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.