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May 22 AEI Event: The Federal Reserve and Financial Stability Risk
A video livestream will be made available on May 22. Please scroll down to view.
Contact Information
Event: Beatrice Lee | Beatrice.Lee@aei.org
Media: MediaServices@aei.org | 202.862.5829
One year after the Silicon Valley Bank failure required a Federal Reserve and Federal Deposit Insurance Corporation bailout, the US banking system is being challenged by large interest rate–related mark-to-market losses on its bond portfolio and a looming commercial property–sector crisis. What was the Fed’s role in these developments, and what should it do now?
Join as AEI scholars and experts discuss the seriousness of these challenges for the banking system and their implications for Federal Reserve policy.
Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon.
Agenda
1:00 p.m.
Introduction:
Desmond Lachman, Senior Fellow, American Enterprise Institute
1:05 p.m.
Panel Discussion
Panelists:
Jan Hatzius, Chief Economist, Goldman Sachs
Desmond Lachman, Senior Fellow, American Enterprise Institute
Bill Nelson, Executive Vice President, Bank Policy Institute
Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics, Hoover Institution
Moderator:
Alex J. Pollock, Senior Fellow, Mises Institute
2:30 p.m.
Q&A
3:00 p.m.
Adjournment
Related Content
Soft Landing, Hard Landing, or Financial Crisis?
Steven B. Kamin and Desmond Lachman | AEI event | January 24, 2024
Has the Fed Produced a Soft Economic Landing?
Desmond Lachman | AEI event | September 21, 2023
AEI May 9: Addressing the Underlying Causes of the Banking Crisis of 2023
View Alex’s address:
AEI, Auditorium
1789 Massachusetts Avenue NW
Washington, DC 20036
In June 2017, then–Federal Reserve Chairwomen Janet Yellen said that because of enhanced Dodd-Frank Act regulations, she did not believe there would be a new financial crisis in her lifetime. Unfortunately, like many Federal Reserve forecasts, this turned out too optimistic as regulators were forced to invoke emergency systemic risk powers to contain contagious bank runs. What went wrong? Was it a failure of monetary policy? Supervision? Regulation? What changes, if any, are needed?
Join AEI as a panel of experts discusses the causes of the recent banking crisis and the federal agencies’ forensic reports and policy prescriptions and shares their own views on what policies, regulations, and supervision practices need to be reformed.
Submit questions to Catriona.Fee@AEI.org.
If you are unable to attend, we welcome you to watch the event live on this page. After the event concludes, a full video will be posted within 24 hours.
Agenda
10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
10:15 a.m.
Panel Discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Andrew Levin, Professor, Dartmouth College
Bill Nelson, Executive Vice President, Bank Policy Institute
Alex J. Pollock, Senior Fellow, Mises Institute
Moderator:
Paul H. Kupiec, Senior Fellow, AEI
12:00 p.m.
Q&A
12:30 p.m.
Adjournment
The Government Debt Ceiling: What Did Eisenhower Do?
July 27, 2011
Published with Anne C. Canfield in AEIdeas.
“Nothing is ever new, it is just history repeating itself”—at least in finance. In his A History of the Federal Reserve,¹ Allan Meltzer describes what happened during the Eisenhower administration when the Treasury ran out of debt authorization and Congress did not raise the debt ceiling. This was in 1953.
In order to keep making payments, the Treasury increased its gold certificate deposits at the Federal Reserve, which it could do from its dollar “profits” because the price of gold in dollars had risen. The Fed then credited the Treasury’s account with them, thereby increasing the Treasury’s cash balance. Treasury then spent the money without exceeding the debt limit.
By the spring of 1954, Congress had raised the debt ceiling from $275 to $280 billion (2 percent or so of today’s limit), so ordinary debt issuance could continue.
The Secretary of the Treasury still is authorized to issue gold certificates to the Federal Reserve Banks, which will then credit the Treasury’s cash account.² This is correctly characterized as monetizing the Treasury’s gold, of which it owns more than 8,000 tons. An old law says this gold is worth 42 and 2/9 dollars per ounce, but we know the actual market value is about 38 times that, at more than $1,600 per ounce.
Should we follow Eisenhower’s example?
Alex J. Pollock is a resident fellow at the American Enterprise Institute. Anne Canfield is president of Canfield & Associates, Washington, D.C.
1. Allan Meltzer, A History of the Federal Reserve, Volume 2, Book 1, pp. 110 and 168.
2. Federal Reserve Bank of New York, 2010 Annual Report, p. 39.
Jan 17 AEI Event: Should the Federal Reserve Raise Its Inflation Rate Target?
Near-zero interest rates prevailed for more than a decade, raising concerns that the Federal Reserve lacked policy tools should stimulus be needed to counteract a recession. While some central banks experimented with negative rates, the Fed adopted quantitative easing (QE) to stimulate the economy without lower rates.
Some economists argue that the Fed should raise its inflation target so that normalized interest rates are high enough to allow interest rate cuts to stimulate the economy without resorting to QE. A recent Wall Street Journal article argues that an optimal inflation target could be as high as 4 percent—or even 6 percent.
Join AEI as a panel of experts discuss arguments for and against changing the Fed’s inflation target.
LIVE Q&A: Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon
Agenda
10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
10:15 a.m.
Panel Discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia Business School
Gerald P. Dwyer, Professor and BB&T Scholar, Clemson University
Thomas Hoenig, Distinguished Senior Fellow, Mercatus Center
Alex J. Pollock, Senior Fellow, Mises Institute
Moderator:
Paul H. Kupiec, Senior Fellow, AEI
11:45 a.m.
Q&A
12:00 p.m.
Adjournment
Dec. 7: AEI: Surprised Again!―The COVID Crisis and the New Market Bubble
Hosted by the American Enterprise Institute. Also video on C-SPAN here.
Alex Pollock and Howard Adler were senior US Treasury officials during the financial markets’ bust-to-boom cycle of the COVID-19 crisis. Their new book, Surprised Again!—The COVID Crisis and the New Market Bubble (Paul Dry Books, 2022), analyzes how the government’s crisis response affected the US financial system. Their clear exposition of the financial stability risks lurking in the Federal Reserve, housing, pension funds, municipal finance, student loans, and cryptocurrencies may surprise many readers with the extent of the financial system problems hiding in plain sight.
Join AEI as Christopher DeMuth and Paul Kupiec engage Mr. Pollock and Mr. Adler in a discussion of the many important issues the authors raise in Surprised Again!
LIVE Q&A: Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon.
Agenda
5:00 p.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
5:10 p.m.
Book Preview:
Alex J. Pollock, Senior Fellow, Mises Institute
Howard B. Adler, Former Deputy Assistant Secretary of the Treasury, Financial Stability Oversight Council
5:35 p.m.
Discussion:
Christopher DeMuth, Distinguished Fellow, Hudson Institute
Paul H. Kupiec, Senior Fellow, AEI
6:00 p.m.
Q&A
7:00 p.m.
Adjournment
AEI Event July 26: Is It Time to Rethink the Federal Reserve?
Via the American Enterprise Institute.
The Federal Reserve is having a bad year. As the Fed struggles to control inflation, it is also being asked to expand its policy remit to include climate change. Moreover, the House of Representatives just passed a bill requiring the Fed to adopt new policy goals of equal employment and wealth outcomes for targeted interest groups beyond its existing goals of price stability and full employment. How will these efforts to “rethink the Fed” affect monetary policy, credit availability, and economic growth?
Join AEI as a panel of experts discusses monetary policy, the Fed’s dual role as central banker and regulator, its independence, and recent congressional and executive branch efforts to further expand its legislative mandates.
Agenda
10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
10:15 a.m.
Panel Discussion
Panelists:
Gerald P. Dwyer, BB&T Scholar, Clemson University
Alex J. Pollock, Senior Fellow, Mises Institute
George Selgin, Senior Fellow, Cato Institute
Moderator:
Paul Kupiec, Senior Fellow, AEI
11:40 a.m.
Q&A
12:00 p.m.
Adjournment
Contact Information
Event: Bea Lee | Beatrice.Lee@aei.org
Media: MediaServices@aei.org | 202.862.5829
Related
Who Owns Federal Reserve Losses, and How Will They Affect Monetary Policy?
Paul H. Kupiec and Alex J. Pollock | AEI Economic Policy Working Paper Series | June 17, 2022
The Fed Is Raising Interest Rates to Make Up for Its Own Inaction
George Selgin | Cato Institute | June 15, 2022
Government Debt and Inflation: Reality Intrudes
Gerald P. Dwyer | American Institute for Economic Research | March 22, 2022
The Federal Reserve Keeps Buying Mortgages
Alex J. Pollock | Mises Institute | January 8, 2022
Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?
Published by the American Enterprise Institute.
By Paul H. Kupiec and Alex J. Pollock
Abstract
For the first time in its 108-year history, the Federal Reserve System faces massive and growing mark-to-market losses and is projected to post large operating losses in the near future. In a 2011 policy statement, the Federal Reserve Board outlined its plan to monetize system operating losses notwithstanding the (apparently) little-known fact that the Federal Reserve Act requires Federal Reserve member banks (the stockholders who own the Federal Reserve district banks) to share at least a portion of district reserve bank operating losses. Contrary to opinions expressed by Federal Reserve system officials, should the Fed abide by the legal requirements in the current version of the Federal Reserve Act, operating losses could impact monetary policy. If the Fed chooses to ignore the law and monetize operating losses, member banks will be in the enviable (if difficult to justify) position of directly benefiting from the current inflation. Because they are now paid interest on their reserve balances and receive guaranteed dividends on their Federal Reserve stock, member banks will monetarily benefit from the Fed’s policy to fight inflation while the public bears Federal Reserve system losses. Meanwhile, the public at large will also face the costs of higher interest rates, reduced growth and employment and losses in their investment and retirement account balances. Should the public recognize the implications of the Fed’s plan to monetize its operating losses, the Fed could face an embarrassing “communication problem”.
Post page here.
Upcoming March 30 event: The Federal Reserve and the everything bubble
Hosted by the American Enterprise Institute (AEI). Register here.
In response to the COVID-19 crisis, the Federal Reserve has expanded its balance sheet at an unprecedented rate, buying almost $5 trillion in US Treasury bonds and mortgage-backed securities in a single year. That buying has occurred in frothy equity, housing, and credit markets, and inflation has surged to levels not seen in almost four decades. With the Federal Reserve set to begin policy normalization this spring, questions remain on how the Fed will balance financial market stability and a brewing inflation crisis.
Please join AEI for a discussion on the constraints that elevated asset and credit market prices place on the Federal Reserve’s ability to regain control over inflation. The panelists will examine what might be done to break the recurrent boom-bust asset price and credit market cycle.
LIVE Q&A: Submit questions to John.Kearns@aei.org or on Twitter with #AskAEIEcon.
Agenda
2:00 PM
Introduction:
Desmond Lachman, Senior Fellow, AEI
2:05 PM
Panel discussion
Panelists:
Jason Furman, Aetna Professor of the Practice of Economic Policy, Harvard University
Desmond Lachman, Senior Fellow, AEI
Kevin Warsh, Shepard Family Distinguished Visiting Fellow, Hoover Institution
Moderator:
Alex J. Pollock, Senior Fellow, Mises Institute
3:15 PM
Q&A
3:30 PM
Adjournment
Contact Information
Event: John Kearns | John.Kearns@aei.org
Media: MediaServices@aei.org | 202.862.5829
AEI Event: Will digital currencies and fintech shape the financial system of tomorrow?
Hosted by the American Enterprise Institute.
Event Summary
On January 28, AEI’s Paul H. Kupiec hosted an event delineating the roles and risks that stablecoins, central bank digital currencies, and other fintech developments might develop in our financial system. Panelists also discussed the actions financial regulators might take to manage financial markets.
Oonagh McDonald of Crito Capital outlined her reservations with the claim that stablecoins will improve upon the financial system. Current fintech developments already are sufficient to increase financial inclusion and efficiency in payments systems.
Charles Calomiris of Columbia University, however, foresees a useful role for stablecoins in the future economy. Stablecoins can develop a more safe, efficient, and rich payment system. For fintech developers, Dr. Calomiris urged that stablecoins should look less like bank deposits and more like perpetual preferred stock. However, large banks have much to lose if fintech companies expand their economic importance.
The Mises Institute’s Alex J. Pollock described the conflict between the government’s monopoly on currency and the issuance of private stablecoins. If a digital currency is tied to the dollar, one is merely creating a new payment system, not a new currency. Dr. Pollock is doubtful a currency not backed by an asset or cash flow can succeed.
— John Kearns
Event Description
Cryptocurrency, stablecoins, central bank digital currency (CBDC), and other fintech technologies are vying to change the way we borrow, lend, and pay one another. Pending financial regulation and potential CBDC issuance will shape the financial system’s evolution and shift the importance of central banks, banks, investment banks, cryptocurrencies, stablecoins, and related exchanges.
Will banks, mutual funds, and traditional broker-dealer exchange markets continue to be the systems we rely on to save, borrow, and make payments? Or will new nonbank fintech ventures and blockchain transactions displace them?
Join AEI as a panel of experts discusses the innovations, regulations, and other factors that will shape the future financial system and affect the broader economy.
Agenda
10:00 AM
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
10:10 AM
Panel discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Oonagh McDonald, Senior Adviser, Crito Capital
Alex J. Pollock, Senior Fellow, Mises Institute
Moderator:
Paul H. Kupiec, Senior Fellow, AEI
11:30 AM
Q&A
12:00 PM
Adjournment
Pollock participates in a discussion with Professor Mark H. Rose
Hosted by the American Enterprise Institute.
R Street Distinguished Senior Fellow Alex J. Pollock took part in a March 27 panel at the American Enterprise Institute to discuss economic historian Mark Rose’s new book, “Market Rules: Bankers, Presidents, and the Origins of the Great Recession.” Other panelists were Rose himself, Richard Sylla of the National Bureau of Economic Research and moderator Paul H. Kupiec of AEI.
Global financial market risks: Entering unchartered territory
Hosted by the American Enterprise Institute.
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AEI Event: Eliminating Fannie Mae and Freddie Mac without legislation
Hosted by the American Enterprise Institute.
A panel of housing finance experts met at AEI last Tuesday to discuss how the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac could be eliminated without legislation. Moderated by R Street’s Alex J. Pollock, the panelists detailed the distortions of the current housing finance system dominated by Fannie and Freddie, and proposed a reform plan that protects homebuyers and taxpayers and does not require Congress to act.
The Bubble Economy – Is this time different?
Hosted by the American Enterprise Institute.
Two decades after Alan Greenspan’s famous “irrational exuberance” speech at AEI in 1996, Dr. Greenspan spoke at AEI again, addressing record-high global stock and bond market prices following unprecedented central bank balance sheet expansions. Following Greenspan’s keynote address, R Street’s Alex J. Pollock led an expert panel that discussed whether the world economy is now experiencing an asset market price bubble and what might be done about it.
AEI Event: Is the Bank Holding Company Act obsolete
Hosted by the American Enterprise Institute.
Most of America’s 4969 are owned by holding companies, so the Bank Holding Company Act of 1956 is a key banking law. But do the prescriptions of six decades ago may not still make sense for the banks of today. The act for most of them creates a costly and arguably unnecessary double layer of regulation. Its original main purpose of stopping interstate banking is now completely irrelevant. One of its biggest effects has been to expand the regulatory power of the Federal Reserve–is that good or bad? Does it simply serve as an anti-competitive shield for existing banks against new competition? Some banks have gotten rid of their holding companies–will that be a trend? This conference generated an informed and lively exchange among a panel of banking experts, including the recent Acting Comptroller of the Currency, Keith Noreika, and was chaired by R Street’s Alex Pollock.
An Emergency Financial Control Board for Puerto Rico
Testimony of
Alex J. Pollock
Resident Fellow
American Enterprise Institute
To the Committee on the Judiciary
United States Senate
Hearing on Puerto Rico’s Fiscal Problems
December 1, 2015
An Emergency Financial Control Board for Puerto Rico
Mr. Chairman, Ranking Member Leahy, and Members of the Committee, thank you for the opportunity to be here today. I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views. Immediately before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. I have published numerous articles on financial systems and credit crises, including municipal debt crises.
The government of Puerto Rico, having run a long series of constant budget deficits, has accumulated a very large debt which according to its own statements, it cannot pay. It is cut off from all normal municipal bond market financing and is running out of cash. The credit ratings of its many debt issuing entities are at the bottom of the scale, with a preponderance of CC ratings from S&P and Fitch and Ca ratings from Moody’s, with additional defaults on or restructurings of government debt expected. With its current budget operations, financial control systems and government structure, it cannot produce clear, audited financial statements. The study performed by former IMF officers earlier this year concluded that “the overall deficit is larger than recognized, its true size obscured by incomplete accounting” and cited “weak budget execution and opaque data.” In addition, public pension obligations, which in insolvency pit pensioners against creditors, are virtually unfunded and an estimated $44 billion pension liability must be added to the $71 billion in debt.
It is my recommendation that the Congress should promptly create an Emergency Financial Control Board to assume oversight and control of the financial operations of the government of Puerto Rico, as Congress successfully did in 1995 with Washington, DC; as New York State, with federal encouragement, successfully did with the insolvent and defaulting New York City in 1975; and as the State of Michigan did with the appointment of an Emergency Manager for the insolvent City of Detroit in 2013. Such Boards have also been used in Cleveland (1980), Philadelphia (1991), and Springfield, Massachusetts (2004). There is plenty of precedent.
Under the United States Constitution, Congress has sovereignty over territories and the clear authority to create such a Control Board. In my opinion, with Puerto Rico’s severe and longstanding financial problems, Congress also has the responsibility to do so.
This should be the first step, prior to other possible legislative actions. I believe that the initial requirement is to establish independent, credible authority over all books, records and other relevant information; to analyze what the true overall financial deficit is; to determine which Puerto Rican government bodies are insolvent, in particular understanding the financial condition of the Government Development Bank which lends to the others; to consider fiscal, accounting and structural reforms which will lead to future balanced budgets and control of debt levels; and to consider in the light of all of these, how the current excessive levels of debt should be addressed. The Control Board should analyze and report to Congress on whether creating a bankruptcy regime for Puerto Rico is warranted as a subsequent legislative action.
The Administration’s statement on “Puerto Rico’s Economic and Fiscal Crisis” includes this proposal: “Enact strong fiscal oversight and help strengthen Puerto Rico’s fiscal governance…Congress should provide independent fiscal oversight.” This goes in the right direction, but is vague. I believe it needs to be something more specific, thus more likely to work: a Control Board. The Administration says financial oversight should “respect Puerto Rico’s autonomy,” but in fact Congress has unquestioned jurisdiction here. As one harsh, but accurate, assessment has it: if you are a subsidiary government and “you screw up your finances bad enough,” you are going to get control and direction from somebody else.
The details of the Puerto Rican government’s financial situation are complex, but the fundamentals are simple and make a familiar pattern. The government of Puerto Rico is broke. In the current century, it has run a budget deficit every single year-- 15 years in a row. Operating deficits have been financed by borrowing. As debts multiplied, debt service was met by additional borrowing. As one municipal bond expert wrote, “The Commonwealth [was] utilizing debt issuance to pay interest on existing indebtedness.” This is the definition of a Ponzi scheme.
Such debt escalations always end painfully when the lenders stop lending, as has now occurred. What must inevitably follow is reform of fiscal operations, default on or restructuring of debt, bailout funding, or permutations and combinations of these. What in particular must be done, and what the complete financial condition is, the proposed Emergency Financial Control Board must take up.
As the government of Puerto Rico recently disclosed:
-“On October 30, 2015 the Commonwealth filed a notice that the Commonwealth would not file its audited financial statements for fiscal year 2014 by October 31, 2015.”
-“The Commonwealth cannot provide an estimate at this time of when it will be able to complete and file its audited financial accounts.”
A municipal bond analyst from UBS opined that the “inability to produce an audited financial statement for a fiscal year that ended almost sixteen months ago is inexplicable.” On the contrary, it is all too explicable, given a financially stressed, insolvent borrower.
Among the “Risk Factors” for investors in its debt, the government currently cites the following:
-“The Commonwealth faces an immediate liquidity crisis.”
-“The Commonwealth does not have sufficient resources to pay its debt obligations in accordance with their terms.”
-“The budget deficit of the Commonwealth’s central government during recent years may be larger than the historical deficits of the General Fund because they do not include the deficits of various governmental funds, enterprise funds, and Commonwealth instrumentalities.”
-“The Puerto Rico Planning Board recently acknowledged the existence of certain significant deficiencies in the calculation of its macroeconomic data.”
-“The assets of the Commonwealth’s retirement system will be completely depleted within the next few years unless the Commonwealth makes significant additional contributions…the Retirement Systems will continue to have large unfunded actuarial accrued liability and a low funding ratio for several decades.”
-“Each fiscal year, the Commonwealth receives a significant amount of grant funding from the U.S. government. A significant portion of these funds is utilized to cover operating costs.”
-“The Commonwealth’s accounting, payroll and fiscal oversight systems have deficiencies due to obsolescence and compatibility issues…this has affected the Commonwealth’s ability to control and forecast expenses.”
-“The Commonwealth has frequently failed to meet its revenue projections.”
-“The Government Development Bank’s financial condition has materially deteriorated and it could become unable to honor all its obligations.”
-The Government Development Bank has historically served as the principal source of short-term liquidity for the Commonwealth and its instrumentalities,” but faces “the inability of the Commonwealth and its instrumentalities to repay their loans.”
-“The Commonwealth has failed to file its financial statements before the 305-day deadline in ten of the past thirteen years, including the most recent fiscal years (2012, 2013 and 2014).”
They themselves have said it. All indications are of a government much in need of emergency, authoritative management help which is not dependent on short-term local politics.
In addition, one Puerto Rican expert testified to the Senate Finance Committee that “Puerto Rico has an excessively bureaucratic and inefficient central government…when it comes to fiscal policy, budgeting, financial recordkeeping, tax collection, business permitting, professional contracting, use of modern technology and overall performance….Anyone who has dealt with the Puerto Rican government knows how opaque and difficult to navigate it can be.” Another expert has described “significant government corruption and predatory rent-seeking behavior,” along with “substantial tax evasion.” Are these assertions true? A Control Board will need to make judgments and then decisions accordingly.
I previously mentioned the robust precedents for Emergency Financial Control Boards. As one analyst correctly observed, “The fundamentals of Puerto Rico resemble those of New York City in the mid-1970s and of other municipalities on which a Financial Control Board has been imposed.”
The closest legal parallel is Washington DC, which had become a financial quagmire by the mid-1990s. Like Puerto Rico, Washington DC, not being a state, is Constitutionally subject to the direct jurisdiction of Congress. Congress responded with the District of Columbia Financial Responsibility and Management Assistance Act of 1995, which created the District of Columbia Financial Responsibility and Management Assistance Authority. (A good political title, which might be adapted for use in Puerto Rico.)
The Act was developed, approved and implemented as a successful bipartisan effort and the Board was given broad powers and authority. These included approving or disapproving financial plans and budgets, implementing recommendations on financial stability and management, approving the appointment of the Inspector General of the District government, having total access to official reports and data, holding hearings, issuing subpoenas, and requiring District officers and employees to carry out its orders.
A very important power, worthy of note, was to approve the appointment of an independent District Chief Financial Officer—an office which continues today.
Two years later, Congress followed up with the National Capital Revitalization and Self-Government Improvement Act of 1997, which set tighter controls. The purposes included: “to improve the ability of the District of Columbia government to match its resources with its responsibilities”—in other words, to run a balanced budget. Another explicit goal of this act is very relevant to Puerto Rico: improvement in tax collection.
Although there were disputes and difficulties along the way, the Washington DC Control Board achieved clear success in financial management and controls, efficiency, and indeed reaching balanced budgets. It adjourned in 2001, after Washington DC achieved its fourth consecutive balanced budget. The city’s bond ratings greatly improved; they have now reached AA/Aa. However, the Board remains in the wings, authorized for a possible return, should Washington DC’s budget discipline ever again slide into aggregate deficits.
Another strong precedent is New York City. Like Puerto Rico, it had run a long series of budget deficits, financed them with ever more debt, and finally needed new loans to service the old ones. In the spring of 1975, the market for the city’s debt closed. By that fall, the city government was out of money and was, with the support of many of its prominent citizens, lobbying desperately for a federal bailout. President Ford wisely turned this down.
Instead a deal was worked out among the federal, state and city governments, resulting in the establishment by New York State of the New York City Emergency Financial Control Board. Other elements of the deal were the default, called a “moratorium,” on the city’s short-term notes; later Congressionally-approved provision of seasonal emergency financing for three years by the U.S. Treasury; and restructuring of debt through bonds issued by the Municipal Assistance Corporation, also established by New York State. The necessity of the Control Board was primary.
Intensely needed reforms of New York City’s spending, management, budget discipline, financial reporting and financial controls were achieved. New York City by now has also improved its bond ratings to AA/Aa. Here is another success story for Control Boards and their ability to bring outside authority and resulting action. As then-Treasury Secretary William Simon later wrote, “The city and state were required to make decisions of a type they had heretofore refused to make.”
The State of Michigan, facing several municipalities in serious financial difficulty, adopted the Local Government and School District Accountability Act in 2011, authorizing the appointment of Emergency Managers, individuals rather than a board, with very broad financial and operating powers. The best known was Kevyn Orr in the City of Detroit, appointed in 2013, but four other Michigan cities have had similar appointments. (It seems to me that the more common practice of appointing a board, with the balance of multiple perspectives and expertise, is a preferred structure.)
In Detroit, the first step was the Emergency Manager. Having analyzed the massive problems and the debt, he concluded that the city’s deep insolvency required a municipal bankruptcy. This largest municipal bankruptcy ever was concluded in 2014, with major losses to creditors, including smaller but significant losses to pension claims. Following the settlement of the bankruptcy, the Emergency Manager has been succeeded by the Detroit Financial Review Commission, which will continue to oversee the city’s budgets and financial management.
Should Puerto follow Washington DC and New York City, working its way through its management and debt problems without a bankruptcy proceeding? --or should it follow Detroit, with a bankruptcy included along with reforms? I believe Congress should first appoint the Control Board for Puerto Rico, and charge it with getting on top of the financial situation, pursuing management reforms, considering the debt servicing issues, and then recommending to Congress whether or not a bankruptcy, which would involve new bankruptcy legislation, is required.
Let’s compare the debt burdens of three of the cases. The government of Puerto Rico’s $71 billion in total debt is 15% greater than the $62 billion, when re-stated to 2015 dollars, of New York City during its 1975 debt crisis. Detroit’s debt, in 2015 dollars, was $19 billion. Since the populations of the three are very different--Puerto Rico, 3.6 million; New York City 7.9 million; City of Detroit, 700 thousand-- we need to view the per capita local government debt. These were, at the time of each crisis, expressed in 2015 dollars:
Puerto Rico $20 thousand
New York City $ 8 thousand
City of Detroit $27 thousand
Puerto Rico is much more heavily indebted per capita than New York City was, but less so than Detroit.
One of the most distressing economic statistics of Puerto Rico is its labor participation rate of less than 40%. There is additional work in the “informal” sector, but that does not generate taxes to pay the government’s debt. So let’s look at local government debt per officially employed person in 2015 dollars:
Puerto Rico $71 thousand
New York City $19 thousand
City of Detroit $90 thousand
Again, the Puerto Rican debt level per employee is much worse than New York City, but 20% less bad than Detroit. Maybe in Puerto Rico the Emergency Financial Control Board will be sufficient to work through the reforms while debts are restructured outside of bankruptcy. I do not think it is possible to say at this point.
In any case, the financial and managerial problems are severe, cash is running out, and time is wasting. In my judgment, Congress should establish the Emergency Financial Control Board for Puerto Rico as a high priority.
Thank you again for the opportunity to share these thoughts.
The Federal Reserve’s Second 100 Years
Published by the American Enterprise Institute.
The Federal Reserve has had a remarkable career in the 100 years since Congress created it on December 23, 1913. What are the Fed’s next 100 years likely to bring?
It is daunting but also liberating to make such guesses about the very long term, since one is bound to get many things wrong. The human mind is incapable of imagining in advance the novelties that so much time will bring. For example, the authors of the Federal Reserve Act could certainly not have even imagined, let alone expected, what their creation has become in a century. They would have been utterly dumbfounded at a Federal Reserve that:
— Is formally committed to, and is producing on purpose, perpetual inflation.
— Has no link of any kind to a gold standard.
— Thinks it is supposed to, and that it is capable of, “managing the economy.”
— Invests vast amounts in, and monetizes, real estate mortgages.
— Has chairmen who achieve media star status, as for example, “The Maestro.”
— Wields the authority of a unitary central bank, centralized in Washington D.C., rather than being a federal system of regional “reserve banks.”
Can we have any hope of making some good predictions? Perhaps. Consider the 100-year predictions that the brilliant F.E. Smith, Lord Birkenhead, made in 1930 in his book, The World In 2030.
Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.
Birkenhead predicted, for example, the then-future revolutions in genetic science, atomic energy, and global communications media, and that in the future “women … will be found at the head of government departments [and] as managing directors of great commercial undertakings.” On the other hand, he did not discuss the monetary system at all, and did not predict the vast experiment in world-wide fiat currency in which we have been living since 1971, whose ultimate outcome is still unknown. Also, Birkenhead imagines that an undergraduate in 2030 preparing to write about the 22nd century would sit down at his typewriter, rather than not even know what a typewriter was.
Birkenhead offered some instructive general observations on the matter of the long future:
— “Remembering a thousand other changes, mechanical, ethical, social, political, and constitutional, we shall, it may be repeated, be wise to declare little impossible in the [next] hundred years.” Yes, including fundamental changes in our ideas about central banking and the beliefs of central bankers.
— “The future stretches before us in this year 1930 murky, obscure, and terrible.” In January, 2014, it still stretches before us murky and obscure but, it seems, less terrible than in 1930. I hope.
Another notable 100-year forecast made in 1930, this one specifically focused on economics, was by John Maynard Keynes in his essay, “Economic Possibilities for Our Grandchildren.” Starting by observing the “bad attack of economic pessimism” in “the prevailing world depression,” Keynes nonetheless predicted an optimistic economic future, about which he was entirely correct.
“In the long run,” he wrote in the midst of the world crisis, “mankind is solving its economic problem. I would predict that the standard of life in progressive countries 100 years hence will be between 4 and 8 times as high as it is today [in 1930].” As of 2013, per capita GDP in the United States was 5 times what is was in 1930, which is an average real growth rate of about 2 percent per year since 1930. If the 2 percent growth continues to 2030, the standard of life will be about 7 times what it was when Keynes made his prediction of 4 to 8 times. A great call.
Looking ahead in the spirit of Keynes for an additional 100 years to 2130, another increase of 7 times would bring it to a level of 49 times that of 1930. Can we imagine that?
If such real growth continues, it will be the result of advances in scientific knowledge, technical innovation, and entrepreneurship. Turning to the Federal Reserve, we find a different 2 percent growth rate: the Fed’s targeted rate of inflation, or depreciation of the currency it issues.
Since 1913, the U.S. consumer price index has increased over 23 times: in other words, a quarter now is about what a penny was when Woodrow Wilson signed the Federal Reserve Act. If the Fed produces a 2 percent annual inflation for its next 100 years, a dollar will be far less than a penny was; it would take about $1.70 to equal the original penny. Merely to stay even in real terms with today, an average household would then need an income of about $350,000. Can we imagine that?
This brings me to a dozen predictions about the Fed’s second century:
1. Lender of Last Resort
Consider a 1994 book, The World in 2020 (a 26-year forecast). “The debt crisis of the 1980s,” it says, “forced the banks to adopt much more cautious lending policies.” As is obvious from the multiple debt crises since 1994, extrapolating post-crisis banking caution is a mistake. Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes. As Paul Volcker wittily said, “About every ten years, we have the biggest crisis in 50 years.” A decade seems like about enough for the waning of institutional memory.
Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes.
An “elastic currency” was the most important purpose of the original Federal Reserve Act and remains a robust idea, as recently demonstrated once again in the panics of 2007-2009, although these also demonstrated once again that having the Federal Reserve does not prevent panics. Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.
Thus my first prediction: The Fed’s lender-of-last-resource function, or the ability to create “elastic currency” in a crisis, will continue to be necessary for at least another 100 years.
2. Shull’s Paradox
Professor Bernard Shull, in his provocative book, The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence, propounds what I call “Shull’s Paradox,” which is that no matter how many or how great are the inflationary and deflationary blunders made by the Fed, its power, prestige, and authority nevertheless always increase. Shull’s book, published in 2005, demonstrated this perverse relationship over the Fed’s first nine decades, and how the Fed, “established as a small and almost impoverished institution,” has nonetheless “emerged as the most influential organization ever established by Congress.” He then speculated, “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”
Shull’s speculation was fully confirmed. The Fed first stoked the great housing bubble from 2002 to 2005, then utterly failed to anticipate the magnitude of its collapse, and on top of that, failed to predict the ensuing steep recession. But in the subsequent legislative reaction, the notorious Dodd-Frank Act, the Fed’s jurisdiction and authority were expanded.
How can we explain the paradox? Perhaps it is the emotional yearning of many people, including politicians, to believe in a wise, “Maestro”-like force to orchestrate unpredictable events — even though no one, including the Fed, can actually do this. The Fed does seem able to inspire a puzzling, naive will to believe.
So I predict that Shull’s Paradox will continue to hold, and the Fed will gain even more power from the next crisis, even if it causes that crisis.
3. Independence
Is the Fed independent, as is often claimed? No. A better description is that of
Chicago Federal Reserve Bank President Charles Evans, who has referred to the “measure of independence” of the Fed.
William McChesney Martin, Fed chairman in the 1950s and 1960s, spoke of the Fed being independent “within the government” — i.e. not independent. Arthur Burns, Fed chairman in the 1970s, reportedly said, “We dare not exercise our independence for fear of losing it.”
Yet many economists are attracted to the idea of a truly independent Fed. It flatters the importance of their macro theories to think it should be so. I believe that inside every macro economist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king, or at least an assistant deputy philosopher-king.
But since the Fed is always “within the government,” I predict that in 2113 it still will not be independent, although the economists of that future day will still be writing about how it should be.
4. Systemic Risk
The Federal Reserve has the greatest power of any institution anywhere to create systemic financial risk for everybody else by its fiat money creation and interest rate manipulations. Given the global role of the dollar, this power runs around the world.
The Dodd-Frank Act has resulted in large banks being called “Systemically Important Financial Institutions,” or “SIFIs.” As such, it is maintained they need extra oversight. It is apparent that the Fed itself is the biggest SIFI of them all.
A good example of this is the massive interest rate risk of its own balance sheet.
Because of this risk, I predict that in the intermediate term the Federal Reserve will be insolvent on a mark-to-market basis.
Let’s go through the math. With so-called “QE,” or quantitative easing, the Fed now owns $2.1 trillion in long government bonds as part of its successful manipulation (so far) to get bond yields lower. In an entirely unprecedented fashion, it also owns $1.5 trillion of fixed rate mortgage securities. That is a total of $3.6 trillion in unhedged outright long positions. The Fed does not disclose the duration of this remarkable portfolio, but 7.5 years would probably be a fair guess.
Suppose interest rates rise a mere 2 percent. The mark-to-market loss would be $3.6 trillion X 2% X 7.5. This would be a mark-to-market loss of $540 billion. The Federal Reserve’s total capital is $55 billion. So the economic loss would be about ten times the Fed’s capital. Q.E.D.
One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.
Would the world care if its principal central bank were so insolvent on a mark-to-market basis? Many Fed defenders say absolutely not, but I don’t think anyone really knows. However, I also predict that the Fed will never admit any such insolvency on its own books. It has already developed for itself a version of “regulatory accounting,” not dissimilar to that practiced by savings and loans in the 1980s, to prevent any such admission. One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.
5. Big Surprises
During the history of the Fed so far, four major changes in the fundamental monetary regime have occurred: going off the gold standard in the 1930s; going on the Bretton Woods system of fixed exchange rates and a gold exchange standard in 1945; the collapse of the Bretton Woods system in 1971; and its replacement by the current global regime of pure fiat currencies and floating exchange rates (a regime which is quite prone to recurring crises).
It does not seem reasonable to assume that any monetary regime will last forever, and that the next hundred years will somehow be immune from fundamental changes. So I predict that in the course of the Fed’s next century, further major changes in monetary regimes will occur, surprising our current expectations — only we don’t know what they will be.
6. Central Banking and Dentistry
Keynes ends his essay on the “Economic Possibilities” of 2030 by thinking about economists and dentists. “The economic problem” — presumably including central banking — he puckishly suggests, “should be a matter for specialists — like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”
However, since then, central banking has still not become scientific like dentistry, nor do its specialists display the progress in scientific knowledge and technique that dentists so admirably do. In another century, I believe central banking, and macro economics, will be no closer to becoming a science like dentistry. Instead, they will, in accordance with their essential nature, continue to be debatable, contestable, uncertain, and ideological.
In other words, in 2113 the Fed will still be heavily political.
7. Maestroism
From the dissimilarity to dentistry, it follows that in the next 100 years, like the last, no Federal Reserve chairman can or will be a sustained, successful “Maestro,” as Alan Greenspan was unfortunately dubbed by the silly media, until he wasn’t. It is more likely that central bankers, like investment managers, will have good runs alternating with bad ones. This is by no means a matter of intelligence, talent, hard work, or leadership, but of the ineluctable uncertainty involved.
8. The Bernanke Legacy
One intriguing uncertainty in the Federal Reserve’s new century is how the Fed under Chairman Bernanke will be judged by future financial historians. It seems certain that its unprecedented quantitative easing, that vast manipulation of long-term bond and mortgage markets, will be heavily discussed. But will economists now in kindergarten or unborn judge “QE” a success or a failure? No one knows, including the Fed itself.
But will economists now in kindergarten or unborn judge ‘QE’ a success or a failure? No one knows, including the Fed itself.
It appears to me that the probability is bimodal: for his QE experiment, Bernanke is likely to go down in future history as either a great hero or a great bum, one or the other, but we don’t know which.
9. Inflation
What 21st-century central bankers had convinced themselves was the “Great Moderation” turned out to be in reality the Era of Great Bubbles and their collapse. In recent decades, the Fed and central banks generally have come to believe in inflation targets, usually of 2 percent a year or so inflation — in other words, perpetual inflation. Is this belief in perpetual inflation sustainable?
Perhaps financial systems with perpetual inflation may break down into crisis too often — the current monetary regime has obviously had plenty of financial crises. So perhaps the cognitive structures and psychological beliefs of central bankers may shift back to a commitment to a long-term stable value of currency, rather than inflation forever.
Such a shift in dominant ideas is certainly possible in 100 years.
10. Government Finance
The first mandate of most central banks is to lend money to the government as necessary. I believe the Federal Reserve will continue to be absolutely essential to the U.S. government, not because of its economic skills, forecasting ability, or financial wisdom, but because it is the reliable and expandable source of deficit finance for the government.
A fiat-currency issuing and government debt buying central bank, of which the Fed is the most important instance, is a hugely valuable asset for the government. I imagine it will still be so in 2113.
11. Legislative Reform
Legislation has been introduced in the U.S. House of Representatives to have a formal congressional review of the performance of the Fed since 1913 (mixed, to be sure) and of its future. Of course, the Fed is a creation of the Congress, and subject to legislative revision at any time. Twice in its first century, in 1935 and again in 1977-78, major reform legislation was enacted. I see no reason to assume that the politicians of the future will always be satisfied with the status quo of today.
In 2113 the Fed will still be heavily political.
So I predict that there will be a “Federal Reserve Reform Act” of 2000-something and/or 2100-something, at least once or twice, in the Fed’s second century.
12. Econocracy
An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro economics is or can be a science.
Financially famous Fed chairmen who were not professional economists include William McChesney Martin, who among other things was the president of the New York Stock Exchange; and Marriner Eccles, who was a banker and businessman from Salt Lake City. Both have Federal Reserve buildings in Washington named after them.
I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.
Finally: Not Rocket Science
Lord Birkenhead, introducing his 100-year predictions, reflected that in the long term, “The results of scientific research control the wealth of nations.” As we have said, central banking, while highly important for better and for worse, is not science.
Robert Solow recently asserted that “central banking is not rocket science.” True, and it will be neither science nor rocket science in 2113. But Solow meant that central banking was easier, while in fact it is harder than rocket science, now and in the future. This is because it must confront the inescapable uncertainty of human minds and deeds interacting, with their strategies, politics, adaptations, creations, surprises, intentions, mutual learning, guessing, risk-taking, cognitive herding, emotions, cupidity, fear, courage, and frequent mistakes, in their financial and economic dimension. This includes the minds and deeds of the central bank itself interacting with all of the others.
It is certain that the Fed will continue to be an interesting and debatable topic in its next 100 years.
Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
This essay is adapted from Pollock’s address at the Loyola University of Chicago Symposium “The Federal Reserve at 100: The First 100 Years, the Present, and the Next 100” on December 6, 2013.
How Many Mandates Does the Fed Have? How Many Can It Achieve?
Written Testimony of
Alex J. Pollock
Resident Fellow
American Enterprise Institute
To the Committee on Financial Services
U.S. House of Representatives
Hearing on “The Many Mandates of the Fed”
December 12, 2013
How Many Mandates Does the Fed Have? How Many Can It Achieve?
Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to submit this written testimony. I am Alex Pollock, a resident fellow at the American Enterprise Institute where I focus on financial policy issues, and these are my personal views. Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general.
My discussion has two main themes:
1. Discretionary fiat-currency central banking is subject to high uncertainty. Therefore the attempts of central banks to “manage” financial and economic stability are inevitably subject to mistakes, and recurring big mistakes. The naive belief that any central bank, or anybody, could actually know enough about the future, and in particular about the future of complex, recursive globalized economies and financial markets, to be an economic “Maestro”, is a fundamental error.
2. While the Federal Reserve is often said to have a “dual mandate,” which would be difficult enough, it fact it has six mandates. The combination of these mandates has created in the Fed a remarkable concentration of power. But the Fed does not, and because the future is unknowable, cannot, succeed at all its mandates.
Uncertainty and the Lack of Knowledge
In the early 21st century, the Fed and other central bankers gave themselves great credit for having engineered what they thought they observed: the so-called “Great Moderation.” But the Great Moderation turned out to be the Era of Great Bubbles. The U.S., in successive decades, had the Tech Stock Bubble and then the disastrous Housing Bubble. In addition, other countries had destructive real estate and government debt bubbles.
Presiding over the Era of Great Bubbles as Chairman of the world’s principal central bank from 1987 to 2006, was Alan Greenspan, a man of high intelligence and wide economic knowledge, with scores of subordinate Ph.D. economists to build models for him. He was then world famous as “The Maestro,” for supposedly being able to always orchestrate the macro economy to happy outcomes. In reality, the idea that anyone, no matter how talented, could be such a Maestro is absurd, but it was widely believed nonetheless, just as the idea that national house prices could not fall was widely believed.
In his new book, Chairman Greenspan relates, with admirable candor, that at the outset of the financial crisis in August, 2007, “I was stunned.” He goes on to discuss the failure of the Fed to anticipate the crisis. For example: “The model constructed by the Federal Reserve staff combining the elements of Keynesianism, monetarism and other more recent contributions to economic theory, seemed particularly impressive,” but “the Federal Reserve’s highly sophisticated forecasting system did not foresee a recession until the crisis hit. Nor did the model developed by the prestigious International Monetary Fund.
Even extremely complex models are abstract simplifications of reality and they do not do well with discontinuities like the panicked collapse of bubbles, so it is not surprising that “leading up to the almost universally unanticipated crisis of September, 2008, macromodeling unequivocally failed when it was needed most, much to the chagrin of the economics profession,” as Greenspan writes.
Central banking is not and cannot be a science, cannot operate with determinative mathematical laws, cannot make reliable predictions of an ineluctably uncertain and unknowable future. We should have no illusions about the probability of success of such a difficult attempt as central banks’ “managing” economic and financial stability, no matter how intellectually impressive its practitioners may be. “We did not anticipate that the decline in house prices would have such a broad-based effect on the stability of the financial system,” as another impressive intellect, Fed Chairman Ben Bernanke, has admitted.
Before the Era of Great Bubbles, a vast Federal Reserve mistake was the Great Inflation of the 1970s, under the Fed chairmanship of distinguished economist Arthur Burns, when annual inflation rates in the U.S. got to double digit levels. In the aftermath of this decade of inflation was a series of financial crises of the 1980s, involving among other things, the failure of 2,237 U.S. financial institutions between 1983 and 1992, and the international sovereign debt crisis of the 1980s. The Great Inflation was created by the Fed itself and its money printing exertions of those days.
In the next decade, the 1980s, with some success and by imposing a lot of pain, the Fed undertook “fighting inflation”—the inflation it had itself caused. In the 2000s, it performed a variation on this pattern: the Fed first stoked the asset price inflation of the colossal Housing Bubble, then worked hard to bail out the Bubble’s inevitable collapse.
The Fed and other fiat-currency central banks are in the money illusion business, trying to affect the costs of real resources by depreciating the currency they issue at more or less rapid rates, by money creation and financial market manipulations. The business of money illusion often turns into the business of wealth illusion, since central banks can and do fuel asset price inflations. Asset inflations of bubble proportions create “wealth” that will evaporate.
Asset price inflation can be intentional on the part of the Fed when it is trying to bring about ”wealth effects,” as it did with the housing boom in 2001-2004 and is now doing again with so-called “quantitative easing,” including its unprecedented $1.5 trillion mortgage market manipulation.
Future financial histories will reflect something their authors will know, but we cannot: what the outcome of the Bernanke Fed’s massive interventions in the long-term government debt and mortgage markets will have been. About this at present we, and the Federal Reserve itself, can only guess. In the 1920s, the then-dominant personality in the Fed, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.” The current Fed has given the bond and mortgage markets a barrel of whiskey, in a way which would have astonished previous generations of Fed governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.
The final outcome of this intervention will probably render the Bernanke Fed in future histories as either a great hero or else as a great bum. The probability distribution appears to me as bimodal, with nothing in between. It represents a remarkable central banking gamble—one which without doubt has greatly increased the interest rate risk of the entire financial system, as well as of the Fed’s own balance sheet. It reflects the ultimate in discretionary central banking with multiple mandates.
How Many Mandates?
We constantly hear, not least from the Fed itself, about how it has a “dual mandate” of price stability and maximizing employment. Experts have debated whether the Fed or any central bank can achieve balancing these two mandates successfully. This question much oversimplifies the problem, for the Fed has not two mandates, but six.
To begin with, the provision of the Federal Reserve Reform Act of 1977 that gives rise to all the talk of a dual mandate actually assigns the Fed three mandates. It provides that the Fed shall: “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Obviously, that is three goals—a triple mandate, not a dual mandate. However, the “moderate long-term interest rates” idea, perhaps because it is impractical, usually gets conveniently left out.
In addition, the Fed has three more mandates. Two are from the original 1913 Act: to provide an elastic currency, and to regulate and promote financial stability. The final mandate is the real essence of central banking: to finance the government as needed.
That makes six mandates. How is the Fed doing on each? Can it ever be expected to achieve them all?
Let us start with “stable prices.” This mandate in its literal sense was dropped by the Fed long ago and is now a dead letter. The Fed’s frequently announced goal is not stable prices, but a relatively stable rate of increase in prices, with a target of 2% inflation a year, continuing indefinitely. Bluntly put, the Fed is committed to perpetual inflation (although I cannot recall seeing it use this honest term) at a rate which will cause average prices to quintuple in the course of an average lifetime. With a straight face, the Fed and other central bankers call this “price stability”—a remarkable example of Orwellian newspeak. While it is confused on the actual legal mandate, a recent article discussing the Fed in Barron’s correctly describes the current practice: “Half of its dual mandate, inflation.”
A classic rationale for inflation is that real wages can be reduced without reducing nominal wages, and that real debts can be reduced without (as much) default on nominal debts. Nonetheless, it is my opinion that the current commitment of the Fed and other fiat-currency central banks to perpetual inflation will be judged in the long run as inconsistent with financial stability, and instead part of the decades of financial instability which began in the 1970s. However that may be, price stability is what we intentionally don’t have.
When the goal of “maximum employment” was added to the governing statute in 1977, many people, including the Democratic sponsors of the bill, believed there was a simple-minded trade-off between inflation and employment. Shortly after enactment of this mistaken idea, the stagflation of the late 1970s demonstrated its error. No one believes it now, but its presence in statute gives the Fed much increased power to exercise inherently uncertain discretionary central banking.
Within a few years of enactment of the “moderate long-term interest rates” mandate, the Fed was pushing interest rates to all-time highs, with the 10-year Treasury interest rate reaching 15% in the early 1980s. This was hardly a “moderate” rate, to be sure.
The history of the Fed and manipulation of long-term rates is instructive. During the 1940s, the Fed was a big buyer of long-term government bonds to finance World War II and to suppress the cost of borrowing for the U.S. Treasury. This was a major precedent considered by Chairman Bernanke for “quantitative easing.” After the war, the Fed continued to hold down interest rates; at length it was debated whether it should. President Truman and his Treasury Secretary thought it should, but in the 1951 “Accord,” the Treasury and the Fed agreed the purchases would end. In the ensuing three decades, interest rates kept rising, making a 30-year bear bond market, until their 1980s peak.
Now we have had an equivalent three-decade long bull bond market and the Fed, of course, is again a big buyer of bonds. It has again been a success at manipulating long-term interest rates downward, to near zero or even negative real rates. That is also not a “moderate” interest rate.
Of far greater seniority and standing is the fourth mandate of the Fed, which stood very first in the Federal Reserve Act in 1913. The legislative fathers of the Fed told us clearly what they wanted to achieve. The original Act begins:
“An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”
In 1913, an elastic currency meant the ability to make loans from the Federal Reserve Banks to expand credit and print money to match the economic exigencies of the moment, whether reflecting the agricultural seasons, the business cycle or a financial panic. In the background was the experience of the Panic of 1907. One hundred years after that, in the Panic of 2007 to 2009, elastic currency was furnished with great energy by the Fed. Although the panic is over, the elastic currency is still very expanded, now called “quantitative easing.”
As intended by the original Federal Reserve Act, an elastic currency is most certainly what we have got, not only in the U.S., but given the global role of the dollar, in the world. That is one mandate fully achieved. It is, as designed, very helpful in panics, but it also fits well with the more recent goal of perpetual inflation.
The fifth mandate is expressed in the beginning of the Federal Reserve Act as “to establish a more effective supervision of banking in the United States,” now also thought of as ensuring financial stability. Although it was hoped at the creation of the Fed that it would make financial crises “mathematically impossible,” in fact in the one hundred years since then there have been plenty of crises, right up to the most recent one. The Fed has full command of a very elastic currency, but the crises keep happening. “Financial crises will always be with us,” as Bernanke has written, “That is probably unavoidable.” I believe that is correct, optimistic hopes about the most recent expansion of the Fed’s supervisory power notwithstanding.
If only the governors, officers and staff of the Fed could know the future! Then they could doubtless avoid the crises. Since they do not and cannot know the future, it is plausibly argued that instead they help cause the crises by discretionary money creation and financial interventions which induce debt, leverage, asset inflation and illusory “wealth,” with recurring unhappy endings.
The sixth and most basic central bank mandate of all is financing the government when needed. In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the Treasury’s interest cost. At three years old, it had lent its full efforts to finance the government during the First World War. It is monetizing Treasury bonds as we discuss it. So convenient a thing it is for a government to have a central bank that almost every government has one.
This fundamental relationship is exemplified in the deal which formed the quintessential central bank, the Bank of England, in 1694. The deal was that the Bank would lend money to the government, in exchange it got a monopoly in the issuance of currency. This is still the basic structure of the Fed’s balance sheet. Equally instructive is the founding of the Bank of France in 1800: “Bonaparte…felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes”—a natural political desire.
Hence the ambivalence of Federal Reserve “independence.” As William McChesney Martin, Fed Chairman in the 1950s and 1960s, said, the Fed is independent “within the government.”
Yet it is true that “the Fed has also become a colossus,” as the provocative historian of the Fed, Bernard Shull, has written. The combined six mandates, whether or not successfully achieved, make what Shull calls “an enormous concentration of power in a single Federal agency that is more autonomous than any other and one in which a single individual, the Chairman, has assumed an increasingly important role.”
The accumulated power of the Fed gives it the greatest potential to create systemic financial risk of any institution in the world, while it is claiming and trying to reduce systemic risk. This fact alone warrants the review of the Federal Reserve and its many mandates which the Committee has wisely undertaken.
Thank you very much for the opportunity to share these views.
The Fed Is as Poor at Knowing the Future as Everybody Else
Testimony of
Alex J. Pollock
Resident Fellow
American Enterprise Institute
To the Subcommittee on Monetary Policy and Trade
Of the Committee on Financial Services
U.S. House of Representatives
Hearing on “The Fed Turns 100: Lessons Learned from a Century of Central Banking”
September 11, 2013
The Fed Is as Poor at Knowing the Future as Everybody Else
Mr. Chairman, Ranking Member Clay, and Members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views. Before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general.
A striking lesson of the 100-year history of the Federal Reserve is how it has been able from its beginning to now to inspire entirely unjustified optimism about what it can know and what it can accomplish.
Upon the occasion of the Federal Reserve Act in 1913, an American Banker writer opined, “The financial disorders which have marked the history of the past generation will pass away forever.” Needless to say, the Fed has not made financial disorders disappear, and not for lack of trying, while it has often enough contributed to them.
In 1914, the then-Comptroller of the Currency expressed the view that with the creation of the Fed, “financial and commercial crises, or panics…seem to be mathematically impossible.” They weren’t.
The unrealistic hopes continued. As a forthcoming history says, “The bankers at the Federal Reserve kept the money flowing in to the American economy at a pitch that held interest rates low and kept expanding business and consumer credit… [but] there was no rise in prices. The business cycle…had finally been tamed—or so it seemed. Economists around the world praised the Federal Reserve. Some even predicted that a ‘new era’ in economics had begun.” This passage sounds like it is describing the central bank optimism of the early 2000s with the so-called “Great Moderation,” but in fact it is describing the 1920s. We know what came next, and the Fed is widely blamed for its deflationary blunders in the crisis of the early 1930s, and again in 1937.
In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the interest rates on government debt, thus doing in great scale exactly what the fathers of the Federal Reserve Act had tried to prevent: monetizing government debt. (The Fed had also lent its full efforts to finance the government during the American participation in the First World War.)
After enjoying the American global economic hegemony of the 1950s, the 1960s brought a new high point in optimism about what discretionary manipulation of interest rates and financial markets could achieve. Otherwise intelligent and certainly well-educated economists actually came to believe in what they called “fine tuning”: that the Fed and government policy “could keep the economy more or less perfectly on course,” as discussed by Fed Chairman Bernanke in his new book, The Federal Reserve and the Financial Crisis. Some economists even held a conference in 1967 to discuss “Is the Business Cycle Obsolete?” It wasn’t.
The fine tuning notion “turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s,” Bernanke writes, “so one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.” Very true.
Indeed, the performance of the Federal Reserve at economic and financial forecasting in the last decade, including missing the extent of the Housing Bubble, missing the huge impact of its collapse, and failing to foresee the ensuing sharp recession, certainly strengthens the case for humility on the Fed’s part, especially when it attempts to forecast financial market dynamics. The poor record of economic forecasting is notorious, and the Fed is no exception to the rule.
If only the Chairman, the Governors, the Presidents and the scores of economists of the Federal Reserve could really know the future! Then they could carry out their discretionary actions without the many mistakes, both deflationary and inflationary, which have marked the history of the Fed. These mistakes should not surprise us. As Arthur Burns, Fed Chairman in the 1970s and architect of the utterly disastrous Great Inflation of that decade, said: “In a rapidly changing world, the opportunities for making mistakes are legion.”
In a 1996 speech otherwise famous for raising the issue of “irrational exuberance,” then-Fed Chairman Alan Greenspan sensibly discussed the limits of the Fed’s knowledge. “There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment and inflation,” he said. (Since it is effectively the world’s central bank embedded in globalized financial markets, the Fed would need not merely a model of the American economy, but one of the world economy.)
“In principle,” Chairman Greenspan continued,” there may be some unbelievably complex set of equations that does that. But we [the Fed] have not been able to find them, and do not believe anyone else has either.” They certainly have not, as subsequent history has amply demonstrated. Moreover, in my view, not even in principle can any model successfully predict the complex, recursive financial and economic future—so the Fed cannot know with certainty what the results of its own actions will be.
Nonetheless, the 21st century Federal Reserve and its economists again became optimistic, and perhaps hubristic, about the central bank’s abilities when Chairman Greenspan had been dubbed “The Maestro” by the media and knighted by the Queen of England. It is now hard to remember the faith he and the Fed then inspired and the confidence financial markets had in the support of what was called the “Greenspan put.”
Queen Elizabeth would later quite reasonably ask why the economists and central banks failed to see the crisis coming. One lesson we can draw from this failure is that a group of limited human beings, none of whom is blessed with knowledge of the future, with all the estimates, guesses, and fundamental uncertainty involved, by being formed into a committee, cannot rationally be expected to fulfill the mystical notion that they can guarantee financial and economic stability.
In the early 2000s, of particular pride to the Fed was that the central bankers thought they were observing a durable “Great Moderation” of macro-economic behavior, a promising “new era,” and gave their own monetary policies an important share of the credit. With an eye on a hoped-for “wealth effect” from rising house prices, the Fed pushed interest rates exceptionally low as the housing bubble was rapidly inflating, which many observers, including me, view as a critical mistake. Chairman Bernanke has since insisted that the Great Moderation was “very real and striking.” Yet, since it is apparent that the Great Moderation led to the Great Bubble and then to the Great Collapse, how could it have been so real?
Economic historian Bernard Shull has explored the paradox that throughout its 100 years, no matter how many mistakes the Fed makes, or how big such mistakes are, it nonetheless keeps gaining more power and prestige. In 2005, he made the following insightful prediction: “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.” Indeed, in the wake of the bubble and collapse, the political and regulatory overreaction came, as it always does each cycle. The Dodd-Frank Act gave the Fed much expanded regulatory authority over financial firms deemed “systemically important financial institutions” or “SIFIs,” and a prime role in trying to control “systemic risk.”
But the lessons of history make it readily apparent that the greatest SIFI of them all is the Federal Reserve itself. It is unsurpassed in its ability to create systemic risk for everybody else through its unlimited command of the principal global fiat money, the paper dollar. As former-Senator Bunning reportedly asked Chairman Bernanke, “How can you regulate systemic risk when you are the systemic risk?” A good question! Who will guard these guardians?
A memorable example of systemic risk is how the Fed’s Great Inflation of the 1970s destroyed most of the savings and loan industry by driving interest rates to levels previously thought impossible. In the 1980s, the Fed under then-Chairman Paul Volcker, set out to “fight inflation”--—the inflation the Fed had itself created. In this it was successful, but the high interest rates, deep recession and sky-high dollar exchange rate which resulted, then created often-fatal systemic risk for heartland industries and led to a new popular term, “the rust belt.” A truly painful outcome of some kind was unavoidable, given the earlier inflationary blunders.
A half-century before that, in 1927, the then-dominant personality in the Federal Reserve, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.” In our times, the Fed has decided to give the bond market and the mortgage market a barrel or so of whiskey in the form of so-called “quantitative easing.” This would undoubtedly have astonished previous generations of Federal Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.
How will this massive manipulation of the government debt and mortgage markets turn out? Will it make the current Fed into a great success or become another historic blunder? In my opinion, neither the Fed nor anybody else knows—about this all of us can only guess. It is a huge and fascinating gamble, which has without doubt induced a lot of new systemic interest rate risk into the economy and remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.
In the psychology of risky situations, actions seem less risky if other people are doing the same thing. That is why, to paraphrase a celebrated line of John Maynard Keynes, a “prudent banker” is one who goes broke when everybody else goes broke. That other central banks are also practicing versions of “quantitative easing” may induce the same subjective comfort. A decade ago, bankers felt a similar effect when they all were expanding mortgage debt together.
Robert Solow recently claimed that “Central banking is not rocket science.” Indeed, it isn’t: discretionary central banking is a lot harder than rocket science. This is because it is not and cannot be a science at all, because it cannot operate with determinative mathematical laws, because it cannot make reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future. We should have no illusions, in sharp contrast to the 100 years of illusions we have entertained, about the probability of success of such a difficult attempt, no matter how intellectually brilliant and personally impressive its practitioners may be.
It is often debated whether the Fed can successfully achieve two objectives, the so-called “dual mandate,” rather than one. It does seem doubtful that it can, but the question oversimplifies the problem, for the Fed has not two mandates, but six.
The precise provision of the Federal Reserve Reform Act of 1977, which gives rise to the discussion of the “dual mandate,” is almost always mischaracterized, for that provision assigns the Fed three mandates, not two. The Fed shall, it says, “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” This is a “triple mandate,” at least. The third statutorily assigned goal is almost always forgotten. It is doubtful indeed that the Fed can simultaneously do all three.
But in addition to these, the Fed has three more mandates. These are: to furnish an elastic currency, the historically first mandate and the principal reason for the existence of the Fed in the first place; to act as the manager of the risks and profits of the banking club, now expanded to include other “SIFIs”; and finally, to provide ready financing for the deficits of the government of which it is a part, as needed.
Let us do a quick review of how the Fed is doing at each of its six mandates.
To begin with “stable prices”: this goal was in fact dropped long ago. The Fed’s goal is not and has not been for decades stable prices, but instead permanent inflation—with a relatively stable rate of increase in prices. In other words, the Fed’s express intention is a steady depreciation of the currency it issues, another idea which would have greatly surprised the authors of the Federal Reserve Act. At its “target” of 2% inflation a year, average prices will quintuple in a normal lifetime. Economists can debate whether a stable rate of price increases rather than a stable price level is a good idea, but you cannot term perpetual inflation “price stability” with a straight face.
Turning to “maximum employment”: Nobody believes any more, as many people believed when this goal was added to the governing statute in 1977, that there is a simple trade-off between inflation and sustained employment. It was still believed when the Humphrey-Hawkins Act of 1978 was passed, although it was already being falsified by the great stagflation of the late 1970s. Humphrey-Hawkins added a wordy provision requiring the Fed to report to and discuss with Congress its plans and progress on the triple mandate. Did these sessions succeed? They obviously did not avoid the financial disasters of the 1980s and 2000s, or the inflation of giant bubbles in tech stocks and housing.
On “moderate long-term interest rates”: As the Treasury’s servant in the 1940s, the Fed kept the yield on long-term government bonds at 2 ½%. After this practice was ended by the “Treasury-Fed Accord” of 1951, a 30-year bear bond market ensued, which ultimately took long-term interest rates to 15% in the early 1980s—this was not a “moderate” interest rate, to be sure. With the Fed’s current massive bond buying, rates on long-term government bonds got to 1½%-2%, which was zero or negative in real terms—also not a “moderate” interest rate.
The fourth mandate stood right at the beginning of the original Federal Reserve Act in 1913. The authors of the Act told us clearly what they wanted to achieve:
“An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”
An elastic currency is most definitely what we have got, not only in the U.S., but given the global role of the dollar, in the world. Indeed, we have one much more elastic than originally intended. This is very handy during financial panics when the Fed is acting as the lender of last resort. The unanswered question is: given a pure paper currency (not originally intended, of course) with unlimited elastic powers, what limits should there be other than the demonstrably fallible beliefs and judgments of the members of the Federal Reserve?
Charles Goodhart’s monograph, The Evolution of Central Banks, makes a strong argument that it helps to understand central banks, including the Fed, by thinking of them as the manager of the banking club, which tries to preserve and protect the banking industry. This becomes most evident in banking crises. It was explicitly expressed in an early Fed plaque: “The foundation of the Federal Reserve System is the co-operation and community of interest of the nation’s banks.” Such candor is not currently in fashion—the fifth mandate is now called “financial stability.” As discussed, this mandate has been expanded by Dodd-Frank beyond banks to make the Fed the head of an even bigger financial club.
Sixth is the most basic central bank function, and Fed mandate, of all: financing the government, a core role of central banks for over three centuries. As economist Elga Bartsch has correctly written, “The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank.” Thus for governments that wish to finance long-term deficits with debt, like the United States, central banks are exceptionally useful, which is one reason virtually all governments have one-- no matter how disappointing the central bank’s performance at stable prices, maximum employment, moderate long-term interest rates, and financial stability may be. Needless to say, the power of financing the government is also dangerous.
Allan Meltzer, an eminent scholar of the Federal Reserve and our colleague on this panel, near the end of his magisterial A History of the Federal Reserve, quotes the classic wisdom of monetary thinker Henry Thornton from 1802-- 211 years ago, who proposed:
“to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction: in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself…. To suffer the solicitations of the merchants, or the wishes of the government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.”
These are sensible guidelines, as my friend Allan suggests. But another lesson of 100 years of Federal Reserve history is that we have still not figured out how to implement them.
Thank you again for the opportunity to share these views.
We Don’t Need GSEs
Testimony of
Alex J. Pollock
Resident Fellow
American Enterprise Institute
To the Committee on Financial Services
U.S. House of Representatives
Hearing on Learning from Mortgage Finance Systems of Other Countries
June 12, 2013
We Don’t Need GSEs
Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to be here today. I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views. Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. From 1999 to 2001, I also served as President of the International Union for Housing Finance (IUHF), a trade association devoted to the international exchange of housing finance ideas and information. In fact, I have just returned to the U.S. from an IUHF conference at which representatives of 42 countries met to share issues and experiences in this sector, which is economically and politically important to all countries.
The American housing finance sector has collapsed twice in the last three decades, once as a government promoted savings and loan-based system, and once as a government promoted GSE-centric system. We should never assume that the particular, highly unusual, historical development of U.S. housing finance should define the limits of our considerations. There is no doubt that there is much to learn of much practical import from examining U.S. housing finance in international perspective, including how experts from other countries view our system from outside.
Comparing our housing finance sector to other countries, the one thing most unusual about it was and is the dominant and disproportionate role played by Fannie Mae and Freddie Mac, as government-sponsored enterprises or GSEs. Fannie and Freddie’s role and was and is unique among housing finance systems. The GSEs themselves used to claim that this made U.S. housing finance “the envy of the world,” a view not shared by the world. When Fannie and Freddie were the darlings of Washington and the stars of Wall Street, they would come to IUHF meetings and boastfully promote their GSE model. But mortgage professionals from other countries were not convinced.
Let us begin by asking and answering five essential questions from an international perspective:
1. Are GSEs like Fannie and Freddie necessary for effective housing finance?
No. This is obvious from the many countries which achieve similar or higher home ownership than the U.S. without them.
2. Did GSEs get for the U.S. an internationally high home ownership rate?
No.
3. Well, did GSEs get for the U.S. an above-average home ownership rate?
No.
4. Are GSEs necessary to have long-term, fixed rate mortgages?
No.
5. Even if they had a disastrous actual outcome, are GSEs the best model in theory?
No.
Along with incorrectly saying that GSEs made U.S. housing finance “the envy of the world,” it was often additionally claimed (without supporting data) that the U.S. had the highest home ownership rate in the world. This seemed plausible to Americans, but was wrong. Interestingly, people in England also claimed that they had the highest home ownership. In fact, England, with a completely different housing finance system and no GSEs, has been and is effectively tied with the U.S. in home ownership rate—both now at 65%, and both in the bottom half, as you will see in the ranking below.
Based on the free use of the U.S. Treasury’s credit, through the so-called “implicit” but very real (as events made clear) guaranty, massive amounts of Fannie and Freddie’s debt securities were sold around the world. The GSEs ran up the leverage of the housing finance sector. As a market distortion which pushed credit at housing, they inflated house prices and escalated systemic risk. Foreign investors helped pump up the housing bubble through the GSEs while being fully protected from the risk, and then were bailed out by the taxes of ordinary Americans. Of course, other countries also made housing finance mistakes, but nobody else made this particular, giant mistake.
The political interest in housing finance begins with what I think is a valid proposition: that in a democracy it is advantageous to have widespread property ownership among the citizens. The experiences of other countries make it obvious that high home ownership levels can be attained without GSEs—and moreover without tax deductions for mortgage interest; without our very unusual practice of making mortgage loans into non-recourse debt; without government orders to make “creative”—that is riskier—mortgage loans, which were part of being a GSE; and with prepayment fees.
The following table, “Comparative Home Ownership Rates,” is an update with the most recent available data of a comparison I presented to the Congress in 2010. It displays home ownership in 28 economically advanced countries. The U.S. ranks 20th, just behind England. The median home ownership rate among these countries is 68%, compared to our 65%.
Comparative Home Ownership Rates
Source: AEI research
How do financial professionals in other countries view the U.S. housing finance sector?
More than a decade ago, when Fannie and Freddie were still riding high, and Fannie in particular was a greatly feared bully boy whom both Washington politicians and Wall Street bankers were afraid to cross or offend, I presented the GSE-centric U.S. housing finance system to the Association of Danish Mortgage Banks in Copenhagen. When I was done, the CEO of one of their principal mortgage lenders memorably summed things up:
“In Denmark we always say that we are the socialists and America is the land of free enterprise. Now I see that when it comes to mortgage finance, it is the opposite!”
He was so right. But now, with Fannie and Freddie continuing to be guaranteed by the U.S. Treasury, able to run with zero capital and infinite leverage, being granted huge loopholes by the Consumer Financial Protection Bureau, and being heavily subsidized by the Federal Reserve’s buying up their MBS, they have a bigger market share and more monopoly power than before. The American housing finance sector is more socialized than ever.
Here’s a view from Britain, where a senior financial official said recently:
“We don’t want a government guaranteed housing finance market like the United States have.”
They don’t want what we have—and we don’t want it either. How do we conceptualize the range of alternate possibilities?
Every housing finance system in the world must address two fundamental questions. The first is how to match the nature of the mortgage loan with an appropriate funding source, so you are not lending long and borrowing short. Different approaches distribute the interest rate risk among the parties involved—lenders, investors, borrowers, governments, taxpayers--in various ways.
Basic sustainable variations observed in different countries include variable rate mortgages funded with short-term deposits; medium term fixed-rate mortgages funded with medium-term fixed rate deposits or bonds; long-term fixed rate mortgages funded with long-term fixed rate bonds or covered bonds. In general, to soundly fund long-term fixed-rate mortgages, you have to have access to the bond market. In an advanced financial system, it does not require a GSE to do this.
The classic example of not achieving the needed interest rate match was the collapse of the American savings and loan industry in the 1980s. What broke the savings and loans was the combination of their interest rate mismatch with the soaring interest rates of the great inflation created by the Federal Reserve in the 1970s. While the lenders were crushed, borrowers who had old 30-year fixed rate mortgages in this period of rising interest rates and inflating house prices did very well.
In contrast, the 30-year fixed rate mortgage was terrible for great numbers of borrowers in the U.S. crisis of the 2000s. With the floating rate mortgage system of England, the rapid fall of interest rates in the housing crisis was automatically passed on to the borrowers in the form of lower payments, which helped contain the crisis. American borrowers faced with falling interest rates and house price deflation, on the other hand, were often locked in to high payments and punished by their 30-year fixed rate mortgages, which thereby made the housing bust worse in this country.
The second fundamental question of housing finance systems is who will bear the credit risk. In most countries, the lender retains the credit risk, which is undoubtedly the superior alignment of incentives. With covered bonds, which are used in many countries, you can simultaneously achieve fixed-rate funding while keeping the lender fully on the hook for the credit performance of the mortgage loans being funded.
The American GSE approach (and also that of private MBS) systematically separates the credit risk from the lender-- so you divest the credit risk of the loans you make to your own customers. This was and is a distinct outlier among countries. It had disastrous results, needless to say.
The most perfect conceptual solution to the two fundamental questions of housing finance, which functions very well in practice in its national setting, is the housing finance system of Denmark. This system has been justifiably admired by many observers. It operates in a small country, but represents big basic ideas.
The Danish mortgage approach to interest rate risk in its funding market is explicitly governed by what it calls the “matching principle.” This means that the interest rate and prepayment characteristics of the mortgage loans being funded are passed on entirely to the investor in Danish mortgage covered bonds. This allows long-term fixed rate mortgages, as well as variable rate mortgages.
At the same time, the entire credit risk is retained by the mortgage bank lenders. They have 100% “skin in the game” for credit risk, in exchange for an annual fee, thus insuring alignment of incentives for credit performance. Deficiency judgments, if foreclosure on a house does not cover the mortgage debt, are actively pursued. In other words, mortgage loans are always made with recourse to the borrower’s other income and assets. This is true in most countries. The U.S. state laws or practices of non-recourse mortgage lending are again a distinct outlier.
The fundamentals of the Danish mortgage system go back over 200 years, to the 1790s. There are no GSEs. The Danish system can deliver long-term fixed rate loans of up to 30 years with a prepayment option. This is a private housing finance system build on quite robust principles, which claims that no mortgage bond holder has suffered a credit loss in over two centuries. Denmark can and in the last decade did have a housing price bubble and bust, but the housing finance sector performed much better through it than did ours, and its covered bonds were sold throughout 2007-09. We should note that the Danish system generates a home ownership rate of 54%, on the low side.
Another interesting case of the splitting of bond market funding and credit risk is that of Cagamas, or the National Mortgage Company of Malaysia. Cagamas buys mortgage loans from lenders, and then issues bonds to finance them, but the mortgage purchases are with full recourse to the lender, so the lender retains 100% of the credit risk and the alignment of incentives.
Cagamas is 80% owned by the banks and 20% by the Malaysian central bank, so it is a GSE, but not a Fannie and Freddie-style GSE. Instead it functionally resembles the Federal Home Loan Banks (FHLBs). FHLBs provide bond market funding for mortgages through advances to banks, but the banks retain all the credit risk. FHLBs also buy mortgages, but only when the bank credit enhances the mortgages it has made. (It may be of interest that of all sizeable American GSEs, considering Fannie, Freddie and the Farm Credit Banks, the FHLBs are the only ones which have never gone broke.)
A very stable, sound, and very conservative housing finance market is that of Germany. Some of its banks got into trouble in this cycle by buying U.S. mortgage securities, but their domestic mortgage market did not experience either a housing price boom-bust or a mortgage credit crisis. The problem is that the German system generates a very low home ownership rate, only 43%--as well as a relatively late age at which people are on average able to buy houses. I imagine that neither of these would be politically acceptable in the U.S.
Nevertheless, there are two German ideas worthy of study. One is the German version of mortgage covered bonds (“Pfandbriefe”). With a statutory basis more than one hundred years old (and, it is claimed, a history going back to Frederick the Great in the 18th century), these covered bonds form and large and relatively stable source of bond-based mortgage funding with no GSE. The issuing bank retains all the credit risk of the mortgage loans. Mortgage loans funded with these covered bonds have a maximum LTV of 60%.
Many people have proposed, and I agree, that the U.S. should introduce covered bonds without a government guaranty as a mortgage funding alternative, as part of escaping from the mortgage market’s subservience to GSEs.
A second German housing finance idea worth considering is their emphasizing the role of savings as an essential part of sound housing finance. The German building and savings banks (“Bausparkassen”) continue to practice the savings contract, which was once also common in this country. By such a contract, the borrower commits to regular savings as part of qualifying for a mortgage loan. This is, in my opinion, a very old-fashioned, very good idea.
Canada makes a pertinent comparison for the U.S., both countries being advanced, stable, financially sophisticated and North American. The Canadian housing finance system, like most in the world, has no GSEs. It is primarily funded on the balance sheets of banks, although Canadian banks are also becoming issuers of covered bonds under new legislation, and it came through the crisis of 2007-09 in much better shape than did we did. Mortgage lending is more conservative and creditor-friendly, and the Canadian system currently produces a higher home ownership rate of 67%.
Although it has no GSEs, Canada does have a very important government body to promote housing finance, which plays a substantial role in the mortgage sector. This is the Canada Mortgage and Housing Corporation (CMHC). Its principal activity is insuring (i.e. guaranteeing) mortgage loans—and it guarantees approximately half of all Canadian mortgages. This is about the same proportion as the combined Fannie and Freddie have of outstanding the U.S. mortgage credit exposure.
But in contrast to the game the U.S. played of pretending that Fannie and Freddie were “private,” and that the government exposure was not really there (it was only “implicit”), CMHC’s status is refreshingly clear and honest. It is a 100% government-owned and controlled corporation. It has an explicit guaranty from the government. It also provides housing subsidies which are on budget and must be appropriated by Parliament. So Canada, while having this large government intervention in the mortgage market, is definitely superior to us in candor and clarity about it.
This exemplifies what I believe to be a core principle: You can be a private company. Or you can be part of the government. But you should never be allowed to pretend you are both. In other words, Fannie and Freddie should cease to be GSEs. Considering the international anomaly and the disastrous government experiment they represent, we should all be able to agree on this.
Thank you again for the opportunity to share these views.
Boom and Bust: Financial Cycles and Human Prosperity (Values and Capitalism)
Published by American Enterprise Institute (AEI) Press. Order here.
While the recent economic crisis was a painful period for many Americans, the panic surrounding the downturn was fueled by an incomplete understanding of economic history. Economic hysteria made for riveting journalism and effective political theater, but the politicians and members of the media who declared that America was in the midst of the greatest financial calamity since the Great Depression were as wrong and misguided as the expansionists of the Roosevelt era. In reality the cyclical nature of market economies is as old as the markets themselves. In a free market system, financial downturns inevitably accompany economic prosperity-but the overall trend is upward progress in living standards and national wealth. While it is helpful to understand what caused the recent crisis, the more important questions to consider are ‘What makes the ‘boom and bust’ cycle so predictable?’ and ‘What are the ethical responsibilities of the citizens of a free market economy?’ In Boom and Bust: Financial Cycles and Human Prosperity, Alex J. Pollock argues that while economic downturns can be frightening and difficult, people living in free market economies enjoy greater health, better access to basic necessities, better education, work less arduous jobs, and have more choices and wider horizons than people at any other point in history. This wonderful reality would not exist in the absence of financial cycles. This book explains why.