Printing Power: The Central Bank and the State

Based on a speech at the Mises Institute Summit, Hilton Head, South Carolina, 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% or more than $1 trillion is held abroad.  All the currency represents zero-interest rate financing of the Fed and the U.S. government.  With interest rates at 5%, 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 its own books to the deposit accounts of banks.  The Fed thereby creates money which it can use to buy the debt securities of the Treasury—in other words, to lend the printed money to the government.  The Fed now has $4.1 trillion in deposits.

Together then, as of October 2024, there is $6.4 trillion of 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 free taxing technique.

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, 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 Ph.D. 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[1]:

          “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 [it] would be granted a charter.  Thus the Bank of England came into existence as an instrument of war finance.”

It worked.  As historian William H. McNeill, in The Pursuit of Power, his study of state power from the 11th to the 20th centuries, observes:

          “The English invent[ed] 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.”

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 behind his British antagonists.  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.  For a state dinner in its early days, the Federal Reserve Board complained that its members were too far back in the order of entry 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 movie on the Fed, they are 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 by arrangements with the Fed to provide for low-cost 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 their 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 U.S. 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, a key need of State power is ready and generous deficit financing.  Most recently, this was evident in the gigantic deficits of the Covid financial and economic crisis and the vast subsidies of its aftermath, leading as we have said, to peak Fed in March 2022.

A “Masterful Manipulation”

We will end with a vivid example of the 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 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 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.

---

[1] The quotations I use are excerpts, with ellipses deleted.

The Swiss National Bank vs. the Federal Reserve: The Fed's Capital Losses in Perspective

Published in The Mises Institute’s Mises Wire.

Switzerland’s central bank, the Swiss National Bank (SNB), lost $3.6 billion in 2023,1  after a gigantic loss of $150 billion in 2022. But after booking these losses, and properly subtracting them from its capital, the SNB still had positive capital of over $70 billion. This gives it the quite respectable capital to total assets ratio of 7.9%. All of these numbers are after marking its investments to market, as is required by the SNB’s governing law, so the capital is a real, marked to market equity. The market value of the SNB’s holdings of gold is $65 billion, which includes a large appreciation, including $1.9 billion in 2023. Since the SNB had an overall loss for the year, it paid no dividends to its stockholders.

“The SNB aims for a robust balance sheet with sufficient equity capital to ensure that it can also absorb high losses,” it states.2  This sound financial principle is the opposite of the official position of the Fed. 

The Federal Reserve, central bank not only to the United States but to the dollar-using world, had a gigantic loss of $114 billion for 2023. It had reported a profit for the full year 2022, but had started losing money in September of that year at the remarkable rate of $2 billion a week. The Fed’s huge losses are continuing into 2024—by its February 28, 2024 report the aggregate losses have reached $154 billion. Since the Fed’s governing law does not permit it to maintain “a robust balance sheet with sufficient equity capital to absorb high losses,” indeed forbids it from doing so, the losses have wiped out the Fed’s capital by more than 3.5 times. 

Of course, the Congresses which passed the Federal Reserve Act and its amendments never intended the Fed to run with negative capital—they simply thought it was impossible for the Fed to lose this much money-- a flawed assumption.

The current capital deficit is shown by the undeniable arithmetic of the Fed’s capital as of February 28. The Fed has paid-in capital of $36 billion and miniscule retained earnings of $7 billion, for total of $43 billion. Starting capital of $43 billion minus Losses of $154 billion = current capital of negative $111 billion.

You will not find this negative capital, which is the real capital, reported on the Federal Reserve balance sheet, however. The Fed insists on the accounting charade of booking its massive losses as an asset, a so-called “deferred asset.” Do you believe, Candid Reader, that losses are an asset? You don’t? Neither do I. Do you believe that losses should be subtracted from capital, as responsibly done by the SNB? So do I! In short, the Fed publishes, not to put too fine a point on it, a phony capital number. But that’s its line, and the Fed is sticking to it.

Unlike the SNB, the Fed owns zero gold to help offset the secular depreciation of all paper currencies.

In spite of its huge losses, negative capital and negative retained earnings, the Fed continues to pay dividends to its shareholders. And the Fed does not mark its investments or its capital to market.

Taken all together, this makes quite an interesting contrast with the SNB. 

The Federal Reserve balance sheet combines the balance sheets of the twelve regional Federal Reserve Banks (FRBs). Here is an update on the real capital as of February 28, 2024 of these individual FRBs, as well as the total Federal Reserve. Eight of the twelve FRBs are technically insolvent, with losses of more than 100% of their capital and thus liabilities greater than their assets. Two other FRBs have lost 98% and 85% of their capital and are steadily approaching technical insolvency. Only two have most of their capital left. Of all the FRBs, the biggest and most important by far is the FRB of New York. It also has far and away the biggest losses and the most negative capital. The total system has a huge capital deficit. Recall that the table shows the real capital numbers, not the contrived ones reported by the Fed.

Real Capital of the Federal Reserve Banks as of February 28, 20243 :

Federal Reserve Bank Real Capital Losses as a % of Starting Capital

New York ($82.4 bln) 655%

Richmond ($15.6 “ ) 284%

Chicago ($ 8.8 “ )  515%

San Francisco ($ 2.8 “ ) 151%

Cleveland ($ 1.5 “ ) 134%

Boston ($ 1.2 “ ) 165%

Dallas ($677 mln) 161%

Kansas City ($ 94 “ ) 120%

Philadelphia $ 31 “ 98%

Minneapolis $ 40 “ 85%

St. Louis $891 “ 8%

Atlanta. $ 1.3 bln 13%

Federal Reserve System ($111 bln) 357%

These capital numbers do not include, unlike the SNB, any mark to market results. The Fed does disclose, quarterly, although not put into its financial statements, the mark to market losses on its portfolio. As of September 30, 2023, the net mark to market loss was the pretty amazing amount of $1.3 trillion. A reasonable guess at the end of February 2024 is that market value loss was about $1 trillion. Thus the mark to market capital would be negative $111 billion plus negative $1 trillion = negative $1.1 trillion.

Do you like your central bank capital positive or negative? I believe that the Fed should be recapitalized, but the Fed itself and most economists fervently dispute this. At the very least, Congress should insist, as would be required by the Federal Reserve Loss Transparency Act,4  a bill introduced by Congressman French Hill, that the Fed keep honest books.

Lots of Red Ink at the Fed

Published by the Mises Institute and RealClear Markets.

The Federal Reserve has officially reported a loss of $57 billion for the first six months of 2023. Quite a number! So the “Federal Reserve Banks Combined Quarterly Financial Report as of June 30, 2023” (CQFR)—a little-known document—is especially notable for its red ink. We can anticipate an annual loss of over $100 billion for 2023 and for the losses to continue into 2024. 1

How does a central bank, especially the world’s greatest and most important central bank, lose tens of billions of dollars in six months? An average person, influenced by the mystique of the Fed, might understandably be baffled by this fact.

To understand what is happening, we need to recall that in addition to being a media star as the manipulator of the world’s dominant currency, the Federal Reserve is a bank—well, actually 12 Federal Reserve Banks (FRBs), covering districts across the United States. Added together they are huge, with total assets of $8.3 trillion (with a T). The FRBs have loans, investments, deposits and borrowings, interest income and interest expense, and profit or loss like other banks do. They also have private shareholders: the commercial banks which are “Fed member banks,” and the FRBs have over them the Washington Federal Reserve Board, which charges them for its expenses.

The combined FRBs are intended to always be profitable because of their unique monopoly in issuing U.S. dollar paper currency. This is a very lucrative privilege which means together they have $2.3 trillion of zero interest cost funding from the dollar bills circulating around the country and the world, which they can invest in interest earning assets. (They print up some money and use it to buy Treasury bonds, simply said.) But instead of making profits, as the combined Fed reliably did for more than 100 years, it is now making giant losses, a historic reversal.

The CQFR shows that in the first six months of 2023 the combined Fed had $88 billion in interest income, but $141 billion in interest expense. So it paid out in interest $53 billion more than it received, and also had to pay its overhead expenses of over $4 billion. 

Why doesn’t it have more interest income? Because the Fed engaged to the tune of about $5 trillion in one of the most classic of financial risks: borrowing short and lending long, and now interest rates have gone very far against it and the risk has turned into real losses. 

The CQFR shows on page 22 that on June 30 the combined Fed owned $5.5 trillion in Treasury Securities with an average yield of 1.96%, and $2.6 trillion of mortgage-backed securities yielding on average 2.20%. In short, it invested in massive amounts of very long-term fixed rate assets and locked in for years a historically low yield of about 2%. Meanwhile, it was funding $5 trillion of these assets with floating rate deposits from banks and borrowings in the form of repurchase agreements, the cost of which rose to over 5%.

You don’t need a degree in banking or a Ph.D. in economics to know that lending money at 2% while you are borrowing money at 5% is a losing proposition. That is what our Federal Reserve Banks did and continue to do.

On top of this, as disclosed in the footnotes of the CQFR on page 7, when the combined Fed’s investments were marked to market on June 30, they had a market value loss of over $1 trillion, or a market value loss of 23 times the Fed’s stated capital.

The CQFR reports a total capital of about $42 billion ($35.6 billion of paid-in capital from the member commercial banks and $6.8 billion of retained earnings, called “surplus”). But note: This total capital is much less than the $57 billion reported loss for the six months of 2023, to which must be added the loss for the later months of 2022 of $17 billion. This total $74 billion of accumulated losses by June 30 must be subtracted from the retained earnings and thus from total capital. But the Fed does not do this—it misleadingly books its losses as an asset (!), which it calls a “deferred asset”-- a practice highly surprising to anyone who passed Accounting 101. Why does the Fed do this? Presumably it does not wish to show itself with negative capital. However, negative capital is the reality.

Here are the combined Fed’s correct capital accounts as of June 30, based on Generally Accepted Accounting Principles. They result in a capital of negative $32 billion:

Paid-in capital            $36 billion

Retained earnings   ($68 billion)

Total capital               ($32 billion)

The Fed wants you to believe that neither its negative capital nor its giant losses matter because it is the Fed and can print money. Many economists agree.

But does it matter that the Fed’s losses will cost not only it, but also the Treasury and the taxpayers, over $100 billion this year and more in the future? Does it matter that on a combined basis its accumulated losses are greater than its private stockholders’ paid-in capital? Does it matter that with negative equity under standard accounting, it is technically insolvent? All of these can be debated, but the numbers certainly do get one’s attention.

We conclude with a simple question: Did the leaders of the Fed intend to lose $57 billion in six months? Did they intend to be looking at a loss of more than $100 billion for this year? Did they intend to have a mark to market loss of more than $1 trillion? It is impossible to believe they did. The liberal supply of red ink they have delivered certainly does not help the Fed’s reputation for knowing what it is doing.

July 3--Sympathy for Thomas Jefferson Day

Everybody knows about July 4, but what was happening on July 3, 1776?  On that day, the draft of the Declaration of Independence submitted by Thomas Jefferson was edited by the Continental Congress, meeting as a committee.  Jefferson had to sit there, “the writhing author,” says my well-worn history of the Declaration, while his words were criticized, deleted and altered.  Jefferson “was far less happy when his handiwork was subjected to what he called the ‘depredations’ of Congress.” He “kept silent for propriety’s sake,” but “in his opinion, they did a good deal of damage [as] the delegates took a hand in the drafting.”  

All those who have worked assiduously on their writing, then had it edited by a committee, will have lively sympathy for Jefferson every July 3!

The Congress “effected economy in words,”  “deleted unnecessary phrases,”  “eliminated the most extravagantly worded of all the charges [against King George],” “deleted a passage in which Scottish mercenaries were coupled with foreign [ones],” changed Jefferson’s final paragraph so as to include in it the precise language of the resolution of independence just adopted [on July 2]”, and “left out several moving phrases of his toward the end.”

I have reviewed the edits made by the Congress, and find that they definitely improved the final, world historical document.  Nonetheless, to sit there while your work suffers “depredations” by a committee of your colleagues, even if they are in fact improvements, is surely difficult.  Our sympathy for the author should be undiminished.

1. Dumas Malone, The Story of the Declaration of Independence, Oxford University Press, 1954.

The Fed’s Capital Goes Negative

Published by the Mises Institute.

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion—just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level. The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen—about how a billion here and a billion there starts to add up to real money—we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative? I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie.

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages. The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses. Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent. Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent.

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury. So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans. Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.

All banks together have tangible capital of about $1.8 trillion. So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

FHLBs—Mission and Possible Improvements

Based on long experience and extensive study of various systems of housing finance and of financial systems generally, I respectfully offer the following thoughts on the mission of and possible improvements in the Federal Home Loan Banks (FHLBs).

Mission

I think the mission of the FHLBs is to support, in key words of the Federal Home Loan Bank Act, “sound and economical home finance,” by linking sound home finance nationwide to the bond market.  FHLBs’ principal activities should always be clearly tied to this mission, which should benefit tens of millions of mortgage borrowers throughout the country.

FHLB member institutions should be those which provide sound and economical home finance.  As markets evolve over time, which types of institutions are eligible membership should adapt to appropriately reflect this evolution.  For example, as commercial banks, originally excluded from FHLB membership, largely supplanted savings and loans in home finance, they were logically made eligible for FHLB membership by the Financial Institutions Reform, Recovery and Enforcement Act of 1989.

In my view, the FHLBs should take minimum credit risk, and all the credit risk of the mortgages they link to the bond market should be borne in the first place by the FHLB member financial institutions.  This is true of both FHLB advances, in which all the underlying assets stay on the books of the member, and for the fundamental concept of the FHLB Mortgage Partnership Finance program, in which the mortgage loan moves, but a permanent credit risk “skin in the game” stays for the life of the loan with the member institution, where it belongs.  Note that this is the opposite of selling loans to Fannie Mae and Freddie Mac, in which the lending institution divests the credit risk of its own customer that results from its own credit decision.

Since the mission of the FHLBs is sound and economical home finance, their subsidizing affordable housing projects is secondary. In an economic perspective, these programs may be seen as a tax on the FHLBs, and in a political perspective, a tactic which allows members of Congress the convenience of creating subsidies without having to approve or appropriate the expenditures.

FHLBs without doubt have important benefits from their government sponsorship.  These benefits should primarily go to supporting sound and economical home finance provided by member institutions throughout the country.  To assert that all or most of these benefits must go to subsidizing affordable housing is obviously disproportionate.

In the “mission” discussions, we can usefully distinguish between two groups of FHLB beneficiaries.  First are those who have also have skin in the game through having put their own money at risk by capitalizing, funding or financially backing FHLB operations.  They are the stockholder-members, the bondholders, and the U.S. Treasury.  Second are those who only receive subsidies from the FHLBs.

Suggested Improvements

1. The FHLBs should be given the formal power to issue mortgage-backed securities, provided these securities are always designed so that serious credit risk skin in the game remains with the member institutions.  This would give the FHLBs a very important additional method to carry out their mission and would be a long-overdue catching up with financial market evolution.

2. The Federal Home Loan Bank Act should be amended specifically to authorize the FHLBs to form a joint subsidiary to carry out functions best provided on a combined, national basis.  The participating FHLBs should own 100% of this joint subsidiary.  This addition to the FHLB Act is needed because of the requirements of the Government Corporations Control Act of 1945, when the U.S. Treasury still owned some FHLB stock.  It has not owned any for 70 years, but the 1945 statutory requirement is still there.

3. The prohibition of captive insurance companies from being FHLB members should be promptly withdrawn.  In my view, this was not only a mistake, but inconsistent with the FHLB Act, which has provided from July 1932 to today that “insurance companies” in general, with no distinctions among them, are eligible for FHLB membership.  I believe to change that required Congressional action, which was not taken.  Any insurance company, including a captive insurance company, which provides sound and economical home finance should be eligible for FHLB membership.

I hope these ideas will be helpful for the ongoing success of the FHLBs.

Alex J. Pollock is a Senior Fellow of the Mises Institute and co-author of the new book, Surprised Again!—The Covid Crisis and the New Market Bubble.  He was previously president and CEO of the Chicago FHLB, president of the International Union for Housing Finance, and Principal Deputy Director of the U.S. Office of Financial Research.

The Government Debt Ceiling: What Did Eisenhower Do?

July 27, 2011

Published with Anne C. Canfield in AEIdeas.

“Nothing is ever new, it is just history repeating itself”—at least in finance. In his A History of the Federal Reserve,¹ Allan Meltzer describes what happened during the Eisenhower administration when the Treasury ran out of debt authorization and Congress did not raise the debt ceiling. This was in 1953.

In order to keep making payments, the Treasury increased its gold certificate deposits at the Federal Reserve, which it could do from its dollar “profits” because the price of gold in dollars had risen. The Fed then credited the Treasury’s account with them, thereby increasing the Treasury’s cash balance. Treasury then spent the money without exceeding the debt limit.

By the spring of 1954, Congress had raised the debt ceiling from $275 to $280 billion (2 percent or so of today’s limit), so ordinary debt issuance could continue.

The Secretary of the Treasury still is authorized to issue gold certificates to the Federal Reserve Banks, which will then credit the Treasury’s cash account.² This is correctly characterized as monetizing the Treasury’s gold, of which it owns more than 8,000 tons. An old law says this gold is worth 42 and 2/9 dollars per ounce, but we know the actual market value is about 38 times that, at more than $1,600 per ounce.

Should we follow Eisenhower’s example?

Alex J. Pollock is a resident fellow at the American Enterprise Institute.  Anne Canfield is president of Canfield & Associates, Washington, D.C.

1. Allan Meltzer, A History of the Federal Reserve, Volume 2, Book 1, pp. 110 and 168.

2. Federal Reserve Bank of New York, 2010 Annual Report, p. 39.

Role of the General Manager

By Alex J. Pollock, 8/1989 

Broad Tasks   |  What Works Well 

1. Build the system of communication | Consistent display of integrity - insight into strengths and weaknesses 

2. Put the right people in the right places | Never be threatened by subordinates - appreciate the best - think long and carefully about managerial change 

3. Give an emotional meaning to the enterprise | Repetition of themes - consistency of words and actions 

4. Imagine and form robust approaches to the future | Time to think - study the long past - flexible ideas 

5. Create openness to the outside | Broad interests - not taking self too seriously - customer focus 

6. Insure the development and maintenance of key competences | Always have little experiments running - build as they succeed - honor the old and new key skills and knowledge 

7. Create psychological security, the ground for common action, out of uncertainty and risks  | Self confidence - be an emotional exporter 

8. Balance between the uncaring outside world demanding change, and the emotional inside organization longing for stability. | Perspective - guiding and teaching - getting others to want to do what is needed - patience

Ten Commandments of Leadership

By Alex J. Pollock, 12/24/87 

1. Drama - Giving emotional meaning to the organization and to the efforts and sacrifices of the individual. Appearing a leader so others will believe they should follow. Providing an element of mystery.

2. Physical presence - Being seen and felt by the ranks as at the head. 

3. Empathy with the ranks - Their problems, sacrifices, risks, fears, hopes. 

4. Detachment - Necessary to think above and beyond the traditions, commitments and beliefs of the organization and to make decisions causing suffering (and in the military, death). 

5. Courage - Sharing the risk. Going on in spite of fear and uncertainty. 

6. Imposing sanctions - Required for coordination of large groups. 

7. Knowledge – Both general knowledge and detailed information on the problems at hand. Historical perspective required. 

8. Decision - Setting the right course at the right time with the appropriate level of abstraction or detail. Taking on the burden of turning actual uncertainty into psychological certainty, the ground of common action. 

9. The right inner circle - Those who will tell the truth, are not awed by your drama, and fill in your gaps and mistakes. 

10. Creation of a personal role - A necessary part of drama. The role must both separate the leader and link him to the ranks through its appeal. Possible components: flamboyance, calm, brilliance, drive, speed, good cheer, human touch, wisdom, determination, idiosyncrasies, heroics, visions. 

Adapted from John Keegan, The Mask of Command.

The Federal Reserve’s Second 100 Years

Published by the American Enterprise Institute.

The Federal Reserve has had a remarkable career in the 100 years since Congress created it on December 23, 1913. What are the Fed’s next 100 years likely to bring?

It is daunting but also liberating to make such guesses about the very long term, since one is bound to get many things wrong. The human mind is incapable of imagining in advance the novelties that so much time will bring. For example, the authors of the Federal Reserve Act could certainly not have even imagined, let alone expected, what their creation has become in a century. They would have been utterly dumbfounded at a Federal Reserve that:

— Is formally committed to, and is producing on purpose, perpetual inflation.

— Has no link of any kind to a gold standard.

— Thinks it is supposed to, and that it is capable of, “managing the economy.”

— Invests vast amounts in, and monetizes, real estate mortgages.

— Has chairmen who achieve media star status, as for example, “The Maestro.”

— Wields the authority of a unitary central bank, centralized in Washington D.C., rather than being a federal system of regional “reserve banks.”

Can we have any hope of making some good predictions? Perhaps. Consider the 100-year predictions that the brilliant F.E. Smith, Lord Birkenhead, made in 1930 in his book, The World In 2030.

Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.

Birkenhead predicted, for example, the then-future revolutions in genetic science, atomic energy, and global communications media, and that in the future “women … will be found at the head of government departments [and] as managing directors of great commercial undertakings.” On the other hand, he did not discuss the monetary system at all, and did not predict the vast experiment in world-wide fiat currency in which we have been living since 1971, whose ultimate outcome is still unknown. Also, Birkenhead imagines that an undergraduate in 2030 preparing to write about the 22nd century would sit down at his typewriter, rather than not even know what a typewriter was.

Birkenhead offered some instructive general observations on the matter of the long future:

— “Remembering a thousand other changes, mechanical, ethical, social, political, and constitutional, we shall, it may be repeated, be wise to declare little impossible in the [next] hundred years.” Yes, including fundamental changes in our ideas about central banking and the beliefs of central bankers.

— “The future stretches before us in this year 1930 murky, obscure, and terrible.” In January, 2014, it still stretches before us murky and obscure but, it seems, less terrible than in 1930. I hope.

Another notable 100-year forecast made in 1930, this one specifically focused on economics, was by John Maynard Keynes in his essay, “Economic Possibilities for Our Grandchildren.” Starting by observing the “bad attack of economic pessimism” in “the prevailing world depression,” Keynes nonetheless predicted an optimistic economic future, about which he was entirely correct.

“In the long run,” he wrote in the midst of the world crisis, “mankind is solving its economic problem. I would predict that the standard of life in progressive countries 100 years hence will be between 4 and 8 times as high as it is today [in 1930].” As of 2013, per capita GDP in the United States was 5 times what is was in 1930, which is an average real growth rate of about 2 percent per year since 1930. If the 2 percent growth continues to 2030, the standard of life will be about 7 times what it was when Keynes made his prediction of 4 to 8 times. A great call.

Looking ahead in the spirit of Keynes for an additional 100 years to 2130, another increase of 7 times would bring it to a level of 49 times that of 1930. Can we imagine that?

If such real growth continues, it will be the result of advances in scientific knowledge, technical innovation, and entrepreneurship. Turning to the Federal Reserve, we find a different 2 percent growth rate: the Fed’s targeted rate of inflation, or depreciation of the currency it issues.

Since 1913, the U.S. consumer price index has increased over 23 times: in other words, a quarter now is about what a penny was when Woodrow Wilson signed the Federal Reserve Act. If the Fed produces a 2 percent annual inflation for its next 100 years, a dollar will be far less than a penny was; it would take about $1.70 to equal the original penny. Merely to stay even in real terms with today, an average household would then need an income of about $350,000. Can we imagine that?

This brings me to a dozen predictions about the Fed’s second century:

1. Lender of Last Resort

Consider a 1994 book, The World in 2020 (a 26-year forecast). “The debt crisis of the 1980s,” it says, “forced the banks to adopt much more cautious lending policies.” As is obvious from the multiple debt crises since 1994, extrapolating post-crisis banking caution is a mistake. Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes. As Paul Volcker wittily said, “About every ten years, we have the biggest crisis in 50 years.” A decade seems like about enough for the waning of institutional memory.

Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes.

An “elastic currency” was the most important purpose of the original Federal Reserve Act and remains a robust idea, as recently demonstrated once again in the panics of 2007-2009, although these also demonstrated once again that having the Federal Reserve does not prevent panics. Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.

Thus my first prediction: The Fed’s lender-of-last-resource function, or the ability to create “elastic currency” in a crisis, will continue to be necessary for at least another 100 years.

2. Shull’s Paradox

Professor Bernard Shull, in his provocative book, The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence, propounds what I call “Shull’s Paradox,” which is that no matter how many or how great are the inflationary and deflationary blunders made by the Fed, its power, prestige, and authority nevertheless always increase. Shull’s book, published in 2005, demonstrated this perverse relationship over the Fed’s first nine decades, and how the Fed, “established as a small and almost impoverished institution,” has nonetheless “emerged as the most influential organization ever established by Congress.” He then speculated, “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”

Shull’s speculation was fully confirmed. The Fed first stoked the great housing bubble from 2002 to 2005, then utterly failed to anticipate the magnitude of its collapse, and on top of that, failed to predict the ensuing steep recession. But in the subsequent legislative reaction, the notorious Dodd-Frank Act, the Fed’s jurisdiction and authority were expanded.

How can we explain the paradox? Perhaps it is the emotional yearning of many people, including politicians, to believe in a wise, “Maestro”-like force to orchestrate unpredictable events — even though no one, including the Fed, can actually do this. The Fed does seem able to inspire a puzzling, naive will to believe.

So I predict that Shull’s Paradox will continue to hold, and the Fed will gain even more power from the next crisis, even if it causes that crisis.

3. Independence

Is the Fed independent, as is often claimed? No. A better description is that of

Chicago Federal Reserve Bank President Charles Evans, who has referred to the “measure of independence” of the Fed.

William McChesney Martin, Fed chairman in the 1950s and 1960s, spoke of the Fed being independent “within the government” — i.e. not independent. Arthur Burns, Fed chairman in the 1970s, reportedly said, “We dare not exercise our independence for fear of losing it.”

Yet many economists are attracted to the idea of a truly independent Fed. It flatters the importance of their macro theories to think it should be so. I believe that inside every macro economist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king, or at least an assistant deputy philosopher-king.

But since the Fed is always “within the government,” I predict that in 2113 it still will not be independent, although the economists of that future day will still be writing about how it should be.

4. Systemic Risk

The Federal Reserve has the greatest power of any institution anywhere to create systemic financial risk for everybody else by its fiat money creation and interest rate manipulations. Given the global role of the dollar, this power runs around the world.

The Dodd-Frank Act has resulted in large banks being called “Systemically Important Financial Institutions,” or “SIFIs.” As such, it is maintained they need extra oversight. It is apparent that the Fed itself is the biggest SIFI of them all.

A good example of this is the massive interest rate risk of its own balance sheet.

Because of this risk, I predict that in the intermediate term the Federal Reserve will be insolvent on a mark-to-market basis.

Let’s go through the math. With so-called “QE,” or quantitative easing, the Fed now owns $2.1 trillion in long government bonds as part of its successful manipulation (so far) to get bond yields lower. In an entirely unprecedented fashion, it also owns $1.5 trillion of fixed rate mortgage securities. That is a total of $3.6 trillion in unhedged outright long positions. The Fed does not disclose the duration of this remarkable portfolio, but 7.5 years would probably be a fair guess.

Suppose interest rates rise a mere 2 percent. The mark-to-market loss would be $3.6 trillion X 2% X 7.5. This would be a mark-to-market loss of $540 billion. The Federal Reserve’s total capital is $55 billion. So the economic loss would be about ten times the Fed’s capital. Q.E.D.

One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.

Would the world care if its principal central bank were so insolvent on a mark-to-market basis? Many Fed defenders say absolutely not, but I don’t think anyone really knows. However, I also predict that the Fed will never admit any such insolvency on its own books. It has already developed for itself a version of “regulatory accounting,” not dissimilar to that practiced by savings and loans in the 1980s, to prevent any such admission. One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.

5. Big Surprises

During the history of the Fed so far, four major changes in the fundamental monetary regime have occurred: going off the gold standard in the 1930s; going on the Bretton Woods system of fixed exchange rates and a gold exchange standard in 1945; the collapse of the Bretton Woods system in 1971; and its replacement by the current global regime of pure fiat currencies and floating exchange rates (a regime which is quite prone to recurring crises).

It does not seem reasonable to assume that any monetary regime will last forever, and that the next hundred years will somehow be immune from fundamental changes. So I predict that in the course of the Fed’s next century, further major changes in monetary regimes will occur, surprising our current expectations — only we don’t know what they will be.

6. Central Banking and Dentistry

Keynes ends his essay on the “Economic Possibilities” of 2030 by thinking about economists and dentists. “The economic problem” — presumably including central banking — he puckishly suggests, “should be a matter for specialists — like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”

However, since then, central banking has still not become scientific like dentistry, nor do its specialists display the progress in scientific knowledge and technique that dentists so admirably do. In another century, I believe central banking, and macro economics, will be no closer to becoming a science like dentistry. Instead, they will, in accordance with their essential nature, continue to be debatable, contestable, uncertain, and ideological.

In other words, in 2113 the Fed will still be heavily political.

7. Maestroism

From the dissimilarity to dentistry, it follows that in the next 100 years, like the last, no Federal Reserve chairman can or will be a sustained, successful “Maestro,” as Alan Greenspan was unfortunately dubbed by the silly media, until he wasn’t. It is more likely that central bankers, like investment managers, will have good runs alternating with bad ones. This is by no means a matter of intelligence, talent, hard work, or leadership, but of the ineluctable uncertainty involved.

8. The Bernanke Legacy

One intriguing uncertainty in the Federal Reserve’s new century is how the Fed under Chairman Bernanke will be judged by future financial historians. It seems certain that its unprecedented quantitative easing, that vast manipulation of long-term bond and mortgage markets, will be heavily discussed. But will economists now in kindergarten or unborn judge “QE” a success or a failure? No one knows, including the Fed itself.

But will economists now in kindergarten or unborn judge ‘QE’ a success or a failure? No one knows, including the Fed itself.

It appears to me that the probability is bimodal: for his QE experiment, Bernanke is likely to go down in future history as either a great hero or a great bum, one or the other, but we don’t know which.

9. Inflation

What 21st-century central bankers had convinced themselves was the “Great Moderation” turned out to be in reality the Era of Great Bubbles and their collapse. In recent decades, the Fed and central banks generally have come to believe in inflation targets, usually of 2 percent a year or so inflation — in other words, perpetual inflation. Is this belief in perpetual inflation sustainable?

Perhaps financial systems with perpetual inflation may break down into crisis too often — the current monetary regime has obviously had plenty of financial crises. So perhaps the cognitive structures and psychological beliefs of central bankers may shift back to a commitment to a long-term stable value of currency, rather than inflation forever.

Such a shift in dominant ideas is certainly possible in 100 years.

10. Government Finance

The first mandate of most central banks is to lend money to the government as necessary. I believe the Federal Reserve will continue to be absolutely essential to the U.S. government, not because of its economic skills, forecasting ability, or financial wisdom, but because it is the reliable and expandable source of deficit finance for the government.

A fiat-currency issuing and government debt buying central bank, of which the Fed is the most important instance, is a hugely valuable asset for the government. I imagine it will still be so in 2113.

11. Legislative Reform

Legislation has been introduced in the U.S. House of Representatives to have a formal congressional review of the performance of the Fed since 1913 (mixed, to be sure) and of its future. Of course, the Fed is a creation of the Congress, and subject to legislative revision at any time. Twice in its first century, in 1935 and again in 1977-78, major reform legislation was enacted. I see no reason to assume that the politicians of the future will always be satisfied with the status quo of today.

In 2113 the Fed will still be heavily political.

So I predict that there will be a “Federal Reserve Reform Act” of 2000-something and/or 2100-something, at least once or twice, in the Fed’s second century.

12. Econocracy

An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro economics is or can be a science.

Financially famous Fed chairmen who were not professional economists include William McChesney Martin, who among other things was the president of the New York Stock Exchange; and Marriner Eccles, who was a banker and businessman from Salt Lake City. Both have Federal Reserve buildings in Washington named after them.

I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.

Finally: Not Rocket Science

Lord Birkenhead, introducing his 100-year predictions, reflected that in the long term, “The results of scientific research control the wealth of nations.” As we have said, central banking, while highly important for better and for worse, is not science.

Robert Solow recently asserted that “central banking is not rocket science.” True, and it will be neither science nor rocket science in 2113. But Solow meant that central banking was easier, while in fact it is harder than rocket science, now and in the future. This is because it must confront the inescapable uncertainty of human minds and deeds interacting, with their strategies, politics, adaptations, creations, surprises, intentions, mutual learning, guessing, risk-taking, cognitive herding, emotions, cupidity, fear, courage, and frequent mistakes, in their financial and economic dimension. This includes the minds and deeds of the central bank itself interacting with all of the others.

It is certain that the Fed will continue to be an interesting and debatable topic in its next 100 years.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.

This essay is adapted from Pollock’s address at the Loyola University of Chicago Symposium “The Federal Reserve at 100: The First 100 Years, the Present, and the Next 100” on December 6, 2013.