Causes of the Great Depression

Published in Law & Liberty.

About every ten years or so, financial crises spoil economic hopes and many best-laid plans. As scary as they are while happening, like everything else, in time, they tend to fade from memory. For example, can you recall the remarkable number of US depository institutions that failed in the crisis of the 1980s? (The correct answer: More than 2,800!)

The weakness of financial memory is one reason for recurring over-optimism, financial fragility, and new crises. But the Great Depression of the 1930s is an exception. It was such a searing experience that it retains its hold on economic thought almost a century after it began and more than 90 years after its US trough in 1933. That year featured the temporary shutdown of the entire US banking system and an unemployment rate as high as 24.9 percent. More than 9,000 US banks failed from 1929–33. Huge numbers of home and farm mortgages were in default, and 37 cities and three states defaulted on their debt. How could all this happen? That is still an essential question, with competing answers.

This collection of Ben Bernanke’s scholarly articles on the economics of the Depression was originally published in 2000. That was two years before he became a Governor on the Federal Reserve Board, and seven years before, as Federal Reserve Chairman, he played a starring world role in the Great (or Global) Financial Crisis of 2007–09 and its aftermath, always cited as “the worst financial crisis since the Great Depression.”

Bernanke’s Essays on the Great Depression has now been republished, with the addition of his Lecture, “Banking, Credit and Economic Fluctuations,” delivered upon winning the Nobel Prize in Economics in 2022. They make an interesting, if dense and academic, read.

“To understand the Great Depression is the Holy Grail of macroeconomics,” is the first line of the first article of this collection. “Not only did the Depression give birth to macroeconomics as a distinct field of study, but … the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.” Indeed it does.

Bernanke points out that “no account of the Great Depression would be complete without an explanation of the worldwide nature of the event.” As one example of this, we may note that Germany was then the second largest economy in the world, and “the collapse of the biggest German banks in July 1931 represents an essential element in the history,” as a study of that year relates. Germany was at the center of ongoing disputes about the attempted financial settlements of the Great War (or as we say, World War I). Widespread defaults on the intergovernmental debts resulting from the war also marked the early 1930s.

“What produced the world depression of 1929 and why was it so widespread, so deep, so long?” similarly asked the eminent financial historian, Charles Kindleberger. “Was it caused by real or monetary factors?” Was it “a consequence of deliberate and misguided monetary policy on the part of the US Federal Reserve Board, or were its origins complex and international, involving both financial and real factors?”

“Explaining the depth, persistence, and global scope of the Great Depression,” Bernanke reflects in his 2022 Lecture, “continues to challenge macroeconomists.” Although he concludes that “much progress has been made,” still, after nearly a century, things remain debatable. This calls into question how much science there is in economics looking backward, just as the poor record of economic forecasting questions whether there is much science in its attempts to look forward.

In economics, it seems, we can’t know the future, we are confused by the present, and we can’t agree on the past. Those living during the Depression were confused by their situation, just as we are now by ours. As Bernanke writes, “The evidence overall supports the view that the deflation was largely unanticipated, and indeed that forecasters and businesspeople in the early 1930s remained optimistic that recovery and the end of deflation were imminent.”

In Lessons from the Great Depression, a 1989 book that Bernanke often references, Peter Temin provides this wise perspective: “We therefore should be humble in our approach to macroeconomic policy. The economic authorities of the late 1920s had no doubt that their model of the economy was correct”—as they headed into deep disaster. “It is not given to us to know how future generations will understand the economic relations that govern how we live. We should strive to be open to alternative interpretations.”

Bernanke considers at length two alternative causes of the Depression and through his work adds a third.

The first is the famous Monetarist explanation of Federal Reserve culpability, referred to by Kindleberger, derived from the celebrated Monetary History of the United States by Milton Friedman and Anna Schwartz. Friedman and Schwartz, writes Bernanke, “saw the response of the Federal Reserve as perverse, or at least inadequate. In their view, the Fed could have ameliorated the deflationary pressures of the early 1930s through sustained monetary expansion but chose not to.” About this theory, Bernanke says, “I find it persuasive in many respects.” However, “it is difficult to defend the strict monetarist view that declines in the money stock were the only reason for the Depression, although … monetary forces were a contributing factor.” It seems eminently reasonable that multiple causes were at work to cause such a stupendously disastrous outcome.

“The Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

A second approach takes as central to the depth of the Depression the effects of governments’ clinging too long to the Gold Exchange Standard. That was the revised version of the gold standard that was put together in the 1920s as the world tried to return to something like the pre-Great War monetary system, which previously had accompanied such impressive advances in economic growth and prosperity. The Classic Gold Standard was destroyed by the Great War, as governments bankrupted themselves, then printed the money to spend on the war’s vast destruction and set off the rampant inflations and hyper-inflations that followed.

After the inflations, there was no simple going back to the monetary status quo ante bellum. However, “the gold standard [was] laboriously reconstructed after the war,” Bernanke relates, referring to the Gold Exchange Standard. “By 1929 the gold standard was virtually universal among market economies. … The reconstruction of the gold standard was hailed as a major diplomatic achievement, an essential step toward restoring monetary and financial conditions—which were turbulent during the 1920s—to … relative tranquility.”

Financial history is full of ironies. Here we had a “major diplomatic achievement” in global finance by intelligent and well-intentioned experts. But “instead of a new era of tranquility,” Bernanke tells us, “by 1931 financial panics and exchange rate crises were rampant, and a majority of countries left gold in that year. A complete collapse of the system occurred in 1936.” The United States left the gold standard in 1933.

Bernanke highlights the comparative studies of countries during the 1930s which found a notable pattern of “clear divergence”: “the gold standard countries suffered substantially more severe contractions,” and “countries leaving gold recovered substantially more rapidly and vigorously than those who did not,” and “the defense of gold standard parities added to the deflationary pressure.” Thus, he concludes, “the evidence that monetary shocks played a major role in the Great Contraction, and that these shocks were transmitted around the world primarily through the working of the gold standard, is quite compelling.” 

So far, we have an explanatory mix of the behavior of central banks faced with huge shocks in the context of the revised Gold Exchange Standard in the aftermath of the runaway inflations stemming from the Great War.

In addition, Bernanke’s own work emphasizes the role of credit contractions, not just monetary contractions, with a focus on “the disruptive effect of deflation on the financial system”—or in macroeconomic terms, “an important role for financial crises—particularly banking panics—in explaining the link between falling prices and falling output.” Bernanke provides a depressing list of banking crises around the world from 1921 to 1936. This list is nearly four pages long.

Bernanke concludes that “banking panics had an independent macroeconomic effect” and that “stressed credit markets helped drive declines in output and employment during the Depression.” This seems easily believable.

Bernanke’s articles also address employment during the Depression. Although economic conditions significantly improved after 1933, unemployment remained remarkably, perhaps amazingly, high. Continuing through all of the 1930s, it was far worse than in any of the US financial and economic crises since. At the end of 1939, US unemployment was 17.2 percent. At the end of 1940, after two full presidential terms for Franklin Roosevelt and the New Deal, unemployment was still 14.6 percent. Very high unemployment lasted a very long time.

The Depression-era interventions of both the Hoover and the Roosevelt administrations focused on maintaining high real wages. As Bernanke writes, “The New Deal era was a period of general economic growth, set back only by the 1937–38 recession. This economic growth occurred simultaneously with a real wage “push” engineered in part by the government and the unions.” But “how can these two developments be consistent?” Well, economic growth from a low level with a government push for high real wages was accompanied by high and continued unemployment. That doesn’t seem like a surprise.

The New Deal real wage push continued what had begun with President Hoover. The Austrian School economist, Murray Rothbard, says of Hoover in the early Depression years, “No one could accuse him of being slack in inaugurating the vast interventionist program.” He quotes Hoover’s statement in 1932 that wage rates “were maintained until the cost of living had decreased and profits had practically vanished. They are now the highest real wages in the world.” Rothbard rhetorically asks, as we might ask of the 1930s in general, “But was there any causal link between this fact and the highest unemployment rate in American history?” As Temin observes about the 1930s, “the Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

Turning to a more general perspective on the source of the Depression, Rothbard observes that “many writers have seen the roots of the Great Depression in the inflation of World War I and of the postwar years.”

Yet more broadly, it has long seemed to me that in addition to the interconnected monetary and credit problems carefully explored in Bernanke’s book, the most fundamental source of the Depression was the Great War itself, and the immense shocks of all kinds created by the destruction it wreaked—destruction of life, of wealth, in economics, in finance, of the Classic Gold Standard, of currencies, in the creation of immense and unpayable debts, and the destruction of political and social structures, of morale, of pre-1914 European civilization.

As Temin asks and answers, “What was the shock that set the system in motion? The shock, I want to argue, was the First World War.”

And giving Bernanke’s Nobel Prize Lecture the last word, “In the case of the Depression, the ultimate source of the losses was the economic and financial damage caused by World War I.” 

Can the Fed Fund the CFPB?

Published with Paul Kupiec in Law & Liberty also published in AEI.

The Consumer Financial Protection Bureau (CFPB) has been a source of controversy since its creation. Critics of the agency have long argued that its independent status is unconstitutional. In a recent decision, however, the Supreme Court affirmed the constitutionality of the CFPB’s funding scheme, even though it circumvents the normal Congressional appropriation process by “allowing the Bureau to draw money from the earnings of the Federal Reserve System.”

This decision belies the Fed’s current financial condition and conflicts with provisions in the Federal Reserve Act. The fact of the matter is that the Fed no longer has any earnings. It currently has huge cash operating losses and must borrow to fund both the Fed’s and the CFPB’s operations. When it is not literally printing dollars to pay these bills, the Fed is borrowing on behalf of the system’s 12 privately owned Federal Reserve district banks—not the federal government. These borrowings are not federally guaranteed. More problematic still is that nine of the 12 Federal Reserve district banks (FRBs) are technically insolvent, as is the Fed System as a whole.

The CFPB’s unique funding structure comes from provisions in the 2010 Dodd-Frank Act. Essentially, it requires that the Fed transfers funds to the CFPB without oversight from the congressional Appropriations Committees. In its 7-2 decision, the Supreme Court upheld these provisions and found that the funding apparatus “constitutes an ‘Appropriatio[n] made by Law’” because it is “drawn from the Treasury.”

One unfortunate bug in the Court’s opinion is that, since the Federal Reserve is currently making losses, there are no Federal Reserve System earnings for the CFPB to draw upon. The system has lost a staggering sum of $170 billion since September 2022, and continues to accumulate more than $1 billion in operating losses each week. Under standard accounting rules, it has negative capital and is technically insolvent. The Fed stopped sending distributions of its earnings to the US Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments to the CFPB at the same time for the same reason.

The second problem with the Court’s decision is that, unless the CFPB draws all its expenses from the Federal Reserve in the form of Federal Reserve Notes, the transferred monies are neither “public money” nor “drawn from the Treasury.” This is the law of the land as codified in the Federal Reserve Act.

When the Federal Reserve posts an operating loss, it must rebalance its accounts. It can do this by (1) selling assets or using the proceeds from maturing assets to cover the loss; (2) reducing its retained earnings, or if there are no retained earnings, reducing its paid in equity capital; or (3) issuing new liabilities. Regardless of how it chooses to rebalance its books, each new dollar of Fed operating loss or dollar spent funding the CFPB causes the Fed’s liabilities to increase relative to its assets, and, under standard accounting rules, the Fed’s liabilities are already greater than its assets.

Because of interest rate increases, the true market value of the Fed’s assets is far less than their book value—a shortfall of about $1 trillion. The Fed has stated that it will hold these assets to maturity to avoid realizing these mark-value losses. Meanwhile, the Fed’s $170 billion in accumulated cash operating losses have already fully exhausted the Fed’s retained earnings and paid in equity capital, so now the Fed must borrow to balance its accounts.

The Fed has three ways it can borrow to pay for the CFPB or new Fed operating losses. It can: (1) issue new Federal Reserve Notes; (2) borrow by increasing deposits at Federal Reserve district banks; or, (3) borrow from financial markets using reverse repurchase agreements. Of these three ways the Fed borrows, only Federal Reserve Notes are explicitly guaranteed by the full faith and credit of the US government and can be considered “public money drawn from the Treasury.” 

According to the Federal Reserve system’s 2023 audited financial statements:

Federal Reserve notes are the circulating currency of the United States. These notes, which are identified as issued to a specific Reserve Bank, must be fully collateralized. …The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize outstanding Federal Reserve notes. … In the event that this collateral is insufficient, the FRA provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks. Finally, Federal Reserve notes are obligations of the United States government.

The Federal Reserve Act does not grant the Fed unlimited authority to print new paper currency to cover its losses or fund CFPB operations. As of May 22, the Fed’s H.4.1 report shows that it owned less than $7.3 trillion in assets but had more than $7.4 trillion in liabilities issued to external creditors, including $2.3 trillion in Federal Reserve Notes. After collateralizing its outstanding currency, the system has $5 trillion in remaining assets, but more than $5.1 trillion in outstanding liabilities other than Federal Reserve Notes. The system as a whole has more than $127 billion in external liabilities that cannot be legally turned into Federal Reserve Notes.

To the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes, the CFPB is not being funded by “public money drawn from the Treasury.”

Under the Federal Reserve Act, about $5 trillion of Federal Reserve System’s current external liabilities are not backed by the federal government but only by the creditworthiness of the 12 FRBs. But nine, including all of the largest FRBs, have negative capital when measured using generally accepted accounting standards. With about $1 trillion in unrecognized market value losses on their securities, the true financial condition of the 12 FRBs is far weaker than their accounting capital suggests. And to make matters worse, only three of the 12 FRBs have enough collateral to redeem all of their external liabilities by printing new paper currency, which is the only federally guaranteed liability FRBs issue.

In addition, the largest funding source for the Fed, deposits in FRBs, are not explicitly collateralized or guaranteed by the federal government. FRB deposits are only protected by the value of FRB assets that are not otherwise pledged. Although the Fed’s depositors may believe they have an “implicit Treasury guarantee” in the same way that Freddie Mac and Fannie Mae bondholders believed that their bonds were guaranteed by the US Treasury, the Federal Reserve Act does not include a federal government guarantee for FRB deposits.

Fed deposits are meant to be protected by FRB paid-in capital and surplus, but that has been fully consumed by the operating losses in nine of 12 FRBs; and also protected in law (but not in practice) by a callable capital commitment and a “double liability” call on member bank resources that is an explicit FRB shareholder responsibility under the Federal Reserve Act. In other words, member banks as FRB shareholders, are legally responsible for some part of any loss incurred by the FRB’s unsecured liability holders, most importantly FRB depositors.

But notwithstanding large operating losses that have completely consumed the capital of most FRBs, the Federal Reserve Board has never utilized its powers under the Federal Reserve Act to increase the capital contributions of member banks or invoke member bank loss-sharing obligations. Indeed, all FRBs, even the most technically insolvent FRB, New York, continue to pay member banks dividends on their FRB shares, as well as make payments to the CFPB from nonexistent earnings. 

If, in the highly unlikely event that FRB member banks were called upon to inject additional capital into their FRB to cover Fed operating losses and CFPB expenses, these monies would clearly not be public monies drawn from the Treasury. Yet, under the Supreme Court’s ruling, the cash proceeds of the call on FRB member banks would be shipped over to pay the expenses of the CFPB. This fact alone seems to contradict the logic of the Supreme Court’s majority decision.

In sum, the Supreme Court’s recent ruling notwithstanding, the CFPB’s funding mechanism currently conflicts with the clear language of both the Dodd-Frank Act and Federal Reserve Act. As long as the Fed continues to suffer operating losses, the CFPB is not being funded with Federal Reserve earnings, and to the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes—and it is not—the CFPB is not being funded by “public money drawn from the Treasury.”

It’s the Fed That’s a Risk to Financial Stability

Published in The New York Sun and The Mises Institute.

Central bankers whistle ‘Dixie’ as mark-to-market losses dramatically shrink the banking system’s economic capital.

Whistling a happy tune, the Federal Reserve vice chairman for supervision, Michael Barr, recently testified to Congress that “overall, the banking system remains sound and resilient.” A more candid view of the risks would be less sanguine.  

Mr. Barr reported that banking “capital ratios increased throughout 2023.” He failed, though, to discuss the mark-to-market losses that have dramatically shrunk the banking system’s economic capital and capital ratios.

A recent study of American banks, including analyses of both their securities and fixed rate loans, estimates that the banking system has at least a $1 trillion mark-to-market loss resulting from the move to normalized interest rates.

Since that loss is equal to half of the banks’ approximately $2 trillion in book value of tangible equity, their aggregate real capital has dropped by about 50 percent. This is just in time for them to be confronted with large potential losses from that classic source of banking busts, commercial real estate, as the prices of many buildings are falling vertiginously.

Given his current position, Mr. Barr could not be expected to mention another particularly large and inescapable threat to financial stability, that from the Federal Reserve itself.  As central bank not only to the United States, but to the dollar-using world, the Fed combines great power with an inevitable lack of knowledge, and its actions are a fundamental source of financial instability.

When the Federal Reserve was created, the secretary of the treasury at the time, William Gibbs McAdoo, proclaimed that the Fed would “give such stability to the banking business that extreme fluctuations in interest rates and available credits… will be destroyed permanently.” A remarkably bad prediction.

Instead, throughout the life of the Fed, the financial system has suffered recurring financial crises and Fed mistakes. Mistakes by the Fed are inevitable because the Fed is always faced with an unknowable economic and financial future.  This explains its poor record at economic forecasting, including inflation and interest rates.

No matter how intelligent its leaders, how many Ph.D.s it hires, how many computers it buys, how complex it make its models, or how many conferences it holds at posh resorts, the Fed cannot reliably predict the future results of its own actions, let alone the unimaginably complex global interactions that create the economy. 

The Fed held both short-term and long-term interest rates abnormally low for more than a decade.  It manipulated long term rates lower by the purchase of $8 trillion of mostly fixed rate Treasury bonds and mortgage securities, mostly funded by floating rate deposits, making its own balance sheet exceptionally risky.  It decided to manage the expectations of the market, and frequently assured one and all that interest rates would be “lower for longer” (until, of course, they were higher for longer).

Observe the result:  Gigantic interest rate risk built up in the banking system. A notable case was Silicon Valley Bank, which made itself into a 21st century version of a 1980s savings and loan, investing heavily in 30-year fixed rate mortgage-backed securities and funding them with short-short term deposits, while its chief executive served on the Board of the Federal Reserve Bank of San Francisco.

SVB was doing basically the same thing with its balance sheet that the Fed was.  In the SVB case, it became the one of the largest bank failures in American history; in the Fed’s case, it has suffered its own mark to market loss of more than $1 trillion, in addition to operating cash losses of $172 billion so far. Adding the mark-to-market losses of the Fed and the banking system together, we have a total loss of $2 trillion. We are talking about real money.

The Fed was the Pied Piper of interest rate risk and consequent losses. 
Jim Bunning was the only man ever to be both a Hall of Fame baseball player and a U.S. Senator. He pitched a perfect game in the major leagues, and he delivered a perfect strike in the Senate when Chairman Ben Bernanke was testifying on how the Fed was going to regulate systemic financial risk. In paraphrase, Senator Bunning asked, “How can you regulate systemic risk when you are the systemic risk?” There is no answer to this superb question.

The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

The relevant text of the Dodd-Frank Act is clear: “Each year (or quarter of such year) . . . the Board of Governors shall transfer to the [Consumer Financial Protection] Bureau from the combined earnings of the Federal Reserve System, the amount determined by the Director to be reasonably necessary . . . ” (emphasis added).

“Earnings” means net profit:

“EARNINGS: Profits; net income.” (Encyclopedia of Banking and Finance)

“Earnings: Net income for the company during a period.” (Nasdaq financial terms guide)

“A company’s earnings are its after-tax net income.” (Investopedia)

“Earnings are the amount of money a company has left after subtracting business expenses from revenue. Earnings are also known as net income or net profit.” (Google “AI Overview”)

“Earnings: The balance of revenue for a specific period that remains after deducting related costs and expenses.” (Webster’s Third New International Dictionary)

The Democratic majority which passed the Dodd-Frank Act on a party line vote in 2010—knowing that it was likely to lose the next election (as it did)—cleverly blocked a future Congress from disciplining the new creation through the power of the purse by granting the CFPB a share of the Fed’s earnings every quarter. With inescapable logic, however, that depends on there being some earnings to share in.

Naturally the congressional majority assumed (probably without ever thinking about it) that the Fed would always be profitable. It always had been. But that turned out to be a wildly wrong assumption.

The Supreme Court has ruled that the CFPB funding scheme is constitutional. The opinion by Justice Thomas finds that nothing in the text of the Constitution prevents such a scheme, despite, as pointed out in Justice Alito’s dissent, the way it thwarts the framers’ separation of powers design.

However, no one seems to have pointed out to the Court that the Federal Reserve System now has no earnings for the CFPB to share in. Instead, the Fed is running giant losses: it has lost the staggering sum of $169 billion since September 2022, and it continues to lose money at the rate of more than $1 billion a week. Under standard accounting, it would have to report negative capital and technical insolvency.

The Fed stopped sending distributions of its earnings to the U.S. Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments from its earnings to the CFPB at the same time for the same reason. This seems to be required by the statute.

It is sometimes said that the payment to the CFPB is based on the Fed’s expenses, not its earnings, because the statute also provides that “the amount that shall be transferred to the Bureau in each fiscal year shall not exceed a fixed percentage of the total operating expenses of the Federal Reserve.” But this “shall not exceed” provision is merely setting a maximum or cap relative to expenses, not a minimum, to the transfer from earnings. The minimum could be and is now zero—unless you think with negative Fed earnings the CFPB should be sending the Fed money to help offset its losses.

Although the situation seems clear, it is contentious. Congress should firmly settle the matter by rapidly enacting the Federal Reserve Loss Transparency Act (H.R. 5993) introduced by Congressman French Hill. This bill provides, with great common sense and financial logic: “No transfer may be made to the Bureau if the Federal reserve banks, in the aggregate, incurred an operating loss in the most recently completed calendar quarter until the loss is offset with subsequent earnings.”

The Fed’s losses continue. Its accumulated losses will not be offset for a long time. Congress should be thinking about whether it wishes to appropriate funds to the CFPB to tide it over.

Chairman Powell and The Fed’s Limits

Published in American Institute for Economic Research, RealClear Policy, and the Federalist Society.

Federal Reserve Chairman Jerome Powell has realistically assessed the limits of the Fed’s knowledge, models, and legislative mandate.  Bravo!  His candor is far superior to any “pretense of knowledge” displayed by central banks and is a sound warning of the mission creep to which their regulatory activities are tempted. 

Speaking at the Stanford Business School in early April, Powell observed that “Of course, the outlook is still quite uncertain.”  Indeed, inflation is looking worse than the Fed had hoped, long-term interest rates have backed up, and short-term rates may not fall from here, or may rise. No one knows, including the Fed. The financial and economic future is fundamentally and inherently uncertain. A better statement would have been, “Of course, the outlook is ALWAYS uncertain.”  

The dismal record of central banks’ economic forecasts confirms that they not only do not, but cannot, know the financial future, or what the results of their own actions will be, or what future actions they may take.  Powell, trained in law and on Wall Street instead of academic economics, seems admirably aware of this truth, a truth uncomfortable for those who wish to put their faith in central banks.  

Powell has previously pointed out that the celebrated “r star” (r*) — the “neutral interest rate” — is a theoretical idea which can never be directly observed.  Economic models depending on it must produce uncertain results.  In trying to be guided by such an idea, Powell wittily suggested, “We are navigating by the stars under cloudy skies.”  That is a really good line and deserves to go down with former Fed Chairman William McChesney Martin’s famous “take away the punchbowl” in central banking lore. 

Central banks’ poor forecasting record reflects both the limitations of human minds, no matter how brilliant, educated, and informed, and also the interactive, recursive, complex, expectational, reflexive, non-predictable nature of financial reality itself, so very different from Newtonian physical systems. Economic and financial systems are not composed of mechanisms (although that is a favorite metaphor in economics) but have among their core dynamics competing minds. 

From this recognition, we see why “the macro-economic discipline can be thought more-or-less as an evaluation of a constant stream of surprises,” as an acute financial observer recently wrote.  Economists, he continued, of course including those employed by central banks, tend to build “models of how the world should work, rather than how it does.  It is not surprising that macro-economic forecasts based on these models fail.”  We may conclude, as Powell seems to suggest, that we should not be surprised by the continuing surprises. 

It is essential not to attribute the forecasting failures of central banks to any lack of intelligence, educational credentials, good intentions, or computer power.  These failures of the highly competent arise because of the fundamentally odd kind of reality created by the economic and financial interactions they are trying to forecast and manipulate. 

Especially difficult is that all economics is political economics, all finance is political finance, and all central banking is political central banking.  Politics is always stirring and dumping spices, and sometimes poison, into the economic stew, especially by starting and prolonging wars, which are the single most important financial events.  Just now we have plenty of war to contend with.   

What are the central bankers to do?  A good place to start is intellectual realism about how genuinely cloudy the economic future is.  As an ancient Roman concluded, “Res hominum tanta caligine volvi.” (“Human affairs are surrounded by so much fog!”) 

Sticking to the Assigned Mission 

Also in his Stanford speech, Chairman Powell cited two well-known goals assigned by Congress to the Fed: maximum employment and stable prices. Note that the second, as written in the Federal Reserve Act, is exactly as Powell stated: “stable prices” — not “stable inflation,” “low inflation,” “perpetual inflation at 2 percent,” or any other price target except “stable prices.”  Obviously, the Fed has not achieved stable prices.  Should it nevertheless take on additional issues not assigned by Congress? 

Powell answered soundly: No. “We need to continually earn [our] grant of independence,” he said, “by sticking to our knitting.” 

He continued in a paragraph well worth quoting at length: 

        To maintain the public’s trust, we also need to avoid ‘mission creep.’  Our nation faces many challenges, some of which directly or indirectly involve the economy.  Fed policymakers are often pressed to take a position on issues that are arguably relevant to the economy but not within our mandate, such as particular tax and spending policies, immigration policy, and trade policy.  Climate change is another current example.  Policies to address climate change are the business of elected officials and those agencies they have charged with this responsibility.  The Fed has received no such charge. 

Very true, it hasn’t. 

Thus, he said, “We are not, nor do we seek to be, climate policymakers.”  Nor is the Fed, nor should it seek to be, a policymaker for illegal immigration, law enforcement, failing public schools, the bankrupt student loan fiasco, insolvent Social Security and Medicaid programs, or scores of other issues.   

Powell’s general conclusion is excellent: “In short, doing our job well requires that we respect the limits of our mandate.” This is consistent with his sensible 2024 Senate testimony that the Fed cannot create a US central bank digital currency without Congressional authorization. 

But when it comes to controlling Fed mission creep regarding climate change, Powell did leave himself a significant hedge that Congress should think about.  This was: “We do, however, have a narrow role that relates to our responsibilities as a bank supervisor.  The public will expect that the institutions we regulate and supervise will understand and be able to manage the material risks they face, which, over time, are likely to include climate-related risks.” 

How narrow is “narrow”?  Will Fed actions in this respect be mandate-disciplined?  Or under a different Fed leadership, might they swell and create a gap in limits big enough to drive a (presumably electric) truck through?  We know that out-of-control financial regulators can decide to act as legislatures on their own, such as in the notorious Operation Choke Point scandal.  Political actors who cannot get the Congress to approve their notions have discovered that the banking system is indeed a choke point for anybody needing to make financial transactions — that is, everybody.  The most dangerous thing about a central bank digital currency is that the Fed itself could become a monopoly choke point operator, the dark possibilities of which have already been demonstrated in China and Canada. 

Congress should applaud Chairman Powell’s candor on uncertainty and strongly support his principle of operating the Fed within the limits of its mandate.  But as Fed leadership and presidential administrations come and go, Congress should itself define, not leave up to the Fed, what “narrow” expansions of the Fed’s role are authorized, and what is beyond the limits. 

Federal Reserve’s Capital Has Now Plummeted to Negative $121 Billion, and Congress Needs To Act

Published in The New York Sun.

Meantime the central bank seeks to palm off on the public the idea that its staggering negative capital is a ‘deferred asset.’

Hold up your hand if you think that the aggregate losses of an organization are an asset of that organization. No hands at all? Absolutely right. Losses are not an asset. That’s accounting 101. Yet the greatest central bank in the world, the Federal Reserve, insists on claiming that its continuing losses, which have accumulated to the staggering sum of $164 billion, are an accounting asset.

The Fed seeks to palm off this accounting entry as a “Deferred Asset.” Why does the Fed do this, which perhaps makes it look tricky instead of majestic? Because it does not want to report that it has lost all its $43 billion in capital and now has negative capital. The inevitable arithmetic is plain: start with the Fed’s $43 billion in capital, lose $164 billion, and the capital has inescapably become negative $121 billion. 

The Fed is not pleased with this answer. In addition to its “Deferred Asset” gambit, it frequently and publicly asserts that negative capital does not matter if you are a money-printing central bank. The idea seems to be that a central bank can always print up more money. The Fed further declares that it is not in business to maximize profits. Even were all this true, it fails to change the correct capital number: negative $121 billion.

If it really doesn’t matter that the Fed has negative capital, why does it not just publish the true number? If the Fed is right, no one will care at all. The Bank of Canada does it right. Its September 30, 2023 balance sheet clearly reports its capital of negative $4.5 billion in Canadian currency. The Bank of Canada also has an agreement with the Ministry of Finance so that any realized losses it takes on its “QE” bond investments “are indemnified by the Government of Canada.” * 

The Fed has no such contract with America’s Treasury. The Fed presumably has an “implied guaranty” from the Treasury, just like Fannie Mae and Freddie Mac did, but there is nothing formal. It seems certain that Congress never dreamed that the Fed could experience the losses and the negative capital that are now reality.

The Fed ran an exceptionally risky balance sheet with little capital. The key vulnerability was and is interest rate risk, the same risk that caused the failure of the savings and loans in the 1980s. The Fed’s capital was a mere 0.5 percent of its total assets. When the Fed incurred big interest rate risk losses starting in 2022, it rapidly lost all its capital because it had so little capital to begin with.

Whose fault was that? 

The reason the Fed had so little capital was the Congress. Anxious to take the profits of the Fed to spend, the Congress limited by law the retained earnings the Fed could build to a mere $6.8 billion, or less than 0.1 percent of the Fed’s assets. Moreover, as the Fed made itself ever riskier, Congress did nothing to either limit the risk, or to increase the capital to reflect the risk.

Did Congress understand the Fed’s balance sheet? If not, Congress is also at fault for that failure. Congress has provided in the Federal Reserve Act, from the original act to today, that the Federal Reserve Banks have a legal call on their commercial bank stockholders to double their paid-in capital. Thus the Fed has the statutory right to raise $36 billion in additional capital.

That would not bring its capital up to zero. It would, though, be a lot better than nothing. Yet the proud Fed has not chosen to issue the capital call that Congress designed, and Congress has not suggested that the Fed do so. Is Congress paying attention to the Fed’s financial condition? 

The Bank of England, which has a formal support agreement from His Majesty’s Treasury, studied the need for central bank capital in a recent working paper.* * It observed that “Financial strength can support central bank independence and credibility.”

“When capital is low,” the Bank of England concluded, “central banks should be able to retain their profits to help strengthen their capital position.” Congress prohibited the Fed from doing this, even as its capital relative to risk got miniscule. 

Congress needs to fix the Federal Reserve Act to allow capital to be built up corresponding to the risks undertaken. Of course, that means Congress has to understand the risks. As for the Fed’s capital at this point, negative $121 billion certainly qualifies as “low.”

________

*  Bank of Canada, Quarterly Financial Report, Third Quarter 2023.

* * Bank of England, ‘Central bank profit distribution and recapitalization,’ Staff working paper no. 1,069, April 2024.

Why Is the Fed Losing Money When It Does Such a Handsome Business With Irredeemable Paper Money Abroad?

At some point a leader will step forward prepared to call the central bank out on its losses.

Published in The New York Sun.

The Federal Reserve issues the most successful irredeemable, pure fiat circulating paper currency in world history, in other words, dollar bills.  These printed pieces of paper are formally titled “Federal Reserve Notes,” but they are not really notes, because a note is a promise to pay, and Federal Reserve Notes don’t promise to pay anything at all. 

Under the original Federal Reserve Act of 1913, Federal Reserve Notes really were notes. Against them the Federal Reserve promised to pay — and did indeed pay for its first 20 years — gold coin to redeem them.  The Federal Reserve Banks were required to hold gold in reserve to make these promises credible.  No more, of course.  

The Federal Reserve, unlike many other contemporary central banks, now owns zero gold.  The only promise the current Fed makes is that it will depreciate the purchasing power of its dollars forever, trying for a depreciation rate of 2 percent per year. In other words, it aims for an 80 percent depreciation over an average human lifetime. 

There is a lot of the Fed’s paper currency in circulation — in total value about $2.3 trillion.  This compares to $492 billion 25 years ago.  Meaning, in one generation, the Fed’s paper money in circulation has increased to 4.7 times its 1998 amount, far faster than nominal GDP, which has grown to 3.0 times its 1998 level.  

In 1998, Federal Reserve Notes in circulation were equal to 5.4 percent of GDP.  This ratio soared to 8.4 percent in 2023, for an increase of 56 percent relative to GDP. How can this have happened when all those years were marked by constant discussions of how we were moving to a cashless society? 

And how can it have happened when everybody can observe the increasing use of credit cards or electronic payments instead of currency?   I keep being surprised by how my own grown children are content to go around with hardly any cash, and how many people pay with cards for trivially small purchases. 

So why has the Fed’s paper currency outstanding increased so much? An instructive contrast is with Canada, a neighboring economy with a sophisticated financial system. The Bank of Canada had C$118 billion in its fiat paper currency in circulation as of September 30, 2023 — 4.1 percent of the Canadian GDP.  

Thus, relative to GDP, the Fed has more than twice the amount of paper currency circulating as does the Bank of Canada. Why? The reason is that the Bank of Canada is only the central bank of Canada, while the Fed is in important respects the central bank of the world.

That means that America’s paper currency, in spite of the Fed’s constant depreciation of its purchasing power, is widely used in numerous other countries, as superior to whatever money is printed up locally. The Fed has estimated that as of 2021, “foreigners held $950 billion in U.S. banknotes.” 

That comes to “about 45% of all Federal Reserve Notes outstanding, including two-thirds of all $100 bills.”  Updating to 2023, we can guess that foreigners hold approximately $1 trillion in American dollar bills. This constitutes a handsome and profitable international business for the Fed.

Its paper currency, with little cost to produce, provides zero-interest funding, which the Fed invests in interest-bearing securities.  This makes profit as easily as falling off a log.  With market interest rates at 5 percent, those $1 trillion in dollar bills are worth about $50 billion a year in net interest income for the Fed.

Thank you, foreign dollar bill holders.  The remaining $1.3 trillion of domestically held currency is worth a net interest income of $65 billion a year, for a combined total of about $115 billion a year.  This is why the Fed should always be profitable.  And yet — what do you know? — it has become the opposite.

In 2023, the Fed racked up a net loss of the truly remarkable sum of $114 billion.  In other words, it ran through its whole margin on currency issuance plus another $114 billion, and its losses continue in 2024 at about $28 billion for the first quarter. Just to mark the point, these losses are highly newsworthy.

The losses result from the Fed’s $6.3 trillion of investments in long-term Treasury bonds and mortgage securities yielding on average a mere 2 percent or so, while the Fed now must pay more than 5 percent on its own deposits and borrowings, putting it financially upside down.

In short, despite its profitable international business of currency printing, the Fed is suffering giant net losses in the same fashion as typical 1980s savings and loans did. This scandal has yet come into focus for the American public, but it’s a fair bet that it will do so — if the right leader steps forward.

Fixing A Big Mistake in Risk-Based Capital Rules

Published in AIER:

We are observing a great debate between the US banking regulators who wish to impose new, so-called “Basel III Endgame” rules to significantly increase bank capital, on one side, and the banks who argue they already have more than enough capital, joined by various borrowing groups who fear loans to them may be made more expensive or less available, on the other. It has been described as “the biggest fight between banks and regulators in the US in years.”

Said the president of the Financial Services Forum, “Additional significant capital increases, such as those of the Basel III Endgame proposal, are not justified and would harm American households, businesses and the broader economy.”

The Acting Comptroller of the Currency “pushed back at banks’ claims…saying the lenders could always cut dividends and buybacks instead.”

The debate generated similar disagreements among members of the Senate Banking Committee in a December 2023 hearing and is ongoing.

Leaving aside the fact there never can be an end to the endless and heavily political arguments about bank capital, what is most remarkable in this debate is what is not discussed. Not discussed is that the Basel risk-based capital requirements completely leave out interest rate risk. In its most common form that is the risk created by lending long at fixed interest rates while borrowing short at floating rates, which can be dangerous, even fatal, to the bank.

Excessive interest rate risk was a principal cause of the large bank failures of 2023, three of the largest failures in US history — Silicon Valley Bank, Signature Bank, and First Republic Bank. Widespread vulnerability due to interest rate risk among banks was, at that crisis point, the reason the American financial regulators declared that there was “systemic risk” to financial stability, so they could make exceptions to the normal rules. These involved promising to pay off uninsured depositors in failed banks with money taken from other banks; having the Federal Reserve offer loans to banks without sufficient collateral, so they would not have to sell their underwater investments; and as in every crisis, offering words of assurance from government and central bank officials that really banks were secure — although this does seem inconsistent with declaring a systemic-risk emergency.

Banking expert Paul Kupiec, in an extensive bottom-up analysis of US banks, concludes that the interest rate risk on their fixed rate securities and loans has resulted in an aggregate mark to market, unrealized but economically real, loss of about $1.5 trillion — a staggering number. The tangible capital of the entire banking system is about $1.8 trillion. The market-value losses on interest rate risk would thus have consumed approximately 80 percent of the banking system’s total tangible capital. If that is right, the banks on a mark-to-market basis would have only about 20 percent of the capital they appear to have. A less pessimistic, but still very pessimistic, analysis suggests that the fair value losses on securities and loans of banks with $1 to $100 billion in assets have in effect reduced regulatory capital ratios by about 45 percent. Applying this to the whole system would suggest a mark-to-market loss from interest rate risk of about $1 trillion. The banking system thus displays a dramatically diminished margin for error, just as it faces the looming losses from the imploding sectors of commercial real estate, a common villain in financial busts.

That interest-rate risk is fundamental is obvious, basic Banking 101. But it is a risk nonetheless very tempting when the central bank has artificially suppressed interest rates for long periods, as it did for more than a decade. Lots of banks succumbed as the Fed, playing the Pied Piper, led them into the current problems. Recent press reports tell us: “Rising Rates Hit Regional Lenders”; “US banking sector earnings tumble 45%” as “the swift rise in interest rates…continues to weigh on lenders”; “Truist Financial swung to a loss”; “Citigroup …reported a net loss for the fourth quarter 2023 of $1.8 billion”; “Higher-for-longer interest rates remain the key risk for real estate assets globally”; and “Bank losses worldwide reignite fears over US commercial property sector”.

The Federal Reserve itself is suffering mightily from the interest rate risk it induced. Its operating losses now exceed $150 billion, and its mark to market loss is approximately $1 trillion. If the aggregate market value loss of the banks is $1 trillion to $1.5 trillion, when we consider the greater banking system to include both the banks and the Fed, its total loss due to interest rate risk is about $2 trillion to $2.5 trillion. The Fed is belatedly introducing into its stress test ideas “exploratory scenarios,” to test the effects of rising interest rates. But “the results will not be used to calculate [required] capital.”

Interest-rate risk was at the heart of the notorious collapse of the savings and loan industry in the 1980s, the hopeless insolvency of its government deposit insurer, and the ensuing taxpayer bailout. People thought the lesson had been learned, and probably it had, but it seems it was forgotten. 

Interest-rate risk remains particularly relevant to mortgage finance, mortgages being the largest credit market in the world after government debt, because of the unique devotion of American financial and regulatory politics to 30-year fixed rate mortgages, which are notably dangerous. So are very long-term fixed-rate Treasury bonds, but bank regulation always promotes buying Treasury bonds to help out the government. Both long Treasuries and 30-year mortgages in the form of the mortgage-backed securities guaranteed by government agencies are in current regulation included as “High Quality Liquid Assets.” The agency MBS are given very low risk-based capital requirements. Treasuries are always described as “risk-free assets” and given zero risk-based capital requirements. But of course they both can and have created plenty of interest rate risk.

However the in-process “Basel III Endgame” debate turns out, Basel international risk-based capital requirements will still fail to address interest rate risk. They will still promote investing in 30-year agency MBS and long Treasuries, in spite of their riskiness. This serves the political purpose of favoring and promoting housing and government finance, but not the soundness of the banking system. 

A complete process of including interest rate risk by measuring the dynamic net exposure to interest rate changes of the total on- and off-balance sheet assets, liabilities and derivatives of a bank, and appropriately capitalizing it, would doubtless be a task of daunting complexity for risk-based capital calculations under the Basel agreements, as evidenced by the Basel Committee’s “Standards — Interest rate risk in the banking book.” But an extremely simple fix to address very large amounts of interest rate risk is readily available.

This is simply to correct the woefully low risk-based capital required for 30-year agency MBS and for very long Treasury debt. These miniscule capital requirements get rationalized by very low credit risk, but they utterly fail to reflect very high interest rate risk.

The risk-based capital required for Treasuries, to repeat, is zero. The risk-based capital for 30-year fixed rate mortgages in the form of agency MBS merely 1.6 percent (a risk weighting of 20 percent multiplied by the base of 8 percent). Contrast this zero or minimal capital to the market value losses now being actually experienced. Using as a benchmark the losses the Federal Reserve had on its investments as of September 30, 2023:

          Treasuries    A loss of 15 percent

          Agency MBS  A loss of 20 percent
 

That more capital than provided under the Basel rules is needed to address the interest rate risk of these long term, fixed-rate exposures appears entirely obvious.

I suggest the risk weights of these investments, so potentially dangerous to banks (not to mention to central banks), should be increased to 50 percent for 30-year agency MBS and 20 percent for long Treasuries, thus giving us risk-based capital requirements of 4 percent (instead of 1.6 percent) for long agency MBS and 1.6 percent (instead of zero) for long Treasuries.

These are guesses and approximations, of course. While simple, they come much closer to addressing the real risk than does the current system. It is time to learn and apply the expensive lessons of interest rate risk once again.

Two sets of objections will vociferously be made. The housing complex will complain that this will make mortgages more expensive. The Treasury (and all finance ministries) will complain that this will make ballooning government deficits more expensive to finance. What do we want? To match the capital to the real risks, or to manipulate the capital regulations to subsidize politically favored borrowers?

I am for the former. Lots of people, alas, are for the latter. This is a perpetual problem of political finance.

Has Anyone Thought About Recapitalizing the Fed, Which Is Underwater by Billions of Dollars?

The answer is ‘yes’ — the authors of the Federal Reserve Act, for starters.

Published in The New York Sun:

The Federal Reserve seems to many people to be a mysterious power, something like the Wizard of Oz in the classic movie version of the story. Yet the Federal Reserve Banks are banks, with assets, liabilities, capital, and profits and losses like other banks. What stands out in the last year and a half are the losses — totaling a staggering sum, $149 billion. The FRBs, in other words, have run through about 3.5 times their total capital.  

The Fed’s real capital as of mid-February 2024 is its stated capital of $43 billion minus the losses of $149 billion, or by ineluctable arithmetic a negative $106 billion. The Fed disguises this in its published financial statements by booking its losses as an asset.  Luckily for it, the Fed is not an SEC filer. It is a striking irony that the greatest central bank in the world feels compelled to fall back on issuing questionable financial statements.

One would like to think that America’s central banking system would be an exemplar of financial probity. Particularly the Federal Reserve Bank of New York. Of the 12 FRBs, the largest and most important is the New York FRB, which is bigger than the other 11 put together. With its losses of $95 billion, it is also far and away the leader in losing money.  

The Fed’s astronomical losses, which continue at the rate of $2 billion a week, have resulted from its taking and imposing on both the Treasury and the taxpayers, as well as on itself, the massive financial risk of investing long and borrowing short to the tune of trillions of dollars. So now it, and the Treasury and the taxpayers, are upside down in a huge, long lasting trade which earns interest at about 2 percent and pays interest at more than 5 percent.

The Federal Reserve’s balance sheet release for February 14 allows an update on the actual capital of each Federal Reserve Bank and of the total Federal Reserve, also showing the accumulated losses of each as a percentage of its stated capital. 

It portrays losses of a magnitude that would previously have been considered impossible by everybody. Note that these numbers do not count the approximately $1 trillion in mark to market losses the Fed has suffered on its investments — only the cash losses from operations are included.

The Fed as a whole and eight of the 12 FRBs are technically insolvent, with liabilities greater than their assets. Two other FRBs have reported losses totaling 83 percent and 94 percent of their capital, with losses continuing.  With combined assets of $7.6 trillion and negative capital, the Fed has infinite leverage. The capital deficit is growing bigger at an annualized rate of more than $100 billion a year.

Did anyone ever think about how to recapitalize a Federal Reserve Bank which is short of capital? The answer is Yes. The authors of the Federal Reserve Act did and provided for it in the Act. The commercial bank members of the Fed are the sole stockholders of the FRBs, and the Act looks to them to contribute new capital.  

The member banks have all purchased only half of their statutory commitment to buy FRB stock. The other half is callable at any time by the Fed. That would be a capital call on the member banks of $36 billion. In addition, the banks are liable to be assessed up to twice their current capital to make good losses of their FRBs. That would not be a purchase of stock, but simply money paid to the Fed to offset losses. The aggregate sum involved could be a $68 billion assessment.

Imagine the outraged comments of banks that were required to make good on their legal commitments as shareholders of FRBs under the Act. Perhaps many of them have never thought about what their exposure is under the law, and will be surprised to learn.

Is the Fed willing to recapitalize itself by following the statutory provisions? Presumably not. It would be humiliating for the Fed, of course, and also it would make the member banks angry. Perhaps the Wizard of Fed will simply stick to the line, “Pay no attention to the man behind the curtain.”

Juvenal’s Greatest Poser: ‘Who Will Guard the Federal Reserve?’

Published in The New York Sun.

The answer is the body in the government that is famously closest to the people.

“Who will guard these guardians?” That poser of Juvenal, satirist of Rome, is an immortal question — nowhere more pertinent, though, than in deciding who should oversee the Federal Reserve. In the Fed, we have supposed guardians of stable prices who have decided by themselves to create perpetual inflation.

Just to mark the point: Guardians of the currency have  decided by themselves to depreciate it forever. Guardians of financial stability have rendered themselves technically insolvent with negative capital now at more than $100 billion. Guardians who cannot make reliable economic forecasts are tirelessly claiming that they should be “independent.”

What total nonsense.  No part of our Constitutional government should be independent of the checks and balances that are part of the Founding scheme and must apply to all its parts. It is naturally the burning desire of every government bureaucracy to be independent of the elected representatives, but the idea that the Fed is “independent” is stated nowhere in the Federal Reserve Act.  

Displaying the contrary idea, the original Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board. A notable description from Fed history is that the Fed has “independence within the government” — something different from being independent. All — 100 percent — of the monetary powers granted in the Constitution to the government are granted to Congress.

It is well past due for Congress to start getting serious about oversight of the Fed within the government by promptly passing two pending bills:  “The Federal Reserve Transparency Act,” reintroduced by Senator Rand Paul, and the “Federal Reserve Loss Transparency Act,” reintroduced by Congressman French Hill. Enacting these mutually consistent bills would be a big step forward.  

The “Transparency Act,” which was previously passed by the House in 2014 with the overwhelming vote of 333 to 92, is commonly known as “Audit the Fed.”  It is about far more than a financial audit of the books, however, as important such audits are.  It is really about giving Congress the knowledge to carry out serious oversight.  As Senator Paul recently wrote, “transparency and oversight of every government institution is imperative.” 

The “Loss Transparency Act” would put Congress in a better position to understand the Fed’s own finances. It would do so by the obviously sensible requirement that the Fed’s balance sheet must apply Generally Accepted Accounting Principles. The bill would also, with admirable common sense, prohibit the Fed from paying the expenses of an unrelated agency while the Fed itself is losing $114 billion a year.

The profound questions of what kind of money is right for our country, including whether the Fed is empowered to create perpetual inflation rather than stable prices, are not decisions that may be made unilaterally by the Fed. And invite only more questions. If perpetual inflation, at what rate? If stable prices, how to ensure sound money? These are inherently political questions. It is hubristic of the Fed to imagine it has the authority to make such decisions. Let it bring formal recommendations to the Congress.

The Fed has an ever-recurring tendency to create inflations, asset price bubbles, systemic risk, and the ensuing painful corrections, because it combines great power with demonstrated, and inescapable, inability to foretell the financial future.  This combination makes it “the most dangerous financial institution in the world.” It needs serious oversight by and substantive interaction with elected representatives of the people who have made themselves expert in central banking questions.

So who should guard the Fed in the constitutional system of checks and balances?  The answer is Congress, with its unambiguous power over money questions clearly designated in the fifth clause of the Constitution’s Article I, Section 8. Congress needs to revise the laws to ensure effective oversight and to organize itself to be the required guardian of the people’s money and the central bank. 

In my opinion, this should include both the Senate and the House banking committees having a subcommittee devoted exclusively to oversight of the Fed, which is the central bank not only to the United States, but to the entire dollar-using world, and to its dominant credit, money and capital markets, and moreover has huge effects on the daily life of the American people by its debasement of the currency.

How to Recapitalize the Federal Reserve

Published in Law & Liberty with Paul H. Kupiec. Also published in RealClear Markets.

The Federal Reserve starts the new year with capital, properly accounted for, of negative $92 billion. How can that be? How can the world’s greatest central bank, the issuer of the world’s dominant reserve currency, be technically insolvent—and by such a huge number?

The answer is that the Fed has accumulated immense operating losses, which by January 3, 2024, totaled $135 billion. Since September 2022, the Fed has been paying out more in interest expense to finance its more than $7 trillion securities portfolio than it receives in interest income. The losses continue into 2024 at the rate of over $2 billion a week. When you subtract the Fed’s accumulated losses, which are real cash losses, from the Fed’s stated capital of $43 billion, you get the Fed’s true consolidated capital, that is: $43 billion in starting capital minus $135 billion in losses equals the current capital of negative $92 billion. This balance sheet math is straightforward and unassailable under generally accepted accounting principles (GAAP).

The Federal Reserve System includes 12 regional Federal Reserve Banks (FRBs), each one a separate corporation with its own shareholders, customers, and balance sheet. Considered on their own, with proper accounting, 8 of the 12 FRBs start 2024 with negative capital. This means their accumulated cash operating losses exceed 100% of their capital. Two others have lost more than 80% of their capital and will exhaust their capital in 2024. Only two FRBs have their capital intact. Their operating losses have been limited because these banks have an especially high proportion of their funding supplied by the paper currency (Federal Reserve Notes) they issue—currency does not pay interest and thus results in lower overall interest expense. Under commercial bank rules, 10 of the 12 FRBs would be classified as severely undercapitalized, as would the entire consolidated Federal Reserve System. As of January 3, 2024, the FRBs true capital numbers are:

Source: Federal Reserve H.4.1 January 4, 2024, and authors’ calculations.

At the current rate the Fed is losing money, its negative capital will exceed $100 billion by February 2024.

You will not find the Fed’s true capital position reported on the Fed’s official consolidated balance sheet or on the individual FRBs’ balance sheets. This is because the Fed—unbelievably—does not subtract its losses from its retained earnings. Instead, it pretends that its growing losses are an asset. “Ridiculous!” you may exclaim. The kindest way to describe this Fed accounting is that it is non-standard, but Congress has allowed the Federal Reserve to determine its own accounting rules. Since its accumulated operating losses have made the actual liabilities of the Fed larger than its assets, the Fed created a new “asset” because it doesn’t want to show that it has negative capital. We do not suggest you try this accounting sleight-of-hand if you are a private bank, a business, or filling out a home loan application.

The Fed claims that, even if it does have negative capital, it doesn’t matter because it can always print all the money it needs. However, there are, in fact, limits to its ability to print paper currency. But even if there were no limits, the Fed’s large negative capital, growing ever more negative each week, certainly makes the Fed look bad—incompetent even—and calls its credibility into question. While it is not widely understood, the deposits in FRBs are unsecured liabilities of each individual FRB. When an FRB has negative capital, the presumed risk-free status of its deposits hinges on a belief that the deposits are implicitly guaranteed by the US Treasury.

Maintaining market confidence in the Federal Reserve System and FRBs is critical. As the Fed’s losses continue to rapidly accumulate, it would be sensible for Congress to recapitalize the Fed and bring it back to positive capital with assets greater than, instead of less than, its liabilities, and restore it to technical solvency. This could be done with four steps, which would fit well with and expand Pollock’s proposals for Reforming the Federal Reserve:

• Suspend FRB dividends

• Exercise the Fed’s existing capital call on its stockholders

• Assess the stockholders to offset Fed losses, as provided in the Federal Reserve Act (FRA)

• Have the US Treasury buy stock in the Federal Reserve, consistent with the original FRA.

Suspend Dividends

When banks or any other corporations are suffering huge losses, especially if they have negative retained earnings, let alone negative total capital, a typical and sensible reaction is to stop paying dividends. Indeed, the Federal Reserve in its role as a bank regulator would insist on this for the banks and holding companies it regulates. The same logic should apply to the Fed itself. The central bank of Switzerland is an instructive example. Like the Fed, the Swiss National Bank is now facing losses but, unlike the Fed, it still has significant positive capital. Nonetheless, the Swiss National Bank has stopped paying dividends for the last two years. When the Fed is losing over $100 billion per year, there is scant justification for it to be paying $1.5 billion in dividends to its member bank shareholders annually.

However, to stop a technically insolvent Fed from paying dividends, Congress has to get involved and amend the Federal Reserve Act. The FRA currently provides that the Fed’s dividends are cumulative. This provision reflects the former belief that the Fed would always make profits. With today’s reality of massive losses, the Federal Reserve Act should be revised to make dividends noncumulative and to prohibit FRB dividend payments if such payments would result in negative retained earnings (“surplus” in Fed terminology) on a GAAP basis.

Exercise the Fed’s Existing Capital Call on its Stockholders

Section 2.3 of the Federal Reserve Act requires every bank that is a member of a Federal Reserve Bank to subscribe to shares of the FRB in an amount tied to the member bank’s own capital. The member-stockholders, however, are required to pay in and have paid in only half of the amount subscribed. The other half is subject to call by the Federal Reserve Board, and if called, must be paid in by the member bank.

The total paid-in capital of the Fed is $36 billion. An additional $36 billion in FRB capital could be raised if the Federal Reserve Board simply exercised its existing statutory call. This would reduce the Fed’s negative capital as of January 3, 2024, by 39%. If the Federal Reserve Board balks at exercising the capital call, Congress should instruct it to do so.

Under our recommended changes to Fed dividend policy, the newly paid-in shares would not receive dividends until FRBs return to positive GAAP retained earnings (“surplus”).

Assess the Stockholders to Offset Fed Losses, as Provided for in the Federal Reserve Act

In a very little-known but very important provision of the FRA, which goes back to its original 1913 enactment, Federal Reserve Bank shareholders are made liable in addition to their subscription to Fed stock, for another amount equal to that subscription, which they may be assessed to cover all obligations of their FRB; in other words, to offset negative capital. A member bank assessment would be a cash contribution to their FRB, not an investment in more stock. Says the FRA, “The shareholders of every Federal reserve bank shall be held individually responsible … to the extent of the amount of their subscriptions to such stock at the par value thereof in addition to the amount subscribed.” (Italics added.)

The total subscriptions to Fed stock are twice the outstanding paid-in capital of $36 billion, so the subscriptions total $72 billion, and the maximum possible assessment on the Fed member banks is thus $72 billion. Since two FRBs, Atlanta and St. Louis, still have their capital intact, the available assessment would be on the other ten FRBs. The maximum assessments would be these FRBs’ paid-in capital of $34 billion times 2, or $68 billion. By comparison, the Fed paid $177 billion in interest and dividends to its member banks in 2023.

The original Federal Reserve Act, as enacted in 1913, provided for the US Treasury to buy Federal Reserve Bank stock, if necessary.

With the maximum assessment on the members of these ten FRBs in addition to calling the unpaid half of the stock subscriptions for all the FRBs, the total raised would be $104 billion ($36 billion in new stock plus $68 billion in assessments). This amount would offset the Fed’s year-end capital deficit of $92 billion and would cover about six weeks of additional losses at the current rate of $2 billion a week.

Doubtless the Fed’s member banks would be exceedingly unhappy with these actions to shore up the capital of the Federal Reserve. But member banks, as the sole shareholders in the FRBs, have a clear statutory obligation to financially support FRBs that will soon have consolidated true negative capital in excess of $100 billion.

Judging by public financial statements disclosures, few—if any—Fed member banks have seriously considered the large statutory contingent liability that membership in the Fed brings. Taking into account FRBs’ financial condition and their shareholders’ clear legal obligations, it seems that FRB member banks should be disclosing this material contingent liability.

Have the US Treasury Buy Stock in the Federal Reserve, Consistent with the Original Federal Reserve Act

Suspending FRB dividends, calling the rest of the member banks’ stock subscriptions, and assessing FRB stockholders the maximum amount would make the Fed’s capital positive again until mid-February 2024. After that, continuing losses will put it back into negative territory and the Fed back into technical insolvency. Given the fact that the Fed is stuck with long-term fixed-rate investments yielding a mere 2%, and that $3.9 trillion of its investments have more than ten years left to maturity, the Fed’s very large cash losses will most likely continue for quite a while.

Another source of recapitalization is needed.

The original FRA as enacted in 1913 provided for the US Treasury to buy Federal Reserve Bank stock, if necessary. (It also provided for possible sale of FRB stock to the public, which did not happen and could not happen under today’s circumstances.) Section 2.10 of the FRA, which has never been amended, empowers an FRB to issue shares to the Treasury to raise needed capital:

Should the total subscriptions … to the stock of said Federal reserve banks, or any one or more of them, be, in the judgment of the organization committee [the Secretary of Treasury, the Secretary of Agriculture, the Comptroller of the Currency], insufficient to provide the capital required therefor, then and in that event the said organization committee shall allot to the United States such an amount of said stock as said committee shall determine. Said United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated, and shall be held by the Secretary of the Treasury, and be disposed of… as the Secretary of the Treasury shall determine.

In a 1941 opinion, the Federal Reserve Board argued: “As originally enacted, the Federal Reserve Act provided for a Reserve Bank Organization Committee … [and] was authorized to allot Federal Reserve Bank stock to the United States in the event that subscriptions to such stock … were inadequate. However, subscriptions by member banks were adequate. … Accordingly, [this section] is now of no practical effect.”

However, the Fed’s financial condition has dramatically changed since 1941. In 2024, the subscriptions to the capital of the FRBs are grossly inadequate—the FRBs cannot maintain positive capital. Allocation of Fed stock to the United States would now be of very significant practical effect.

In light of the Fed’s technical insolvency, ongoing huge losses, and massively negative capital, Congress could sensibly amend Section 2.10 to read as follows:

Should the total subscriptions to the stock of the Federal reserve banks and the further assessments of the shareholders be insufficient to maintain positive capital as measured by GAAP for any one or more of the Federal reserve banks, then the Board of Governors of the Federal Reserve shall allot to the United States such an amount of said stock as the Board shall determine will bring the capital as measured by GAAP of these Federal reserve banks to not less than $100 million and maintain the consolidated capital of the Federal Reserve System as measured by GAAP at not less than $1.2 billion. The United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated and shall be held by the Secretary of the Treasury. Said stock may be repurchased at par by a Federal reserve bank or banks at any time, provided that after the repurchase, the capital of each Federal reserve bank as measured by GAAP shall be not less than $100 million and that the consolidated capital of the Federal Reserve System as measured by GAAP shall be not less than $1.2 billion.

The stock purchased by the Treasury would be non-voting, since the FRA provides that “Stock not held by member banks shall not be entitled to voting power.”

If over the next 15 months the Fed loses the same $135 billion as it has in the last 15 months, the Treasury would own about $123 billion in par value of FRB stock by March 31, 2025, and the member banks would own $72 billion after the capital call. The Treasury would thus own about 62% of the consolidated Fed stock but could not vote its shares. Over the long-term future, the FRBs would repurchase the Treasury’s shares as their finances permit.

With these four steps, the recapitalization of the Federal Reserve would be complete. Our proposed consolidated capital of $1.2 billion compared to the Fed’s beginning of 2024 total assets of $7.7 trillion, would give the Fed a leverage capital ratio of 0.016%—small indeed, but always positive. In other words, this revised section of the Federal Reserve Act would mean that the Treasury would, as it does for Fannie Mae and Freddie Mac, ensure that over time, the most important central bank in the world would never again be technically insolvent, no matter how big its losses.

"The Most Important Price of All"

Published in Law & Liberty.

In The Price of Time, Edward Chancellor has given us a colorful and provocative review of the history, theory, and profound effects of interest rates, the price that links the present and the future, which he argues is “the most important price of all.” 

The history runs from Hammurabi’s Code, which in 1750 BC was “largely concerned with the regulation of interest,” and from the first debt cancellation (which was proclaimed by a ruler in ancient Mesopotamia) all the way to our world of pure fiat currencies, the recent Everything Bubble (now deflating), cryptocurrencies (now crashing), and the effective cancellation of government debt by inflation and negative interest rates.

The intellectual and political debates run from the Old Testament to Aristotle to John Locke and John Law, to Friedrich Hayek and John Maynard Keynes, to Xi Jinping and Ben Bernanke, and many others.  

As for the vast effects of interest rates, a central theme of the book is that in recent years interest rates were held too low for too long, being kept “negative in real terms for years on end,” with resulting massive financial distortions for which central banks are culpable. 

The Effects of Low Interest Rates

Chancellor chronicles how over the centuries, many writers and politicians have favored low interest rates. They have in mind an image of the Scrooge-like lender, always a usurer lending at excessive interest, grinding down the impoverished and desperate borrower—not unlike contemporary discussions of payday lending. For example, Chancellor quotes A Discourse Upon Usury, written by an Elizabethan judge in 1572, which describes the usurer as “hel unsaciable, the sea raging, a cur dog, a blind moul, a venomus spider, and a bottomless sacke…most abominable in the sight of God and man.” Presumably, the members of the American Bankers Association and of the Independent Community Bankers of America would object to this description.

In fact, the roles of lender and borrower have often been and are in large measure today the opposite of the traditional image. This was already clear to John Locke, as Chancellor shows us. The great philosopher turned his mind in 1691 to “Some Considerations of the Lowering of Interest Rates” and “saw many disadvantages arising from a forced reduction in borrowing costs” and lower interest rates paid to lenders. For who are these lenders? Wrote Locke: “It will be a loss to Widows, Orphans, and all those who have their Estates in Money”—just as it was a loss in 2022 to the British pension funds when these funds got themselves in trouble by trying to cope with excessively low interest rates. Moreover, who would benefit from lower interest rates? Locke considered that low interest rates “will mightily increase the advantages of bankers and scriveners, and other such expert brokers … It will be a gain to the borrowing merchant.” Lower interest rates, Chancellor adds, would also benefit “an indebted aristocracy.”

In Chancellor’s summary, “Locke was the first writer to consider at length the potential damage produced by taking interest rates below their natural level.” Locke’s position in modern language includes these points:

•           Financiers would benefit at the expense of ”widows and orphans”

•           Wealth would be redistributed from savers to borrowers

•           Too much borrowing would take place

•           Asset price inflation would make the rich richer

Just so, over our recent years of too-low interest rates, ordinary people have had the purchasing power of their savings expropriated by central bank policy and leveraged speculators of various stripes made large profits from overly cheap borrowing, while debt boomed and asset prices inflated into the Everything Bubble.

The central bankers knew what they were doing with respect to asset prices. Chancellor quotes a remarkably candid statement in a Federal Open Market Committee meeting in 2004, in which, as a Federal Reserve Governor clearly put it:

[Our] policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of the distortion is deliberate and a desirable effect if the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand.

That boosting asset prices was “deliberate” is correct; that it was “desirable” seems mistaken to Chancellor and to me. “The records show that the Fed had used its considerable powers to boost the housing market,” he writes (I prefer the phrase, “stoke the housing bubble”). What is worse, the Fed did it twice, and we had two housing bubbles in the brief 23 years of this century. In 2021, the Fed was inexcusably buying mortgage securities and suppressing mortgage rates while the country was experiencing a runaway house price inflation (now deflating).

In general, “Wealth bubbles occur when the interest rate is held below its natural level,” Chancellor concludes.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes.

Bad Press

On a different note, he mentions that suppression of interest rates could lead to “Keynes’ long-held ambition for the euthanasia of the rentier,” using Keynes’ own memorable, if unpleasant, phrase. The recent long period of nearly zero interest rates, however, led to huge market gains on the investments of the rentiers, and caused instead the euthanasia of the savers—or at least the robbing of the savers.

Our recent experience has shown again how borrowers may be made richer by low interest rates, as were speculators, private equity firms, and corporations that levered up with cheap debt. “It is clear that unconventional monetary policies…had a profound impact on inequality,” Chancellor writes, “the greatest beneficiaries from the Fed’s policies [of low interest rates] were the financial elite, who got to enhance their fortunes with cheap leverage at a time when asset values were driven higher by easy money.”

Historically there was a question of whether there should be interest charged at all. “Moneylenders have always received a bad press,” Chancellor reflects, “Over the centuries… the greatest minds have been aligned against them”—Aristotle, for example, thought charging interest was “of all modes of making money…the most unnatural.” The Old Testament restricted charging interest, but as Chancellor points out, the Book of Deuteronomy makes this important distinction: “You shall not lend upon interest to your brother, interest on money, interest on victuals, interest on anything,” but “To a foreigner you may lend upon interest.” This raises the question of who is my brother and who is a foreigner, but does seem to be an early acceptance of international banking. It also makes me think that anyone who has made loans from the Bank of Dad and Mom at the family interest rate of zero, will recognize the intuitive distinction expressed in Deuteronomy.

Needless to say, loans and investments bearing interest prevail around the globe in the tens of trillions of dollars, the moneylenders’ bad press notwithstanding. This is, at the most fundamental level, because interest rates reflect the reality of time, as Chancellor nicely explains. One thousand dollars ten years from now and one thousand dollars today are naturally and inescapably different, and the interest rate is the price of that difference, which gives us a precise measure of how different they are.

A perpetually intriguing part of that price is how interest compounds over long periods of time. “The problem of debt compounding at a geometrical rate has never lost its fascination,” Chancellor observes, and that is certainly true. “A penny put out to 5 percent compound interest at our Savior’s birth,” he quotes an 18th-century philosopher as calculating, “would by this time [in 1773]… have increased to more money than would be contained in 150 millions of globes, each equal to the earth in magnitude, all solid gold.”

The quip that compound interest is “the eighth wonder of the world” is often attributed to Albert Einstein, but Chancellor traces it to a more humble origin: “an advertisement for The Equity Savings and Loan Company published in the Cleveland Plain Dealer” in 1925. “Compound interest… does things to money,” the advertisement continued, “At the Equity it doubles your money every 14 years.” This meant the savings and loan’s deposits were paying 5% interest—the same interest rate used in the preceding 1773-year calculation, but that case represented 123 doublings.

The mirror image of sums remarkably increasing with compound interest is the present value calculation, which reduces the value of future sums by compound interest running backward to the present, a classic tool of finance. Just as we are fascinated, as the Equity Savings and Loan knew, by how much future sums can increase, depending on the interest rate that is compounding, so we are also fascinated by how much today’s market value of future sums can shrink, depending on the interest rate. 

If the interest rate goes from 1% to 4%, about what the yield on the 10-year Treasury note did in 2021-2022, the value of $1,000 ten years from now drops from $905 to $676, or by 25%. You still expect exactly the same $1,000 at exactly the same time, but you find yourself 25% poorer in market value.

Central Bank Distortions

In old British novels, wealth is measured by annual income, as in “He has two thousand pounds a year.” One role of changing interest rates is to make the exact same investment income represent very different amounts of wealth. If interest rates are suppressed by the central banks, it makes you wealthier with the same investment income; if they are pushed up, it makes you poorer. If they change a lot in either direction, the change in wealth is a lot. The math is elementary, but it helps demonstrates why interest rates are, as Chancellor says, the most important price. 

In the 21st century, “The Federal Reserve lowered interest rates to zero and sprayed money around Wall Street.” But if the interest rate is zero, $1,000 ten years in the future is worth the same as $1,000 today, a ridiculous conclusion, and why zero interest rates are only possible in a financial world ruled by central banks.

More egregious yet is the notion of negative interest rates, which were actually experienced on trillions of dollars of debt during the last decade. “The shift to negative interest rates comprised the central bankers’ most audacious move,” Chancellor writes. “What is a negative interest rate but a tax on capital—taxation without representation.” With negative interest rates, $1,000 ten years in the future is worth more than $1,000 today, an absurd conclusion, likewise proof that negative interest rates can only exist under the rule of central banks.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes. In his ideal world, expressed on the book’s last page, “central banks would no longer be able to pursue an active monetary policy,” and “guided by the market’s invisible hand, the rate of interest would find its natural level.” Given all the mistakes central banks have made, with the accompanying distortions, this is an attractive vision, but unlikely, needless to say.

Hearkening to Hayek: How About a Free Competition Between Bitcoin, Paper Money, and Gold?

Published in the New York Sun:

That object of volatile speculation, the Bitcoin, is not a physical coin or any physical object at all. It is certainly not a gold coin and is not redeemable or backed by anything, let alone gold coins. Yet it is endlessly pictured in press illustrations as a gold coin with a “B” stamped on it.

Go ahead, kid me. These illustrations are a notable marketing success for Bitcoin, but why is there such an urge among publishers to show Bitcoins as gold coins? Not one of them would dream of illustrating United States dollars as gold coins — though our own government has tried the trick.

Gold coins are physical reality, while Bitcoins, being electronic accounting entries in a complex computer algorithm, never are. Gold coins with their durability, beauty, and scarcity will still be there even if all electric systems are knocked out and your computers don’t work at all.

The ubiquitous visual suggestion that Bitcoins are gold coins is, though, a misrepresentation. How could one more accurately suggest in an illustration the electronic accounting entry which Bitcoin is, given that one can’t actually draw a Bitcoin? Could one  show a drawing of a computer screen with Bitcoin prices on it?

For those who reasonably maintain that the unbacked Bitcoin is simply a form of gambling, a computer screen with an electronic roulette wheel on it might be used. Dollars are often depicted in publications as paper currency. Paper currency is physical reality which also will still be there if the electricity and the computers don’t work.

Then again, too, it’s only cheap paper which can be endlessly depreciated by its issuing central bank. Paper currency is normally convertible into bank deposits and vice versa. Yet if the bank fails, paper currency looks a lot better than deposits. It would be there, still at par, when the bank has folded, and one would not need to worry about what government bailouts may be in process.

Even so, in holding the paper currency, one would still be a target of the inflationist drive of the Federal Reserve and other central bankers. One would be holding a unit of money, in respect of the Fed has formally set a goal of depreciating at an average of two percent — forever. 

Historically, it would have been accurate to depict dollars as gold coins. Gold coins denominated in dollars freely circulated for parts of our history. Dollar paper currency was redeemable in and backed by gold. Bank deposits were withdrawable in gold coins. The Federal Reserve was required by law to hold gold collateral against its paper currency.

This gold standard world is hardly even imaginable by most people today. It ended in 1933 when the government made owning gold illegal for American citizens, with criminal penalties. This prohibition, which lasted more than 40 years, was remarkably oppressive. It enabled a vast expansion of government power.

The Nobel laureate Friedrich Hayek, in his 1974 essay “Choice in Currency,” argued that “With the exception… of the gold standard, practically all governments in history have used their exclusive power to issue money in order to defraud and plunder the people.” 

Therefore, Hayek asked, “why should we not let people choose freely what money they want to use?” Bitcoin enthusiasts love this idea, and propose Bitcoin as the alternative money to escape the monetary control of inflationist central banks.

Despite its remarkable record as an object of speculation, Bitcoin has a scant record as a currency in general use. What a contrast to the long history of gold-backed currency.

That a revived gold-backed currency would become a renewed alternative to pure paper currencies was Hayek’s actual hope. “It seems not unlikely that gold would ultimately reassert its place…if people were given complete freedom to decide,” he wrote. This would require paper and accounting money defined as a weight of gold and freely redeemable in gold coins.

Would such a money based on gold coins be chosen by the people over paper dollars and Bitcoins in a free competition? How instructive it would be, although directly against the self-interest of every deficit-monetizing government, to run this comparison.

A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

It’s time for universities to share the burden of student loan defaults

Published with Arthur Herman in The Hill.

While the nation is rightly worried about the proliferation of antisemitism on its college campuses, another higher education abuse also needs prompt attention.

On Dec. 6 – St. Nicholas Day – President Biden handed student loan defaulters another $5 billion gift in debt forgiveness. The administration’s eagerness to win the votes of student loan borrowers by shifting the cost of student debt from borrowers to taxpayers now adds up to $132 billion of student loans those borrowers will not have to pay — even though the Supreme Court ruled a related scheme unconstitutional last June.

But if borrowers don’t pay the debts they incurred and default on their debts, someone else has to pay. Right now, that someone else is American taxpayers. Now it’s time that the cost of nonpayment of student loans be shared by those who have benefitted the most directly from federal student loans: namely, the colleges and universities themselves.

By inducing their students to borrow from the government, higher education institutions collect vastly inflated tuition and fees, which they then spend without worrying about whether the loans will ever be repaid. This in turn incentivizes them to push the tuition and fees, and room and board, ever higher — by an average of 169 percent since 1980, according to a Georgetown University study.

In short, in the current system the colleges get and spend billions in borrowed money and put all the loan risk on somebody else — including those student borrowers who responsibly pay off their own debt and those who never borrowed in the first place, not to mention taxpayers, whether they attended a college or not.

This perverse pattern of incentives and rewards must stop. A more equitable model would insist that colleges have serious “skin in the game.” It would insist that they participate to some degree in the losses from defaulted and forgiven loans to their own students.

This idea has been thoughtfully discussed and proposed in Congress before, but now is the time to implement a model that realigns incentives and rewards in our national student loan system and distributes the burden of risk more equitably.

The first principle should be that the more affluent the college is, the higher its participation in the losses should be. The wealthiest colleges with massive endowments should be covering 100 percent of any losses on federal loans to their students, which they can easily afford. Others can cover a lower, but still significant, percentage, but every college that finances itself with federal student loans should assume some real cost when its students default on their loans. Four million student loans enter default each year, not counting the Biden scheme for student loan “forgiveness,” which creates even more losses.

Specifically, we propose the following “skin in the game” requirements for colleges on losses from federal student loans to their students, based on their endowment size:

Endowment Size     Cumulative Rank in Endowments   Coverage of Losses

Over $10 billion                           Top 0.6%                                          100%

$5 billion to $10 billion                Top 1.1%                                            80%

$3 billion to $5 billion                  Top 1.7%                                            60%     

$2 billion to $3 billion                  Top 2.6%                                            40%

All others                                         100%                                            20%

Any fair observer would have to conclude that this represents a rational and efficient matching of benefits and costs.

Moreover, we propose that the most affluent colleges that participate in federal student loans, such as Harvard, Yale and Stanford, should contribute to a “Trust to Offset Losses from Federal Student Loans” through an excise tax on their endowments — some of which are larger than the GDP of sovereign countries. 

This tax would apply to only about the top 1 percent or 2 percent of college endowments. The trust would then be used to offset some of the remaining losses the less affluent colleges cannot pay, thus sharing the wealth of the top 1 percent or 2 percent to help others in need.

For the excise tax to fund the Trust to Offset Losses, we propose:

Endowment Size           Cumulative Rank In Endowments          Tax Rate                     

Over $5 billion                             Top 1.1%                               1% per annum

$2.5 to $5 billion                          Top 2%                                   0.5% per annum

It seems only fair that the wealthiest colleges be asked to contribute to cover the student loan losses the Biden administration is sticking taxpayers with. After all, they benefited the most from the Great Tuition Bubble since the 1980s, just as subprime mortgage brokers benefited in the Great Housing Bubble in the early 2000s.

Since Biden’s St Nicholas Day gift to student borrowers simultaneously gave a large lump of coal to the taxpaying public, not to mention to those borrowers who made every sacrifice to meet their loan obligations, it’s high time to give the rest of us a Christmas present of a new model for government student loans. The proper model should be one that will keep on giving as colleges and universities take on the responsibility and accountability they have shirked until now.

How Can It Be That a ‘Thief in the Night’ Is Loosed by the Federal Reserve Under the Nose of a Passive Congress?

And what would it mean if Congress were active in the decisions?

Published in The New York Sun and also the Federalist Society.

The Federal Reserve is a problem for the constitutional order of our republic. How can it be that the central bank considers itself able to unilaterally impose permanent inflation on the country, without legislative debate or approval?

The shifting theories believed by central banks are among the most important of macro-economic factors. The chairman of the Federal Reserve Board between 1951 and 1970, William McChesney Martin, characterized inflation as “a thief in the night.” 

In remarkable contrast, the Fed under Ben Bernanke, chairman between 2006 and 2014, explicitly committed itself and the country to inflation forever at the rate of 2 percent a year, thus assuming that constant inflation should not only be taken for granted, but pursued. 

If the purchasing power of the currency continuously depreciates at the rate of two percent per year, as the Fed now promises, in the course of a single lifetime, average prices would quintuple. At three percent, as is sometimes suggested, prices in a lifetime would multiply by ten times. At four percent, they would multiply by 23 times.

Is this the kind of money the American people want? I don’t think so. Congress did acquiesce in the 1970s to the executive move to fiat money, untied to gold, as previously required by the Bretton Woods agreement, and later removed legislative ties of the dollar to gold. 

That’s the kind of money wanted by those who long to expand government power and finance it by an unlegislated inflation tax. The Congress didn’t, though, call for, enact, or approve a policy of pursuing inflation per se.  It wrote into the Federal Reserve Reform Act of 1977 a requirement that a principal goal of the Fed is “stable prices.”

The nature of money and the stability of its value is an essential political and social question. William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” On the other hand, we may proclaim, “You shall not drown mankind in a flood of paper money.” Who gets to choose between inflationist money and sound money?

Not the Fed by itself. Coining money, and regulating the value thereof,  are questions profoundly requiring the Congress. They are specifically enumerated in the Constitution as among the powers granted, in Article One, Section Eight, to Congress.

The press is full of references to “the Fed’s” two percent inflation target. But if there is to be such a target, it should be “the country’s” target, not “the Fed’s” target. The Fed’s proposal to constantly depreciate the people’s money should have been presented to the elected representatives of the people for approval or rejection. It wasn’t.

How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and depreciation of the currency at some rate of its own choosing? The only explanation I can think of is pure arrogance. 

Being the most powerful financial institution in the world and the purveyor of the dominant fiat currency might lead the Fed to an excessively high opinion of its own authority. At the same time, the Fed has crucial and dangerous inherent weaknesses.

It has demonstrated beyond question its inability to predict the financial and economic future. It can inflate disastrous asset price bubbles as well as consumer prices. It is unable to know what the results of its own actions will be.

This inability is notably shown by its own financial performance: a net loss of $111 billion since September 2022, as reported on October 19, tens of billions in net losses still to come, and a mark to market loss on its investments of more than $1 trillion.

Congress should, first and foremost, amend the Federal Reserve Act to make it clear that setting any “inflation target” requires review and approval by Congress, as a public choice between kinds of money. And make it clear that the Fed lacks  unilateral power to decide the nature of the money the Congress provides.

Congress should also cancel the two percent inflation target announced by the Fed, until the Congress has approved such an action or provided some other guidance — say, “stable prices” — a goal that is already stated in the Federal Reserve Act, but is being evaded.

Stable prices imply a long-run average inflation rate of approximately zero — in other words, a goal of sound money. All in all, we need to control the powerful and dangerous Federal Reserve by using the checks and balances of our constitutional republic.

Reforming the Federal Reserve

Published in Law & Liberty.

The Federal Reserve creates and manipulates the dominant fiat currency of the world. It produces the inflation of its supply and the continuous depreciation of its purchasing power. It manipulates dollar interest rates and the cost of debt, makes elastic the availability of credit (especially during financial crises), finances the government, and monetizes federal deficits in amounts limited only by the statutory debt ceiling. It is often imagined to be “managing the economy,” although, in fact, no one can successfully do that. It is a central bank not only to the United States, but to the entire dollar-using world. In short, the Fed is the most powerful financial institution there is or ever has been. That such a power is concentrated in a single, unelected institution is a problem for the constitutional order of the American republic.

Equally fundamental is that the Fed is always subject to deep uncertainty. It has clearly demonstrated its inability (like everyone else’s) to predict the economic or financial future, and it is inherently unable to know what the results of its own actions will be. Its remarkable power combined with its inescapable lack of knowledge of the future makes it the most dangerous financial institution in the world. This is true no matter how intelligent or brilliant its officers may be, however good their intentions, however many hundreds of economists they hire, or however complex the computer models they build. 

At the famous Jackson Hole central banking conference in August 2023, Fed Chairman Jay Powell, with admirable candor, pointed out some essential uncertainties in the current Federal Reserve debates. “We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty” about monetary policy, which is “further complicated by uncertainty about the duration of the lags” with which the policy operates and the “changing dynamics [that] may or may not persist.” He continued, “These uncertainties, both old and new, complicate our task.” They certainly do, and this is true of the Fed’s monetary issues at all times.

Powell used an apt metaphor in this respect: “We are navigating by the stars under cloudy skies.” The President of the European Central Bank, Christine Lagarde, used a different metaphor: “There is no pre-existing playbook for the situation we are facing.” But the former Governor of the Bank of England, Mervyn King, in his book, The End of Alchemy, drew a blunter conclusion from it all: “If the future is unknowable, then we simply do not know and it is pointless to pretend otherwise.”

All this should increase our skepticism about how much independent power central banks should have, and whether there is a meaningful path for reform.

Uncertainty and Big Losses 

A good example of the results of uncertainty is the Fed’s own dismal financial performance and growing technical insolvency. The Federal Reserve made net losses of $105 billion as of September 27, 2023 since September 2022. That shocking number is getting rapidly bigger. The Fed continues to lose money at the rate of about $9.5 billion a month or $114 billion a year and the losses may continue for a long time. The accumulated losses are already more than double the Fed’s total capital of $43 billion—indeed, the losses had shriveled its capital, when properly measured under Generally Accepted Accounting Principles (GAAP), to negative $50 billion when Chairman Powell was speaking at Jackson Hole. The Fed’s properly measured capital is likely headed for a negative $100 billion or worse by early 2024. The Fed finances this negative capital by borrowing, which increases the consolidated government debt and is a cost to taxpayers. 

The scale of the losses it is suffering doubtless came as a surprise to the Fed. This is apparent from the woefully inaccurate forecasts of continued “lower for longer” interest rates which it made while amassing trillions of investments in long term, fixed-rate Treasury and mortgage securities with very low yields—including, for example, the 1.25% Treasury bond not maturing until 2050—and funding them with floating rate liabilities. In doing so, the Fed created for its own balance sheet a $5 trillion interest rate risk position similar to that of a giant savings and loan. Such a position would inevitably produce huge losses if interest rates rose to anything like historically normal levels of 4% or 5%. They did, and the losses have followed.

It is impossible to believe that the leadership of the Federal Reserve planned and consciously intended to lose over $100 billion. (As you read this, ask yourself if you believe it.) Fed officials knew they had created a very large interest rate risk position, but as an old boss told me long ago, “Risk is the price you never thought you would have to pay.” The combination of the unknowable future with great financial power joined forces to put this massive cost on the taxpayers without a vote of the Congress.

An Independent Power?

Should the Fed have been able unilaterally to commit the country to perpetual inflation and perpetual depreciation of the dollar’s purchasing power at the rate of 2% per year? The correct answer is “no.”

The media is full of references to “the Fed’s” 2% inflation target—but it should be “the country’s” target. The Fed’s proposal about the nature of the people’s money should have been presented to the elected representatives of the people for approval. The U.S. Constitution provides among the powers of the Congress: “To coin Money [and] regulate the Value thereof.” Regulating the value of the national money and deciding whether it should be stable, or perpetually depreciating, and if so, at what rate, involve inherently political questions. 

Let us review the always-striking math of compound growth rates and apply it to inflation. Stable prices imply a long-run average inflation of approximately zero. At 1% inflation, average prices will more than double in a lifetime of 80 years. At 2% inflation, prices will quintuple. At 3%, they will go up by 10 times. At 4% inflation, prices in a lifetime will go up by 23 times. Which would the sovereign people through their representatives choose? William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” How about “You shall not drown mankind in a flood of fiat money”? This is not up to the Federal Reserve to decide on its own.

The Federal Reserve Act specifies “stable prices” as an institutional Fed goal. The concept of “stable prices” is not the same as “a stable rate of inflation,” which the Fed now calls “price stability,” a misleading rhetorical shift.

It is often claimed, especially by the Fed itself, that the Federal Reserve is, or at least ought to be, “independent.” Supporters of the Fed, especially academic economists, join this chorus. Earlier generations of Fed leaders were more realistic. They spoke of the Fed as “independent within the government”—that is, not really independent. In this context, we may recall that the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board.

“Independent” might mean independent of the U.S. Treasury, so that the Treasury cannot require the Fed to print up money to finance its deficits. However, the Fed has had significant experience as the willing servant of the Treasury. This was especially prominent during wars, such as when the Fed committed to buy however many long-term Treasury bonds it took to keep their yield down to 2.5% during World War II. Similarly, the Fed’s “quantitative easing” artificially lowered the cost of financing Treasury deficits for years. In financial crises, as it did in the Covid crisis, the Fed works hand in glove with the Treasury to finance bailouts.

Alternately, “independent” might mean independent of the Congress. In this sense, the Fed should not be independent. As a matter of fundamental government design, it should be in a system of effective checks and balances to which the Congress is essential. 

Since the original Federal Reserve Act in 1913, there have many amendments to the act, with notable Federal Reserve reform legislation in the 1930s and in 1977–78. After its unprecedented actions in the twenty-first century so far, I suggest that it is time again for serious reform of the Federal Reserve.

Reforming the Fed

With the foregoing problems in mind, I recommend eight specific reforms to promote responsibility to the elected representatives of the people in a system of Constitutional checks and balances, bring greater emphasis on genuine price stability, and align expectations with the realities of limited knowledge and pervasive uncertainty.

1. First and foremost, the Congress should amend the Federal Reserve Act to make it clear that the Fed does not have the authority unilaterally to decide on the nature of U.S. money, an essential public question. The revised act should provide that the maintaining or setting of any “inflation target” requires review and approval by Congress. This would make it consistent with the practice of other democratic countries, notably the father of the inflation targeting theory, New Zealand, where the inflation target has to be an agreement between the central bank and the parliamentary government. The original New Zealand target was zero to 2%. But no long-term target for depreciating the money the government provides and imposes on the people should be set without legislative approval.

A true public discussion of the “Money Question,” as they called it in the long debates that ultimately gave birth to the Federal Reserve, would be salutary.

In contrast to those historic debates, how in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? A new reform would straighten it out on that, establishing that the Fed is not a committee of independent economic philosopher-kings, but “independent within the government,” subject to the checks and balances reflecting a constitutional republic.

2. Consistent with the first reform, the Congress should cancel the 2% inflation target set unilaterally by the Fed until it has approved that or some other guidance. For better guidance, I recommend price stability, or a long-run average target inflation of approximately zero, cyclically varying in a range of perhaps -1% to +1%. This would be a modern form of “sound money.” A range is needed, because it is entirely unrealistic to think the inflation rate should be the same at all times, when every other economic factor is always changing. As an interim step, one could live with New Zealand’s original range of zero to 2%. 

3. From 1913 to 2008, the Fed’s investments in mortgages were exactly zero, reflecting the fundamental principle that the central bank should not use its monopoly money power to subsidize specific sectors or interests. The Fed’s buying mortgage securities was an emergency action in a housing finance crisis that has now been over for more than a decade. Its mortgage investments should go back to zero. The Fed made itself into the world’s biggest savings and loan; its mortgage portfolio totaled $2.5 trillion in August 2023. So the run-off will take a long time, but the Fed’s mortgage investments should finally go to zero and stay there, at least until the next mortgage finance crisis.

4. The fundamental structure of the Fed’s consolidated balance sheet, and the balance sheets of the 12 individual Federal Reserve Banks, should be reviewed by Congress, including their capitalization. An iron principle of accounting is that operating losses are subtracted from retained earnings and therefore from capital. Unbelievably, the Fed’s accounting does not follow this principle, but embarrassingly pretends that its operating cash losses are an intangible asset. This is in order to avoid reporting its true capital. Properly measured, using GAAP, at the end of August 2023, the Fed’s consolidated capital was negative $52 billion.

All Federal Reserve member banks have bought only one-half of the Fed stock to which they have subscribed, and the other half is callable at any time by the Federal Reserve Board. The Fed could raise $36 billion in new capital by issuing a call for the other half. It should do this, with due notice, to bolster the depleted or exhausted capital of the various Federal Reserve Banks.

In addition, the Fed is authorized by the Federal Reserve Act to assess the member bank shareholders up to 6% of the member’s own capital and surplus to offset Federal Reserve Bank losses. Since these losses otherwise become costs to the taxpayers, the Fed should discuss with Congress whether it should proceed to make such assessments.

5. The Fed should be required to use standard U.S. GAAP accounting in reporting its capital. It would not have to go as far as the Central Bank of Switzerland, which by law reports its earnings and capital on a mark-to-market basis, making its earnings and capital reflect the realities of market prices. The Fed’s mark-to-market loss as of June 2023 is over $1 trillion. Recognizing the Fed’s argument that these are “paper losses,” the Fed could continue to disclose them but not book them into capital. However, operating cash losses like the Fed is experiencing without question reduce capital and the Fed should be instructed to adopt GAAP in this respect. As Bishop Joseph Butler said, “Things and actions are what they are. … Why then should we desire to be deceived?”

 6. Dividends on Fed stock should be paid only out of Federal Reserve Bank profits. The Federal Reserve Banks pay attractive dividends, defined by the Federal Reserve Act, to their member bank shareholders: 6% dividends to small banks and the 10-year Treasury note rate, now over 4%, to larger banks. This is fine as long as the Fed is making money, but, as is little known, the act does not require profits to pay dividends and also makes the dividends cumulative, so they have to be paid, now or in the future. These statutory provisions obviously never contemplated that the Federal Reserve would someday be making gigantic losses. If Federal Reserve Banks have lost so much money that they have negative retained earnings, let alone negative total capital, they should not be paying dividends, and any dividends should not be cumulative. Otherwise, such dividends are being paid in effect by the taxpayers. 

7. Congress should revoke the Fed’s payment of the expenses of the Consumer Financial Protection Bureau. When the Fed is losing more than $100 billion a year, it is ridiculous for it to be paying over $700 million a year in the expenses of an unrelated entity for which it has no management responsibility. Far worse than ridiculous, it is against the Constitutional structure of the U.S. government, depriving Congress of its essential power of the purse. This issue may be decided by the Supreme Court in a current case involving whether the CFPB’s funding by the Fed violates the U.S. Constitution. It seems obvious to many of us that it does, and that whatever amount of money the Congress wants to spend on the Consumer Financial Protection Bureau, it ought to be appropriated in the normal way.

8. In general and throughout all considerations of the Federal Reserve, all parties, including the Congress and the Fed itself, should be realistic about the inherent inability of the Fed to reliably forecast the economic or financial future or to “manage the economy” or to know what the results of its own actions will be. In the memorable phrase of F. A. Hayek’s Nobel Prize Lecture, there should be no “pretense of knowledge” about central banking.

These proposed reforms reflect the lessons of the Federal Reserve’s eventful twenty-first-century career so far. As it heads for its 110th birthday, they would move the Fed, with its power and with its danger, toward operating more effectively in the context of our Constitutional republic.

The New Bank Bailout

Taxpayers are covering Federal Reserve losses, for which member banks are supposed to be liable.

Published in the Wall Street Journal with Paul H. Kupiec.

Taxpayers are bailing out Federal Reserve member banks—institutions that own the stock of the Fed’s 12 district banks—and hardly anyone has noticed. For more than 100 years, our central-banking system has made a profit and reliably remitted funds to the U.S. Treasury. Those days are gone. Sharp rate hikes have made the interest the Fed pays on its deposits and borrowing much higher than the yield it receives on its trillions in long-term investments. Since September 2022, its expenses have greatly exceeded its interest earnings. It has accumulated nearly $93 billion in cash operating losses and made no such remittances.

The Fed is able to assess member banks for these losses, but it has instead borrowed to fund them, shifting the bill to taxpayers by raising the consolidated federal debt. That tab is growing larger by the week. Under generally accepted accounting principles, the Fed has $86 billion in negative retained earnings, bringing its total capital to around negative $50 billion.

Each of the Fed’s 12 district banks, except Atlanta, has suffered large operating losses. Accumulated operating losses in the New York, Chicago, Dallas and Richmond, Va., district banks have more than consumed their capital, making each deeply insolvent. A fifth district bank, Boston, is teetering on insolvency. At the current rate of loss, five others will face insolvency within a year and the taxpayers’ bill will grow by more than $9 billion a month until interest rates decline or the Fed imposes a capital call or assessments on its member banks.

The Federal Reserve Act requires that member banks subscribe to the shares issued by their district bank in a dollar value equal to 6% of a member institution’s “capital” and “surplus”—the definitions of which depend on the depository institution’s charter. Member banks must pay for half their subscribed shares, while the remaining half of the subscription is subject to call by the board.

The act empowers the Fed to compel member banks to contribute additional funds to cover their district reserve bank operating losses up to an amount equal to the value of their membership subscription. The provision reads: “The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part” (emphasis added).

In the century when district banks were reliably profitable, these provisions posed only a remote risk to Fed shareholders. The central bank didn’t need member banks to make any additional contributions. As district banks’ consolidated losses approach $100 billion, however, the risks to Fed stockholders have risen. If called on, member banks are legally responsible to make these payments. At a minimum, they should disclose this potential liability.

The risk is that the more than 1,400 Fed-shareholder banks could receive a call on their resources equal to as much as 9% of their capital and surplus—a call for a 3% additional equity investment and 6% cash payment to offset district bank losses. Member banks could be on the hook to contribute three times the capital they currently own in their district bank, or $108 billion in total for the central-bank system.

The Securities and Exchange Commission requires every registered firm to include in its annual 10K reports “an explanation of its off-balance sheet arrangements.” The provision applies to securities issued by banks and bank holding companies that are traded on national exchanges, but enforcement is delegated to the federal regulatory agencies that aren’t requiring Fed member banks and their holding companies to disclose the Fed’s contingent resource claim as a material risk or as a contingent liability.

Consider the Goldman Sachs Group, which includes at least two Fed member banks. The company’s 10K for 2022 includes page after page devoted to discussion of the group’s regulatory, market, competition, operational, sustainability and climate-change risks. Not included in that list is the risk of being compelled to recapitalize and share in the losses of its Fed district banks.

The larger of the two is a member of the New York Federal Reserve Bank, a district bank with accumulated losses of nearly $62 billion, or more than four times its $15 billion stated capital. A smaller Goldman Sachs Trust bank is a member of the Philadelphia Fed, a bank with $821 million in accumulated losses.

Goldman’s member banks had almost $44 billion in capital and surplus, according to our analysis of its June regulatory-call report data. Applying the 3% equity-investment and 6% cash-payment requirements, we calculate that Goldman would face a maximum contingent call of approximately $4 billion—a sum that would exceed the combined 2022 income of its two Fed member banks.

Those sums aren’t mere rounding errors, and they shouldn’t be placed on taxpayers’ tab. Federal bank regulators should require Fed member banks that are registered with the SEC and their holding companies to disclose their risks of being called on to prop up the finances of their Federal Reserve district banks.

The Fed Is Losing Tens of Billions: How Are Individual Federal Reserve Banks Doing?

Published in the Mises Institute with Daniel J. Semelsberger. Also published in RealClear Markets.

The Federal Reserve System as of the end of July 2023 has accumulated operating losses of $83 billion and, with proper, generally accepted accounting principles applied, its consolidated retained earnings are negative $76 billion, and its total capital negative $40 billion. But the System is made up of 12 individual Federal Reserve Banks (FRBs).1 Each is a separate corporation with its own shareholders, board of directors, management and financial statements. The commercial banks that are the shareholders of the Fed actually own shares in the particular FRB of which they are a member, and receive dividends from that FRB. As the System in total puts up shockingly bad numbers, the financial situations of the individual FRBs are seldom, if ever, mentioned. In this article we explore how the individual FRBs are doing.

All 12 FRBs have net accumulated operating losses, but the individual FRB losses range from huge in New York and really big in Richmond and Chicago to almost breakeven in Atlanta. Seven FRBs have accumulated losses of more than $1 billion. The accumulated losses of each FRB as of July 26, 2023 are shown in Table 1.

Table 1: Accumulated Operating Losses of Individual Federal Reserve Banks [2]

New York ($55.5 billion)

Richmond ($11.2 billion )

Chicago ( $6.6 billion )

San Francisco ( $2.6 billion )

Cleveland ( $2.5 billion )

Boston ( $1.6 billion )

Dallas ( $1.4 billion )

Philadelphia ($688 million)

Kansas City ($295 million )

Minneapolis ($151 million )

St. Louis ($109 million )

Atlanta ($ 13 million )

The FRBs are of very different sizes. The FRB of New York, for example, has total assets of about half of the entire Federal Reserve System. In other words, it is as big as the other 11 FRBs put together, by far first among equals. The smallest FRB, Minneapolis, has assets of less than 2% of New York. To adjust for the differences in size, Table 2 shows the accumulated losses as a percent of the total capital of each FRB, answering the question, “What percent of its capital has each FRB lost through July 2023?” There is wide variation among the FRBs. It can be seen that New York is also first, the booby prize, in this measure, while Chicago is a notable second, both having already lost more than three times their capital. Two additional FRBs have lost more than 100% of their capital, four others more than half their capital so far, and two nearly half. Two remain relatively untouched.

Table 2: Accumulated Losses as a Percent of Total Capital of Individual FRBs [3]

New York 373%

Chicago 327%

Dallas 159%

Richmond 133%

Boston 87%

Kansas City 64%

Cleveland 56%

Minneapolis 56%

San Francisco 48%

Philadelphia 46%

St. Louis 11%

Atlanta 1%

Thanks to statutory formulas written by a Congress unable to imagine that the Federal Reserve could ever lose money, let alone lose massive amounts of money, the FRBs maintained only small amounts of retained earnings, only about 16% of their total capital. From the percentages in Table 2 compared to 16%, it may be readily observed that the losses have consumed far more than the retained earnings in all but two FRBs. The GAAP accounting principle to be applied is that operating losses are a subtraction from retained earnings. Unbelievably, the Federal Reserve claims that its losses are instead an intangible asset. But keeping books of the Federal Reserve properly, 10 of the FRBs now have negative retained earnings, so nothing left to pay out in dividends.

On orthodox principles, then, 10 of the 12 FRBs would not be paying dividends to their shareholders. But they continue to do so. Should they?

Much more striking than negative retained earnings is negative total capital. As stated above, properly accounted for, the Federal Reserve in the aggregate has negative capital of $40 billion as of July 2023. This capital deficit is growing at the rate of about $ 2 billion a week, or over $100 billion a year. The Fed urgently wants you to believe that its negative capital does not matter. Whether it does or what negative capital means to the credibility of a central bank can be debated, but the big negative number is there. It is unevenly divided among the individual FRBs, however.

With proper accounting, as is also apparent from Table 2, four of the FRBs already have negative total capital. Their negative capital in dollars shown in Table 3.

Table 3: Federal Reserve Banks with Negative Capital as of July 2023 [4]

New York ($40.7 billion)

Chicago ($ 4.6 billion )

Richmond ($ 2.8 billion )

Dallas ($514 million )

In these cases, we may even more pointedly ask: With negative capital, why are these banks paying dividends?

In six other FRBs, their already shrunken capital keeps on being depleted by continuing losses. At the current rate, they will have negative capital within a year, and in 2024 will face the same fundamental question.

What explains the notable differences among the various FRBs in the extent of their losses and the damage to their capital? The answer is the large difference in the advantage the various FRBs enjoy by issuing paper currency or dollar bills, formally called “Federal Reserve Notes.” Every dollar bill is issued by and is a liability of a particular FRB, and the FRBs differ widely in the proportion of their balance sheet funded by paper currency.

The zero-interest cost funding provided by Federal Reserve Notes reduces the need for interest-bearing funding. All FRBs are invested in billions of long-term fixed-rate bonds and mortgage securities yielding approximately 2%, while they all pay over 5% for their deposits and borrowed funds—a surefire formula for losing money. But they pay 5% on smaller amounts if they have more zero-cost paper money funding their bank. In general, more paper currency financing reduces an FRB’s operating loss, and a smaller proportion of Federal Reserve Notes in its balance sheet increases its loss. The wide range of Federal Reserve Notes as a percent of various FRBs’ total liabilities, a key factor in Atlanta’s small accumulated losses and New York’s huge ones, is shown in Table 4.

Table 4: Federal Reserve Notes Outstanding as a Percent of Total Liabilities [5]

Atlanta 64%

St. Louis 60%

Minneapolis 58%

Dallas 51%

Kansas City 50%

Boston 45%

Philadelphia 44%

San Francisco 39%

Cleveland 38%

Chicago 26%

Richmond 23%

New York 17%

The Federal Reserve System was originally conceived not as a unitary central bank, but as 12 regional reserve banks. It has evolved a long way toward being a unitary organization since then, but there are still 12 different banks, with different balance sheets, different shareholders, different losses, and different depletion or exhaustion of their capital. Should it make a difference to a member bank shareholder which particular FRB it owns stock in? The authors of the Federal Reserve Act thought so. Do you?

______________

1. In order of their district numbers, which go from east to west, the 12 FRBs are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

2. Federal Reserve H.4.1 Release, July 27, 2023

3. Our calculations based on the July 27 H.4.1 Release.

4. Ibid.

5. Ibid.

Will the Fed take the medicine one of its presidents prescribes for other banks?

Published in The Hill.

The president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, like an old doctor for ailing banks, recently prescribed a stern regimen for those in weakened conditions from big mark-to-market losses on their long-term investments and loans. Speaking at a National Bureau of Economic Research panel this month, Kashkari pointedly asked: 

“What can a bank do that is already facing large mark-to-market losses?” 

An excellent and hard question, for the losses have already happened, economically speaking. Of course, these banks can passively hold on and hope that interest rates will go back down to their historic lows, and hope that depositors will stop demanding higher yields or departing elsewhere. 

Besides hoping, what can they do?

Doctor Kashkari unsympathetically reviewed the possible medicines, all bitter. These, he said, were three: 

1. Try to raise more equity. 

2. Sell the underwater assets. 

3. Cut dividends. 

Considering these options, Kashkari observed that raising equity may not be so easy or attractive, since investors may not be inclined to invest in funding losses. Divesting the underwater assets by definition means selling at a loss, so the unrealized losses become realized losses on the accounting books.  This perhaps would render the bank formally undercapitalized or worse and may frighten large depositors — will they run?

The third option of cutting dividends then appears as the most practical way to conserve some capital, but as Kashkari asked rhetorically, how many bank CEOs are likely to want to cut their dividends? So he proposed new stress tests with high-interest rates, which would lead to restricting the dividends by regulatory order.

Physician, Heal Thyself! 

Kashkari did not mention that the biggest bank in the country, the one he works for, is facing particularly large mark-to-market losses. The $8 trillion Federal Reserve has net mark-to-market loss of $911 billion as of its last report on March 31. This mark-to-market loss is a remarkable 21 times its total capital of $42 billion. Moreover, according to my calculations, the Fed appears to be heading for an operating loss of about $110 billion for the year 2023. 

So it is timely and appropriate to apply “Doctor” Kashkari’s three possible medicines to the Federal Reserve itself.  

1. The Fed is clearly in a position to raise more equity in the face of its losses if it chooses to. All the commercial bank members of the Federal Reserve are required to subscribe to stock in the Federal Reserve according to a formula based on their own capital, but they all have bought only half of their required subscriptions. The Fed has the right to call for the purchase of the other half at its discretion. It could issue that call right now, and double its paid-in capital. But will it?   

1. The Fed could obviously sell some of its underwater investments. But just as for other banks, that would turn unrealized losses into realized losses and make the Fed’s existing accounting losses even bigger. As the leading investor in mortgage-backed and long-term Treasury securities, large sales by the Fed could move market prices downward, increasing its mark-to-market losses on the remaining investments. Although it has produced projections of realizing losses by sales of underwater investments, the Fed, like the banks Kashkari discussed, chooses not to sell. 

1. How about dividends then? The Fed is paying rich dividends of 6 percent to small banks and the 10-year Treasury yield to large banks while it is running an estimated annual loss of about $110 billion, has a $911 billion mark to market loss, and properly accounted for per my calculations, has negative capital of $38 billion, which is getting more negative each week. It is borrowing money to pay its dividends. And what would a high interest rate stress test applied to the Fed’s massive interest rate risk show? Should the Fed take Kashkari’s dividend medicine and restrict or skip its dividends in light of its huge losses? Revising Kashkari’s rhetorical question, how many Federal Reserve presidents and governors want to do that, including the president of the Federal Reserve Bank of Minneapolis? 

As that president explained, when you already have large economic losses, none of the options are appetizing.