Conservatives set the stage for another CFPB funding fight

Published in The Hill.

Alex Pollock, a senior fellow at the right-leaning Mises Institute, suggested that the Dodd-Frank Act blocked a future Congress from “disciplining” the agency with “the power of the purse” by granting it a share of the Fed’s earnings. 

“With inescapable logic, however, that depends on there being some earnings to share in,” Pollock wrote in a post on the blog run by the Federalist Society, a conservative legal group. 

Podcast: Consumer Financial Protection Bureau Wins in Supreme Court But Can the Fed Continue to Fund the CFPB Without Earnings?

Published by Ballard Spahr. Also in JD SUPRA,

Special guest Alex J. Pollock, Senior Fellow with the Mises Institute and former Principal Deputy Director of the Office of Financial Research in the U.S. Treasury Department, joins us to discuss his recent blog post published on The Federalist Society website in which he urges Congress to look into the question of whether the Federal Reserve can lawfully continue to fund the CFPB if (as now) the Fed has no earnings. We begin with a review of the Supreme Court’s recent decision in CFSA v. CFPB which held that the CFPB’s funding mechanism does not violate the Appropriations Clause of the U.S. Constitution. Alex follows with an explanation of the CFPB’s statutory funding mechanism as established by the Dodd-Frank Act, which provides that the CFPB is to be funded from the Federal Reserve System’s earnings. Then Alex discusses the Fed’s recent financial statements and their use of non-standard accounting, the source of the Fed’s losses, whether Congress when writing Dodd-Frank considered the impact of Fed losses on the CFPB’s funding, and how the Fed can return to profitability. We conclude the episode by responding to arguments made by observers as to why the Fed’s current losses do not prevent its continued funding of the CFPB, potential remedies if the CFPB has been unlawfully funded by the Fed, and the bill introduced in Congress to clarify the statutory language regarding the CFPB’s funding.

Alan Kaplinsky, Senior Counsel in Ballard Spahr’s Consumer Financial Services Group, hosts the conversation.

Alex’s blog post, "The Fed Has No Earnings to Send to the CFPB," can be found here.

Causes of the Great Depression

Published in Law & Liberty.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Can the Fed Fund the CFPB?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fed Losses May Sour CFPB’s Supreme Court Win

Published in Inside Mortgage Finance:

“Because of the losses, the Fed stopped sending its surplus to the Treasury Department, and it should have done the same for the CFPB, Alex Pollock…”

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

Published in The New York Sun and The Mises Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

Challenging the CFPB After CFPB v. CFSA

Published in Ballard Spahr L.L.P.:

On May 20, Professor Emeritus Hal Scott from Harvard Law School, wrote an op-ed in the Wall Street Journal entitled: “The CFPB’s Pyrrhic Victory in the Supreme Court” and on May 21, Alex J Pollock wrote an article which was published on The Federalist Society website entitled: “The Fed has no earnings to send to the CFPB,” Professor Scott and Mr. Pollock stated that Federal Reserve System started incurring losses in September, 2022, that such losses continue to the present day and that the Fed is projected to incur losses until 2027.

The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

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

“Earnings” means net profit:

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

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

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

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

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

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

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

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

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

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

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

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

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

Chairman Powell and The Fed’s Limits

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

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

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

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

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

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

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

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

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

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

Sticking to the Assigned Mission 

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

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

He continued in a paragraph well worth quoting at length: 

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

Very true, it hasn’t. 

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

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

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

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

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

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

Published in The New York Sun.

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

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

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

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

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

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

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

Whose fault was that? 

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

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

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

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

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

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

________

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

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

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

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

Published in The New York Sun.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Letter: FDIC Swiss stance — case of pot calling kettle black

Published in the Financial Times:

One may doubt the diplomatic wisdom of the decision of the chair of the US Federal Deposit Insurance Corporation to criticise the Swiss government’s handling of the Credit Suisse failure (Report, April 11), but one cannot fail to be amused by the FDIC pot calling the Swiss kettle black.

Far from using “standard bank closure powers”, the FDIC and other US regulators in 2023 gave assurances all was in good shape, in an attempt to avoid widespread panic in the banking system, and then took the extraordinary action of guaranteeing all the uninsured deposits of collapsing banks. This cost the FDIC $16bn it could not afford; it took these billions from other banks to save wealthy venture capitalists and crypto barons from taking a moderate and well-deserved haircut on the uninsured deposits they so imprudently held in sometimes extravagant amounts. The Swiss are probably too polite to point out to the FDIC chair that this was certainly an unfortunate precedent.

Alex J Pollock Senior Fellow, Mises Institute, Lake Forest, IL, US

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.

Register here

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

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Desmond Lachman | AEI event | September 21, 2023

Register here

The Fed Doesn’t Know the Natural Rate of Interest

Published in The Wall Street Journal.

Mr. Levy describes the Fed’s permanent problem: It doesn’t and can’t know what the natural rate of interest is. Everyone should pity the members of the Federal Open Market Committee, who must inwardly confess that they can’t know the answers, yet have to play their parts in the Fed melodrama nonetheless.

Alex J. Pollock

Senior fellow, Mises Institute

Lake Forest, Ill.

Appeared in the March 14, 2024, print edition as 'Fed Doesn’t Know the Natural Rate of Interest'.

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

Published in The Mises Institute’s Mises Wire.

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

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

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

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

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

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

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

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

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

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

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

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

New York ($82.4 bln) 655%

Richmond ($15.6 “ ) 284%

Chicago ($ 8.8 “ )  515%

San Francisco ($ 2.8 “ ) 151%

Cleveland ($ 1.5 “ ) 134%

Boston ($ 1.2 “ ) 165%

Dallas ($677 mln) 161%

Kansas City ($ 94 “ ) 120%

Philadelphia $ 31 “ 98%

Minneapolis $ 40 “ 85%

St. Louis $891 “ 8%

Atlanta. $ 1.3 bln 13%

Federal Reserve System ($111 bln) 357%

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

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

Event: Talks With Authors: Better Money: Gold, Fiat, Or Bitcoin?

Hosted by the Federalist Society:

In Better Money: Gold, Fiat, Or Bitcoin?, monetary expert Lawrence H. White delves into the timely debate surrounding alternative currencies amidst the backdrop of constant inflation in the fiat currency world. Better Money explains and analyzes gold, fiat dollars, and Bitcoin standards to evaluate their relative merits and capabilities as currencies. It addresses common misunderstandings of the gold standard and Bitcoin, and scrutinizes the evolution of currency, particularly the interplay between market and government roles. White provides provocative analysis of which standard might ultimately provide better money, and argues that we need a market competition among them.

Please join us as Professor Lawrence White joins discussants Alexandra Gaiser and Bert Ely, and moderator Alex Pollock to discuss Better Money.

Featuring: 

• Prof. Lawrence H. White, George Mason University

• Alexandra Gaiser, General Counsel, Strive

• Bert Ely, Principal, Ely & Company, Inc.

• Moderator: Alex J. Pollock, Senior Fellow, Mises Institute

Federal Reserve Losses and Monetary Policy

Published by the American Enterprise Institute with Paul H. Kupiec.

Past monetary policy decisions have resulted in the Fed suffering more than $140 billion in accumulated cash losses in addition to $1 trillion in unrealized losses on its securities portfolio. The Fed System and the majority of Reserve Banks are technically insolvent on a GAAP basis. Fed officials claim that the Fed’s losses and negative GAAP capital do not compromise its ability to conduct monetary policy because the Fed can create money to cover its losses, however large the losses may become. The Fed’s narrative leaves out important details including that the Fed’s ability to print paper currency is limited by law and deposits held at insolvent Reserve Banks are unsecured liabilities that are legally at risk because they lack a federal government guarantee. We calculate the GAAP capital of each Reserve Bank and the System, and estimate depositors’ loss exposures under current law. We review the current legal framework in place for addressing insolvent Reserve Banks. We conclude that the framework will be ignored, and the Fed will continue to operate at a loss while deeply technically insolvent as long as depositors maintain their belief that Fed deposits are protected by an implicit federal government guarantee. Congressional action may be needed should this confidence waiver.

Read the full paper here.

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

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

Published in The New York Sun:

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

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

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

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

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

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

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

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

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

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

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

Grant’s Current Yield Podcast: Interest Rates, Home Loan Banks, and more

Published on Grant’s Current Yield Podcast:

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

Published in The New York Sun.

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

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

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

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

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

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

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

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

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

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

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

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