The Fed’s ‘temporary’ mortgage-backed security experiment will last decades

Published in The Hill with Paul Kupiec. Also published in RealClear Markets.

It has been nearly 14 years since Federal Reserve Chairman Ben Bernanke told Congress that the Fed’s emergency quantitative-easing policy, of which the most radical part was buying mortgage-backed securities, was “temporary” and would be “reversed.”  

The Fed made huge mortgage-backed securities purchases. The purchases pushed mortgage interest rates to artificially low levels, stoked the second great house price bubble of the 21st century and made houses unaffordable for many. 

In addition, these mortgage-backed securities investments unintentionally caused massive Fed losses. They are costing the Fed and taxpayers billions of dollars a month and will for years to come, as there is no practical way for the Fed to reverse its very large, deeply underwater mortgage-backed securities investment. 

The Fed created a giant, loss-making mortgage-backed securities portfolio. It currently owns $2.3 trillion in mortgage-backed securities mostly bought at the top of the market when mortgage yields were artificially low. 

Today, these mortgage-backed securities are worth far less than the Fed paid for them. The June 30 Fed financial statement shows an unrealized market value loss of $423 billion on the Fed’s mortgage-backed securities investments. This loss is nearly 10 times the Fed’s financial statement reported capital of $43 billion. 

We say “reported capital” because the Fed has suffered $207 billion in realized cash operating losses that it has amazingly not deducted from its reported capital. Using standard accounting rules, per our estimate, the Fed’s actual capital as of Oct. 30, is $43 billion minus its accumulated cash operating loss of $207 billion; or negative $164 billion.  

In addition, the Fed has $423 billion in unrealized mortgage-backed securities market value losses because interest rates today are much higher than the rates the Fed earns on its mortgage-backed securities. 

The Fed invested in 30-year fixed-rate mortgage-backed securities, almost all of which have remaining maturities of more than 10 years. It earns about 2.2 percent interest on its mortgage-backed securities but pays a 4.9 percent interest rate to fund them. 

The Fed has a negative 2.7 percent spread on these mortgage-backed securities meaning that it costs the Fed an annualized $62 billion to own these securities. Remarkable asset-liability management!  

The Fed’s cash losses are also losses to the U.S. Treasury. So without any congressional approval, the Fed’s very large, very underwater mortgage-backed securities investment is imposing tens of billions of dollars of costs annually on taxpayers.   

According to a congressional testimony about the Fed’s emergency investments by Chairman Bernanke on June 12, 2014: 

“What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the Fed’s balance sheet will be normalized, and there will be no permanent increase … in the Fed’s balance sheet.”

It is now 2024. How long is “temporary”? Why doesn’t the Fed just sell its mortgage-backed securities and put the problem behind it?   

It is not practical for the Fed to sell all its mortgage-backed securities. If it sold them, the Fed would, under the unrealistic assumption that it could sell its mortgage-backed securities at their current estimated market value, realize $423 billion in new cash losses. We estimate that would make the Fed’s capital, measured using standard accounting rules, negative $587 billion. 

While the Fed would, we expect, continue to claim that it had $43 billion in capital, the $423 billion in market value losses would become actual cash losses and have to be reported in the Fed’s profit and loss statement. Reporting such a huge cash loss would not only be an embarrassment but could trigger congressional investigations and unwanted oversight. 

More realistically, the Fed would simply not be able to sell its mortgage-backed securities for its current fair value estimate. The Fed’s $2.3 trillion investment is a massive position. It is so big that in reality it can’t be sold. There are about $9.4 trillion in total mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae of which, the Fed owns almost 25 percent. 

If the Fed tried to quickly sell its portfolio, the sale would crash the mortgage-backed securities market and result in a cash loss much larger than $423 billion. It could reduce the inevitable negative market price impact by liquidating its mortgage-backed securities gradually over time, but the mere announcement that the Fed planned to sell would lower prices in the mortgage-backed securities market. 

Moreover, either approach would push up mortgage interest rates — hardly a welcome political outcome. 

It seems likely the mortgage-backed securities will be on the Fed’s balance sheet until they finally mature. In the meantime, they will continue racking up billions of dollars in cash losses each month. 

It looks like the Fed is stuck with very large, losing “temporary” mortgage-backed securities investments for a long time to come. 

Alex J. Pollock is a senior fellow at the Mises Institute. Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The Revolt at the Fed

Editorial published in The New York Sun:

Congressman Wright Patman was trying to get the Fed audited like any other federal agency. The bank demurred. The late Patman is lucky he’s not alive today, when, as our Alex Pollock has been warning, the Federal Reserve’s real capital is now negative $158 billion. That puts its own light on Martin’s contention that the bank is not part of the government’s three branches. Who’s on the hook for that negative capital?

Should the Fed Be Independent or Accountable?

The central bank has lost all its capital more than four times over, and its real capital today is negative $158 billion.

Published in The New York Sun.

As October 2024 begins, the Federal Reserve’s accumulated operating losses have passed the astonishing amount of $200 billion — to be specific, its losses reached $201.2 billion as of October 2. * Besides far exceeding the Fed’s capital, these losses are also a $201 billion and growing hit to taxpayers.  This alone must call into question the Fed’s claim that it should be “independent.”

Even without the losses, the Fed’s refrain that it both is and should be independent contradicts the fundamental American Constitutional principle that all parts of the government must be subject to checks and balances from others.  The Fed, like all government bureaucracies, yearns to be free from the mere elected representatives of the People. 

Because it is such an immensely powerful part of the government, the Fed especially needs to have the fundamental checks and balances principle firmly applied to it. Nevertheless, the Fed’s independence claim is supported by many commentators, particularly economists and journalists. This seems to reflect the Fed’s formidable public relations skills and the human longing to believe that the inherently uncertain economic world can be taken care of by some benevolent philosopher-kings in the Fed.

Consider that the Fed is in essence an attempt at central planning and price fixing. In this attempt, it uses changing and debatable theories and data reflecting the past.  There is no data on the future. Neither the Fed nor anybody else has the knowledge of the future which would be required to “manage the economy.”  

So the Fed could not, say, know what the results would be of its unprecedented monetizing of $8 trillion in long-term Treasury debt and mortgages, or that one result would be its massive losses. This bloating of its balance sheet by “quantitative easing” was accurately described by the former Fed chairman, Ben Bernanke, as “a gamble.”

The Fed’s efforts share the impossibility of the requisite knowledge with all tries at government central planning, as demonstrated by Ludwig von Mises and Friederich Hayek.  Neither the Fed nor anybody else can know, but only guess about, to take another example, what the celebrated “neutral rate of interest” is or was or will be. 

That this theoretical neutral rate is called “r-star” gave rise to the brilliant and honest aphorism of Fed Chairman Jerome Powell: “We are navigating by the stars under cloudy skies.” While flying by the seat of its pants, gambling with trillions of dollars of other people’s money, and navigating by the stars under cloudy skies, how independent should it be?

In 1964, the Domestic Finance Subcommittee of the House Committee on Currency and Banking held hearings on “The Federal Reserve After Fifty Years.”  The Chairman of the Banking Committee was then the Democrat from Texas Wright Patman.  Among the conclusions were: “An independent central bank is essentially undemocratic”; and “Americans have been against ideas and institutions which smack of government by philosopher-kings.”

These propositions in American political philosophy are still correct. The Fed should not be a philosopher-king. It should be accountable.  My conclusion is that the Fed should be independent from the President and the Treasury Department, but accountable to the Congress. The Congress possesses the Constitutional Money and Taxing Powers which the Fed serves.

We must include taxation because the inflation the Fed creates is a tax, which takes the People’s purchasing power and transfers it to the government. If Congress exercises its authority, it can rewrite the Federal Reserve Act and instruct, redirect, restructure,or even abolish the Fed. It, after all, created the Fed in the first place.

It can review anything about the Fed it wants to.  The definition of the kind of money America will have, whether the nation will have stable prices or perpetual inflation, and if inflation, at what rate, are all essential Congressional responsibilities, not prerogatives of the Federal Reserve.  So are the powers and the organization of the Fed. 

That underscores the need for Congress to review whether it wants a national goal of 2 percent inflation forever with perpetual depreciation of the currency — meaning a policy that the money the government issues should become less valuable.

The financial statements of the Fed also warrant scrutiny by Congress.  Losses of $201 billion compared to the Fed’s total capital of $43 billion means the Fed’s real capital is negative $158 billion.  It has lost all its capital more than four times over.  If the Congress is not happy with a technically insolvent central bank, it could recapitalize it, as part of establishing the Fed’s Constitutional accountability.

___________

* Federal Reserve H.4.1 Release, October 3, 2024, Section 6.

Printing Power: The Central Bank and the State

Based on a speech at the Mises Institute Summit, Hilton Head, South Carolina, October 12, 2024.

“Printing Power” in our title has a double meaning:  it can mean “printing power”—the power to print money which central banks have.  But we will focus on “printing power”—the central bank’s money printing as an essential source of the power of the State, including of course the Federal Reserve’s printing to promote the power of the United States government.

The Fed is good at literal printing, exercising its monopoly of currency issuance granted by the government.  It has outstanding $2.3 trillion in pure paper money circulating around the world, of which perhaps 45% or more than $1 trillion is held abroad.  All the currency represents zero-interest rate financing of the Fed and the U.S. government.  With interest rates at 5%, this means a potential profit of $115 billion a year for them by the Fed’s having issued the currency.

The Fed is also good at metaphorical “printing,” which is simply entering credits on its own books to the deposit accounts of banks.  The Fed thereby creates money which it can use to buy the debt securities of the Treasury—in other words, to lend the printed money to the government.  The Fed now has $4.1 trillion in deposits.

Together then, as of October 2024, there is $6.4 trillion of currency and deposits used to finance the American State’s programs, payroll, interventions, subsidies, and wars.  The Fed can and does use its buying power to keep the interest cost of the government’s debt lower than it would otherwise be.  At peak Fed in March 2022, the Fed owned $8.4 trillion in Treasury debt and government mortgage securities.

Because the central bank prints power for the State, virtually all governments want and have one. 

The real first mandate of every central bank is to finance the government of which it is a part, thereby enhancing and promoting the State’s power.  In addition to lending the government money, the central bank taxes the citizens on behalf of the government by creating inflation.  Taxing by inflation transfers purchasing power from the People to the State without the bother of having to enact tax legislation.  From the viewpoint of the government, the central bank provides a free taxing technique.

The ability to run budget deficits is key to the power of the State.  It wants to keep paying soldiers, buying munitions, paying all the employees of the government bureaucracies, funding its projects, sending money to political constituencies and friends at home and abroad, even if it is out of money.  But it won’t run out of money if it has its central bank to print up what it needs.

You will not find this real first mandate of central banks anywhere in the Federal Reserve’s copious public relations materials.  You will find a lot of discussion about setting interest rates, the “dual mandate” of maximum employment and stable prices (now redefined by the Fed as perpetual inflation), fighting inflation, regulating banks, and promoting financial stability, but never a mention of the essence of central banking: financing the government.

Our colleague Joe Salerno has discussed the evolution of economists from critics to friends of state power.  I will add that running deficits and printing money also allow the government to hire and pay more economists.  As is often noted, the Fed itself is the country’s largest employer of Ph.D. economists.

The First Mandate in Central Bank History

The history of central banks clearly displays their link to government power as a constant theme.  We will review a few examples.

First, the model and most important central bank in the world before it was displaced by the Fed was the Bank of England.  Why and how was the Bank of England created?  As we read in Bernard Shull’s excellent book on the Fed, The Fourth Branch[1]:

          “In 1694, the British Parliament desperately needed funds to finance its [war] with Louis XIV of France.  It accepted a novel plan to establish a bank that would raise capital and promptly lend it to the government at [a] bargain rate.  In return [it] would be granted a charter.  Thus the Bank of England came into existence as an instrument of war finance.”

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

          “The English invent[ed] an efficient centralized credit mechanism for financing war by founding the Bank of England.  The result was to assure Great Britain of naval superiority throughout the early eighteenth century.  Easy credit made it possible to expand the scale of British naval effort quite rapidly whenever a war emergency required.”

In America, Alexander Hamilton, the father of the First Bank of the United States, the ultimate progenitor of the Fed, wrote in 1781:

          “Great Britain is indebted for the immense efforts she has been able to make in so many illustrious and successful wars essentially to that vast fabric of credit raised on the foundation [of the Bank of England].”

Nor was the lesson lost on Napoleon, who created the Bank of France a century behind his British antagonists.  Organizing the bank in 1800, Napoleon rationally said he wanted a bank he could rely on to lend him money when he needed it.

When the Federal Reserve was established another century later, the Federal Reserve Board met in the Treasury Building and was chaired by the Secretary of the Treasury.  It seemed less important then than now.  For a state dinner in its early days, the Federal Reserve Board complained that its members were too far back in the order of entry with insufficient prestige.  They took this complaint to the Treasury Secretary, who took it to the President, Woodrow Wilson.  “They can come in after the fire department,” said Wilson.

Today the Fed is the leading financial fire department in the world, although as James Grant wittily added in the new Mises movie on the Fed, they are also the leading financial arsonist.

What really made the Fed’s reputation was its role in financing the American intervention in the First World War.  Quoting Shull again:

          “When the United States entered the war in April 1917, the System turned its effort to supporting the Treasury’s deficit financing. The Treasury’s plan was to sell securities at as low a cost as possible by arrangements with the Fed to provide for low-cost borrowing to purchase them.  [The Fed] was enlisted in the marketing and promotion of securities.  Banks were encouraged to borrow in order to purchase Treasury securities and to extend credit to their customers to do so.   Preferential rates were established for borrowing from the Federal Reserve Banks to purchase government securities.  The Federal Reserve Banks became great bond-distributing organizations.”

The Fed had energetically carried out its real first mandate.  Said the Treasury Department appreciatively in 1918:

          “Without [the Fed], it would be impossible to finance the tremendous credits required to assist the foreign governments making common cause with us against Germany, and to take care of the extraordinary expenditures entailed by our part in the war.”

Or you might say, the Fed was essential to financing America’s entanglement in the First World War, which led to immense growth in the size and reach of the Wilsonian U.S. government.

Said the Fed of itself:

          “From the outset, [the Federal Reserve] recognized its duty to cooperate unreservedly with the Government to provide funds needed for the war and to suspend the application of well-recognized principles of economics and finance.”

To repeat, a key need of State power is ready and generous deficit financing.  Most recently, this was evident in the gigantic deficits of the Covid financial and economic crisis and the vast subsidies of its aftermath, leading as we have said, to peak Fed in March 2022.

A “Masterful Manipulation”

We will end with a vivid example of the central bank printing power.

At the beginning of the crisis of the First World War in 1914, the Bank of England was the greatest central bank in the world.  Yet the Bank engaged in fraud to deceive the British public in order to finance the British war effort. 

The first big government war bond issue of the war raised less than a third of its target sales to the public, but this real result was kept hidden.  “The shortfall was secretly plugged by the Bank, with funds registered individually under the names of the Chief Cashier and his deputy to hide their true origin,” we learn from a Bank of England article published a century later.  In other words, the Bank of England bought and monetized the new government debt and lied about it to the public to support the government’s war plans.

The lie passed into the Financial Times under the headline, “OVER-SUBSCRIBED WAR LOAN”—an odd description, to say the least, of an issue with its allocation to the public in fact undersubscribed by two-thirds.

But responsible officers of the Bank of England and the British government thought speaking the truth would endanger future government borrowing and be a propaganda victory for Germany.  The famous economist John Maynard Keynes wrote a secret memorandum to His Majesty’s Treasury, in which he described the Bank of England’s actions as “compelled by circumstances” and that they had been “concealed from the public by a masterful manipulation.”

A “masterful manipulation”!  One very helpful to the British State, so it could get itself into the incredible disaster of the First World War.

To sum up:

Central banks are a terrific means to enhance the power of the State by printing power.  They cannot be properly understood without this insight.

---

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

The Fed’s Remarkable ‘Independence’ Claim

Published in AIER’s The Daily Economy.

In the course of human events, the Federal Reserve is constantly declaring itself independent — that it both is and should be independent. The specific issue of whether this unelected body should be independent of the elected President has again been raised in the 2024 presidential campaign. The general issue of whether a central bank as part of the government can or should be independent is classic. 

Given the foundations of American political philosophy, to say that the Federal Reserve should be independent is a remarkable claim. The Constitutional bedrock of the American government is that all its parts be subject to checks and balances from others. Should one immensely powerful part of the government, the Fed, be exempt from checks and balances? It seems to me that the answer is obvious: of course not. 

Yet many people, especially economists and journalists, believe the Fed should somehow be independent. How can this be? That the Fed itself should unendingly promote this idea, and therefore its own power, is not a surprise. Every government bureaucracy yearns to be free of any meaningful oversight and discipline by the mere elected representatives of the People. But by what feat of public relations brilliance did the Fed manage to convince so many others of this hardly self-evident proposition? 

The Fed’s Knowledge Problem 

Put simply, the Fed is an ongoing attempt at central planning and price fixing. It is an unelected committee whose actions are based on debatable and changing theories applied to data which is already from the past by definition. The Fed fixes the price of money, performs various bailouts and lends to the government. (For all this, its preferred, more dignified name is “monetary policy.”)  

The promoters of Fed independence share an unspoken and mistaken assumption: that the Fed is competent to have unchecked power of price fixing and manipulating money and credit–or in a more grandiose vision, of “managing the economy.” Although in fact neither the Fed nor anybody else can have the knowledge required to do this, it is assumed that the Fed knows what the results will be of, for example, monetizing $8 trillion of long-term bonds and mortgages. These unprecedented “quantitative easing” investments were accurately described by former-Fed Chairman Ben Bernanke as “a gamble.” The Fed cannot know what the results of its own actions will be — rather, it is flying by the seat of its pants.  

An insightful old story compares the Fed’s monetary task to trying to land a 747 aircraft with the windshield painted over, and with instruments which tell it only approximately where the aircraft was and approximately how fast it was flying 15 minutes ago. The Fed’s problem is even harder than this, since financial actors are always anticipating what it may do, and therefore the airport it is trying to reach is in effect moving around. Moreover, the Fed has to be constantly busy trying to promote the crew’s credibility and assure the passengers on this 747 that there is nothing to worry about because it is in control. 

Like all attempts at central planning, the Fed’s efforts are faced with recursive complexity and inescapable uncertainty. Although it will have some successes, it is also doomed to recurring failures. It cannot escape the problems of an unknowable economic and financial future and an insufficiently understood present. Even how to interpret the economic past always remains debatable. In short, the Fed inevitably suffers from the knowledge problem of all central planners demonstrated by Ludwig von Mises and Friedrich Hayek.  

Neither the Fed nor anybody else can know, but only guess about, for example, what the celebrated “neutral rate of interest” is or was or will be. That this theoretical neutral rate is called “r-star” gave rise to the brilliant and honest aphorism of Fed Chairman Jerome Powell: “We are navigating by the stars under cloudy skies.” 

How Should the Fed Fit into the Constitutional System of Checks and Balances? 

While flying by the seat of your pants, gambling with many trillions of dollars, and navigating by the stars under cloudy skies, how independent should you be? 

The Chairman of the House Committee on Banking and Currency in 1964 was Wright Patman, a populist Democrat from Texas and sharp critic of the Fed. He conducted hearings that year in which the Committee’s Domestic Finance Subcommittee reviewed in detail “The Federal Reserve After Fifty Years.” Here are some of their conclusions: 

“An independent central bank is essentially undemocratic.” 
“Americans have been against ideas and institutions which smack of government by philosopher kings.” 
“Our democratic tradition alone will be enough to make many thoughtful people demand a politically accountable central bank.” 
“To the extent that the [Federal Reserve] Board operates autonomously, it would seem to run contrary to another principle of our constitutional order — that of the accountability of power. 

It seems to me that these conclusions of 60 years ago are all exactly correct (although I do not agree with other conclusions of the report). 

If one agrees with Wright Patman that government by philosopher kings is contrary to American principles, that the Fed should not try to be a philosopher-king and should therefore be accountable and not independent, the question remains: to whom should the Fed be accountable and from whom independent?  

My conclusion is that the Fed should be independent of the President and the Treasury, but it should be accountable to, not independent of, the Congress. The Congress is the possessor of the Constitutional Money Power (“To coin money [and] regulate the value thereof”) and the Taxing Power (“To lay and collect Taxes”). The Fed serves as a critical part of both. We must include taxation because the inflation the Fed creates is in fact a tax, which takes the People’s purchasing power and transfers it to the government. 

The President and the Treasury 

It is natural that the President and his Treasury Department should want to control the Fed, since this gives them the power to keep spending money when they are in deficit, by having the Fed print it up. Presidents of both parties have often wanted lower, or at least not higher, interest rates for political purposes and used their influence with the Fed accordingly.  

The Treasury Department of course likes lower interest rates which reduce the cost of the debt it issues, and reduce the amount of new debt needed to pay the interest on the old debt. This natural connection was displayed in the original version of the Federal Reserve Act in 1913, which made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board (this provision was in force until 1935). 

For extended times in Federal Reserve history, especially during major wars and emergencies — beginning with the American entry into World War I in 1917 when it was three years old — the Fed has been subservient to the Treasury Department. In these times, the Fed devoted itself to loyally financing the government’s deficit as needed. It did so again during the Covid financial and economic crisis and aftermath in 2020-21. Will the Fed repeat this performance in the future? Given a war or other emergency big enough, it will. 

Historically, under the master politician Franklin Roosevelt, “the Treasury controlled most decisions” and “the Federal Reserve had a subsidiary role,” according to Allan Meltzer’s magisterial A History of the Federal Reserve. Also during this period, the Treasury took every ounce of the Federal Reserve’s gold. Meltzer summarizes this period as the Fed “in the backseat.” 

The intense dispute between President Truman and his Treasury Department, on one side, and the Fed, on the other, in 1951 is notable in Fed history. Truman was in the middle of the Korean War, the American Army had retreated down the Korean peninsula under the Chinese onslaught, and the Treasury had to finance the war. They wanted the Fed to keep buying Treasury bonds at the rate pegged since World War II at 2.5 percent. But in this instance, the Fed thought interest rates should rise a little. Truman told the Fed Chairman, Thomas McCabe, “That is exactly what Mr. Stalin wants. He then in effect forced out McCabe and put in a new Chairman who he thought was his own man, William McChesney Martin of the Treasury Department. Martin, however, favored somewhat higher rates to control inflation and a Fed “independent within the government.” Truman called Martin to his face a “traitor.” 

President Lyndon Johnson had a memorable dispute with the Fed, when the Fed raised interest rates to confront the rising inflation from Johnson’s Vietnam War and welfare expansion deficits. “How can I run the country and the government if… Bill Martin is going to run his own economy?” the furious President reportedly demanded. Martin (who as Fed Chairman was on his fourth President) traveled to Johnson’s Texas ranch to discuss the issue. Johnson called Martin’s action “despicable” and according to one report, physically pushed the proper Martin around the living room of the ranch, shouting at him. Quite a scene to picture. 

We come to the interesting relationship between President Nixon and Fed Chairman Arthur Burns. Meltzer writes, “Ample evidence…supports the claim that President Nixon urged Burns to follow a very expansive policy and that Burns agreed to do it.” In Burns’ defense, Meltzer adds that at that time “many economists and politicians…wanted to reduce unemployment using highly expansive policies.” Wittily and cynically, Nixon said he hoped the independent Fed Chairman would independently decide to agree with the President. 

Burns is said to have remarked with fine irony, “We dare not exercise our independence for fear of losing it.” 

The Fed is always in a web of presidential and financial politics. President Trump’s pressure on Fed Chairman Jerome Powell to lower interest rates, while delivered in some characteristic language, repeated the historical precedents. 

We can safely predict that this natural tension between the President, the Treasury and the Fed will continue into the future as far as we can imagine. Nonetheless, the Fed should be Constitutionally accountable to the Congress, not to the President and the Treasury.  

The Congress 

At all times, the Fed remains a creature of Congress, if the Congress exerts its authority. If Congress has the will and the political forces align, it can rewrite the Federal Reserve Act and in so doing, redirect, instruct, restructure, or even abolish the Fed. In addition, as the then-President of the New York Fed testified during the 1964 hearings, “Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to.” Should Congress audit the Fed? Of course, any time it wants to. 

The definition of the kind of money the nation will have is an essential Congressional responsibility, not a prerogative of the Federal Reserve. Another Congressional responsibility is definition of the powers and organization of the Fed. The Congress in the past has often legislated on these central public questions, including: 

•   The Gold Standard Act of 1900 — defining money. 

•  The Federal Reserve Act of 1913 — creating the Fed. 

•  The Gold Reserve Act of 1934 — taking away the Fed’s gold and taking the country off the gold standard into a fiat paper money standard. 

•  The Banking Act of 1935 — reorganizing and centralizing the Fed. 

• The Bretton-Woods Agreement Act of 1945 — taking the United States into a new international monetary system. Central to it was the commitment to foreign governments that the US would redeem dollars for gold at the fixed rate of $35 per ounce (The dollar has since depreciated against gold by more than 98 percent). In 1971, under President Nixon, the US reneged on the Bretton-Woods Agreement, putting the world on a pure fiat money regime and enabling the Great Inflation of the 1970s. 

•  The Federal Reserve Reform Act of 1977 — trying to make the Fed more accountable to Congress and assigning the Fed its so-called “dual mandate” of maximum employment and stable prices. 

•  The Humphrey-Hawkins Act of 1978 — suggesting a long-term inflation goal of zero if consistent with the dual mandate. 

Regarding the essential political goal of stable prices, in 2012 the Fed on its own authority, without the approval of Congress, redefined “stable prices” to mean perpetual inflation. It unilaterally proclaimed that the United States should have 2 percent inflation forever. At that rate, in a single lifetime of 80 years, average consumer prices will quintuple. Whether America wants that kind of constantly depreciating currency is a fundamental political question for the Congress. 

How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? It suggests a certain arrogance — something a philosopher-king could do, but not a government body subject to Constitutional checks and balances. The idea should have been submitted to the Congress for approval. It wasn’t. 

Therefore I propose a Federal Reserve Reform Act of 2025, numbering among its provisions these: 

• Congress should cancel the 2 percent inflation target set unilaterally by the Fed until Congress has approved that or some other guidance. For better guidance, I suggest price stability. This would mean a long-run average inflation rate of approximately zero — or perhaps for political agreement, between zero and one percent. The Fed should be a key participant in this discussion, but not the decision-maker. 

• Congress should make it clear that the Fed in general does not have unilateral authority to decide on the nature of US money, which is an essential public question, and that any such decision requires review and approval by Congress. 
  

• Congress should seriously review the financial statements of the Fed. Since the Fed has now lost $200 billion over the last two years, it has burned through all its retained earnings and all its paid-in capital more than four times over. This massive loss means that the Fed’s real capital is now negative $156 billion. Any organization that claims independence, even if it doesn’t really have it, ought at least to be solvent. Congress should recapitalize the Fed. 

Such reforms would constrain the Federal Reserve’s declarations of independence with Constitutional accountability. 

Event video: AEI: Is the Federal Reserve Behind the Curve?

Watch the video here.

Event Summary

On October 8, AEI’s Desmond Lachman hosted Donald Kohn of the Brookings Institution, Nathan Sheets of Citigroup, William White of the C. D. Howe Institute, and Alex J. Pollock of the Mises Institute to discuss whether the Federal Reserve was behind the curve in cutting interest rates to support the economy.

The panelists generally agreed that while the Fed has had considerable success in regaining inflation control without inducing a recession, the Fed should be more forward-looking in making its policy decisions. They agreed that the Fed’s task is complicated by a high degree of uncertainty as to future shocks. These included the risk that the Middle Eastern conflict could cause a spike in oil prices and that the commercial real estate sector’s slump could adversely affect regional banks, as well as an unsustainable public debt situation, an increasing tide of protectionism, and the collapse of China’s real-estate market.

Each panelist commented on whether the Federal Reserve’s recent decision to cut interest rates was consistent with meeting its 2 percent inflation target and avoiding an economic recession. They agreed that while signs were encouraging, it was too early make a final judgment. The event concluded with an audience Q&A.

—Jack Rowing

Event Description

Following years of ultra-easy monetary policy, the Federal Reserve has over the past two years pursued a tight monetary policy to regain control over inflation. As inflation shows signs of easing, the debate about the pace of lowering interest rates has intensified.

This event will discuss whether the Fed has successfully achieved a soft economic landing and how Fed policy has affected financial stability.

Submit questions to Jack.Rowing@aei.org or on Twitter with #AskAEIEcon.

Event Materials

Event Transcript

Agenda

2:00 p.m.
Opening Remarks:
Desmond Lachman, Senior Fellow, American Enterprise Institute

2:05 p.m.
Panel Discussion

Panelists:
Donald Kohn, Robert V. Roosa Chair in International Economics, Brookings Institution
Desmond Lachman, Senior Fellow, American Enterprise Institute
Nathan Sheets, Global Chief Economist, Citigroup
William White, Senior Fellow, C. D. Howe Institute

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

3:30 p.m.
Q&A

4:00 p.m.
Adjournment

A European Fannie/Freddie?

A bad idea

Published in Housing Finance International Journal.

The U.S. national housing finance market is uniquely dominated by two government mortgage companies, Fannie Mae and Freddie Mac. They do exactly the same thing, creating mortgage-backed securities that are de facto government-guaranteed. They are both completely dependent on the credit support of the U.S. Treasury, and thus dependent on American taxpayers. Both went broke in 2008, and both were bailed out by the Treasury, which still owns $193 billion of their senior preferred stock, sixteen years later. Both are in an unending conservatorship of a very political government bureaucracy, the Federal Housing Finance Agency. They are in effect a single huge market intervention and subsidy.

Fannie/Freddie are truly massive, with combined assets of US$ 7.6 trillion.1 They create a systemically risky concentration of national mortgage credit exposure in Washington DC. They are and always have been politicized. They are popular with many politicians because they can be used to create subsidies to favored political constituencies without Congress having to appropriate funds. They are highly popular with Wall Street firms because they create securities easy to sell to domestic and global investors by using the credit of the U.S. Treasury.

Fannie/Freddie were central to causing the U.S. housing bubble of 1999-2006 and its subsequent collapse,2 and supported the explosive house price inflation of 2019-2022, which has made U.S. house prices widely unaffordable.

Should the European Union import this dubious American idea? A distinguished committee chaired by the former Governor of the Bank of France, Christian Noyer, thinks so. Its April 2024 white paper, “Developing European Capital Markets to Finance the Future,” proposes a “European securitization platform,” which would “target a massive asset class,” and “target a homogeneous and low-risk asset class, such as residential loans.”

The paper maintains that “a European platform for securitization could be a powerful tool for deepening capital markets.” So it might, but an essential requirement of the proposal is to move credit risk to the government at a combined European level, analogously to what Fannie/Freddie do. “To achieve the objectives the platform must grant a European guarantee of last resort for securitization of mortgage or SME loans.”3 By providing the guarantee, “a common platform would create a new common safe asset.” The safety for the investors comes from the guarantee: “Any residual heterogeneity would be eliminated, from the investor’s point of view, by a broad government guarantee.” In other words, remove the credit risk from the investors by moving it to the government and the taxpayers.

The U.S. model is clearly in mind: “Platforms for issuing and guaranteeing mortgagebacked securities are long-established in the US,” the proposal observes, and “Guaranteed securitized assets broadly work as safe assets, especially agency MBS,4 which are used as collateral in almost one-third of repo transactions in the United States and trade at close to sovereign rates.”

In short, what is being proposed is a European Fannie/Freddie.

Well aware of the housing finance bailouts previously provided by U.S. taxpayers, the white paper sets an “objective of zero cost for public finances” for a European securitization platform. The zero public cost objective is a nice idea, but the American experience warns of many government guarantee schemes which were similarly supposed to be selffinancing, but failed instead. The Federal Savings and Loan Insurance Corporation, the Farm Credit System, the Pension Benefit Guarantee Corporation, the federal Student Loan program, and of course Fannie/Freddie, all became insolvent and costly to the public finances. Confronted by the combination of political pressures to subsidize current borrowers and the uncertainty of future credit crises, it is very difficult for government guarantee programs to achieve their zero public cost aspirations.

The white paper introduces a further difficulty. The platform is to operate with a European-level guarantee, and “supervision at EU-level should be mandatory.” Nonetheless, “The guarantee provided by the platform should be structured to exclude any transfers between Member States.” This is certainly different from the American model with respect to U.S. states. It is impossible to imagine how Fannie/Freddie could operate without pooling income and losses among states, and it is likewise hard to imagine how European-wide guarantees could involve no transfers among Member States. How this is proposed to work is not clear.

The white paper displays a particular danger of all government guarantee schemes. It develops a securitization proposal obviously designed for mortgage loans, based on the need for “low risk” and “homogeneous” loans with a “standardization objective.” Then it slips in, doubtless as a political thought, that maybe the platform could also be used for commercial loans to small and medium-sized enterprises (“SMEs”). Such loans are of an entirely different kind, with fundamentally different risk characteristics. This is a good example of how a government guarantee is always subject to political pressure to move to riskier loans, just as Fannie/Freddie were pressured into buying low quality, nonprime mortgages, helping inflate the housing bubble.

The European Fannie/Freddie proposal has been accurately criticized by Mark Weinrich, Secretary General of the International Union for Housing Finance.5 I will stress four of Mark’s arguments, then state them less diplomatically. His arguments and my changes follow:

Weinrich: “Government backing of mortgage-backed securities can encourage risky lending practices, as lenders may believe that losses will ultimately be absorbed by the government.”

Pollock: “…as lenders will believe that losses will ultimately be absorbed by the government.”

Weinrich: “Government intervention in the mortgage market can distort pricing and allocation of credit.”

Pollock: “Government intervention…will distort pricing and allocation of credit.”

Weinrich: “A centralized entity would concentrate mortgage risk with a single institution, potentially creating a single point of failure.”

Pollock: “…thereby creating a single point of failure.”

Weinrich: “Creating a centralized European securitization platform could increase systemic risk.”

Pollock: “…will increase systemic risk.”

All of these problems have already characterized Fannie/Freddie in the American experience. Creating a massive government guarantee while claiming that it will be selffinancing tempts people to believe it will be free. It won’t be.

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[1] Fannie Mae and Freddie Mac, 10-Q filings, June 30, 2024.

[2] See Peter J. Wallison, Hidden in Plain Sight, 2015; and Alex J. Pollock, Boom and Bust, Chapter 7, “A $5 Trillion Government Failure,” 2011.

[3] We address the troublesome addition of “or SME loans” below.

[4] “Agency” MBS are Fannie/Freddie MBS plus those of Ginnie Mae, which has a separate government guarantee.

Can the Federal Reserve Buy Gold? Should It?

Published in Law & Liberty with Paul H. Kupiec.

Since the sixth century BC reign of Croesus of Lydia, refined gold has served as a monetary store of value. Today, many central banks, including the European Central Bank, the Swiss National Bank, the German Bundesbank, the Bank of France, the Bank of Italy, the Dutch National Bank, the Bank of Japan, the Reserve Bank of India, the People’s Bank of China, and the Monetary Authority of Singapore among others, hold gold as an investment and reserve against their monetary liabilities. It may surprise some that, in contrast, the Federal Reserve owns no gold at all.

The original 1913 Federal Reserve Act required the Fed to hold substantial amounts of gold to back its outstanding Federal Reserve Notes and member bank deposits. In 1934, the Roosevelt administration pushed for, and Congress passed, legislation that made it illegal for US persons, including the Federal Reserve, to hold gold for monetary purposes. Fed resistance notwithstanding, it was required by law to hand over all its gold to the US Treasury. The last link between gold and the US dollar was severed in the early 1970s and all legal prohibitions against US persons buying, selling, and holding gold were repealed shortly thereafter. Fifty years later many US citizens and financial organizations hold gold investments, but the Federal Reserve has not owned any gold since 1934.

This raises two interesting questions: Can the Fed today legally buy, sell, and hold gold? And if it can, should it?

The History of Gold and the US Dollar

From 1900 until 1933, a US dollar was legally redeemable for “25.8 grains of gold nine-tenths fine” or $20.67 per fine troy ounce of gold. On April 5, 1933, one month after taking office, as part of his emergency actions in the financial and economic crisis, following the temporary closing of all banks, President Franklin Roosevelt issued an executive order prohibiting American individuals, partnerships, associations, or corporations from owning (so-called “hoarding”) gold. The order required all Americans to turn in their gold to a Federal Reserve Bank, with criminal penalties for violations, receiving in exchange paper dollars at the official price of $20.67 per troy ounce. This radical executive action was subsequently endorsed in a joint Congressional resolution and later in statute.

That year Congress also passed the Emergency Farm Mortgage Act of 1933. Part 8 of this law empowered the President:

By proclamation to fix the weight of the gold dollar in grains of nine tenths fine and also to fix the weight of the silver dollar in grains nine tenths fine at a fixed ratio in relation to the gold dollar as in such amounts as he finds necessary … but in no event shall the weight of the gold dollar be fixed so as to reduce its present weight by more than 50 per centum.

President Roosevelt soon exercised this power.

The Gold Reserve Act of 1934 required Federal Reserve Banks to send all of their gold to the Treasury in exchange for “gold certificates” with a fixed dollar-denominated value of $20.67 per fine troy ounce of gold transferred to the Treasury. These certificates, still on the balance sheet of the Fed today, cannot be redeemed for gold. The 1934 Act reaffirmed the legal prohibition against Americans owning gold for monetary or investment purposes and further required that circulating gold coins be withdrawn and melted into gold bars, ended gold coinage, and suspended the domestic redemption of US currency in gold.

The day after the passage of the Gold Reserve Act in January 1934 and the transfer of all Federal Reserve gold to the Treasury, President Roosevelt increased the official price of gold to $35 per ounce. The dollar became worth only 15.236 grains of gold nine-tenths fine, or just 59 percent of a dollar’s 1933 value in terms of its legal weight of gold. This generated a large dollar-denominated profit for the Treasury, a profit that would otherwise have belonged to the Fed. 

Since 1934, the US legal price of gold has been increased twice, but now bears no resemblance to gold’s market price. In 1972, the US legal price was raised from $35 to $38 per fine troy ounce. In 1973 it was raised again to $42.22. Today, the market price of gold is about $2,500 per ounce.

There are 480 grains of pure gold in a fine troy ounce. With gold at $2,500 per ounce, one US dollar is worth 0.192 grains of pure gold. In terms of grains of gold, a present-day US dollar buys less than 1% of the amount that a 1933 dollar would buy. Said differently, a penny in 1933 was worth more in terms of its weight in gold than a dollar is today.

In 1971, President Nixon severed the last tie between gold and the value of the US dollar by ending the post-World War II Bretton Woods agreement that gave foreign governments the option to redeem dollars for gold at the official price. Subsequently, Congress passed legislation repealing the sections of the Gold Exchange Act that made it illegal for Americans to own gold, and President Gerald Ford revoked Roosevelt’s 1933 executive order.

Central Banks and Gold

Federal Reserve notes, the circulating currency of the United States, by law, must still be fully collateralized by the Fed. But they are not redeemable for anything except for other Federal Reserve notes, an equivalent value in coins that have no intrinsic metallic value, or a deposit liability of the Fed.

The Fed’s founders would be appalled that the collateral backing US currency does not include any gold.

Many central banks have substantial investments in gold. According to the World Gold Council, the above-ground global stock of gold is approximately 212,582,000 kilograms, about 15.4 percent of which is owned by central banks and national treasuries. Many central banks have experienced significant gains from their holding of gold reserves as the market price of gold more than doubled in the past 6 years. In some cases, recent revaluation gains on central bank gold investments have offset losses on central banks’ investments in long-term fixed-rate bonds.

Source: Authors’ calculations. 2024* is the market price of gold on August 28, 2024. All other prices are year-end market closing prices of gold as reported by moneymetals.com.

According to a recent IMF Working Paper, central banks hold gold because it is “seen as a safe haven,” regarded as “respectable and confidence inspiring,” is liquid, provides portfolio diversification, has historically been a reliable store of value, a hedge against inflation, and a hedge against unanticipated systemic shocks to financial stability. In a 2023 interview, Aerdt Houben, Director of the Financial Markets Division of the Dutch National Bank, explained:

The beauty of gold is that … it retains its value. That’s one of the reasons why central banks hold gold. Gold has intrinsic value unlike a dollar or any other currency, let alone Bitcoin. … It’s a fungible product. It’s a liquid product, you can buy and sell it almost anywhere in the world. … Gold is like solidified confidence for the central bank. … If we ever unexpectedly have to create a new currency or a systemic risk arises, the public can have confidence in DNB because whatever money we issue, we can back it with the same value in gold. … If everything collapses, then the value of those gold reserves shoots up.

The IMF paper discusses how, in recent years, the central banks of Russia, China, India, and Turkey have purchased significant amounts of gold in response to US and allied nations’ financial sanctions. Sanctioned countries’ central banks face restrictions on selling reserves held in US dollars, Euro, and Yen securities. Gold held outside an owner’s country can be impounded. Sanctioned national central banks have responded by buying significant amounts of gold and holding it domestically.

Including gold as an instrument of open market operations would provide the Fed a means of increasing or decreasing bank reserves independent of any direct effect on market interest rates.

Can the Fed Own Gold Today?

The Fed owns no gold or other assets to hedge the interest rate risk of its long-maturity fixed-rate securities. The post-COVID 19 inflation required the Fed to substantially increase interest rates which generated more than $1 trillion in unrealized market value losses on its huge fixed-rate securities portfolio. In addition, it has nearly $200 billion in actual accumulated cash operating losses. With 20/20 hindsight, it is clear that the Federal Reserve System could have avoided some of these losses if, instead of investing only in fixed-rate long-term securities, it had diversified and included some gold in its investment portfolio. But could it have done so?

The current Federal Reserve Act as amended still explicitly states that every Federal Reserve Bank, in its open market operations, has the power “to deal in gold coin and bullion at home or abroad.” The provisions of the Gold Reserve Act of 1934 which made it illegal for US persons, including the Federal Reserve, to hold gold for investment or monetary purposes were repealed long ago. Specifically, the Par Value Modification Act of 1973 repealed Sections 3 and 4 of the Gold Reserve Act of 1934—the sections that prohibited US citizens and Federal Reserve banks from buying and holding gold. Public Law 93-373, signed in August 1974, provided that, after December 31, 1974:

No provision of any law in effect on the date of enactment of this Act, and no rule, regulation, or order in effect … may be construed to prohibit any person from purchasing, holding, selling or otherwise dealing in gold in the United States or abroad.

Moreover, President Ford issued Executive Order 11825 on December 31, 1974, formally revoking President Roosevelt’s Executive Order 6102 of 1933 which prohibited Americans from “hoarding” gold. The provisions of the Gold Reserve Act of 1934 that suspend citizens’ right to redeem Federal Reserve notes for gold at the official price, however, remain in place.

Since the legal meaning of “any person” includes a Federal Reserve Bank, a plain language reading of the 1973–74 legislation suggests that Federal Reserve banks can today buy, hold, or sell gold without limitation in the course of their open market operations and have been able to do so since January 1, 1975.

Can the Fed today legally buy and hold gold? We think so, but thus far we have been unable to confirm our opinion in our discussions with former senior Fed officials and financial market experts—no one seems to know. Nor is this question answered in any of the official Federal Reserve materials of which we are aware and our query to the Fed’s official website remains unanswered. The answer to this question should not be a mystery. The Board of Governors of the Federal Reserve should speak authoritatively on the question and explain why the Fed can or cannot buy and sell gold in the course of conducting monetary policy.

If the Fed Can Own Gold, Should It?

The Federal Reserve is a unique central bank as the sole issuer of the world’s dominant fiat, or pure paper, currency. The global holding of fiat dollars is a great advantage to the US Treasury, famously and accurately characterized by the French in the 1960s as an “exorbitant privilege,” in financing the US government.

At the time of the Bretton Woods Conference in 1944, the chief American negotiator, Harry Dexter White, argued, “To us and to the world, the United States dollar and gold are synonymous.” In 2024, the price of gold and the purchasing power of the US dollar are more like opposites. Does the Fed’s reluctance to hold gold reflect ideological resistance within the Fed and the Treasury to reestablish a distant link between gold and the US dollar, even if gold ownership offered advantages for the Fed’s and the country’s finances?

The Fed’s use of debt securities for open market operations has a direct impact on market interest rates, be they short-term Treasury, long-term Treasury, or repo rates, or the rates paid on government-guaranteed mortgage-backed securities. Including gold as an instrument of open market operations would provide the Fed a means of increasing or decreasing bank reserves independent of any direct effect on market interest rates. If conducted at scale, of course Fed gold dealings could impact the market price of gold and the revenues of gold producers.

One possible problem is that the US legal price of gold was set by statute more than 50 years ago. If the Fed bought gold at $2,500 per ounce, would it have to value gold on its financial statements at its legal price of $42.22 per ounce? Or would the Fed’s power to set its own accounting standards allow it to value gold at its current market price or at historical cost? In the future, when the Fed regains profitability, the accounting treatment of unrealized capital gains on gold would in part determine the Fed’s required remittances to the Treasury once the Fed’s surplus exceeds its legal maximum of $6.785 billion. Could the Fed, as do some other central banks, book gold at historical cost and retain unrealized gains as a “hidden reserve”? Conversely, how would the Fed account for unrealized decreases in the market price of gold?

It is curious that few experts seem to know for certain whether it is legal for the Fed to use gold as an instrument of open market operations. It is also puzzling why there is little if any discussion of the potential benefits or costs of using gold as a tool of monetary policy and as a Federal Reserve asset. We think these issues merit serious discussion.

How Can One Understand the Federal Reserve’s Nearly $200 Billion in Losses?

Published in The New York Sun.

Can you understand how it can be that the Federal Reserve, the world’s greatest and by far most important central bank, has now lost the astounding sum of $193 billion?  If not, one is surely not alone. Since September 2022, the Fed has lost money  every month.  These unprecedented losses continue, and this fall they will in the aggregate pass $200 billion.

The Fed has a powerful mystique, which it works hard at cultivating.  It intensely wants to be credible — that is, for you to believe in it (“credo” in Latin means I believe), and perhaps you do.  The people’s belief is an important source of the Fed’s power, and its power is a key source of the government’s power. 

We can accurately say that the Fed prints power by printing money.  The Fed does not want little things like $200 billion in losses to shake your belief — like the Wizard of Oz, it exclaims, “Pay no attention to that man,” or those losses, “behind the curtain.” It puts its losses behind an accounting curtain that pretends that losses are an asset.

These operating losses are not, as is sometimes mistakenly said, mere “paper” losses. They are real, cash losses. The Fed is suffering negative net interest income because its cost of funds is much greater than the income on its investments. The $193 billion in operating losses exceeds the Fed’s $43 billion in total capital by more than four times.

Thus at present, it has no earnings, no retained earnings, and no capital. In addition to that, it had a mark to market loss of over $1 trillion as of its June 30 financial statements. How can this be? How can the bank with the hugely profitable monopoly of issuing the world’s dominant reserve currency, be losing a fortune?

To understand the Fed, or any central bank, you have to divide it analytically into two different parts, and account for the functions and the profits of the two parts separately. The Fed does not do this, although the logic is classic and was already required for the Bank of England by the Bank Charter Act of 1844, also called “Peel’s Bank Act,” after Sir Robert Peel, the Prime Minister who promoted it. 

The Bank of England was divided by Peel’s Act into an Issue Department and a Banking Department. The idea at the time was to tie the paper currency firmly to gold. That has disappeared in both theory and practice, but the Bank of England still keeps its books according to this fundamental division of functions. So should the Fed.  

The Issue Function of the Fed exploits its government-granted monopoly of issuing the American currency. Its liabilities are the $2.3 trillion in currency outstanding, the paper dollars held not only in America, but all over the world. From a profitability point of view, these are wonderful liabilities for the central bank.

The currency is a non-interest bearing, perpetual, non-redeemable source of funds. The Issue Function’s assets are the $2.3 trillion in investments financed by the currency issued. These investments are typically government bonds.

Why is issuing currency so profitable?  If, in 2023, the Issue Function of the Fed had used its $2.3 trillion simply to buy Treasury bills, it would have received about a 5 percent yield. The result would have been interest expense of zero and interest income of $115 billion.

If operating expenses were $1 billion (a guess), the net profit would have been $114 billion. It looks like the Issue Function unwisely, or perhaps foolishly, invested its funds in long-term bonds at 2 percent, at the bottom of interest rates. Even so, it still had a profit of $45 billion in 2023.

The Federal Reserve as a whole lost $114 billion in 2023, the profits of the Issue Function notwithstanding.  That means that the Banking Function — i.e. the rest of the Fed, with its QE investments, mortgage securities, deposits, loans, expenses, and a lot of risk — actually lost the $114 billion plus the entire $45 billion profit from the Issue Function’s currency monopoly. Thus the Fed’s Banking Function for 2023 lost $159 billion — and that’s only for one year.

For the two years ending this September 30, I estimate the Fed’s Banking Function will have lost about $290 billion.  Quite a number, and the losses continue.  If the Fed were to adopt the two-department approach, it would help the Congress and the public understand what it is doing, with a hat tip to Sir Robert Peel.

BankThink The CFPB is funded by the Fed's profits. Trouble is, there are none

Read the article in American Banker here.

A Monetary Reform Agenda for the GOP, Should It Win the Coming Election

Published in The New York Sun.

It’s been half a century since the collapse of the Bretton Woods gold exchange standard — how do we like the results?

This month will mark the 53rd anniversary of the radical move to a global monetary system of pure paper money.  This system is governed by the changing theories of central banks, especially by the theories of the Federal Reserve, the issuer of paper dollars for the world.

On August 15, 1971, President Nixon felt compelled to renege on the international commitment of the United States to redeem in gold dollars presented to our treasury by foreign governments, and all were forced to set sail on an uncharted sea of fiat currency.

How do we like the results? Since then, average U.S. consumer prices, as measured by the Consumer Price Index, have increased by 670 percent. In other words, the purchasing power of the dollar has fallen by 87 percent.

In terms of its gold value, before 1971 it took $35 to equal an ounce of gold, now it takes about $2,400, a depreciation of the dollar versus gold of more than 98 percent.  In terms of financial stability, there have been financial crises in every decade: the 1970s, 1980s, 1990s, 2000s, 2010s and 2020s.

It’s quite a record for the Nixonian monetary era. Yet the monetary powers granted to our government in the Constitution are granted to Congress, which must bear the ultimate blame for legislating the era of fiat money, meaning paper dollars that must be accepted because of a government fiat.

Suppose that following this year’s election, Republicans control both the administration and the Congress, and suppose they decide to move America to a sounder, Constitutional monetary regime.  Here are eight specific steps they could take.

• Reinforce in legislation the already existing statutory instruction to the Federal Reserve that it is supposed to pursue “stable prices.” This straightforward term has been warped by the Fed’s unilateral announcements that “stable prices” really means perpetual inflation. The Fed’s current theory is that average consumer prices should rise forever, at some rate that the Fed itself would set unilaterally.  Since 2012, the Fed has proclaimed that its “target” for this rate is 2 percent a year, but it believes it could target more inflation, if it decided to — again unilaterally.  

• Formally revoke the 2 percent inflation target proclaimed without congressional debate or approval.  Amend the Federal Reserve Act to make it clear that setting the value of money requires review and approval by Congress — that the Fed may propose, but not decide, the nature of the money the government provides to and imposes on the people.  The central bank is an operational, not an imperial, function.

• Congress should debate and decide what kind of “inflation target,” if any, is consistent with the stipulated goal of “stable prices.”  As a first step, it might set a target at “zero to 2 percent,” so there is no commitment to perpetual inflation.  Or it might specify a long-run average inflation rate of approximately zero, in the context that periods of high productivity growth reduce prices while increasing the standard of living.

• Allow gold-redeemable currencies to compete with the Fed’s paper dollar, consistent with the famous proposal of F. A. Hayek that people should be free to choose the money they prefer.  Hayek’s proposal has been an inspiration for cryptocurrency proponents, but he really hoped it would lead to a remonetization of gold by consumer choice.

• Establish in both the Financial Services Committee of the House and the Banking Committee of the Senate new Subcommittees on the Federal Reserve.  This is to develop the disciplined understanding of central banking issues needed to provide effective oversight of the Fed, its theories, its actions and its risks, which affect every citizen of the United States and every country in the world.  

• Reform the accounting practices of the Federal Reserve, by instructing it to follow GAAP in calculating the Federal Reserve Banks’ retained earnings and capital. The Fed should no longer be able to lose amounts vastly greater than its capital, as it has, and then hide the resulting negative capital. It should honestly report its capital position to the public. Then Congress should consider recapitalization of the Fed.

• Instruct the Fed that its investing in mortgage securities, which is by definition a credit allocation and a market distortion that increases house prices, can only be a temporary, emergency intervention. Specify that the Fed’s more than $2 trillion pile of mortgage securities must be reduced to zero over a reasonable time.

• Finally, Congress should expressly state that it does not suffer from the illusion that the Fed has any special ability to know the future, and that the Fed’s urge to unilateral discretion must be subject to constitutional checks and balances.

Without Chevron, the Fed has crucial questions to address

Published with Paul H. Kupiec in The Hill.

On June 28, the Supreme Court overturned the Chevron Doctrine, which previously allowed unelected government bureaucracies to interpret their governing statutes to stretch and expand their agencies’ powers.

Now, unless regulatory powers are explicit in law, federal agencies’ interpretations of their authority will no longer be given deference by the courts when challenged. Congress should remove legislative ambiguities or risk the uncertainty of potential judicial challenges to Federal Reserve powers.

The Federal Reserve is the most powerful unelected body in the country. What could the demise of the Chevron Doctrine mean for the Fed?

When Sen. Jack Reed (D-R.I.) posed this question during the Fed’s recent semiannual congressional testimony, Chairman Jerome Powell said the Fed was “very focused on reading the actual letter and intent of the law and following it very carefully,” calling the practice “a strong intuitional value that we have.”

“Those are brand-new decisions that just came down, and we are in the process of studying them,” Powell said.

Considering the Fed’s history of expanding its powers using creative interpretations of its authorizing legislation, Powell’s answer made us chuckle. The demise of the Chevron Doctrine gives the Fed’s legal eagles lots to ponder.

First, consider the all-important issue of preserving the value of the dollar. In the Federal Reserve Act, Congress instructed the Fed to pursue “stable prices” — a self-evidently clear direction. The Fed, with no congressional debate or approval, reinterpreted its congressional assignment as a duty to promote inflation at the rate of 2 percent per year forever.

Thus, the Fed, without any change in its congressional remit, construed “stable prices” to mean quintupling prices — reducing the dollar’s purchasing power by 80 percent — over an 80-year lifetime.

Stable prices? George Orwell may still be alive, well and working at the Federal Reserve Board.

While obfuscation of the term “stable prices” may be the most consequential example of the Fed’s failure to abide by the letter of the authorizing legislation, it is by no means unique. Consider the Federal Reserve Board’s decision to design its own disingenuous accounting standards to hide the fact that the combined Fed system losses — $183 billion since September 2022 — have consumed all of the system’s capital, and then some.

The Federal Reserve Act also requires the Fed to publish informative financial statements of the Federal Reserve Banks. While the Fed reports losses, it does not subtract losses from its retained earnings, as any bank it regulates must and as standard accounting rules require.

Instead, astonishingly, the Fed classifies its losses as an asset. It books its losses as the opaquely titled “Deferred asset — remittances to the Treasury.” This dubious accounting allows the Fed to report its capital as positive $43 billion when using standard accounting rules, its capital is negative $140 billion. We have been unable to find the law that authorizes the Fed to create a new accounting standard.

Next, consider the Federal Reserve Board’s decision to continue paying the expenses of the Consumer Financial Protection Bureau (CFPB) notwithstanding the fact that the Fed’s payments to the CFPB have been violating the funding provision of the Dodd-Frank Act since September 2022.

The Dodd-Frank Act created the CFPB and provides for its funding. The act does not classify the CFPB’s funding as a Federal Reserve Board expense, but instead, directs that the CFPB be funded out of the Federal Reserve system’s earnings.

The Dodd-Frank Act requires the board of governors to “transfer to the bureau from the combined earnings of the Federal Reserve System, the amount determined by the director to be reasonably necessary.”

Congress could have made CFPB expenses an explicit expense of the Federal Reserve Board and instructed the Fed to pay the CFPB’s expenses using Federal Reserve Act authority whether the Fed had any earnings or not. But it didn’t.

In May, the Supreme Court affirmed the constitutionality of using Fed earnings that otherwise would have been transferred to the Treasury to pay the CFPB’s expenses. This decision did not consider whether it was legal for the Fed to transfer money to fund the CFPB when the Fed has had no combined earnings.

Under a clear reading of the Dodd-Frank Act and the Supreme Court’s recent decision, when the Fed has no earnings, it has no earnings to transfer to the CFPB, just as it has no earnings to send to the Treasury.

The Fed has not offered any legal defense for continuing to pay the CFPB’s expenses. It owes one to Congress and the public.

Other policy questions arise in the post-Chevron world. These include the authority to take on massive balance sheet risk without approval from Congress — a risk that has generated more than a trillion dollars of unrealized market value Fed losses, engineering international agreements governing domestic bank capital and credit regulations that are, in all but name, treaties that should require Senate approval and actively embracing executive branch climate change policies without explicit congressional authority.

The demise of the Chevron Doctrine creates new uncertainty regarding Federal Reserve powers not clearly enumerated in current law. Unless Congress preemptively addresses legislative ambiguities, the economy will face the risks associated with the uncertain outcomes of potential judicial challenges to Federal Reserve powers.

Newsletter: An update from William Isaac

Published in a newsletter by Secura Isaac:

Weekend Reading

Aug 2

….

My friend Alex Pollock published an important column in the New York Sun titled "The Federal Reserve Lacks the ‘Earnings’ With Which Legally To Fund the Consumer Financial Protection Bureau."

Letter: Who do you think had the biggest US bond expos­ure?

Published in the Financial Times.

“Long-dated bonds are still a dan­ger­ous place to be right now,” an investor in hedge funds is quoted as warn­ing in the report by Kate Duguid and Cos­tas Mour­selas “Hedge funds revive ‘Trump trade’ in bet on US bonds” (Report, July 19).

I would say he is right.

So who would you guess has the biggest naked risk pos­i­tion in very long-dated US bonds and mort­gage-­backed secur­it­ies, super-lever­aged, fun­ded short, and unhedged? None other than the lead­ing cent­ral bank in the world — the US Fed­eral Reserve.

As of July 17, the Fed owns — exclud­ing its pos­i­tion in short-term Treas­ury bills — the vast sum of over $6tn in Treas­ury notes and bonds and very long mort­gage-backed secur­it­ies. Of this sum, $3.8tn still has more than 10 years left to matur­ity, accord­ing to the Fed’s own report.

The Fed had a mark-to-mar­ket loss of over $1tn on its invest­ments in its most recent quarterly state­ment (March 31), against its repor­ted total cap­ital of $43bn. Quite a not­able example of asset-liab­il­ity man­age­ment!

Alex J Pol­lock

Senior Fel­low, Mises Insti­tute, Lake Forest, IL, US

The Federal Reserve Lacks the ‘Earnings’ With Which Legally To Fund the Consumer Financial Protection Bureau

The central bank is in circumstances that the authors of Dodd-Frank failed to anticipate — it’s been operating at a loss.

Published in the New York Sun.

The Federal Reserve cannot legally fund the Consumer Financial Protection Bureau now, because the Fed has no earnings and no retained earnings.

The Supreme Court may have recently affirmed the constitutionality of the bureau’s statutory funding provision “allowing the Bureau to draw money from the earnings of the Federal Reserve System,” as the Court wrote. That, though, does not change the fact that since there are no earnings, there is nothing from which to draw.

The Dodd-Frank Act provides: that each year “the Board of Governors shall transfer to the Bureau from the combined earnings of the Federal Reserve System” the amount determined by the bureau’s director “to be reasonably necessary….” The emphasis was added by the Sun.

The fatal fact for the CFPB is that the Dodd-Frank Act funds the bureau only from the Fed’s combined earnings. The problem is that currently there are no such earnings and instead the Fed is suffering spectacular losses. The combined Federal Reserve has reported losses so far this year at the remarkable average rate of about $7.8 billion per month and has not had a penny of earnings since September 2022.

It has instead accumulated the hitherto inconceivable deficit of $179 billion in operating losses. These losses have wiped out the Fed’s retained earnings of a mere $6.8 billion, leaving real retained earnings of a negative $173 billion, not to mention having also wiped out the Fed’s total paid-in capital of only $37 billion.

The Democratic majority that passed Dodd-Frank on a party line vote in 2010, knowing that it was likely to lose the congressional elections of later that year — as it did — longed to evade having its legislative child, the CFPB, disciplined by the power of the purse of a future Congress.

So it decided to find a way to exempt it from needing any future congressional appropriations. The then-majority’s trick to achieve this was to provide in the statute that the CFPB would get a share of the Federal Reserve’s earnings each year, instead of having to get appropriations from the Congress.

At that point, it was easy to assume that the Fed would always have earnings into which the CFPB could dip. The Fed had been profitable for almost a century. Who in 2010 expected that the Fed would ever show a loss of $179 billion? Nobody at all. Yet the losses continue to mount up.

The Federal Reserve properly stopped sending distributions to the American Treasury in September 2022 because it had no earnings to distribute. It should have stopped sending payments to the CFPB at the same time for the same reason. The Fed is not authorized to send nonexistent earnings to the CFPB or the Treasury.

Under standard accounting principles, the Fed has negative retained earnings, negative capital, and is technically insolvent. For going on two years, it has been borrowing, principally in the form of unsecured deposits in the Federal Reserve Banks, to pay the CFPB’s expenses, thereby making its own retained earnings and capital more and more negative. These payments to the CFPB have not been and are not drawn from earnings.

With the arrival of gargantuan Federal Reserve losses instead of earnings, we have conditions that the authors of the Dodd-Frank Act never thought would happen. Yet they wrote what they wrote, and they voted it in, so now Fed payments to the CFPB violate Dodd Frank. As long as the Fed continues to suffer operating losses, there is no legitimate funding for the CFPB from the Fed. Indeed, the CFPB’s funding has not been legitimate since September 2022.

The logical thing is for the CFPB to figure out how to ask Congress for appropriations and for Congress to be demanding that without appropriations there can be no spending by the CFPB. This would bring about a proper separation of government powers, now that the cleverness of the Dodd-Frank authors confronts an unexpected reality.

Examining the New Debate on CFPB Funding

Published in Patomak Global Partners.

To generalize, one side, led by Hal Scott, Alan Kaplinsky, Alex Pollock and Paul Kupiec, offers a relatively narrower construction of the term that means something like “net income” or “profits,” while the other side led by Adam Levitin and Jeff Sovern, offers a relative broader construction that means something like “any income.” The correct construction of the term appears material to CFPB operations, with the narrower construction perhaps prohibiting transfers from the Board of Governors under present circumstances, whereas the broader construction permits them. The debate has now advanced past the theoretical, with Director Chopra fielding questions about the meaning of the term in Congressional hearings last month. This post does not presume to resolve the debate today, but instead seeks to offer additional context that may be relevant to continued scholarship.

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.”