The Golden Road Out of the Debt Crisis

Published in The New York Sun.

America has a chance to introduce into its monetary system a role for the gold that’s already owned by the government.

The value of a dollar has sunk to a new low, less than 1/3,000th of an ounce of gold. Yet according to a woefully outmoded American law, the federal government must account for its more than 8,100 tons of gold at a completely irrelevant valuation set more than 50 years ago, when the dollar’s value was much higher — about 1/42nd of an ounce.

That outdated number stems from the precise language of the 1973 Act to Amend the Par Value Modification Act, still in force, legally stipulating that the gold value of the dollar is fixed at “forty-two and two-ninths dollars per fine troy ounce.” In other words, the law values the dollar at 1/42.22nd of an ounce of gold.

Yet in the gold market, the dollar is fetching less than a 3,000th of an ounce — another way of saying that gold is trading at more than $3,000 per ounce, about 71 times the statutory price. In other words, the statutory price is less than 2 percent of the market price. How does this antique artifact survive?

Whatever was the case in 1973 when Congress reduced the legal value of the dollar — to 1/42.22nd of an ounce of gold, from 1/38th of an ounce — for us in 2025, after a further half-century of depreciation of American paper money, the statutory price makes no sense at all.

It comes from a law passed 52 years ago in a different world of political finance. Why hasn’t it been updated with a more realistic relationship between gold and the dollar?

Gold’s value in terms of the dollar, having dropped to a 3,000th of an ounce from a 42.22nd of an ounce, has gone up by about 7,000 percent from the statutory price. That means in terms of gold, the value of the dollar has plunged by more than 98 percent.

In accounting terms, this means that the Treasury has what amounts to a giant capital gain on the gold it owns. Although the gain is unrecognized on the government’s books, it has already happened and is already real.

At a market price of $3,000 per ounce, this capital gain, in round numbers, amounts to $2,958 per ounce on the Treasury’s 261.5 million ounces of gold. That translates, theoretically at least, into a total unrealized profit of about $773 billion. That is a big enough number to get anybody’s attention, and for any Secretary of the Treasury to think about.

When Treasury Secretary Bessent recently said, “We're going to monetize the asset side of the U.S. balance sheet for the American people,” many financial commentators immediately thought of the Treasury’s gold and how it might be turned into a big realized gain and spendable cash. This can certainly be done, but not in any case until Congress amends the official dollar value set by the 1973 act.

The possibilities are important for the fundamental theory and politics of money, because they would reintroduce some monetary role for gold a half-century after America led the world into its current inflationary, pure paper money system in 1971. That was when President Nixon ordered the Treasury to default on the international commitment of the United States to redeem dollars for gold.

Suppose that Congress brought the official price of gold up to reality. The Treasury would immediately realize a $773 billion gain on the government’s books. To turn the gain into cash it would not have to sell any gold, but could borrow against it.

For example, the Treasury could issue gold bonds, as it did historically, and as monetary theorist Judy Shelton, in her book “Good as Gold,” has suggested it do again. (The Treasury would have to overcome the issue of having defaulted on its former gold bonds in 1933.)

With a more radical return to historical practice, the Treasury could issue gold-backed currency in competition with Federal Reserve notes. This, though, would take further controversial legislation.

Much simpler and more direct would be for the Treasury to issue Gold Certificates, which are already authorized by the Gold Reserve Act of 1934, but now would be based on the current value of its gold. The profit on the gold could then be easily monetized by depositing these certificates in the Federal Reserve, which would correspondingly credit the deposit account of the Treasury with the Fed. Voila! Money ready to spend without issuing more Treasury bonds.

As Paul Kupiec and I have previously pointed out, this would be an efficient way to create interim financing for any future debt ceiling crisis.

We should certainly bring the finances of the United States current with the reality of the vast rise of the value of its gold with respect to the dollar and the vast fall of the value of the dollar with respect to gold. At the same time, we could open our monetary theory and practice up to a renewed monetary role for gold.

To do so, Congress could immediately amend the Par Value Modification Act by enacting a "Gold Value Modification Act of 2025" that deletes the former official price of "forty-two and two-ninths dollars," and replaces it by "the fair market value of gold as certified by the Secretary of the Treasury."

The U.S. debates what to do about Fannie and Freddie, after their 17 years in government conservatorship

Published in Spring 2025 Housing Finance International Regional round up: news from around the globe

For international observers to understand the U.S. housing finance system, they must understand Fannie Mae and Freddie Mac. To understand Fannie and Freddie, they must understand how huge and how completely intertwined with the government these giant mortgage finance companies are.

As for huge, between them, Fannie and Freddie have US$ 7.7 trillion in assets – that is “trillion” with a T. This is composed of $4.3 trillion for Fannie and $3.4 trillion for Freddie.[1] They are by far the most important factors in the $14 trillion U.S. residential mortgage system and the main thing that makes the U.S. system unique in the world.

As for intertwined, Fannie and Freddie still have some private shareholders, but they are primarily owned by the U.S. Treasury Department, which as of December 31, 2024 holds senior preferred stock in them with a liquidation preference of $341 billion, or about 2.5 times their combined book equity. In other words, without this government investment, Fannie and Freddie would be insolvent. As part of the Treasury’s bailout of Fannie and Freddie in 2008, they were put in and remain in government conservatorship, which means subject to total government control.

In addition, also arising from the bailout, the Treasury owns warrants giving it the right to purchase at the exercise price of one-thousandth of a cent per share – that is, to get basically for free – enough new shares to give the Treasury a 79.9% share of the common stock of both companies. Why 79.9%? Because at 80%, the government would have to consolidate Fannie and Freddie’s debt on its books, a bookkeeping outcome the Treasury does not like.

Exercising the warrants could give the Treasury a large profit, but the warrants expire in September 2028 – during the term of the current Trump administration. This creates a duty for the Treasury Department to do something to realize their value before they expire. The Treasury could sell the warrants, exercise the warrants and then sell the stock, or exercise the warrants and simply hold the common stock, just as it holds the senior preferred stock.

Some people view the expiration date of the warrants as an incentive to release Fannie and Freddie from their 17-year long conservatorship to some new status. The arrival of the Trump administration has started new debates about what should happen next.

An essential question in these debates, one which cannot be avoided, is the nature of the government guarantee that Fannie and Freddie will get in the future. In my opinion, there is no possible outcome that does not involve a government guarantee. With this in mind, we consider the essence of Fannie and Freddie and the historical evolution which brought the U.S. mortgage system to this complex problem in political finance.

Fannie and Freddie are thinly capitalized, even with the massive government investment in them. They have a combined $7.5 trillion in liabilities and bear more than half the mortgage credit risk of the whole country. This unwise concentration of risk is possible because every penny of it is effectively guaranteed by the Treasury. Investors in Fannie and Freddie’s obligations don’t have to worry about Fannie and Freddie’s high leverage or anything else about their financial risk – Fannie and Freddie’s mortgage-backed securities can be sold and traded by Wall Street firms all over the world based on the credit of the U.S. government and potential taxes on the American people.

Fannie started life in 1938 as simply a part of the government. Its debt was government debt and any profits it made accrued ultimately to the Treasury.

Thirty years later, in 1968, in a gigantic blunder in government finance, Fannie was turned into a “government-sponsored enterprise” (GSE). This was done to get a bookkeeping result: to get the debt of Fannie off the government books, as President Lyndon Johnson’s budget deficits ballooned.

To be a “GSE” means you have private shareholders, but you also have a free government guarantee of your debt. It was constantly claimed that this GSE guarantee was only “implicit.” Nonetheless, it was and is fully real. This was demonstrated by the $190 billion Treasury bailout of Fannie and Freddie in 2008. That bailout completely protected all their creditors, even – egregiously – holders of subordinated debt. Creditors of GSEs are always saved by the government, and everybody knows it.

In Fannie’s original 1938 form, the risk was public and the profit was public. In the GSE form, as Congressman J. J. Pickle of Texas sardonically observed in 1992, “The risk is 99% public and the profit is 100% private.”

Pickle’s point fully applies to the new Fannie and Freddie debates of 2025. The financial essence of a GSE is that the huge value of the free government guarantee is a gift to the private shareholders. This is obviously a bad idea, but a great many politicians have been convinced to support it. Might they be again?

Congress chartered Freddie to join Fannie as another GSE in 1971. The two became in time an exceptionally profitable dominating duopoly with soaring prices for their stock, because no private firm can compete with the free government guarantee of a GSE. They both, but especially Fannie, developed remarkable arrogance and Fannie was widely feared for its bully-boy tactics and political clout.

As the Book of Proverbs tells us, “Pride goeth before destruction and a haughty spirit before a fall.” As the housing bubble collapsed in 2008, Fannie and Freddie, having greatly expanded in bad loans, had their fall and their humiliation. The price of their stocks went down 99%. The Treasury bailed out all their creditors, foreign and domestic, and Fannie and Freddie, under complete government control, sent their profits to the Treasury. They had ceased to be GSEs and had been turned into “GOGCEs”: Government-Owned and Government-Controlled Enterprises. This is what they remain at present.

As GOGCEs, Fannie and Freddie now pay for their government guarantee by giving the Treasury all their profit in the form of increased value of the Treasury’s senior preferred stock. Should they be turned back into GSEs and again given their government guarantee for free?

Supporters of the idea claim this would be a “privatization.” But Fannie and Freddie would not be private companies if they once again had a free government guarantee and if once again “the risk was 99% public and the profit was 100% private.” This would not be a privatization, but a “re-GSEification” with the value of the government guarantee as a gift to the private shareholders. You can easily see why private shareholders would love this idea – and why taxpayers should not.

You can also easily see the required solution to this problem: in any proposed exit from conservatorship, Fannie and Freddie should pay an ongoing fair price to the Treasury for the guarantee which makes their business possible.

Setting that price is an unavoidable requirement in the Fannie and Freddie debates. Based on the model of U.S. deposit insurance for the largest banks, the price should be assessed on Fannie and Freddie’s total liabilities. Based on U.S. deposit insurance finances,[2] I estimate the minimum fee would be about 8 basis points (0.08%) per year. That would now cost Fannie and Freddie together about $6 billion per year – not expensive at all for the essential factor that allows their trillions in obligations to be easily sold and traded all over the world.

The fundamental principle is that Fannie and Freddie should never again get a free government guarantee.

[1] Fannie Mae and Freddie Mac Form 10-K filings, December 31, 2024.

[2] Federal Deposit Insurance Corporation, Annual Report 2023.

April 17: GMU: The Great Debate: How to Modernize Financial Regulation and Create Economic Stability in a Digital Age

Click here to register and learn more abut the event.

Join George Mason University’s (GMU) Center for Assurance Research and Engineering (CARE), the Financial Technology & Cybersecurity Center (Center), the Donald G. Costello College of Business, and a host of experts for a wide ranging discussion of what a financial regulatory structure equipped to deal with the realities of today’s financial services sector should look like.

-=-=-=-=-=-

The Great Debate:  How to Modernize Financial Regulation and Create Economic Stability in a Digital Age

Co-Chairs:

Dr. Jean-Pierre Auffret
Director, Research Partnerships, Costello College of Business, George Mason University; Director, Center for Assurance Research and Engineering (CARE), College of Engineering & Computing, George Mason

Thomas P. Vartanian
Executive Director of the Financial Technology & Cybersecurity Center
Author, 200 Years of American Financial Panics, Crashes, Recessions and Depressions, And the Technology That Will Change It All; The Unhackable Internet: How Rebuilding Cyberspace Can Create Real Security and Prevent Financial Collapse

LOCATION

In-person and Online

Van Metre Hall, George Mason University, Fairfax Drive, Arlington, VA, USA

DATE & TIME

Thursday April 17th 2025
8:30 AM - 5:30 PM

_______________

9:10 – 10:10 a.m. Panel:

Greg Baer
President & CEO, Bank Policy Institute
Gary Gorton
Professor Emeritus of Management & Finance
Yale School of Management
Author, Misunderstanding Financial Crises: Why we don’t see them coming
Elizabeth McCaul
Alex Pollock
Senior Fellow, Mises Institute
Author, Finance and Philosophy--Why We're Always Surprised

Click here to register and learn more abut the event.

Mortgage Markets and Crony Capitalism

Published by the Mises Institute.

America’s residential mortgage market is mostly controlled by government. Ryan McMaken and Alex Pollock talk about how government corporations like Fannie Mae are fueling America’s housing affordability crisis.  

Listen to the episode here.

Debate Is Buzzing Over Whether Fannie and Freddie Are Ready To Be Released From Conservatorship

Only if, our columnist says, they are fully shorn of any free guarantees by the government.

Published in The New York Sun.

The arrival of the new Trump Administration has revived debates about releasing Fannie Mae and Freddie Mac from the conservatorship and total government control which came with their bailout by the U.S. Treasury in 2008, nearly 17 years ago. What should happen next is a major financial system issue, since Fannie and Freddie are giant firms, with combined assets of more than $7.7 trillion.  

The most important factor in the “release” decision is seldom mentioned: Should the future Fannie and Freddie, as in their pre-bailout past, get a free government guarantee of all their obligations, now totaling $7.5 trillion? In other words, should Fannie and Freddie’s shareholders get a taxpayer subsidy of billions of dollars a year? The answer is that this costly mistake of the past should not be repeated.

Fannie started life in 1938 as a straightforward part of the government. Its debt was government debt and any profits it made accrued ultimately to the Treasury.

In a strategic blunder in government finance, Fannie was turned into a “government-sponsored enterprise” (GSE) in 1968 to achieve a bookkeeping result: to get its debt off the government’s books as President Lyndon Johnson’s deficits ballooned.  

A GSE is a corporation with private shareholders but also a free government guarantee of its debt. This guarantee is only “implicit,” it was always said, but it is fully real, as demonstrated by the 2008 bailout that fully protected all creditors, even subordinated debt holders. Creditors of GSEs are always saved by the government.

The financial essence of a GSE is that the massive value of the free government guarantee is a gift to the private shareholders. 

Freddie joined Fannie as another GSE in 1971. The two became in time an exceptionally profitable dominating duopoly, since no private firm can compete with the free guarantee of a GSE. They both, but especially Fannie, developed remarkable arrogance and Fannie was widely feared for its bully-boy tactics.  

As the Book of Proverbs tells us, “Pride goeth before destruction and a haughty spirit before a fall.” As the housing bubble collapsed in 2008, Fannie and Freddie had their fall, having invested excessively in bad loans. Then came their bailout and government conservatorship. From being GSEs, they were turned into “GOGCEs”: Government-Owned and Government-Controlled Enterprises. That is what they remain at present, not GSEs.

This has meant their government guarantee is no longer free, because in effect, they pay for it as part of giving the Treasury all their net profits in the form of increased value of the Treasury’s bailout senior preferred stock. The value of the Treasury’s preferred stock in Fannie and Freddie is now up to $334 billion from its original $190 billion. 

In addition, the Treasury owns warrants with the right to acquire at the exercise price of one-thousandth of a cent per share new common shares of Fannie and Freddie giving Treasury a 79.9% ownership of the common. Why 79.9%? Bookkeeping again. At 80%, the government would have to consolidate Fannie and Freddie’s debt on its books.

These warrants expire in September 2028—during the term of the current Trump administration. This creates a Treasury duty to do something before they expire. For example, Treasury could exercise its warrants, which has virtually no cost, and simply hold the new shares.

But some people view this expiration date as an incentive to free Fannie and Freddie from their long conservatorship by what they claim would be a “privatization.” But it would not be a privatization and Fannie and Freddie would not be private companies if they once again got a free government guarantee.  

Such a deal would simply be turning them back into GSEs, with the value of the government guarantee as a gift to the private shareholders. You can easily see why the private shareholders of Fannie and Freddie like this idea and why the taxpayers should not.

In any proposed exit from conservatorship, Fannie and Freddie should pay a fair price to the Treasury for the very real government guarantee that makes their business possible.

Setting that price would involve spirited discussions. Based on the model of deposit insurance for the largest banks, a fair price should be assessed on Fannie and Freddie’s total liabilities and might be about 8 basis points (0.08%) per year. That would now cost Fannie and Freddie about $6 billion per year— not expensive at all for what allows their trillions in obligations to be easily sold and traded all over the world, no matter how risky Fannie and Freddie themselves may be.

The essential principle is that Fannie and Freddie should never again get a free government guarantee.

Government's Role in Central Banking - Playing with Fire

Featuring interviews with Ron Paul, Tom DiLorenzo, Joseph Salerno, Mark Thornton, Jim Grant, Alex Pollock, and Jonathan Newman, Playing with Fire explains what the Fed is, where it came from, and why it is so dangerous. Perhaps most importantly of all, Playing with Fire shows why we need to end the Fed altogether. Watch the full film here: https://bit.ly/4hh2pBB

Countries Don’t Go Broke. Governments Do.

Published by the Mises Institute:

The United States is not immune to this, but remains relatively insulated—for now—thanks to the fact that the dollar is in greater demand than sterling, and therefore so is US debt. I asked Mises Institute Senior Fellow Alex Pollock about Dalio‘s comment, and Pollock replied with an important point about whether or not “countries” go broke: 

Ray Dalio is certainly right to highlight the issue of sovereign defaults.  Based on the FT‘s article, I have already ordered a copy of Dalio’s forthcoming How Countries Go Broke.  

I do want to object to the book’s title, however. It is not countries, but governments, which overborrow and go broke.  The debtor is the government.  The government is quite distinct from the country, although in common parlance the two are often confused.  It is the government of the United States, for example, not the country, which defaulted five times on its debt between being unable to pay interest on time in 1814 and reneging on its solemn commitment to redeem dollars for gold in 1971.  These five defaults do not count the failure to pay its debt by the Confederate government, defaults by a number of individual U.S. state governments, or the historic bankruptcies of the governments of the City of Detroit and the Commonwealth of Puerto Rico.

Monetary Policy That Holds the Fed Accountable

Published by the Cato Institute.

The so‐called dual mandate calls for the Fed to achieve both price stability and maximum employment. Now that the Fed has also become responsible for guarding against financial instability, it really operates under an even broader mandate.[2]

2. The Fed Is as Poor at Knowing the Future as Everybody Else, Before the US House of Representatives Subcommittee on Monetary Policy and Trade of the Committee on Financial Services, 113th Cong., 1st Sess. (September 11, 2013)(testimony of Alex Pollock).

How Can the Federal Reserve Pay Dividends to Its Shareholders When It Has No Profits?

Published in The New York Sun.

Although the Federal Reserve is — and thinks of itself as — part of the government, 100 percent of the $37 billion in paid-in stock of its twelve component Federal Reserve Banks is owned by private shareholders. This was part of the political compromise of the original 1913 Federal Reserve Act.

The shareholders are the commercial banks that are the members of the respective Federal Reserve Banks. Remarkably, these private shareholders are getting dividends from the Reserve Banks even when the combined Fed has no profits, no saved up past profits (retained earnings), and hugely negative actual capital.  Any private bank which tried to pay dividends under these circumstances would be sternly prohibited by the Fed from doing so.

For the first nine months of 2024, the Federal Reserve Banks in the aggregate paid more than $1.2 billion in dividends to their shareholders. Yet at the same time, they together posted losses totaling $63 billion.  On an annualized basis, they are paying dividends of $1.7 billion, for a dividend yield of about 4.5 percent, while losing about $80 billion, with negative retained earnings and capital.  How is that possible — or ethical — one might wonder.

The Fed’s performance on this score was even more remarkable in 2023.  For that year, the combined federal reserve banks paid $1.5 billion in dividends to the shareholders, while losing the nearly unimaginable sum of $114 billion.  That was a loss of 2.6 times the total capital they claim to have. 

The Fed’s officers and energetic public relations efforts assert that for the Fed, having negative capital, i.e. being technically insolvent, doesn’t matter.  Even were that true, how could it justify paying dividends when there are no profits, past or present, with which to pay them.

As of January 1, 2025, the combined FRBs have accumulated losses of $216 billion from losing money in every single month since October 2022.  In proper and obvious accounting, one subtracts losses from retained earnings. That is ineluctable. The Fed, though,  does not do this.  It wishes one to believe instead that its vast accumulated losses are an asset, opaquely called a “deferred asset,” so it can show positive capital on its balance sheet.

What do they take us for? It is easy to understand why the Fed does not want its financial statements to subtract its $216 billion in losses from its stated $7 billion in retained earnings: because then it would have to show that its actual retained earnings are negative $209 billion. Which they are.  

Further subtracting that $209 billion from the total paid-in capital of $37 billion, the Fed would then have to show the world that its actual capital is negative $172 billion.  Which it is. If the Fed really believes that its technical insolvency doesn’t matter, why is it intent on hiding the numbers?

Turning to the individual FRBs, as of January 1, 2025, ten of the twelve have negative retained earnings and negative capital, being thus technically insolvent.  They should not be paying any dividends. Yet two FRBs, Atlanta and St. Louis, could. It might seem odd to have two FRBs paying dividends and ten not, but it accurately reflects the regional logic of the system as designed in 1913.

The Federal Reserve Bank of New York is far and away the biggest and most important FRB, with the most clout.  Its assets equal those of all the other eleven FRBs put together.  Its accumulated losses are bigger than all the others put together.  

Properly subtracting the New York FRB’s $131 billion in accumulated losses from its retained earnings of $2 billion gives it actual retained earnings of a negative $129 billion. This easily wipes out its paid-in capital of $13 billion and leaves an actual capital of negative $116 billion. The members of the New York FRB lead the parade of Fed stockholders who should not be receiving any current dividends. 

Curiously, the Federal Reserve Act stipulates that Fed dividends are cumulative.  Thus, if not paid, they would still have to be accrued as a liability and paid out of the profits of some future time before the American Treasury gets paid anything from those profits.  Fed losses do matter. They increase the federal deficit and increase the national debt. Fed dividends when the Fed has no profits increase the deficit and debt further.

It would be salutary for FRB stockholders to learn that they do have some skin in the game as equity investors and that when there are no profits, no retained earnings, and no capital, there will also be no dividends paid.

Caution warranted on Strategic Bitcoin Reserve

Published by the Competitive Enterprise Institute:

At a recent price of Bitcoin of $100,000, the purchase prescribed by this bill would cost the government $100 billion. But there’s more. Paul Kupiec and Alex Pollock – scholars respectively of the American Enterprise Institute and the Mises Institute — point out in The Hill that if this purchase were made by the Federal Reserve, the Fed would have to borrow money for this purchase at current interest rates, which are now above 4 percent. That means that over 20 years, the Fed’s operating cash losses could come to “more than 100 percent of the investment.”

A Calm Analysis of the Panic of 2008

Published in Law & Liberty.

It makes sense that the 2008 bailouts inspired a lot of emotion, rhetoric, and hyperbole. Hundreds of billions of dollars had just been lost, the government was rescuing arguably undeserving institutions and their creditors, and the financial system seemed to be wavering on the edge of an abyss. Sixteen years after the panic, though, Todd Sheets manages to stay calm, analytical, and generally convincing in his new book discussing the Great Housing Bubble, its causes, its acceleration, its collapse, and the costly aftermath. 2008: What Really Happened dispassionately reviews the actions of key parts of the US government that were central to creating each stage of the bubble and bust over a decade.

In the early 2000s, Sheets tells us, he “had a growing concern that the Fed’s cheap-money policies were destined to end badly.” Then came the first financial crisis of the then-new twenty-first century. This disaster, we should remember, arrived shortly after we were assured by leading central bankers that we had landed safely in a new age of “The Great Moderation.” In fact, we landed in a great overleveraged price collapse.

In economics, the future is unknowable, we are usually confused by the present, and we can easily misinterpret the past. Sheets believes that “historical review reveals … a lengthy delay from an economic crisis to an understanding of what really happened.” He tells us that the book is a result of deciding, while reflecting on the crisis, that “I was confused about big-picture economic matters I had long taken for granted and realized it was time for a new self-study program … focused on financial history.”

Five Phases of the Bubble

Sheets’ study has resulted in an instructive historical framework for understanding the development from growing boom to colossal bust. He proposes five principal stages:

1. The pre-Bubble era, pre-1998: This era is now 26 years, or a whole generation, away from today. Sheets emphasizes the long historical period when average house price increases approximately tracked general inflation. “In the century preceding the housing bubble, house prices more or less tracked inflation,” he writes, “increases in real house prices were negligible.” He believes this is historical normalcy. One might argue that the average real increase in US house prices had been more like 1 percent per year (as I did at the time in graphing the Bubble’s departure from the trend), but that does not alter the fundamental shift involved.

2. Liftoff, 1998–2001: “Beginning in 1998, housing prices suddenly departed from these long-term historical trends,” Sheets notes. In other words, the Bubble starts inflating ten years before the final panic. “Real home prices suddenly begin to increase at an average annual rate of 4.7% during Liftoff.” Why did they? We will discuss below Sheets’ proposals for the principal cause of each phase.

3. Acceleration, 2002–2005: In this phase, “the rate of real home price appreciation began to accelerate even more rapidly”—it “shot up again, to an average annual rate of 8.3%, reaching a peak of 10.4% in 2005.” Remember that Sheets is always dealing always in real price increases—those on top of the general rate of inflation. At this point, it seemed to many people that buying houses with the maximum amount of mortgage debt was a sure-fire winning bet. From 1998 to 2006, Sheets calculates that in real terms, house prices “appreciated over 10 X the level of cumulative appreciation in the 100 years before the bubble.”

4. Deceleration, 2006: “The rate of increase in real house prices slowed dramatically” in the transition year of the inflation turning into deflation of the bubble.

5. Crash, 2007-2012: Home mortgage debt had by now become much more important to the US economy than before, surging strikingly, as Sheet’s table of mortgage debt as a percent of GDP shows:

A lot of people had made a lot of money on the way up, but any potential mortgage debt losses now had a much bigger potential negative impact than before. How much bigger? We were about to discover. Then, “beginning in 2007, real house prices declined … eventually falling about one-third.” Indeed, house prices fell for six years, until 2012. Between 1998 and 2012 we thus approximated the biblical seven fat years followed by seven lean years. There were vast losses to go around, defaults, failures, continuing bad surprises, and a constant cry for government bailouts, as inevitably happens in financial crises.

Sheets helpfully divides Phase 5, the Crash, into four component stages. For many of us, he reenergizes memories that may have been fading by now, and for those younger without the memories, provides a concise primer. Thus:

5(a) Awareness, June 2007-October 2007: “Hedge funds managed by Bear Stearns and BNP Paribas that were heavily concentrated in US home mortgages announced significant write-downs.” Oh-oh, but there was still much uncertainty about the implications for wider problems. “The markets still had no idea of just how precipitously housing prices would fall.” The Federal Reserve embarrassingly and mistakenly opined that the problems were “contained.” The stock market rose until October 2007. Showing some earlier awareness of looming problems, in March 2007 the American Enterprise Institute had a conference on “Implications of a Deflating Bubble,” which I chaired. We were pessimistic, but not pessimistic enough.

5(b) Stress, November 2007-August 2008: “A steady procession of substantial mortgage-related write-downs and losses were announced by a wide swath of financial institutions.” Two of my own favorite quotations from this time epitomize the growing chaos. “Hank,” the chairman of Goldman Sachs told the Secretary of the Treasury, Henry Paulson, “it is worse than any of us imagined.” And as Paulson himself summed it up: “We had no choice but to fly by the seat of our pants, making it up as we went along.”

In July 2008, “the Fed invoked special emergency provisions that enabled it to supply bailout financing” to Fannie Mae and Freddie Mac, the dominant mortgage companies. Fannie and Freddie are called “GSEs,” or government-sponsored enterprises. Their creditors believed, even though the government denied it, that “government-sponsored” really meant “government-guaranteed.” The creditors were correct. In the same July, “President Bush signed a bipartisan measure to provide additional funds” to Fannie and Freddie. These two former titans of the mortgage market, the global bond market, and US politics were tottering. But Sheets stresses a key idea: “Markets found additional reassurance in the idea that federal authorities would continue to intervene,” as they did when Fannie and Freddie went broke but were supported by the US Treasury in early September. In a financial crisis, the universal cry becomes “Give me a government guarantee!”

5(c) Panic, September 2008-February 2009: The Treasury and the Fed provided government guarantees and bailed out the creditors of Bear Stearns, Fannie Mae, and Freddie Mac. But on September 15, 2008, “the authorities unexpectedly allowed Lehman Brothers to fail.” Whereupon “the money markets lurched into a state of panic,” their confidence in bailouts punctured. As Sheets relates, this was followed by a series of additional, giant government guarantees and bailouts to try to stem the panic.

5(d) Recovery, March 2009-forward: “What the [panicked] short-term financing markets were looking for,” Sheets concludes, “was unconditional assurance that none of the remaining critical institutions—Citigroup, Merrill Lynch, or Bank of America—would become the next ‘Lehman surprise.’ The final bailout package for these critical institutions was announced in mid-January of 2009.” In 2009 bank funding markets stabilized and the stock market recovered. That is where Sheets’ history concludes, but we should remember that house prices did not finally stop falling until 2012, and the Fed’s abnormally low interest rates resulting from the Crash continued for another decade—through the financial crisis of 2020 and until 2022. But that is another story.

What were the fundamental causes of the ten-year drama of the housing bubble and its end in disaster? “A plausible theory of causation must explain the sudden onset and the distinct phases of the bubble,” Sheets sensibly argues, thus that different phases had different main causes. As he identifies the principal cause of each phase, it turns out that the US government, in various manifestations, is the prime culprit.

“The Liftoff phase of the bubble in 1998 was triggered by the rapid expansion undertaken by Fannie Mae and Freddie Mac,” Sheets concludes. The timing fits: “The sudden acceleration of GSE growth coincided with the onset of the housing bubble.” And the magnitudes: “88% of the excess growth in mortgages outstanding relative to the Base Period originated from the GSEs.”

Fannie and Freddie could have so much impact because they were the dominant competitors, had key advantages granted by the Congress, had deep political influence and allies—but most importantly—operated with a government guarantee. This was only “perceived” and “implied” it was said, but it was nonetheless entirely real. That enabled their debt obligations to be sold readily around the world, as they set out to and did expand rapidly, notably in riskier types of mortgages, seeking political favor as well as more business.

Fannie and Freddie’s rapid expansion was linked to the push of the Clinton Administration to expand homeownership through “innovative” (i.e. risky) mortgages. This was a perfect combination of factors to launch a housing bubble. Sheets correctly observes that Fannie and Freddie’s role was “aided and abetted by federal housing policy.”

He sympathetically discusses Franklin Raines, Fannie’s CEO from 1999–2004, whose “move back to Fannie Mae coincided almost exactly with the onset of the housing bubble.” This section should also have considered James Johnson, CEO from 1991–1998, the real architect of Fannie’s risky, politicized expansion. Both of them combined politics at the highest level in the Democratic Party with housing finance, a combination which produced, as Sheets says, “just the opposite of what was intended.”

Sheets’ conclusions are consistent with those of Peter Wallison’s exhaustive study, Hidden in Plain Sight, which states, “There is compelling evidence that the financial crisis was the result of the government’s own housing policies.” So that no one misses the point, Sheets reiterates, “We can safely conclude that the Liftoff phase of the housing bubble was caused by the GSEs, with the support of the federal government.”

In the acceleration phase, Sheets writes that “the Federal Reserve became the driving force behind the further escalation of real housing price appreciation” by suppressing interest rates to extremely low levels, including negative real interest rates. This made mortgage borrowing seem much cheaper, especially as borrowers shifted to adjustable-rate mortgages.

“The Fed dramatically lowered short-term interest rates in order to deal with the collapse of the Internet stock bubble in 2000 and then held rates at historically low levels. … The Fed pushed the real fed funds rate down to an average of minus 0.6% during the Acceleration phase.” And “Where did the stimulus go? Into housing.”

Sheets notes that after the Internet stock bubble burst in 2000, the Fed lowered short-term interest rates and held them at historic lows. That stimulus, he says, went into housing. I call this the “Greenspan Gamble,” after the famous Fed chairman of the time, who was then admired as “the Maestro” for his timely monetary expansions. As Sheets says, the Fed ended up with the housing bubble instead—which cost Greenspan his “Maestro” title.

After the Fed started increasing rates again in 2005–2006, the housing bubble decelerated, and then collapsed in 2007. House prices started to go down instead of up, the start of the six-year fall. Subprime mortgage defaults went up. Specialized subprime mortgage lenders went broke. The problems spread to leading, household-name financial institutions. In the fourth quarter of 2007, “Citigroup, Bank of America, and Wachovia announced steep profit declines due to mortgage write-downs, … Merrill Lynch announced the largest quarterly loss in the firm’s history, … Citigroup revealed [huge] pending write-downs … [and there was] the steady drumbeat of massive mortgage write-downs, historic losses, and jettisoned CEOs”—all this showed the bust had arrived, just as it had so many times before in financial history, and it kept getting worse.

When Fannie and Freddie went down in September 2008, it provided an affirmative answer to the prescient question posed by Thomas Stanton way back in his 1991 book, A State of Risk: “Will government-sponsored enterprises be the next financial crisis?” That took the crash to the brink of its panic stage. As discussed above, the panic began when the funding market’s expectation that Lehman Brothers would be bailed out by the government was surprisingly disappointed. Peak fear with peak bailouts followed.

Sheets believes this no-bailout decision for Lehman was a colossal mistake, describing the date of Lehman’s bankruptcy as “a day that will forever live in financial infamy.” He provides a summary of internal government debates leading up to the failure, considers the argument that the Treasury and the Fed had no authority to provide a bailout, and finds it unconvincing: “I believe that they could have chosen to bail out Lehman if given sufficient political backing, and that such a step would have averted the Panic stage of the crisis.”

Wallison relates that the decision seems to have originated as a negotiating position of Treasury Secretary Henry Paulsen, who explained that he thought “we should emphasize publicly that there could be no government money … this was the only way to get the best price.” Paulsen also “declared that he didn’t want to be known as ‘Mr. Bailout.’” Wallison is a former general counsel of the Treasury Department and thinks, like Sheets, that authority to rescue Lehman was available: “Paulsen and [Fed chairman] Bernanke … telling the media and Congress that the government didn’t have the legal authority to rescue Lehman … was false.”

What would have followed if there had been a bailout of Lehman, since the deflation of the housing bubble would still have continued? That is a great counterfactual issue for speculation.

2008: What Really Happened ends a good read with two radical thoughts about politically privileged institutions:

Given the understanding of the bubble set forth here, the keys to preventing a similar crisis in the future are relatively straightforward: Eliminate the role of the GSEs in the national housing markets. Eliminate or dramatically curtail the ability of the Federal Reserve to inflate asset bubbles.

Great proposals, with which I fully agree. But Sheets, like the rest of us, does not expect them ever to happen, so he does expect, and so do I, that we will get more bubbles and busts.

The Great Pretenders: 50th Anniversary of Hayek’s Nobel Prize Acceptance Speech Is Marked — and What an Apt Moment

Published in The New York Sun.

The economic sage saw that the attempts of central bankers to control the markets is based on a ‘pretense of knowledge.’

This is the 50th anniversary of Friedrich Hayek’s 1974 Nobel Prize Lecture, “The Pretense of Knowledge.” In his brilliant presentation, which applies particularly to central banks and their yearning to be economic philosopher-kings, Hayek explained the inherent limits of economics and the inevitable failure of trying to make it a predictive mathematical science. 

This was nicely ironic, since the formal name of the award he was receiving is the “Sveriges Riksbank Prize in Economic Sciences,” which celebrates both the “economics is science” idea and the world’s oldest central bank. “Economics is history trying to be physics,” a Wall Street friend told me years ago. He might equally have said, “It is philosophy trying to be physics.” 

As Hayek maintained, in the attempt to be physics — to be used for top-down control by central banks — economics has not, but more importantly, cannot succeed. In 1974, Hayek pointed out that “the serious threat of accelerating inflation,” which became the disastrous Great Inflation of that decade, “has been brought about by policies which the majority of economists recommended and even urged.”

Among the things they got wrong was the “Phillips Curve” economic theory that inflation would bring lower unemployment. “The dominant ‘macro-economic theory,’” Hayek predicted, “is likely to make later large-scale unemployment inevitable.”Indeed, the decade ended with simultaneous high inflation and high unemployment. 

Said Hayek, expressing the contrasting theory: “Unemployment indicates that the structure of relative prices and wages has been distorted (usually by monopolistic or government price fixing).” What are central banks but monopolists of the paper currency and a government committee to fix prices (interest rates). 

The Federal Reserve once again demonstrated its power to distort relative prices and credit allocation through its purchase of $2.7 trillion in mortgage securities. That vast monetization of mortgages stoked the second great house price inflation of the 21st century and succeeded in making houses unaffordable for large numbers of Americans, once the abnormally low mortgage interest rates the Fed created went back to normal.

It’s obvious when you think about it, but societies of human beings are not mechanisms with mathematical laws governing their behavior.Instead they are, in Hayek’s term, “phenomena of organized complexity,” fundamentally different in nature from a physical system. They have a different “manner in which the individual elements are connected to each other.” In short, they are connected by minds, and ideas are causal forces in their behavior.

Acting human beings in a society or a market are always looking ahead, anticipating what the actions of the central bank or other parts of the government will be, trying to influence others, changing their beliefs, strategizing, trying to bluff or mislead opponents, forming expectations in response to each other’s expectations. 

The resulting reality is marked by deep recursiveness, reflexivity, and uncertainty. It represents “a sum of facts which in their totality cannot be known to the scientific observer or to any other single brain.” This knowledge so dispersed is “the source of the superiority of the market order,” Hayek said. It is also the source of the poor record of central bank forecasts, the checkered history of central banking in general, and the impossibility of making economics into physics.

So pity the Federal Reserve governors and presidents who must meet to fix prices as the Federal Open Market Committee.All of them must know in their hearts, each one, that they do not and cannot know the economic and financial future. With 50 more years of institutional experience since Hayek spoke at the Nobel Prize ceremony, they must know that economics is not and cannot be a mathematically predictive science. 

Yet they are forced to make forecasts and guesses while they cannot know what the results will be. “All the world’s a stage,” no doubt, and the Fed cannot avoid being on the stage, and the show must go on. What, though, do the actors in this show really think? Let us hope they have taken to heart Hayek’s lesson that the “insuperable limits to knowledge” ought to teach humility, so that central bankers remain skeptical about their own forced guessing. 

What if, in the end, central bankers believe in the “pretense of knowledge” of their own press releases and flatter themselves that they really are in possession of the scientific, mathematical power to manipulate everybody else for their own good? Hayek ended his great lecture by warning against the danger of this “fatal striving to control society,” which produces tyrannical behavior.

The Federal Reserve plunges into the mortgage market and takes a bath

Published in Housing Finance International Journal.

The most important central bank in the world, the Federal Reserve, owned on September 30, 2024, the staggering sum of $2.3 trillion in mortgage securities, making it by far the biggest investor in the “agency MBS” market which dominates U.S. housing finance. These are the mortgage securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, which total $9.3 trillion. Thus, the central bank owns 25% of the total relevant market, a massive concentration of interest rate and market risk. How has the Fed done on this investment?

The Fed’s mortgage securities portfolio had, as of September 30, a mark-to-market loss of $315 billion, or more than 7 times its stated total capital of $43 billion. The average yield on its mortgage securities portfolio is only 2.2%, while its deposits are costing it 4.65%, for a negative spread on these investments of 2.45%. This means the Fed has an annualized operating loss on its mortgages of $56 billion, equal to a cash loss per year of 130% of its stated total capital. (The Fed is in addition losing money on its portfolio of long-term Treasury bonds.) The underlying mortgages of the Fed’s mortgage securities are primarily 30-year fixed-rate loans, so they have a long time yet to run. In this respect, the Fed looks just like the biggest 1980s-style savings and loan in history. It is quite amusing to think about what Federal Reserve examiners would say to any regulated bank which ran such risk and produced such outcomes!

Moreover, the Fed must transfer most of any profits it makes to the U.S. Treasury, so when the Fed has losses, its losses are also losses to the Treasury and costs to the taxpayers, imposed on them without legislation or Congressional approval. The Fed’s losses increase the government deficit and the government’s debt. As the provocative financial observer Wolf Richter has written, we are “in the era of the money-losing Fed.” The U.S. has never been in such an era before.

In the process of making these losing investments, the Fed greatly distorted the U.S. housing market. Its purchases of mortgage securities with newly created money, or the monetization of mortgages, resulted in a rapid expansion of abnormally cheap mortgage credit, driving the interest rates on 30-year fixed rate mortgages to below 3%, and fueling a rapid acceleration in house prices which has made them unaffordable to large segments of the American population. This was the Second U.S. Housing Bubble of the still young 21st century.

Many people, including me, thought that when U.S. mortgage interest rates inevitably went back to normal levels of 5%-6% or more, average U.S. house prices would fall. They did fall a little, but then started back up. With the standard U.S. 30-year mortgage now costing 6.8%, U.S. house prices nonetheless went up about 4% over the last 12 months.

The most common theory to explain this surprising outcome is that the lucky borrowers of 3% mortgages with the rate fixed for 30 years don’t want to lose the large financial advantage of their abnormally cheap debt by moving, so they disproportionately stay in their houses, thereby reducing the normal supply of houses available for sale and holding up house prices. If this be true, it is another striking source of distortion in the housing market by the Fed.

Quoting Wolf Richter again: “If [house price] charts look absurd it’s because the housing market has become absurd. Housing market charts should never ever look like this. They’re documenting the crazy distortions triggered by the Fed’s monetary policies.” I believe Wolf is correct about this.

Does a huge position in mortgage securities belong on the balance sheet of the U.S. central bank? An authoritative Federal Reserve study of what assets the Fed might invest in, in addition to Treasury securities, is Alternative Instruments for Open Market and Discount Window Operations (2002), written by an expert Federal Reserve System Study Group. This careful study articulated as two of its essential principles that the Fed should:

“Structure its portfolio and undertake its activities so as to minimize their effect on relative asset values and credit allocation within the private sector.”

“Manage its portfolio to be adequately compensated for risks and to maintain sufficient liquidity in its portfolio to conduct potentially large actions on short notice.”

It is apparent that the Fed’s mortgage investments have violated both these principles.

As for the first, they had a major effect on relative asset values, pushing the price of houses up at double-digit annual rates. And they were a massive allocation of credit by the central bank to a particular sector within the private economy, namely housing.

Regarding the second principle, instead of being adequately compensated for its risks, the Fed is suffering, as discussed above, operating and market value losses on its mortgage investments far greater than its capital. As for liquidity, the Fed can’t get out of its mortgage position in any short term—the position is too big relative to the market. Selling it would entail realizing the portfolio’s market value deficit, thus turning paper losses into cash losses.

It is not a practical possibility for the Fed to liquidate its mortgage portfolio on short notice. If it did manage to sell, at least $315 billion in new cash losses would have to be reported in its profit and loss statement. Adding these to the $210 billion in operating losses it has already reported, that would bring its total cash losses to well over half a trillion dollars. Recall that this is also an increase in the federal deficit and the federal debt. Such losses would not only be an embarrassment to the Fed, but might trigger Congressional attention it doesn’t want.

Worse, the Fed would not be able to unload its mortgage securities for as much as its fair value estimate. Trying to quickly sell its massive position would drive the market prices down against it, causing a loss much greater than $315 billion--indeed it might crash the mortgage-backed securities market. Even the announcement that the Fed planned to sell its securities gradually over time would probably lower MBS prices and thereby increase mortgage interest rates—hardly a welcome political outcome.

So it looks like the Fed will have to just hold its losing mortgage securities until the underlying 30-year mortgages slowly mature over time, as “the era of the money-losing Fed” continues. It does not appear that anyone, including the new Trump Administration, can change this outcome.

Looking further forward, the troublesome results of the Federal Reserve’s mortgage investing experiments will certainly provide good material for future historians and theorists of central banking and housing finance.

Letter: Double standards add insult to depositors’ losses

Published in the Financial Times.

“Oklahoma bank failure reveals double standard” (November 23), Lex rightly says, but the US deposit insurance double standard is even more egregiously unfair than the article suggests. Many of the uninsured depositors of Silicon Valley Bank were wealthy venture capital, private equity and cryptocurrency firms and barons, who would without doubt claim for themselves top financial expertise. They should have known the risks they were taking with their outsized, unsecured, uninsured deposits.

Moreover, these financial experts should have been on top of the mismanaged state of that bank in which they had so much at risk. Instead of having other people’s money taken to make them whole, they richly deserved the haircuts they would otherwise have had on the remarkably imprudent risk they voluntarily took.

I imagine these bailed-out Silicon Valley depositors deserved the losses they didn’t take far more than do the uninsured depositors in Lindsay, Oklahoma, (population 2,866) deserve the losses they are taking.

The Great Pretenders

It is 50 years ago Wednesday that economist Friedrich Hayek accepts his Nobel Prize with a warning about economists.

Published in The New York Sun.

It will be 50 years on Wednesday since economist Friedrich Hayek’s Nobel Prize lecture, “The Pretense of Knowledge,” our Alex Pollock reminds us. That was the speech in which Hayek decried the “accelerating inflation” of the day — and the bitter irony that it had “been brought about by policies which the majority of economists recommended and even urged governments to pursue.” He concluded: “As a profession we have made a mess of things.”

It was of a piece with Hayek’s role as a contrarian in the economics profession that his “brilliant presentation,” Mr. Pollock notes, “explained the inherent limits of economics and the inevitable failure of trying to make it a predictive mathematical science.” Fifty years on, Hayek’s warning “applies particularly to central banks and their yearning to be economic philosopher-kings,” Mr. Pollock adds. Is this anniversary being marked by the pretenders at the Fed?

…

The refusal to consider gold as a factor in monetary deliberations reflects the failure to heed Hayek’s warning of 50 years ago. Mr. Pollock conveys a hope that institutions like the Fed “have taken to heart Hayek’s lesson that the ‘insuperable limits to knowledge’ ought to teach humility.” Central bankers, in Mr. Pollock’s telling, have reason to be “skeptical about their own forced guessing.” Yet if there is one thing that is in short supply at the Fed, it’s humility.

The Misesian: Printing Power: The Central Bank and the State

Published by the Mises Institute and in the Misesian.

This essay is adapted from a speech delivered at the Mises Institute’s Supporters Summit in Hilton Head, South Carolina, on October 12, 2024.

“Printing Power” in our title has a double meaning: It can mean “printing power”—the power to print money, which central banks have. But we will focus on “printing power”—the central bank’s money printing as an essential source of the power of the state, including of course the Federal Reserve’s printing to promote the power of the United States government. 

The Fed is good at literal printing, exercising its monopoly of currency issuance granted by the government. It has outstanding $2.3 trillion in pure paper money circulating around the world, of which perhaps 45 percent, or more than $1 trillion, is held abroad. All the currency represents zero-interest-rate financing of the Fed and the US government. With interest rates currently at 5 percent, this means a potential profit of $115 billion a year for them by the Fed’s having issued the currency. 

The Fed is also good at metaphorical printing, which is simply entering credits on the deposit accounts of banks in its own books. The Fed thereby creates money which it can use to buy the debt securities of the Treasury, or, in other words, to lend the printed money to the government. The Fed now has $4.1 trillion in deposits. 

All together then, as of October 2024, there is $6.4 trillion in currency and deposits used to finance the American state’s programs, payroll, interventions, subsidies, and wars. The Fed can and does use its buying power to keep the interest cost of the government’s debt lower than it would otherwise be. At peak Fed, in March 2022, the Fed owned $8.4 trillion in Treasury debt and government mortgage securities. 

Because the central bank prints power for the state, virtually all governments want and have one. 

The real first mandate of every central bank is to finance the government of which it is a part, thereby enhancing and promoting the state’s power. In addition to lending the government money, the central bank taxes the citizens on behalf of the government by creating inflation. Taxing by inflation transfers purchasing power from the people to the state without the bother of having to enact tax legislation. From the viewpoint of the government, the central bank provides a technique for more freely taxing the public. 

The ability to run budget deficits is key to the power of the state. It wants to keep paying soldiers, buying munitions, paying all the employees of the government bureaucracies, funding its projects, and sending money to political constituencies and friends at home and abroad, even if it is out of money. But it won’t run out of money if it has its central bank to print up what it needs. 

You will not find this real first mandate of central banks anywhere in the Federal Reserve’s copious public relations materials. You will find a lot of discussion about setting interest rates, the “dual mandate” of maximum employment and stable prices (now redefined by the Fed as perpetual inflation), fighting inflation, regulating banks, and promoting financial stability, but never a mention of the essence of central banking: financing the government. 

Our colleague Joe Salerno has discussed the evolution of economists from critics to friends of state power. I will add that running deficits and printing money also allow the government to hire and pay more economists. As is often noted, the Fed itself is the country’s largest employer of PhD economists.

The First Mandate in Central Bank History

The history of central banks clearly displays their link to government power as a constant theme. We will review a few examples. 

First, the model and most important central bank in the world, before it was displaced by the Fed, was the Bank of England. Why and how was the Bank of England created? As we read in Bernard Shull’s excellent book on the Fed, The Fourth Branch: “In 1694, the British Parliament desperately needed funds to finance . . . [its war] with Louis XIV of France. . . . It accepted a novel plan . . . to establish a bank that would raise capital and promptly lend it to the government at a bargain rate. . . . In return, [the plan’s proponents] would be granted a charter. . . . Thus the Bank of England came into existence as an instrument of war finance.” 

It worked. Historian William H. McNeill, in The Pursuit of Power, his study of state power from the eleventh to the twentieth centuries, observes that the English invented “an efficient centralized credit mechanism for financing war by founding the Bank of England. . . . The result was to assure Great Britain of . . . naval superiority throughout the early eighteenth century. . . . Easy credit made it possible to expand the scale of British naval effort quite rapidly whenever a war emergency required such action.” 

In America, Alexander Hamilton, the father of the First Bank of the United States, the ultimate progenitor of the Fed, wrote in 1781: “Great Britain is indebted for the immense efforts she has been able to make in so many illustrious and successful wars essentially to that vast fabric of credit raised on the foundation [of the Bank of England].” 

Nor was the lesson lost on Napoleon, who created the Bank of France a century after his British antagonists founded the Bank of England. Organizing the bank in 1800, Napoleon rationally said he wanted a bank he could rely on to lend him money when he needed it. 

When the Federal Reserve was established another century later, the Federal Reserve Board met in the Treasury Building and was chaired by the secretary of the Treasury. It seemed less important then than now. Before a state dinner in its early days, the Federal Reserve Board complained that its members were too far back in the order of entry into the dinner, with insufficient prestige. They took this complaint to the Treasury secretary, who took it to the president, Woodrow Wilson. “They can come in after the fire department,” said Wilson. 

Today the Fed is the leading financial fire department in the world, although as James Grant wittily added in the new Mises documentary on the Fed, it is also the leading financial arsonist.

What really made the Fed’s reputation was its role in financing the American intervention in the First World War. Quoting Shull again: “When the United States entered the war in April 1917, the System turned its effort to supporting the Treasury’s deficit financing. . . . The Treasury’s plan was to sell securities at as low a cost as possible . . . and . . . by arrangements with the Federal Reserve, to provide for lowcost borrowing to purchase them. . . . [The Fed was] enlisted in the marketing and promotion of securities. . . . Banks were encouraged to borrow in order to purchase Treasury securities and to extend credit to customers to do so. . . . Preferential . . . rates were established for borrowing from the [Federal] Reserve Banks to purchase government securities. . . . The Federal Reserve Banks became great bond-distributing organizations.” 

The Fed had energetically carried out its real first mandate. Said the Treasury Department appreciatively in 1918: “Without [the Fed], it would be impossible to finance the tremendous credits required to assist the foreign governments making common cause with us against Germany, and to take care of the extraordinary expenditures entailed by our part in the war.” 

Or you might say the Fed was essential to financing America’s entanglement in the First World War, which led to immense growth in the size and reach of the Wilsonian US government. 

Said the Fed of itself: “From the outset, [the Federal Reserve] recognized its duty to cooperate unreservedly with the Government to provide funds needed for the war and to suspend the application of well-recognized principles of economics and finance. 

To repeat, ready and generous deficit financing is key to state power. This was most recently evident in the gigantic deficits of the covid financial and economic crisis and the vast subsidies of its aftermath, which led, as we have said, to peak Fed in March 2022.

“A Masterful Manipulation”

We will end with a vivid example of central bank printing power. 

At the beginning of the crisis of the First World War, in 1914, the Bank of England was the greatest central bank in the world. Yet the bank engaged in fraud to deceive the British public in order to finance the British war effort.

The first big government war bond issue of the war raised less than a third of its target sales to the public, but this real result was kept hidden. “The shortfall was secretly plugged by the Bank, with funds registered individually under the names of the Chief Cashier and his deputy to hide their true origin,” we learn from a Bank of England article published a century later. In other words, the Bank of England bought and monetized the new government debt and lied about it to the public to support the government’s war plans. 

The lie passed into the Financial Times under the headline “Over-subscribed War Loan”—an odd description, to say the least, of an issue with its allocation to the public in fact undersubscribed by two-thirds.

But the responsible officers of the Bank of England and the British government thought speaking the truth would endanger future government borrowing and be a propaganda victory for Germany. The famous economist John Maynard Keynes wrote a secret memorandum to His Majesty’s Treasury in which he described the Bank of England’s actions as “compelled by circumstances” and said that they had been “concealed from the public by a masterful manipulation.” 

“A masterful manipulation”! One very helpful to the British state, so it could get itself into the incredible disaster of the First World War. 

To sum up, central banks are a terrific means to enhance the power of the state by printing power. They cannot be properly understood without this insight.

13th Annual Housing Center Conference

Hosted by the American Enterprise Institute.

“…they should go back to the original Trump regulation which we helped the data together with our friend Alex Pollock…”

[at time stamp 1:56:50]

The Day Lyndon Johnson Pushed the Fed Chairman Around the Room While Shouting Curses at Him

Yet it turns out that the president still isn’t the boss of America’s central bank.

Published in The New York Sun.

Whether President Trump could fire Chairman Jerome Powell of the Federal Reserve has become the subject of front-page stories and public speculation. It highlights the constitutional and legal question, “Who is the boss of the Fed Chairman?” It’s the Congress. The Fed, though, is always in a web of presidential politics. 

So recurring tension between presidents and Fed chairmen is to be expected. Presidents naturally would like to be able to create, as desired, all the money they want to spend and to keep down the interest cost of our Treasury’s debt. Presidents are boss of the Treasury Department, but not of the Fed. This has often led to frustration.

When the Fed had raised interest rates that President Lyndon Johnson opposed, LBJ angrily demanded: “How can I run the country and the government if… Bill Martin is going to run his own economy?” The Fed chairman at the time, William McChesney Martin, went to Johnson’s Texas ranch to discuss the issue. Johnson called Martin’s action “despicable,” and, it is said, physically pushed Martin around the room while shouting and swearing at him.

“He was very disagreeable,” said Martin later, though the higher interest rates stayed.

There is one case in history where a President actually forced out a Fed chairman, though unable to formally fire him. President Truman and Chairman Thomas McCabe had been disagreeing about whether the Fed should keep buying Treasury bonds at the pegged wartime rate of 2.5 percent, which Truman and his Treasury Secretary wanted. 

There was still a war on — the Korean. About the Fed’s allowing higher interest rates on Treasury bonds, Truman told McCabe, “That is exactly what Mr. Stalin wants.” Finally, Truman told McCabe, whom he had appointed as Fed chairman three years before, that “his services were no longer satisfactory.” McCabe bitterly resigned.

Truman then appointed Martin as Fed Chairman, thinking Martin would be loyal to the Treasury. Yet Martin did not wish to continue the peg, and Truman called Martin a “traitor” to his face. Then Martin stayed on as Fed Chairman for 19 years, overlapping with five presidents.

About Martin’s relationship to the executive branch, the Fed chairman said, “That is not to say that the Federal Reserve should operate in isolation from the Treasury. On the contrary, we enjoy cordial and close relations…and we are working together in harmony.” However, this was not always the case.

President Nixon seems to have had better luck with Chairman Arthur Burns. “Ample evidence…supports the claim that President Nixon,” with his eye on re-election, “urged Burns to follow a very expansive policy and that Burns agreed to do it,” wrote Allan Meltzer in his history of the Fed.

With wit and cynicism, Nixon said that he hoped the independent chairman would independently decide to agree with the President. The key principle in political philosophy behind the tension between presidents and Fed chairman was well stated in congressional testimony by Martin in 1964.

“The question is whether the principal officer in charge of paying the Government’s bills should be entrusted also with the power to create the money to pay them,” Martin said. We must agree with Martin that the answer to that question is no. That does not mean the Fed is accountable to no one.

The case for accountability was forcefully put by Congressman Wright Patman, chairman of the House Committee on Banking between 1963 and 1975: “I have long been concerned about the aloofness of the Federal Reserve from both the executive branch and the Congress,” Patman said. 

Congressman Wright Patman, right, speaks with monetary expert James H.R. Cromwell, left, and Speaker Bankhead at the Capitol in 1937. Library of Congress via Wikimedia Commons

“Although the Federal Reserve is a creature of Congress, it is not subject to any of the usual Government budgetary, auditing, and appropriations procedures,” he added. “Also, the Federal Reserve is not required to obtain approval for its policies.” Today’s Fed thinks it can unilaterally commit the country to perpetual inflation at 2 percent a year without congressional approval.

Patman continued, “This sort of unbridled freedom… isn’t compatible with representative democratic government.”  I would say that he was right. It is compatible with a Platonic theory of rule by philosopher-kings, but not compatible with our constitutional republic.

The new president should work with the new Republican Congress, which has undoubted Constitutional authority over the Fed and over the nature of our money, to bring accountability to the Fed and move America in a direction of sound and stable money.

The Fed’s ‘temporary’ mortgage-backed security experiment will last decades

Published in The Hill with Paul Kupiec. Also published in RealClear Markets.

It has been nearly 14 years since Federal Reserve Chairman Ben Bernanke told Congress that the Fed’s emergency quantitative-easing policy, of which the most radical part was buying mortgage-backed securities, was “temporary” and would be “reversed.”  

The Fed made huge mortgage-backed securities purchases. The purchases pushed mortgage interest rates to artificially low levels, stoked the second great house price bubble of the 21st century and made houses unaffordable for many. 

In addition, these mortgage-backed securities investments unintentionally caused massive Fed losses. They are costing the Fed and taxpayers billions of dollars a month and will for years to come, as there is no practical way for the Fed to reverse its very large, deeply underwater mortgage-backed securities investment. 

The Fed created a giant, loss-making mortgage-backed securities portfolio. It currently owns $2.3 trillion in mortgage-backed securities mostly bought at the top of the market when mortgage yields were artificially low. 

Today, these mortgage-backed securities are worth far less than the Fed paid for them. The June 30 Fed financial statement shows an unrealized market value loss of $423 billion on the Fed’s mortgage-backed securities investments. This loss is nearly 10 times the Fed’s financial statement reported capital of $43 billion. 

We say “reported capital” because the Fed has suffered $207 billion in realized cash operating losses that it has amazingly not deducted from its reported capital. Using standard accounting rules, per our estimate, the Fed’s actual capital as of Oct. 30, is $43 billion minus its accumulated cash operating loss of $207 billion; or negative $164 billion.  

In addition, the Fed has $423 billion in unrealized mortgage-backed securities market value losses because interest rates today are much higher than the rates the Fed earns on its mortgage-backed securities. 

The Fed invested in 30-year fixed-rate mortgage-backed securities, almost all of which have remaining maturities of more than 10 years. It earns about 2.2 percent interest on its mortgage-backed securities but pays a 4.9 percent interest rate to fund them. 

The Fed has a negative 2.7 percent spread on these mortgage-backed securities meaning that it costs the Fed an annualized $62 billion to own these securities. Remarkable asset-liability management!  

The Fed’s cash losses are also losses to the U.S. Treasury. So without any congressional approval, the Fed’s very large, very underwater mortgage-backed securities investment is imposing tens of billions of dollars of costs annually on taxpayers.   

According to a congressional testimony about the Fed’s emergency investments by Chairman Bernanke on June 12, 2014: 

“What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the Fed’s balance sheet will be normalized, and there will be no permanent increase … in the Fed’s balance sheet.”

It is now 2024. How long is “temporary”? Why doesn’t the Fed just sell its mortgage-backed securities and put the problem behind it?   

It is not practical for the Fed to sell all its mortgage-backed securities. If it sold them, the Fed would, under the unrealistic assumption that it could sell its mortgage-backed securities at their current estimated market value, realize $423 billion in new cash losses. We estimate that would make the Fed’s capital, measured using standard accounting rules, negative $587 billion. 

While the Fed would, we expect, continue to claim that it had $43 billion in capital, the $423 billion in market value losses would become actual cash losses and have to be reported in the Fed’s profit and loss statement. Reporting such a huge cash loss would not only be an embarrassment but could trigger congressional investigations and unwanted oversight. 

More realistically, the Fed would simply not be able to sell its mortgage-backed securities for its current fair value estimate. The Fed’s $2.3 trillion investment is a massive position. It is so big that in reality it can’t be sold. There are about $9.4 trillion in total mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae of which, the Fed owns almost 25 percent. 

If the Fed tried to quickly sell its portfolio, the sale would crash the mortgage-backed securities market and result in a cash loss much larger than $423 billion. It could reduce the inevitable negative market price impact by liquidating its mortgage-backed securities gradually over time, but the mere announcement that the Fed planned to sell would lower prices in the mortgage-backed securities market. 

Moreover, either approach would push up mortgage interest rates — hardly a welcome political outcome. 

It seems likely the mortgage-backed securities will be on the Fed’s balance sheet until they finally mature. In the meantime, they will continue racking up billions of dollars in cash losses each month. 

It looks like the Fed is stuck with very large, losing “temporary” mortgage-backed securities investments for a long time to come. 

Alex J. Pollock is a senior fellow at the Mises Institute. Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The Revolt at the Fed

Editorial published in The New York Sun:

Congressman Wright Patman was trying to get the Fed audited like any other federal agency. The bank demurred. The late Patman is lucky he’s not alive today, when, as our Alex Pollock has been warning, the Federal Reserve’s real capital is now negative $158 billion. That puts its own light on Martin’s contention that the bank is not part of the government’s three branches. Who’s on the hook for that negative capital?