% of the broadly defined money supply (M2).

What's Different? So, what’s different about bitcoins?  These are created by private operators on request by those who wish to acquire them. They are “stored” on a computer (your own or the operators) or mobile phone 'ap.'

Bitcoins circulate via the internet totally outside the traditional banking system when used to acquire goods and services from entities willing to accept them.  They intersect with the banking system only when someone wishes to buy or sell them in exchange for an official “legal tender” currency, such as the U.S. dollar or the Euro.

What is to prevent private operators from creating as many bitcoins as they can sell?  The combination of an extremely complex mathematical/statistical formula and internet-based peer review of each operator’s activity provides a fairly robust control mechanism. The formula apparently is designed to permit no more than 21 million bitcoins from being created.

Virtues. What are the virtues of bitcoins?  Proponents cite privacy (no bank record-keeping involved), ease of acquisition and use (all that is needed is internet access), no top down regulation, and security. However, all of these virtues have to be qualified, and one major short-coming will have to be overcome before bitcoins become something more than a techie fad.

Sending and receiving bitcoins requires internet addresses.  Most countries’ intelligence agencies have the capability to trace such activity, even if they don’t know the precise details of the transaction. In addition to operational snafus, domestic internet systems are susceptible to politically motivated interruption on a countrywide basis, as we know from events in Syria and China.

At the moment, the bitcoin network and protocols are self-regulated in the sense that issues affecting their operation are resolved via a consensus of operators responsible for creating them.  However, financial regulators in various countries are moving towards some degree of oversight and control, although it may be a lengthy process.

Security Issues. There are at least three important security issues that most bitcoin proponents pay little attention to: the inviolability of the algorithm used to create the currency and the competence and integrity of the middlemen who (1) operate the exchanges where bitcoins are traded against other currencies, (2) hold bitcoin balances for clients or (3) create bitcoin applications designed to facilitate transactions from your mobile phone or computer. One log of such problems, including losses for bitcoin holders, can be found on Wikipedia.

All forms of money attract counterfeiters and Ponzi-schemers, whether it’s fools’ gold or warehouse receipts. And any internet-centered money is going to attract hundreds of thousands of would-be scammers from around the world.  If just one critical piece of the algorithm and protocols that undergird bitcoins is compromised, it is hard to see how that currency can survive.

The major short-coming of bitcoins is their inability to function as a credible 'store of value,' a core characteristic of widely-accepted forms of money. The only way to have a substantial amount of bitcoin held or used by people is to make them comfortable that someone will make them a reasonable price if they want to liquidate bitcoin for another currency or asset, such as gold.

Volatility. On May 10 bitcoins were trading at $120 on Mt. Gox, the largest bitcoin exchange.  However, over the past 30 days, the value of a bitcoin has ranged from $50 to $266. Such a wide fluctuation tells us that there is scant liquidity in the market for anyone who wishes to buy or sell a large amount of bitcoin over a short period. That is confirmed by the fact that the average daily volume of U.S. dollar transactions at Mt. Gox in the same period was only $19 million.

In short, despite all the publicity and breathless promotion by some, it is hard to see bitcoins becoming a significant feature of the future monetary landscape.

 

 

YES, TOO MUCH DEBT IS BAD FOR YOU

 

If you followed the media frenzy earlier this month about the discovery of an error in an academic paper analyzing the relationship between a country’s level of debt and its economic performance, you had plenty of company.

The paper by Professors Reinhart and Rogoff demonstrated that there is a close relationship between a country’s debt level and weak economic growth.  Three academics at the University of Massachusetts Amherst tried to replicate the calculations and discovered an Excel spreadsheet error that overstated slightly the magnitude of that relationship.  See the chart below for how much different the error made, taken from an excellent note on the Seeking Alfa web site.  

 

The Reinhart/Rogoff conclusion that the more debt a country takes on, the slower its rate of growth remains reasonable, if not as drastic as their original results would suggest.  That was not the message most of the chattering class in national media conveyed;  instead, their message was that the boys up at Amherst had refuted the basic notion that too much debt can be bad for you. Paul Krugman in the New York Times rejoiced and used the Excel error to make another rabid attack on “austerity mania,” defined as 

. . . the obviously intense desire of policy makers, politicians and pundits across the Western world to turn their backs on the unemployed and instead use the economic crisis as an excuse to slash social programs.

I wonder what Professor Krugman has to say about the front page article in this past Sunday’s Times with the headline, “Danes Rethink A Welfare State Ample to a Fault.”?  It is well worth reading for everyone.  At least some countries are waking up to the reality of how social welfare programs and high marginal tax rates can destroy the work ethic and eventually end up impovershing most everyone.  

A LOW GROWTH FUTURE FOR THE U.S.?

 Professor Robert J. Gordon at Northwestern University is a distinguished and respected economist.  So when he opines that 'the rapid economic progress of the United States over the past 250 years could well turn out to be a unique episode in human history,' his peers and the chattering classes listen.

Gordon's thesis, as developed in a paper for the National Bureau of Economic Research and summarized in a Wall Street Journal op-ed last December, is that the waves of growth-stimulating innovation that brought us railroads, clean water, electricity, the telephone, the automobile,and the computer/internet have played themselves out.  He argues that there is no comparable wave today. While innovations may continue, he asserts that there will be "a decline in the usefulness of future inventions in comparison with the great inventions of the past."

Conceding he might be wrong in this assertion, Gordon then asserts there are six "headwinds" in the process of dragging long-term growth to half or less of the 1.9 percent annual rate experienced between 1860 and 2007. The culprits are demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt.

Thus Gordon's bottom line: "Future growth [in the United States] in real GDP per capita will be slower than in any extended period since the late 19th century." In other words, Gordon gives congenital pessimists and worry-worts a long menu of prospective growth-dampening causes.

Not so fast, Professor Gordon.  There are a variety of valid criticisms of Gordon's conclusion, or at least with the fervor and certainty with which he advances it.

For starters, Dr. Roger Pielke at the University of Colorado has pointed out that Gordon's presentation of historical data is highly selective and analytically misleading, suggesting little growth before the Industrial Revolution and successive downward steps in U.S. growth in recent years. Pielke's reading of the data suggests otherwise.

More importantly, Gordon's long-standing skepticism regarding the contribution of computers and the internet to economic growth continues to bias his analysis. For example, in his NBER paper he asserts that "the rapid development of the web and e-commerce after 1995 [was] . . . largely completed by 2005."  Presumably the good professor does not yet have (or use to its full capacities) a "smart" cell phone.

The marrying of rapid advances in telecommunications with terra-byte cloud storage, computational linguistics and natural language processing has unleashed a staggering amount of innovative activity. Perhaps the most fundamental shift this basket of innovations is fueling is the massive reduction in the cost and availability of information of all kinds - to nearly everyone in the world. Such a reduction cannot but help to stimulate innovation in the U.S. as well as abroad. Surprisingly, there is no discussion of this development in Gordon's paper.

Consequences of the Internet, et al.  For economic growth, there are two major consequences of this reduction in information costs: the ease and speed at which new growth-enhancing ideas and innovations can be acquired and put to work by enterprising individuals, and a massive rise in the volume of "information" that is consumed by individuals.

The original "internet" provides a useful example of the first consequence.  In the United States the invention and deployment of the telegraph in the 19th century significantly decreased the capital requirements and increased the productivity of the railroad industry by reducing the need for double-tracking. A single line (with occasional sidings) could now be safely used by trains travelling in opposite directions. But it took several decades before management was comfortable enough with the reliability of the new technology to deploy it. When they did, the savings on rails alone, as calculated by Alexander Field, were equivalent to two and a half years of U.S. steel production at 1890 rates.

A contemporary example might be the accelerating spread of "telemedicine"  - the ability to use high bandwidth telecommunications to monitor, diagnose, prescribe and even treat or operate on patients outside the hospital or doctors' offices. Might not growing concern over federal deficits and financing Medicare put increasing pressure on providers to expand telemedicine services at an even faster rate?

 

The measurement issue.  More troublesome to this commentator is the issue of measuring the value of the rapid rise in the volume of information "consumed" by internet users.

An increase in GDP, the most commonly used measure of economic growth, is based on the market value of transactions, e.g. price times volume. But how does government estimate the volume of consumer purchases of internet services?  By the dollar volume of sales.  But such sales are generally for just getting on line, not actual activity on the internet. While volume-related pricing is beginning to emerge, particularly for media publications, it is still in its infancy.

An excellent discussion of the problems in measuring this aspect of the internet's contribution to economic growth can be found on The Economist's web site.  I share one commentator's conclusion that "GDP has done an especially bad job of estimating the path of output in recent years. The economy has performed far better than GDP would indicate." If true, that would undermine the good professor's case.

In conclusion, although I am mindful of the injunction that "history is a series of reactions against the law of compound interest," I find Professor Gordon's thesis excessively gloomy, even if some of the six "headwinds" that he cites are bothersome storm clouds.

THE BUDGET SEQUESTER: THANK YOU, MR PRESIDENT

My favorite aphorism dealing with government budgeting comes from a former Chairman of the President’s Council of Economic Advisors under Ronald Reagan, Murray Weidenbaum:  “Good budgeting is the uniform distribution of dis-satisfaction.”

The impending “sequester” in Washington, which will cut Federal government spending by a very modest $85 billion in a $3.6 trillion budget, is not totally uniform, since it leaves untouched Social Security, Medicare, and the salaries of Congress and Presidentially-appointed types.  But most of the remaining departments and agencies – and their “clients” – will feel some pain.  In an imperfect world, this is progress.

Why should we thank President Obama for this state of events?  Because in July 2011 his advisors, chief of whom was Jack Lew, now about to be Secretary of the Treasury, cooked up the sequester proposal.  They had it approved by the President and then pitched it, successfully, to Senate Majority Leader Harry Reid.  The rest, as they say, is history.  It’s all in yesterday’s Washington Post, detailed by none other than long-time, White House chronicler, Bob Woodward.

President Obama and his flacks are now trying to rewrite history.  An honest description of the law’s birth would be statements from both sides, that “it was the best we could do at the time.”  And, maybe, it will turn out to be a not-so-bad big step towards bringing the budget under control.

INCOMES AND INEQUALITY: "GENERATIONAL THEFT" IS THE REAL ISSUE

I suggested in a recent post that the AARP, the old folk's lobby in Washington, is effectively in charge of the Federal Government's budget. The AARP's primary mission of the moment is to make sure that Social Security and Medicare remain untouched by any Congressional budget cutting initiatives.

Not surprisingly, with a payroll of $360 million a year ($938,000 for the chief executive officer, according to IRS filings) and revenues exceeding $1.2 billion AARP has been extraordinarily successful, as the chart below (updated from the one in my earlier post) demonstrates.

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                   Source:  Current Population Reports, P60-243, Table H10 

Young households' incomes have declined almost 10% since 1980 after adjustment for inflation - from just over $33,000 to roughly $30.000 in 2011.  At the same time, old folks' incomes trended upward for the entire period and now exceed young households'.  Congratulations, AARP.

Perhaps the best term to describe this development is "generational theft." It appears in a recent powerful op-ed in the The Wall Street Journal, jointly authored by a Democrat, an independent, and a Republican (all with political smarts).  The piece examines the ways in which current federal spending and tax policies are "doing grievous harm to the country's long-term growth prospects"  and emphasizes  that they "consitute a clear and present danger to the prospects for the next generation."

"Profoundly Unfair."  Authors Canada, Druckenmiller and Warsh point out that Social Security and Medicare as currently structured "are not just unaffordable, they are profoundly unfair" to the younger generation. So far as changing these entitlements, Congress and the President continue "to allow the immediate to trump the important." 

The Federal Reserve comes in for some well-deserved criticism: by supressing interest rates and trying to boost stock prices, the heat is off Congress to deal with its "spending addiction" and to undertake real reforms. (One of the authors is a former Federal Reserve Board member.)

The recent postponement of "the fiscal cliff" with its grab bag of special interest tax breaks is cited as another example of crony capitalism and corporate welfare which adds to the problem.  More generally, the failure "to deal with runaway spending will burden the country's children with higher interest rates and a debt bomb that will come due in their lifetimes."

In short, the absence of credible action by Congress and the Executive means that we are "saddling school-age children with more debt, weaker economic growth, and fewer opportunities for jobs and advancement."

Donate $660 million?  If the AARP really wanted to help solve our country's deep-rooted fiscal problems it should concede that its members need to share the pain of dealing with them.  Alternatively, it could go out of business and donate its $660 million net worth to the Social Security trust fund.

 

 

 

ACADEMIC HUBRIS AND MONETARY POLICY

With so much invested in academic papers and policy debates (private and public) plus, perhaps, an interest in being re-appointed Federal Reserve Chairman, it is not surprising that Ben Bernanke has been loath to concede that current policies are, at best, ineffective - or perhaps even counter-productive.

Now the Chairman's academic peers are opening up. And none more forcefully than the highly-respected John Taylor of Stanford University and a former Treasury official. In an incisive Wall Street Journal op-ed, "Fed Policy is a Drag on the Economy", Taylor lays out the case for current policy being counter-productive, as I suggested in my November note, "The Federal Reserve and the Law of Unintended Consequences."

In addition to the uncertainty about what happens when Fed policy will have to reverse course and start liquidating Treasury bonds and mortgage-backed securities, Taylor focuses on the fact that with interest rates close to zero, lenders have little incentive to extend credit at such rates, particularly to small- and medium-sized borrowers.  While the big boys can raise billions in the credit markets at historically low rates, it's much tougher for the small fry.  Taylor notes that while credit to corporate businesses has expanded by 12% over the past two years, lending to noncorporate borrowers has declined.

Taylor also suggests that what I call "intellectual tyranny" or academic hubris is playing a part. The economic models used by the Fed (some of which Taylor himself created) were "not designed and are not useful for evaluating the Fed's unconventional policies of the past few years."  Indeed, Taylor charges that current policies, heavily influenced by these models, "perversely . . . increase unemployment while they repress the classic signaling and incentive effects of the price system."

In other words, keeping short-term interest rates at historically low levels, buying $85 billion monthly of long-term bonds and mortgage-backed securities and committing to keep doing so for an extended period is having the opposite effect that proponents promise.

Despite today's relatively bland summary of discussion at the latest meeting of FOMC, there is clearly growing discomfort among the Reserve Bank presidents who participate in these meetings. These individuals are not as susceptible to pressure from the White House and Washington lobbyists as Board Members.  May they take Professor Taylor's arguments into the fray.

 

GLOBAL PRE-EMINENCE: WHAT DO WE MEAN?

As US executive director at the World Bank in the early 1980s, I knew what it meant to be the representative of the dominant world power.

I had more votes on any issue that came before the Board of Directors than any one else, could veto any change to the Bank’s constitution, and got my phone calls returned promptly from most everyone. We didn’t win on every contentious issue, but the batting average wasn’t bad.

A Fading U.S.?  Today there is plenty of soul searching about a fading U.S. on the global scene. The most recent example is a recent N.Y. Sunday Times article by Adam Davidson suggesting, based on the policies of the United Kingdom under Prime Minister Harold McMillan in the mid-1950s, that we “adjust to a smaller role in the world.”

The last time this point of view rose to prominence was when Japanese steel, cars, TVs, and Sony Walkmen overwhelmed sleepy American industrial giants and drove many of them to bankruptcy.

That was a good thing. The rest of the country woke up. Rather than spend their time complaining about Japanese subsidies, exchange rates, and low wages, many American manufacturers started studying Japanese production techniques, quality control, and attentiveness to what customers really wanted. The South Koreans were even faster learners.

The Japanese got lazy and rested on their oars. Their banks loaded up on bad credits and eventually paid a steep price. They refused to truly open up their economy to the rest of the world.

A Dominant China?  Today the 500 pound gorilla in the room is China. “Aren’t you worried about China?” I am frequently asked by friends, colleagues and students. My answer is, “no – up to a point.” A truly prosperous China is a great asset to the world economy, just as the United States has been.

The Chinese have a long way to go: per capita incomes in China in 2010 according to the World Bank were $4,240 compared to $42,050 in the U.S. A more prosperous China should be a better customer for U.S. exports and a more integrated member of the global trading system.

But with 1.3 billion people, a more prosperous China that is comfortable with a global perspective and reliant on foreign supplies of raw materials becomes a much more influential factor in regional and global politics, financial and economic issues. That is clearly influencing Chinese diplomacy, military priorities, and foreign aid programs. And there is every reason to expect increased encounters with U.S. interests in a multitude of new economic, regional, and financial venues.

Thoughtful, forward-looking American diplomacy supported by credible military power, can help reduce inevitable friction and ensure the protection of our legitimate interests. A sensible resolution to our “fiscal cliff” federal budget debate could relieve many near-term anxieties.

A Truly Prosperous World?  Today, value-creating ideas and technology can proliferate with the speed of the internet. When government and special interests stand aside, even just a bit, extraordinary things can happen, whether in China, India or Africa. Widely-shared economic growth has resulted in the dramatic reduction in global poverty rates, particularly in China, over the past twenty years.

If these conditions dominate throughout the globe, then “there is no reason why the whole world should not be as rich as the leading industrial country” in the words of Stephen Parente and Nobel Prize winning economist Edward Prescott. Is that an outcome to be feared?

Note: This piece originally appeared as an op-ed with the title "Staying on Top of the World" in the December 18th issue of The Pittsburgh Post-Gazette. 

THE LURE OF TAX LOOPHOLES

Why do most Democrats in Washington demand that tax rates on the wealthy rise but defend nearly all of the $1 trillion plus worth of “loopholes” in the personal income tax code that disproportionately benefit the same people? 

Consider the chart below which shows the percentage of total income paid by wealthy taxpayers to the IRS in recent years. The positive correlation for the past 30 years between average and top marginal tax rates is surprisingly weak – only 0.15 for the top 20% and even less, 0.11 for the top 1%.  Notice in particular what happened as a result of the 1986 tax bill which reduced the top marginal tax rate from 50% to 28%.  Average taxes paid by the top 1% were nearly 3% higher in the five years after 1986 than in the previous five year period, despite the lower marginal tax rate.

Source:  Tax Policy Center, http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=456

What happened?  A major factor was the elimination, thanks to the 1986 law, of the widespread use of tax shelters, a massive loophole. "Shelters" ran the gamut from cattle feeding and quarter horse partnerships to all manner of real estate transactions.

Plugging the Loopholes. So, what kinds of loophole plugging might yield a similar result this time around?  Below is a table from the November 2 issue of The Wall Street Journal based on a recent Congressional estimate of the tax revenue lost from the major “tax preferences.”  (The “carried interest” loophole savings, about which soak-the-rich partisans rave, are too small to make the list – about $2-3 billion annually.)

At over $1 trillion a year, there is plenty of rich ore in this mine to work with.  Of course, a draconian “plugging” program would touch middle income households, particularly those with health insurance. But the bulk of additional revenues would come from those in the top 20% and likely raise the top 1%’s tax bill to an average of 30%.  This sizable potential revenue dwarfs the $85 billion a year that the Administration’s FY 2013 budget would generate from letting the top marginal rate revert to 39.6%

Percentage v. Marginal Rates.  You would think that raising the percentage of income that the wealthy hand over to the IRS would be the primary objective of President Obama, Nancy Pelosi and their like.  Instead, the President keeps saying, as he did in his recent weekly radio talk , “if we’re serious about reducing our deficit . . .  and if we’re serious about protecting middle-class families, then we’re also going to have to ask the wealthiest Americans to pay higher tax rates.  That’s one principle I won’t compromise on.”

However, earlier this year the White House was busy promoting the Buffet Rule –millionaires shouldn't pay less than 30% of their income in taxes.  In its “Buffet Rule Report” the White House declared that we should not continue “to allow some of the wealthiest Americans to use special tax breaks to avoid paying their fair share.” If their "fair share" is 30% of total income, that level was reached by the top 1% (which includes lots of non-millionaires) every year between 2003-2006 with the current marginal tax rate of 35%. 

The White House, recognizing that a higher marginal tax rate cannot raise significant revenue, has resurrected its FY 2013 budget proposal to limit nearly all tax loophole benefits for the wealthest to 28% of income. But this would only yield $40-$50 billion according to the Congressional Joint Committee on Taxation. A limit that applied to all taxpayers, such as the 2% cap suggested by Martin Feldstein, would have yielded $280 billion in 2011. (And keep in mind that nearly half of households pay no income tax.) 

The Lure of Loopholes. Why do so many Democratic politicians (and not a few Republicans) like tax loopholes?  For three reasons:

1. Most loopholes are multi-year in nature.  That means that the yearly scrutiny normally directed at a spending subsidy is lacking.  Once drilled, a loophole is devilishly hard to plug up.
2. Taking the lead in putting a loophole in the tax code typically results in political support, a shower of campaign contributions and other largesse from the beneficiaries – mortgage bankers, solar cell manufacturers, health insurers, educational institutions, and municipal bond underwriters for starters.
3. For the activist politician, the thrill of “doing something” that appears to result in a measurable outcome (solar cells on the roof, a housing boom?) must be a satisfying outcome (at least until the boom busts).

In short, Democrats are drawn to the drilling and preservation of tax loopholes so that Government can be in the wealth redistribution business via the tax code, not just through the spending side of the budget.  But in doing so they nuture special interest groups that seek to expand their specific loopholes and can, in the medium run, impose a dead weight loss on the economy.

Objective: A Level Playing Field.  Striving for a level playing field and playing few favorites takes a special kind of literate and wise politician. Having such people in Parliament was one of the principal secrets of the Industrial Revolution in Britain.  It would be a great gift if we could look forward to a comparable group in the United States Congress - and in the White House.

 

 

 

STUDENT LOAN UPDATE

 For a despressing update on the growing burden of student loan debt - and the meager returns that far too many indebted students get on their college years - look at "The Needless Tragedy of Student Loan Defaults" in the latest issue of Business Week.

The core of the problem - and its solution - was analyzed and documented in this blog's "Too Big to Fail" series on higher education two years ago.  Herewith a short excerpt from the August 26, 2010 post:

1.  In the past 20 years the percentage of high school "completers" who immediately enrolled in a two- or four year college has risen nearly 20 percentage points - to 69% in 2008 (US Department of Education).

2.  Fewer than 25% of 2010 high school graduates possessed the academic skills necessary to pass college entry-level courses, according to test results from the widely-administered ACT college entrance exam (Wall Street Journal, August 18). This is essentially unchanged from five years ago.

It is reasonable to conclude from (1) and (2) that high schools are graduating a shoddy product and that colleges are admitting close to twice as many unqualified students as qualified ones.

Higher admission standards at two- and four-year colleges will not only reduce the number of indebted washouts, but will also put pressure on high schools to do a better job educating all their students, even those who do not go on to college.

MONEY MARKET FUNDS, CRONY CAPITALISM AND EXTRACTIVE INSTITUTIONS

There is no better current example of the evils of "crony" v. truly free-market capitalism than the struggle to reform the rules by which the money market fund industry has wormed its way into the financial system.  

Creatures of Regulation. Money market funds (MMFs) are creatures of regulation.  They became attractive in the 1970s when Regulation Q, limiting the interest rates that federally-regulated institutions could pay depositors, was promulgated. When market rates rose above the regulatory rate ceiling, innovating financial institutions designed money market funds which could pay close to market rates. "Prime" MMFs invest largely in commercial paper - short-term corporate I.O.U.s. Others focus on Treasury securities or short-term municipal paper.

MMF sponsors, such as Reserve Fund, Fidelity Investments, and Federated Investors, persuaded the SEC (their Federal regulator) to let them to price their shares  at $1 under most circumstances, even if the underlying assets fluctuated in value. Thus, MMF shares looked almost like bank deposits, especially when they could be redeemed on demand with checks.

Fund shares differ in one major respect from bank deposits: they are not insured by the FDIC.  But the disparity between the banks' maximum allowable interest rates and market interest rates was so wide that the MMFs took off shortly after they were introduced.  By 2008, they had over $3.7 trillion in assets.

A Failed Business Model. The denouement came in 2008. The Reserve Primary Fund, one of the original and largest MMFs was forced "to break the buck" when the biggest "name" in its portfolio, Lehman Brothers, filed for bankruptcy.  The chart below details this event. "Prime" institutional MMFs (used by investment managers), heavily invested in private sector commercial paper, experienced massive withdrawals by their investors. The Federal Reserve and the U.S. Treasury took a series of actions to bail out this "too big to fail" industry.  The most important of these was the Treasury's guarantee of MMF shares @ $1.00.  This program lasted until September 2009.

The Treasury's action stopped a potentially ruinous "run" on the financial system generally.  But the need to intervene destroyed the MMF industry"s up-until-then successful attempt to market MMF shares as "just as good as" insured bank deposits. The run on MMFs demonstrated that the underlying business model could not survive in a volatile financial environment. It failed a severe, market-driven, stress test.

One of the few sensible initiatives in the Dodd-Frank financial reform legislation was to direct the federal regulatory agencies to make sure that MMFs would no longer be a de-stabilizing factor in the financial system. 

The Securities and Exchange Commission wrestled with this issue for over two years.  But a majority of the Commission members refused to approve a credible regulatory solution, demonstrating once again, that all too frequently the SEC is a pawn of the Investment Company Institute (ICI), the mutual fund industry's trade association - and the key Congressmen and Senators on the receiving end of ample campaign cash from financial industry donors.  In short, crony capitalism at its purest.

An Extractive Institution. Looked at more broadly, the ICI is a choice example of what Daron Acemoglu, a leading economic historian, calls an "extractive institution."  This is a political mechanism "designed by the politically powerful to extract resources from the mass of society for the benefit of the few . . . this elite designs, maintains, and benefits from these extractive institutions."

The regulatory issue is now in the hands of the  Financial Security Oversight Council (FSOC), a high-level entity also created by Dodd-Frank.  This group has the power to insist that MMFs' business model undergo substantive changes, of which the most effective would be to require them to give up the $1 @ share accounting fiction. Investors would then be reminded daily that their funds are at risk.

Such a change would, no doubt, lead many current investors to withdraw funds from "prime" MMFs and put them in insured deposits or Treasury bills. The existing MMF business model would wither away. 

Do the Right Thing. It is encouraging to note that one major industry sponsor of MMFs, Walt Bettinger, CEO of Charles Schwab, has broken with the ICI position in an op-ed in The Wall Street Journal. He concedes that "a variable net-asset value is the right thing to do," at least for "prime" MMFs.

It would be a most welcomed event if Mr. Bettinger's peers and all those politicians who are nourished by the ICI and its member firms decided, for once, to do "the right thing."