The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

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

“Earnings” means net profit:

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

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

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

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

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

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

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

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

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

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

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

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

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

Surprise, the Only Constant

Published in the Federalist Society.

A review of Alex Pollock & Howard Adler, Surprised Again! The COVID Crisis and the New Market Bubble (2022)

I approach phenomena that I don’t understand with good cheer and don’t give in to them. I’m above them. Man should be aware that he is above lions, tigers, stars, above everything in nature, even above what is incomprehensible and seems miraculous, otherwise he’s not a man but a mouse afraid of everything.

The House with the Mezzanine: An Artist’s Story, Anton Chekhov

In the late 1980s, the United States experienced what was called the “Savings and Loan Crisis.” Savings and loan associations (S&Ls), firms much like banks, had committed the financial sin of borrowing short and lending long: they borrowed by taking deposits repayable in the near term to finance their making of longer-term thirty-year residential and other real estate loans at fixed interest rates. As interest rates eventually rose, the S&Ls and investment firms found themselves having to pay higher and higher amounts of interest to cover the low fixed amounts of interest they were receiving from their borrowers. That is a financial practice in which one can engage, albeit not indefinitely. Regulators and investors nonetheless were surprised when many S&Ls failed, costing the federal government billions of dollars.

Even after that, in the late 1990s and early 2000s, the government and financial markets incented banks and investment firms to lend to higher-risk low-income borrowers to purchase homes. Policymakers thought sincerely that relaxed lending standards would enable lower-income persons to more quickly and easily realize the American dream of home ownership, which would in turn enable them to build up equity in their newly purchased homes as home values rose. That equity could be used to start a small business or send children to college. Unfortunately, home prices did not continue to rise relentlessly and eventually dropped, leaving lenders with inadequate collateral. As these borrowers eventually were unable to repay their loans, the lenders found themselves holding loans of dubious and uncertain value, and investors were surprised. This all came to a head in 2008 with what is now called the “Great Financial Crisis.” Regulators charged with protecting our financial system were surprised again.

Read the rest here.

June 16 event: The 2023 Bank Runs and Failures: What Do They Mean Going Forward?

Hosted by the Federalist Society.

William M. Isaac - Chairman - Secura/Isaac Group

Keith Noreika - Executive VP & Chairman, Banking Supervision & Regulation Group - Patomak Global Partners

Lawrence J. White - Robert Kavesh Professorship in Economics - Leonard N. Stern School of Business, New York University

MODERATOR

Alex J. Pollock - Senior Fellow - Mises Institute

This year’s sudden collapse of First Republic, Silicon Valley, and Signature banks were the second, third, and fourth largest bank failures in US history, bringing perceived systemic risk and bailouts of wealthy depositors. In addition, the global Credit Suisse bank collapsed and commercial real estate losses threatened. Politicians, regulators, and bankers are debating why the massive regulatory expansion following the last crisis didn’t prevent the renewed failures. Some emphasize repetition of the classic financial blunder of buying long and borrowing short. Others question the 2018 reforms to the Dodd-Frank Act, or cite the monetary actions of the Federal Reserve. Various proposals include more deposit insurance, mark-to-market accounting, higher capital requirements, more stress tests, or bigger regulatory budgets.

Our expert panel discusses the issues and risks going forward, the outlook for new legislation and regulation, and what, if anything, should be done.

Federalist Society virtual event: Cryptocurrency Regulation in the Aftermath of FTX

Hosted by the Federalist Society. Click here for more.

The collapse of FTX has intensified the debate about how cryptocurrencies should be regulated, including proposed federal legislation. With a string of cryptocurrency failures and tens of billions in losses for investors, increased regulation has become a hot topic. As Bloomberg summarized: “Crypto is squarely in the cross hairs of Washington” and “Oversight of digital assets is among the most pressing issues for US financial watchdogs.”

Should cryptocurrency firms be regulated as banks? Should cryptocurrency assets be regulated as securities or as commodities? If so, who is the right regulator? Do we need new federal legislation? With enhanced financial and risk disclosures, should cryptocurrency firms only be subject to standard commercial law and, if they fail, normal bankruptcy proceedings? These issues will be addressed by this fourth in a continuing series of cryptocurrency webinars presented by the Federalist Society’s Financial Services and E-Commerce Practice Group.

Featuring:

The Honorable Cynthia Lummis, United States Senator, Wyoming 

Jerry Loeser, Of Counsel, Winston & Strawn LLP (Retired)

Steve Lofchie, Partner, Financial Services, Fried Frank

Alex J. Pollock, Senior Fellow, Mises Institute

Moderator: J.C. Boggs, Partner, Government Advocacy and Public Policy, King & Spalding

Opening remarks:

The Fed’s Operating Losses Become Taxpayer Losses

Published in the Federalist Society with Paul H. Kupiec.

The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?

The Fed’s Mark to Market Loss Approaches $1 trillion, while the write-off of student loans hits $420 billion

Published in the Federalist Society:

In May of this year, Paul Kupiec and I estimated that the Federal Reserve’s mark to market loss on its unprecedented portfolio of Treasury bonds and mortgage securities had grown to the staggering amount of $540 billion. Now we have the Fed’s official numbers for the end of June, which by then, it turns out, were much worse than that.

Down in the footnotes of the recently released financial statements of the combined Federal Reserve Banks for the second quarter of 2022, we find this startling disclosure: the mark to market loss on June 30 had increased to $720 billion. That’s a number to get your attention, even in these days of counting in billions, especially when compared to the Fed’s reported total capital on the same date of only $42 billion. The Fed’s mark to market or economic loss at the end of the second quarter was thus 17 times its total capital, making it deeply insolvent on a mark to market basis. (Woe to any bank supervised by the Fed which gets itself in the same situation! Oh yes, we know the Fed will earnestly insist that it is different, but that doesn’t change the fact of the market value losses.)

Since the reporting date at the end of June, interest rates have gone higher, the market value of the Fed’s massive investment portfolio has shrunk even more, and the mark to market loss has gotten even more huge. Using the price sensitivity the Fed’s portfolio displayed in the first six months of 2022, we estimate that the market value loss has during the third quarter increased by $275 billion, bringing it to about $995 billion.

The loss is $995 billion now, we guess, but if interest rates rise further toward more normal levels from their previously suppressed lows, the Fed’s mark to market loss will easily reach and exceed $1 trillion. The irony of course is that the Fed was buying heavily to build its $8.8 trillion portfolio at a market top created by its own actions. In addition, the Fed is moving toward generating operating losses, even if it never sells any of its underwater bonds and mortgage securities, because it must finance its long-term fixed rate assets with floating rate liabilities at ever-higher interest rates. These operating losses will mean the federal budget deficit will be bigger since it will lack the normal contributions from Fed profits, possibly for a long time.

In the very same eventful quarter, President Biden ordered (with dubious legality) the government not to even try to collect on hundreds of billions of dollars of defaulted student loans it had made and instead to write them off. The Congressional Budget Office estimates the cost to the budget of writing off these bad debts to be $420 billion. One must conclude that, considered as a lending program, as it was enacted to be, the federal student loan program is an utter and egregious failure. It has its own deep irony, since a decade ago the CBO claimed the program would be a big source of profits to the government.

Consider these two losses together—one in the Fed’s investing and one in making government student loans. It certainly makes one doubt the acumen of the federal government as a financial manager.

Event Sept 14: What’s Next for Crypto: Implications of Deflated Prices and Turmoil in Cryptocurrency Markets

Teleforum hosted by the Federalist Society.

Events of 2022 brought a "crypto winter," with average prices of cryptocurrencies falling about 70% from their 2021 highs, the bankruptcy of several crypto companies, the complete collapse of a popular so-called "stable" coin, unexpected suspensions of withdrawals by some crypto issuers, large losses by individual investors, and heightened efforts toward expanded regulation and legislation.  What does this all mean going forward?  Was this simply the end of another bubble and popular delusion which will now wither?  Or was it the winnowing out of a typical innovative overexpansion, with a more mature ongoing cryptocurrency industry continuing, perhaps one with significant regulation?  This webinar will examine where crypto will go from here.

Featuring:

Bert Ely, Principal, Ely & Company, Inc.

Alexandra Gaiser, Director of Regulatory Affairs, River Financial

Steven Lofchie, Corporate Partner, Fried Frank

J.W. Verret, Associate Professor of Law, Antonin Scalia Law School, George Mason University

Moderator: Alex Pollock, Senior Fellow, the Mises Institute

Register here.

Event: Central Bank Digital Currency--Efficient Innovation or the End of the Private Banking System?

Hosted by the Federalist Society.

Central Bank Digital Currencies (CBDC) are the subject of a global debate.  In one version, individuals and businesses would hold deposits directly with the central bank.  Critics point out that the Federal Reserve would then control how these deposits are used, allocating credit to private-sector borrowers and to government spending, arguing that CBDCs would eviscerate the private banking industry and create government surveillance of all financial transactions in the accounts. An alternate version is that CBDCs take the form of a tokenized dollars, distributed through the banking system and operating in parallel with paper currency and bank accounts.  Supporters say this could yield lower transaction costs and more rapid settlement of payments, and could strengthen the international role of the U.S. dollar.

Featuring:

Bert Ely, Principal, Ely & Company, Inc.

Chris Giancarlo, Senior Counsel, Willkie Digital Works LLP; Former Chairman, US Commodity Futures Trading Commission

Greg Baer, President & Chief Executive Officer, Bank Policy Institute

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

Let Me Vote Those Shares for You

Published in the Federalist Society.

BlackRock’s idea to give institutional clients more control over how shares of stock are voted could be a good step. Some, such as Alex Pollock, say that it is still a ladder with the first rung above the head of most investors.

The fundamental idea of owning stock in a corporation is that shareholders acquire, along with their investment, ownership rights in the company, including the right to vote on company questions commensurate with their investment. These questions can include composition of the board of directors, compensation for company executives, company auditors, and company investment and disclosure policies, among others.

As Alex Pollock notes in an October 13 letter to the editor of the Financial Times, BlackRock acknowledges, “The money we manage is not our own, it belongs to our clients.” Hence, BlackRock’s new policy idea.

. . .

BlackRock hopes to relieve some of that pressure by passing it on to investment funds that place their clients’ money with BlackRock. As Alex Pollock explains in his Financial Times letter, however, “BlackRock is handing zero voting power to the real owners of the shares which it manages as agent.” It is making it easier for others—the fund managers of your investments—to vote your shares, but they do not own your shares. You do, and the BlackRock proposal does not reach to you to learn what you think.

Your broker-dealer cannot vote your shares. In many cases, though, the managers of funds through which you own stock can. They can use your investments to vote as if they were their investments. That can give them a lot of financial and, increasingly, political clout. With your money, they can pursue their agenda, not yours.

Alex Pollock recommends in his letter that “All investment agents, both broker-dealers and asset managers alike, should have the same requirements: no voting of shares by the agents without instructions from the principals.” “From the principals” means from you, the shareholder. That is the requirement for broker-dealers. Why should it not apply to the fund managers who, without your money, would have nothing but their own?

Fireside Chat: Alex Pollock and Fifty Years Without Gold

Hosted by the Federalist Society.

Fifty years ago, on August 15, 1971, President Richard Nixon put the economic and financial world into a new era. Through his decision to "close the gold window," he fundamentally changed the international monetary system into the system of today, where the whole world runs on pure fiat currencies. "The dollar was the last ship moored to gold, with all the other currencies on board, and the U.S. cut the anchor and sailed off." Nobody knew how it would turn out. Fifty years later, we are completely used to this post-Bretton Woods monetary world with endemic inflation and floating exchange rates, and take it for granted. Nobody thinks it is even possible to go back to the old world: We are all Nixonians now. How shall we judge the momentous Nixon decision in its context and since? A fundamental question with pluses and minuses remains. Is the international monetary system now permanently open to more money printing and more monetization of government debt, making faith in central banks misplaced, and expectation of an ideal monetary policy foolish?

Featuring:

• Alex J. Pollock, Distinguished Senior Fellow, R. Street Institute, Author of Fifty Years Without Gold

• Moderator: Hon. Wayne A. Abernathy, Chairman, Federalist Society Financial Services & E-Commerce Practice Group

Event Transcript

[Music]

Dean Reuter:  Welcome to Teleforum, a podcast of The Federalist Society's practice groups. I’m Dean Reuter, Vice President, General Counsel, and Director of Practice Groups at The Federalist Society. For exclusive access to live recordings of practice group Teleforum calls, become a Federalist Society member today at fedsoc.org.

Evelyn Hildebrand:  Welcome to The Federalist Society's virtual event. This afternoon, September 16, we are holding a fireside chat with Mr. Alex Pollock to discuss his recent article published last month and entitled, "Fifty Years Without Gold."

      My name is Evelyn Hildebrand, and I'm an Associate Director of Practice Groups at The Federalist Society. As always, please note that all expressions of opinion are those of the experts on today's call.

      Today we are fortunate to have with us Mr. Alex Pollock and Mr. Wayne Abernathy. I will introduce Wayne, who will be moderating this afternoon's discussion. Wayne is a former U.S. Treasury Assistant Secretary for Financial Institutions, and he's also the chair of The Federalist Society's Financial Services and E-Commerce Practice Group Executive Committee. We're very pleased that he's agreed to moderate this afternoon. He will introduce Mr. Pollock.

      After our speaker gives opening remarks, we will turn to audience questions. If you have a question, please enter it into the Q&A feature at the bottom of your screen. You can enter questions at any time during the program, but we will handle those towards the end of this afternoon. And again, if you have a question, please enter it at the bottom of your screen in the Q&A tab.

      With that, thank you for being with us today. Wayne, the floor is yours.

Hon. Wayne A. Abernathy:  Thank you very much, Evelyn. And very much appreciate all of those who are joining with us, and most especially, I would say, opportunity -- and a pleasure. Whenever you have the chance to sit and have a chat with Alex Pollock, you’ll always learn something and you'll enjoy it. So I think you'll enjoy this conversation today.

      Alex Pollock is a Distinguished Senior Fellow at the R. Street Institute in Washington D.C. He was the principal deputy director of the Office of Financial Research at the U.S. Treasury from 2019 into 2021. I'd also point out that the depth of experience that Alex has is very much hands-on. He was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 through 2004 -- a very eventful period of time in the transition and the evolution of the policies of the Federal Home Loan Bank system, and a lot of opportunities to learn, with hands-on -- working with the financial system.

      He is the author of the book, Finance and Philosophy: Why We're Always Surprised -- much as we were in 2020. I had the privilege, shortly after that book was published, of having an interview like this with Alex on The Federalist Society's tab where we talked about the book and were able to discuss some of the really very important, but also very interesting, points there. And so that's -- if you want, you can go onto The Federalist Society page and probably go and look up Alex Pollock, type in that book, and you might even find that conversation that we had. It was wonderful.

      He is also the author of numerous articles in a variety of different publications and frequent testimony before Congress. Today, we will be discussing some very important issues. I also want to mention -- I thought this was interesting. I was not aware of this, Alex. Alex serves as a director of the Great Books Foundation, where he was chairman of the board from 2006 to 2014.

      Now, as the introduction to what Mr. Pollock is going to talk to us about -- in the class of important anniversaries nearly missed, the most recent August was the 50th anniversary of the day in 1971 when the financial and monetary world changed by the unilateral action of the president of the United States and the U.S. Treasury. Alex Pollock is here today to help us remember, and also to understand why we need to remember, that important event, as well as to understand why it continues to affect the lives of all of us today.

      Alex will offer a few remarks to set the table, then he and I will engage in a bit of a conversation, after which we will turn to the questions that you have submitted to us. Evelyn has explained, you can submit those at any point by just going down to the Q&A tab. The chat tab is, frankly, for you to communicate with other listeners. But if you want to give us a question, use the Q&A tab, if you would do that. We will draw from that Q&A tab and bring those questions to the fore and share them with all of you. And most importantly, Alex will share his answers. And that's the opportunity we'll have. And now let me turn to Mr. Alex Pollock.

Alex J. Pollock:  Thank you, Wayne, very much. As always, it's a real pleasure to have a discussion with you and to be here with The Federalist Society thinking about this 50th anniversary of a truly fundamental and definitive event in the monetary system of the whole world. The system President Nixon created in 1971 is our system of today, and tomorrow, as well, and for as many tomorrows as we can now foresee. And the issues it entails are -- and did entail, starting in 1971 -- are very much still with us in the debates we're having now.

      The title of this essay, "Fifty Years Without Gold" was not what I called the essay for, as you know, the editors get to pick the title of publications. The "Without Gold" title stresses what we don't have. But what I wanted to really stress about the anniversary of August 15, 1971 was what we do have, and still have, and that is to say, a worldwide pure fiat currency -- that is to say, pure paper and accounting entry money system -- everywhere in the world, with floating exchange rates among fiat currencies, hugely powerful central banks, which operate as part of their respective governments. Along with this has come, and continues, endemic inflation, and indeed, central banks, which promise to give us inflation forever -- that is, they promise to depreciate their fiat currencies without limit.

      Now, this is a remarkable contrast. And it all comes from that eventful Sunday announcement in 1971. It's a remarkable contrast to the idea of what was previously called "honest money," which classic central bankers thought they were responsible to maintain. "Honest money" meant money with a stable value, not a constantly depreciating value. But now, we all take for granted as normalcy the system that comes from 1971—a pure-fiat-money, pure-paper-currency system with endemic inflation. That just seems like normal to all of us, whereas before 1971, this world would have been considered extremely abnormal. But nobody now thinks it's possible to go back to that old Bretton Woods system, or before it, a gold-standard-of-one-kind-or-another system. And it probably isn't possible to go back.

      So this brings me to the title of what I called the essay originally -- and the title I like better -- which is, "We Are All Nixonians Now." Yes, when it comes to the world's monetary system, at least, we are all Nixonians now. Now, this is, you will recognize, a play on Nixon's own statement that we are all Keynesians now, as he said. But whereas, in fact, we're not all Keynesians, in fact, we are all Nixonians everywhere in the world, practically everybody who -- at least who thinks about the issue on this topic.

      Now, what does it mean that we're all, everywhere in the world, Nixonians now? Well, part of what we might think about is it's interesting to consider the price -- or what is really more appropriately thought of as the exchange rate -- of gold and the dollar. You will remember that at the time of Bretton Woods, the United States had promised to redeem in gold any outstanding dollar liabilities in the hands of foreign governments. Long before that, they had taken away the ability of US citizens to redeem dollars for gold. But they still promised it for foreign governments at $35 an ounce. So for $35 in dollars, you got one ounce in gold, or alternately stated, for a dollar, you got 1/35 of an ounce of gold.

      Now, of course, it's now about $1,800 an ounce, or alternately stated, about 1/1800 of an ounce of gold for a dollar. And you will see, if you do the math, this represents a 98 percent -- 98 percent -- devaluation of the dollar with respect to gold since Nixon's speech on that Sunday evening in 1971.

      Now, how ironic, in retrospect, is the claim of the principal US negotiator at the Bretton Woods conference, Harry Dexter White, that, as he put it, "The United States dollar and gold are synonymous"? That statement from 1944 sums up nicely the vast gulf between the intellectual world of Bretton Woods and the Nixonian world and the Nixonian beliefs of today. But more important than the role of gold in this discussion -- just as I mentioned in talking about the titles of what one might call this essay -- is the monetary role of central banks as part of their governments, now everywhere in the world.

      As the invitation to this webinar asks, is the international monetary system now permanently open to more money printing and more monetization of government debt, making faith in central banks misplaced and an expectation of an ideal monetary policy foolish? Now, the answers to this series of questions are, yes, yes, yes, and yes. Yes, the international monetary system is now permanently open to more money printing. Yes, the international monetary system is now vastly more open to the monetization of government debt, as we're experiencing these days. We might note it's also open to the monetization of real estate mortgages by the federal reserve big time -- for a couple of trillion dollars -- and to other assets, such as equity securities by the Central Bank of Switzerland, for example.

      And yes, faith in central banks, should you happen to suffer from it, is misplaced. And yes, the expectation of an ideal monetary system is foolish. Such a thing does not exist. There is no ideal. There are only trade-offs. As usual in economics and in politics, everything has a cost and nothing is free. So we should note, for example, while Nixon's decision and announcement of 1971 avoided the default by the United States when people were demanding gold and they would run out of gold, well -- but they could avoid that default only by defaulting on their commitment to redeem dollars at all.

      The next big cost of the decision was the so-called great inflation of the 1970s which was immensely destructive and maybe is a little hard to remember for many people now. But the runaway inflation was the dominant financial reality of the time. Following the inflation of the 1970s came a series of financial crises. First, a disastrous series of crises in the 1980s, and then another series of crises in the 1990s, and then in the 2000s and then in the 2010s, and then, of course, in 2020. So the monetary system of pure fiat currencies and floating exchange rates, which had strong and serious financial theoretical support and practical reasons to do it, has gotten us into -- we might have had them anyway, who knows -- but we have had a whole series of credit and foreign exchange and financial crises—about one a decade.

      Now, what would have happened if President Nixon had made a different decision 50 years ago? First, of course, we have to remember that Nixon and his advisors, as you may remember, went for several days to Camp David to debate all this and work this out. And they knew at the time -- and we should remember that nobody knew what would happen after this announcement. They decided what they were going to do, but then nobody really knew how it would turn out. But they did know that they had to do something. It looked like there was a building run on gold, and of course, like any fractional reserve system, the United States had many multiples of dollar liabilities outstanding greater than the amount of gold they had as people started to demand their gold back. And France is a particular example.

      In retrospect, it's a great decision they made to take the gold instead of the rapidly depreciating dollar. Other countries at the time did not demand gold, particularly the ones that were most dependent on United States military protection and were big dollar holders— namely Germany -- West Germany, at the time -- and Japan, were loyal holders. And they took the losses when we reneged on Bretton Woods. But certainly, others were demanding gold. And France, notably, was demanding gold. And they could see the gold running down. So they had to do something.

      Secretary of the Treasury Connally, at the time, said, "We're sending out our gold by the bushel full," or words to that effect. We've got to do something and we've got to do it now. So that's what they decided to do. So they had to do something, but they didn't have to just cut off the redemption in gold. They could have devalued the dollar in terms of gold. And they knew that. That had various problems with it. One, it's very politically unpopular to announce you're devaluing your currency. Now, note, what they did resulted in devaluation, but it wasn't formally a devaluation.

      And the uncertainty is also hard. If you devalue, you have to devalue to some other number, but what is it? $70 an ounce? The Prime Minister of England suggested a decade before, to President Kennedy, "You're at $35 an ounce, just go to 70." Well, that would be a 100 percent rise in the gold price or fall in the dollar. Would it be -- one of my academic friends suggested to me recently, they should have gone to $100 an ounce in '71, and that would have been better. But nobody knows. You can't even know in retrospect, let alone for them at the time, what the right number was.

      Now, two of the participants at Camp David before the 1971 announcement -- namely, the chairman of the Federal Reserve, Arthur Burns, and a future famous chairman of the Federal Reserve, Paul Volcker -- both favored trying to keep Bretton Woods going, effectively devaluing, working it out with the other countries. But that was not the decision. The decision was to stop redemption of gold. However, even then, in his speech, President Nixon -- and I remind you this was a Sunday evening at prime time and on TV. They cut off other popular programming to bring you this announcement announcing the suspension of gold convertibility, along with other things -- and by the way, blaming it all on the international money speculators.

      But what Nixon said, specifically, was, "I've ordered Secretary Connally, temporarily, to cease redemption of gold." Temporarily. Well, of course, it turned out to be permanent, and maybe will always be permanent. But at the time, they thought maybe it would be temporary and they'd work something else out. So you have all this uncertainty. They had to do something. They could have done other things, but this is what they did choose at the time. And it's a choice that we still have today. So what did happen was, for the first time ever in history, in peacetime, there was a worldwide fiat currency system. Note that it was common in wars to debase your currency and print up however much money you needed to pay the soldiers and to buy the ammunition and the tanks. But in peacetime, this is the first time ever.

      And so here we are now, with this system. Now, and going forward, we’re all Nixonians. And they have these problems, like, if it's just up to the central banks, as part of the governments that they are, to print up however much money they want, well, where does the discipline come from? Why don't you print up any amount and have as much inflation as somebody might be surprised by? But you caused it anyway. And there's, of course, the temptation of politicians who always want to spend to make their constituents happy. Suppose you can spend without taxing. It's kind of a political dream to just have the central bank print up what you need.

      Borrow the money from the central bank, which is really just borrowing the money from yourself, which is really not borrowing at all. It's printing it up. This opens the temptation to so-called modern monetary theory. I write that "modern" monetary theory because printing up the money is an exceptionally old financial idea. And so we have all these temptations. We're living them now. How much printing can there be without doing serious damage? And it all goes back to Sunday evening, August 15, 9:00 p.m. Eastern time, President Nixon's famous announcement, which we need to remember because it's so important for now and in the future. Thanks, Wayne.

Hon. Wayne A. Abernathy:  Thank you, Alex. Plenty of interesting things there. And not knowing quite where to begin, let me go back to a historical question to help this conversation go forward. And I want to really go back to the Bretton Woods system. This was created -- the system -- in the midst of World War II. And it was, supposedly, to be something that was going to last as far as the eye could see. It was supposed to be a new way of dealing with the issues of how the countries exchanged with one another and traded with one another, and so forth.

      And so the question I have -- was the Bretton Woods system doomed to, eventually, the kind of failure where you would get a significant country like the United States -- or maybe a France or another country -- that would have its currency so far out of whack that the only way that you could address the problem would be to suspend that system? Or could they actually have muddled along?

Alex J. Pollock:  Bretton Woods, as you say, Wayne -- and that's a really good question -- was created -- it wasn't quite in the middle of the war. It was 1944 when they could see the end coming. And they wanted to avoid the mistakes that had been made after the First World War and then led into the 20s and the 30s. And I think they did a pretty good job. When you think Bretton Woods didn't last very long, as a historical idea -- I mean, it was approved by the Congress and became law, or became an agreed-upon international treaty, in 1945. It lasted until 1971. So that's 26 years—not very long. But on the other hand, as a human creation, maybe 26 years is pretty good.

      It survived through the amazing rebirth of economic growth and rebuilding of the world after the unbelievable destruction of World War II. So it had a good day. But did it have a fatal flaw? The fatal flaw -- you said that some country -- they knew that any time you set parities -- because under Bretton Woods, you had a fixed exchange rate between major currencies -- everybody had a say. Alright, it's four pounds to the dollar -- four dollars to the pound, or four Deutschmarks to the dollar, as it was, or four Swiss francs, and so on. But they knew that those would need to be adjusted from time to time, that things would change, some people would do better than others, some people would have more inflation, some would be more competitive, and you'd have to change them. And so they built the changing the parities into the system.

      And then they built in, through the original meaning of the international monetary fund, a kind of bank to finance the period of tension when things had to be changed. But what couldn't be changed in Bretton Woods was the unique position of the United States. Everybody pegged their currency to the US dollar, and the US promised to redeem dollars in gold. And that, as it became clearer -- as the 1950s and 1960s progressed -- and it seemed especially clear to the French who described this arrangement as the exorbitant privilege given to the United States because it meant the United States could run up its foreign debt the way no one else was allowed to. And the French resented this greatly. And perhaps others did as well, but the French were very vocal about it.

      Anyway, so you had this unique position of the United States. Now, did that mean the system had to fail? I don't -- it certainly meant that you’d have to have a big change someday when it turned out that the parity set for the dollar was not sustainable. Would that have happened without the Vietnam War and the Lyndon Johnson guns and butter inflation? Maybe not. So it depended on the -- you might say on the international geopolitics of the world and the American role. But it certainly did give a unique role for the United States. As I said before, could it have been fixed by just adjusting the parity—the dollar—so you depreciated the dollar against gold? After all, whether you have enough gold or not depends on the price. I mean, if you make the exchange rate in dollars -- on enough dollars per ounces of gold, you'll always have enough gold. Those are all imponderables. But it certainly had -- Bretton Woods, like all human creations, had built-in tensions and problems just like the current Nixonian system does.

Hon. Wayne A. Abernathy:  It sounds like, from what you're saying, Alex, that the Bretton Woods system, as it was put in place, given the prominent role of the United States, was that it was to act as a discipline on United States economic policy.

Alex J. Pollock:  Yes, that's true. Yes.

Hon. Wayne A. Abernathy:  And Nixon, in essence, decided, rather than face that discipline, "I'm going to throw it off." Is that correct? Would you say that's right?

Alex J. Pollock:  I think that's right, although it was too late by then. By the time Nixon was looking at this problem -- and his very smart and top-class set of advisors all gathered out there at Camp David -- by that time, it was too late to face that this would -- the dollar was going to go down one way or another because the lack of discipline all happened during the 1960s with the run-up of US foreign obligations and US inflation. But yes -- and that's, of course, one of the things the French really resented was that everybody else was disciplined by the system, but not the United States in the short run although the system was intended, as you so rightly say, to be a discipline in the long run. And the redeemability of a currency is always a discipline on the central banks printing, and on the government spending.

      Well, of course, governments and central banks don't like to be disciplined by something outside themselves, like a need to redeem. And the United States didn't either. And as I said, you have to think about it in the context -- the Cold War is on, there’s world geopolitical competition going on, you have the amazing recovery of the European and Japanese, in particular, economies by this time. So there are going to be these stresses. I don't think Bretton Woods could have survived without major changes, like in the US dollar parity. Whether it could have been adjusted, of course, is one of those things that you can always debate because no one knows what the true counterfactual would have been.

Hon. Wayne A. Abernathy:  Taking a step from then into today -- still, the significant role of the United States -- the United States dollar in the global economy continues, maybe not quite as much as it was in '71, but it still predominates. What is the discipline on the US dollar today? Or on US economic policy, vis-à-vis the global community? We understand the disciplines we have within the United States. What acts as a discipline globally? Or does the rest of the world basically just have to take how US economic policy is affecting the dollar and affecting them?

Alex J. Pollock:  Yes. That is a key point. I think one of the surprises out of 1971 and the cutting off of redeemability was the dollar continued right on as the world's dominant currency in spite of the fact that it depreciated a lot. I mentioned -- well let's think of the Swiss franc, since it didn't turn into the euro -- four Swiss francs to the dollar in 1971. Today, less than one Swiss franc will buy you a dollar; 360 Japanese yen in 1971 -- today, less than a hundred or so. So the dollar did have tremendous depreciation. But its amazing role as dominant international currency continues. And along with that, the ability -- the exorbitant privilege, as the French said, to get other people to finance you by holding your liabilities, continues.

      Well, the reason for that is the underlying, enterprising strength of the American market economy and its huge size relative to other people. But note -- put all the euro countries together; they're about as big as the United States. They don't have that dollar, so there are some other things in there as well like the deficit in the financial markets. But I think it is a surprise that, having cut off what -- at least if you were Harry Dexter White -- you thought was an essential idea, as did most people at this time -- this link of gold to the dollar -- now suddenly, that went away. But the dollar is still dominant, and we still maintain our exorbitant privilege. So now believers in cryptocurrencies and bitcoins think that those might change it, but that's another discussion.

Hon. Wayne A. Abernathy:  That is another discussion, and certainly one that we can look at another time. I do note, though, that at least for the last several years, there's been, at least, talk at the European community that they would like to see the euro be something of a challenge to the dollar in terms of its international role. So far, that hasn't gone very far. I was at a meeting a few years ago in Beijing where we had -- through translation, I heard -- I presume the translation was fair -- we had a speaker from the Chinese Communist Party, making a very impassioned speech about how the role of the US dollar had to end. But I haven't seen anything that's really done that. But I think, to the extent the Bretton Woods system assumed that the US role was permanent, is it a mistake to assume that the US dollar role today is a given, or can't actually -- or could actually become a troubled thing?

Alex J. Pollock:  Well, if we were having this webinar in, let's say, July 1914, instead of August 1914 -- in July 1914, we would’ve assume that the dominant worldwide role of the pound sterling -- which was the king currency of the whole world and the currency of the capital markets capital of the world, namely London -- looked pretty solid. And it wasn't, as it turned out. It was basically destroyed by the First World War, which gave the dollar the chance to assume its then-dominant role in New York to replace London, basically, all as a result of the printing that all of the countries involved in the First World War did to finance the war and to destroy the value of their currencies while they were at it.

      So no, nothing is permanent. We know that. All things are tradeoffs. And certainly, both Chinese and Europeans and bitcoin enthusiasts and whatnot think, "Well, couldn't we replace the role of the dollar?" And I don't think you should always -- you should never assume such things can't happen because the world has a way of surprising us. As an author of a book once said, "We’re always surprised." And our imaginations do not limit the possibilities of the world, just like, I think, the world was surprised by Nixon's action in 1971 -- still with us today. I don't think there's much chance we're going back to pre-1971, but in the fullness of time, it seems to me, we certainly could go to something other than we've got.

      You asked me before, Wayne, and I didn't answer, "What is the limit, or what is the discipline?" And of course, the limit of money-printing -- whether you call it modern monetary theory or something else -- is always destruction of the value of the currency, otherwise known as rapid inflation. And that will destroy wages and destroy savings. It does it slowly if the inflation is fairly low. But it does it rapidly and noticeably if the inflation is high. The Federal Reserve, in December last year, predicted 2021 inflation would be 1.8 percent. That was another of their completely mistaken forecasts, of which there are many over the years.

      And one of the reasons why it's so hard to have discipline on central banks is that nobody, including the central banks themselves, really knows what the results of their actions will be. But the discipline is, I believe -- and the most important one -- the [inaudible 00:36:19] between, as I said, what they used to call "honest money" -- that is to say, money that maintained its value versus a money -- which it becomes clear, both to the domestic population and to the international holders -- is rapidly depreciating in value. And that is an ongoing discipline, which, I believe, cannot be avoided.

Hon. Wayne A. Abernathy:  That brings me to the other question I'd like to ask. And perhaps, as I ask this question, and Alex answers it, you may have some questions you wish to point. But this is -- as you're mentioning, the discipline sounds like there is, in a sense, a market discipline there, that whatever you try to do to avoid the markets, the markets assert themselves. And I'm wondering, wasn't it better to replace the Bretton Woods system of government-pegged values with a system where the markets, by and large, decided the values of currency? We, in essence, have that domestically, but we didn't have that internationally. But now, don't we have both?

Alex J. Pollock:  Well, domestically, we have, of course, vibrant markets. We hope to keep them vibrant under the various pressures of the day. But we also have a mandated single currency. Now, if you were really a total free-market thinker, you might like to have, as Friedrich Hayek proposed in 1974, multiple currencies operating within a domestic economy, as well. That’s one of the foundational ideas of the cryptocurrency -- the multiple competing currency.

      Now, at the time, in 1971, of course there were strong voices. Milton Friedman was the leading thinker of this, saying, "Well, of course you have to have floating exchange rates because nobody knows what the right exchange rate is." George Schultz, who was one of the principal advisors at the Camp David meetings leading up to Nixon's announcement, favored floating exchange rates. And theoretically, it's appealing, isn't it? You say, "Well, we don't know what it should be, so we'll let the market decide." And that's what most people still think. As I said in the article, if you ask almost any economist, "Was this a good thing that Nixon did in 1971?" they say, "Absolutely. Get rid of this outmoded link to the barbarous relic, as Keynes called gold, and we just have a market."

      And you know, that's an argument, but it doesn't get you to the point I'd like us all to understand. It doesn't get us to the ideal world. It gets us to a world where there's still plenty of problems -- like, where, then is the discipline because it really isn't just a market. It's a market plus the manipulations of the central banks. That's what the exchange market is, just like interest rates. We don't have an interest-rate-free market. In fact, everyone runs around saying, "Well, the Federal Reserve sets interest rates." That's the opposite of a market idea. You don't have the market setting interest rates. Same is true of exchange rates. There is a market, but there is also the interventionist manipulative activities of all the various central banks in this market. And that's one reason why we can be sure that we won't ever reach the ideal world.

Hon. Wayne A. Abernathy:  One of our participants has a question now, if I can put that to you. And I think it ties into this discussion where we are. It reads as follows, "Some historians to Roman times link debasing the currency -- Roman times of printing money, or as they would make impure gold -- to the need to tax capital to tackle inequality. Do you see any linkage to these three issues—inequality, capital taxation, and the non-gold free printing of money by the global superpower?" That's the question.

Alex J. Pollock:  Well, I'll just start off by saying, I mentioned that "modern" monetary theory is one of the oldest ideas. And this questioner, by bringing up the Romans -- and before that, the Greeks -- depreciating the currency was an idea that was already there. I have to just take a minute to tell one of my favorite stories, which is the story of the tyrant Dionysius of Syracuse, who borrowed money from his subjects, found that he was unable to pay in silver, as he had promised. So his response was simply to expropriate all the silver coinage—the drachmas—from the citizens. They had to turn them in to the government on pain of death. And after they turned them in, he melted them down, and restamped, according to the story, each one drachma coin, two drachmas, and then paid off the debt. Well, that's exactly what governments and central banks do now. And that's a form of taxation.

      So if your idea is that you want to take money from some people and give it to other people, well, debasing the currency is one way to do it. It's a very handy way for politicians to do it because you don't have to enact any legislation. You just do it through your central bank. It's a sneaky way of taking some people's money and giving it to the people who vote for you. I have to tell, in this context -- thank you, whoever you are, for the great question -- do you know the difference between banking and politics? You may have heard this before, Wayne. I don't know. What's the difference between banking and politics? Banking is borrowing money from the public and lending it to your friends. Politics is taking money from the public and giving it to your friends. And debasing the currency is one way to do that.

Hon. Wayne A. Abernathy:  Another question, here. And actually, this is -- if you're willing to take something -- a cryptocurrency question, if I may.

Alex J. Pollock:  Oh, sure.

Hon. Wayne A. Abernathy:  Someone has asked that.

Alex J. Pollock:  Sure.

Hon. Wayne A. Abernathy:  Here's the question. "So, are cryptocurrencies a new step away from monetary discipline, or a step back toward them? And depending upon the nature of the cryptocurrencies to those which countries would benefit, and so forth, under what we see out there, are there certain countries that benefit more than others?"

Alex J. Pollock:  Well, I think that a pure cryptocurrency, like Bitcoin, is an ultimate fiat currency because although we have fiat currencies pure paper, they are hooked to governments who have armies and force and the ability to make people do things. A Bitcoin is a pure fiat currency. It isn't redeemable in anything. It gives its holder no right to any collateral or redemption, and also, it doesn't have any force behind it. So, that's maybe even a purer fiat currency, a privately issued -- a key theoretical point in all this is, can a privately-issued fiat currency, as opposed to a government-issued fiat currency, actually serve as a currency? And I think the answer to that, actually, is no, but we're still experimenting with that in the market.

      So-called stable-value currencies are, themselves, backed by other fiat currency. They're just a dollar substitute—a kind of payments mechanism. And some of them, at least, say, "Well, we are backed by the so-called dollar reserves." But they're pretty reticent about saying what those dollar reserves consist of. But note, the currency does not give you the right to redeem in dollar reserves, at least in some cases. And depending on what reserves -- as so-called -- you choose to hold -- let's say you'd like to have some junk bonds in your reserves, or Russian debt, or whatnot, what you have is exactly a bank, and the problems of any fractional reserve bank. Maybe the assets won't be sufficient to cover your liabilities. And there -- you're just going to repeat banking.

      Now, as to what countries could benefit -- I think if you talk about cryptocurrencies and countries, then you shift into this very current debate, on which I have written, about whether central banks themselves should issue cryptocurrencies or digital currencies. I guess you can't call them, really, cryptocurrencies if they're issued by the central bank, but it's the same idea. Should there be a pure digital currency issued by various central banks? And then some people say, "Well, this is another way that China wants to create a more powerful currency for itself, and therefore, a more powerful government, by having a Chinese popular central bank or government-issued digital currency." Should the Federal Reserve issue its own digital currency?

      What you might think -- just build on the -- if it succeeded -- on the already existing dominance of the US dollar in international payments. It would certainly make the central banks more dominant than the private banks, which is one of the big drawbacks to them. Remembering that, a long time ago, central – I say, take the Bank of England -- was set up as a special bank with special privileges, but it was a general bank. It did business with the public and made loans. Well, a central bank, which became the dominant deposit-taker through its digital currency, and thereby had all this money, which it had to do something with, and so it made loans. It would be kind of a retrogressive movement backwards in central bank history to central banks, which are competitive with all the private banks as opposed to having a particular role.

      So none of these things are clear, as always, in economics and finance. And I have a saying, which is, "In every economic question, you can always find numerous economists on both sides, or perhaps on all sides, of the issue." Which only shows, it's not a science. It's a kind of philosophical theory. And that's certainly true of all these questions of cryptocurrencies and how this will or should play out.

Hon. Wayne A. Abernathy:  I think it also shows that, really, many of these questions -- certainly with regard to currencies and money and so forth -- they aren't as new as we may think them to be.

Alex J. Pollock:  Oh, for sure.

Hon. Wayne A. Abernathy:  They are really quite old, aren't they?

Alex J. Pollock:  Yes, for sure.

Hon. Wayne A. Abernathy:  Here's a question I think relates to that. "Would you be in favor" -- this is one we've received here from one of our participants -- "Would you be in favor of a return to a gold-based monetary system if it ever became politically possible. And would this require a change in legal tender laws to allow gold to legally compete with the central bank fiat money?"

Alex J. Pollock:  Yes. Well, I think what I would be in favor with, in lines of Hayek's theory, is competitive currencies. If you had a currency, redeemable in gold at a given rate -- you know, get such and such an ounce of gold for whatever unit of this currency is -- that might be a very interesting experiment to let it compete with the fiat currency issued by the government in the form of its central bank -- and used to finance potentially limitless deficits through monetization, as I said before, let alone mortgages, through monetization.

      However, there's very little chance that any government would like this idea of allowing competitive currencies. On the issue of legal tender, that's a really important one, historically. At one time, 150 years ago in this country, the issue of legal tender was one of the hottest topics. And there were a series of interesting cases which ended up in the Supreme Court about whether it was constitutional for the United States government to have made its non-redeemable paper currency during the Civil War a legal tender that you had to take if you had previously entered into a contract requiring payment in gold. And as you may remember, the Supreme Court first held that it was unconstitutional, and then President Grant appointed a couple more justices, and the next time around, they held that it was constitutional. But it was a big issue in the day.

      And that's an issue we've sort of forgotten about, the forcing of currency on the public -- which is a fiat currency through legal tender. Of course, that had a rerun in the 1930s, when the United States government -- what seems amazing now -- confiscated all the gold of its citizens, gave them paper money -- depreciated paper money, instead. It happened in 1933. That ended up in the Supreme Court, too. And the Supreme Court held, by a vote of 5-4, that the government, being a sovereign, had the power to do this because if you're a sovereign, you can do these sorts of things.

Hon. Wayne A. Abernathy:  As I recall, then --.

Alex. J. Pollock:  Even for The Federalist Society, a fundamental philosophy, Wayne.

Hon. Wayne A. Abernathy:  Oh, absolutely. And I think these constitutional questions are important. That's why you have a constitution, is to try to deal with these perennial questions. And in that case that you mentioned, I think there is also the issue of whether the paper, or debt, of the government, that said it was to be paid in gold -- and the government said, "Well, we're not going to pay that in gold anymore" -- whether that was unconstitutional. As I recall, the courts upheld that as well.

Alex J. Pollock:  No, you're absolutely right. That was. They used the same cases. And you're absolutely right. Nobody disputed, including the government itself, that the clear and unambiguous commitment of the government to pay in gold on its bonds had been made. But I like to summarize this in the following saying, "What does it mean to be sovereign when it comes to debt? It means if you don't feel like paying, you don't have to. You just default, just like Nixon in '71." Well, I know we entered into these Bretton Woods agreements saying we would redeem these dollars, if you're a foreign government, for gold. But by the way, we're not doing it.

      And of course, this was extremely controversial at the time. A lot of other foreign countries and their governments were up in arms about this. And you may remember, there's a well-known -- I was going to say famous, but maybe it's notorious -- statement of the Secretary of the Treasury, John Connally, at the time, who said to the Europeans, who were upset, "It's our currency, but it's your problem."

Hon. Wayne A. Abernathy:  That reminds me of the Pollock law of finance, as I recall, which is, "Debts that cannot be repaid, will not be repaid."

Alex J. Pollock:  Thank you. Absolutely right.

Hon. Wayne A. Abernathy:  It's a matter of who bears the loss, really.

Alex J. Pollock:  That's exactly right. Exactly right. And we're going through that again now, in the aftermath of the Covid crisis and its financing. Now, it's going to be all about who bears the loss. Well, one of the ways you force people to bear the loss is by inflating, is by monetization, and putting the loss on the holders of your currency or savings denominated in your currency.

Hon. Wayne A. Abernathy:  And now, a question here. As we've been talking about the role of gold, one of our participants asked this question, "What about other commodities being the support for currency? Doesn't a floating exchange rate system just replace gold as a reference commodity with currency itself, or are there other commodities that could compete with gold and be, maybe, more broadly accepted domestically or internationally?"

Alex J. Pollock:  That's a classic question, as well, and a good one. And many people have proposed some kind of a basket of commodities that might be a basis for a currency. Theoretically, you could certainly imagine it. You know, you get some kind of a generalized commodity index or something. It's hard to do practically because how do you form the index? And what are the weightings? And the world changes and -- just like it did for the Bretton Woods parities -- but it’s certainly, theoretically, conceivable. Gold is handy, as we know, because it lasts forever and it doesn't rust, and it's fairly small, if you want to carry some coins around as one family of famous investment bankers who got out of Germany in time -- 1938 or so -- said, "The only real wealth is what you can take with you inside a toothpaste tube or sewed inside your clothes." And gold qualifies there.

      But this is a classic and perfectly sensible idea. As I remember, Irving Fischer, who wrote a wonderful book on the money called The Money Illusion -- the difference between the real inflation-adjusted value of money and the nominal value of money -- back in, I don't know, 1910, or something like that, later on, was one of the followers of central banks trying to stabilize prices, as they used to do, as opposed to constantly inflating prices. And he, as I recall, had some kind of an idea like this, of a basket of commodities you're trying to stabilize against. I think it's one of those things it's harder to do in practice than in theory.

Hon. Wayne A. Abernathy:  And I have a short question that's been asked here, but I presume the answer is not short. But, "Do you have a definition of 'the dollar?'"

Alex J. Pollock:  Well, yeah. That's an easy definition. It's a unit of account on the books of the Federal Reserve. It's sometimes represented by a piece of paper that says, "This is one dollar." Or you can exchange that piece of paper. It interchanges with the books in the Federal Reserve for an accounting entry called "the dollar," whereas, of course, before, at least if you were a foreigner, the definition of a dollar was 1/35 of an ounce of gold.

Hon. Wayne A. Abernathy:  In essence, what fiat currency has done is made it a flexible definition.

Alex J. Pollock:  Yes. Well, and of course, if you're a central banker or a politician, that's what you like. You know that, Wayne, having worked on legislation.

Hon. Wayne A. Abernathy:  We're getting near the end of our time, but I do want to -- this further question, which goes to one that I've had for a while. As you know, a question I've had is, "When the Bretton Woods system disappeared, why did the Bretton Woods institutions remain?" And someone -- one of our participants is asking the question -- is maybe the IMF special drawing rights work as some kind of basis for global currencies?

Alex J. Pollock:  Well, that's what they thought in the 1960s, when these were created, the special drawing. Of course, the special drawing rights are only a basket of fiat currencies. But that's what they were hoping at the time because, already in the 60s, one of the things that President Nixon said in his speech in 1971 was, "We keep having these dollar crises, one a year." And this was all during the 60s as the US deficits were higher and inflation was higher, and the dollar was under pressure, and people were building up large-dollar claims in foreign hands. And SDRs were meant to be a potential way around it. It never seemed to have worked too well, but it definitely was the theory at the time.

      Can I just stick in one more comment? I meant to say this before. In the 1971 speech, of course, it wasn't only about stopping to redeem dollars for gold. It was also an amazing thing, really, for what you would have thought a basically market-oriented administration to do -- was to put in wage and price controls. And you, before, Wayne, said something -- "Well can't you just control these things? But does the market ultimately overcome them?" And of course, that's what happened in the early 70s. They put in wage and price controls. It turned into a vast bureaucracy. It didn't succeed in the end. And when they finally had to be taken off, then the inflation exploded in the mid-1970s and on. So, yes, you try these control mechanisms, but in the end, they won't work either.

Hon. Wayne A. Abernathy:  Well, as with all very fascinating conversations, the clock is against us. And it would pretty much run out of the time we've allocated. But this conversation, of course, will continue. One that we really didn't get into as much, and we'll certainly save that for another day, is how the end of Bretton Woods opened up the door for just, almost, limitless deficit spending all around the world, for economies all around the world.

Alex J. Pollock:  Oh, yes. And what we have today -- that's why this is so relevant. What we have today -- deficit spending is made possible by monetization, which is the freedom of the central banks, which as I suggested, you should not foolishly have faith in -- all created by the action of President Nixon 50 years ago. So this is history, but it's also very lively today and going forward. We’re living in this Nixonian world with all of the problems that go along with it.

Hon. Wayne A. Abernathy:  Where do we find the discipline? And that's, of course, the question.

Alex J. Pollock:  Yes.

Hon. Wayne A. Abernathy:  Any final words before we conclude?

Alex J. Pollock:  Well, that's a great final question. So let's work on that. Where do we find the discipline? We know that under the Constitution of the United States, the discipline is supposed to come from the Congress. The money power is clearly vested in the Congress. And one of the astonishing acts of arrogance, really, was the Federal Reserve saying, on its own, it could set an inflation target, and depreciate the currency infinitely. Now, can we get such discipline from the current Congress? Doesn't seem too likely. But one might hope that there would be a Congress, someday. These are deep and hugely important, but classical, problems. Unfortunately, answers aren't that easy.

Hon. Wayne A. Abernathy:  Thank you very much. Wonderful discussion. And certainly, as we say, the conversation will continue. Evelyn, I think the time is back to you— Evelyn Hildebrand, from The Federalist Society.

Evelyn Hildebrand:  Yes. Thank you very much to you, Wayne and Alex, for this great discussion. Thank you to our audience. You sent in questions and comments and participated. Very grateful for everyone's time this afternoon. If you have any questions or comments for The Federalist Society, please send those to us at info@fed-soc.org. And we welcome your comments. And I would only add our gratitude to our speaker and our moderator this afternoon. And with that, we are adjourned. Thank you, everyone.

[Music]

Dean Reuter:  Thank you for listening to this episode of Teleforum, a podcast of The Federalist Society’s practice groups. For more information about The Federalist Society, the practice groups, and to become a Federalist Society member, please visit our website at fedsoc.org.

What Does the Fed Know that Nobody Else Knows?

Published in Law & Liberty and in the Federalist Society.

When it comes to the financial and economic future, everybody is myopic. Nobody can see clearly. That includes the Federal Reserve.

As François Villeroy de Galhau, the Governor of the Bank of France, recently said in a brilliant talk, central banks are subject to four uncertainties. These are, in my paraphrased summary:  

1) They don’t really know where we are.

2) They don’t know where we are going.

3) They are affected by what other people are going to do, but don’t know what others will do.

4) They know there are underlying structural changes going on, but don’t know what they are or what effects they will have.  

Yet it appears that central banks usually feel the urge to pretend to know more than they can, in order to inspire “confidence” in themselves, and to try to manage expectations, while they go on making judgments subject to a lot of uncertainty, otherwise known as guesses.

A refreshing exception to this pretense was the speech Federal Reserve Chairman Jerome Powell gave in last August at the annual Jackson Hole symposium, 2018. He reviewed three key “stars” in monetary policy models: u* (“u-star),” r* (“r-star”) and ϖ (“pi-star,”), which are respectively the “natural rate of unemployment,” the “neutral rate of interest,” and the right rate of inflation.  None of these are observable and all are of necessity theoretical, so in a clever metaphor, Powell candidly pointed out that these supposedly navigational stars are actually “shifting stars.” Bravo, Mr. Chairman!

Let’s consider this question: What does the Fed know that nobody else knows? Nothing.

Can the Fed know what the right rate of inflation is? No. Of course, it can guess. It can set a “target” of steady depreciation of the dollar at 2% per year in perpetuity. Can it know what the long-term results of this strategy will be? No.

Moreover, nobody knows or can know what the right interest rate is. That includes the Fed (and the President). Interest rates are prices, and government committees, like the Federal Open Market Committee, cannot know what prices should be. That (among many other reasons) is why we have markets.

The Wall Street Journal recently published an article by James Mackintosh, “Fed Is Shifting the Goal Posts, and Investors Should Care.” With shifting goalposts or shifting stars, the Fed cannot know where they should be, but investors should and do indeed care very much about what the Fed thinks and does.

This is because, as we all know, the Fed’s actions or inaction, and also, financial actors’ beliefs about future Fed actions or inaction, can and do move prices of stocks and bonds substantially. Indeed, the more financial actors believe that Fed actions will move asset prices, the more it will be true that they do.

Mackintosh discusses whether the Fed’s inflation target will become “symmetric”—that is, the target would change into an average of periods both over it and under it, rather than a simple goal. Thus, sometimes “inflation above 2% is as acceptable as inflation below 2%.” Ah, the old temptation of governments to further depreciate the currency never fades for long.

“Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds,” the article reports, and opines that the change could have “big implications for markets,” that is, for asset prices. That seems right.

But the 2 percent inflation, whether as an average or as a simple goal, “isn’t up for debate.” Why not? The Humphrey-Hawkins Act of 1978, the same act that gave the Fed the so-called “dual mandate” which it endlessly cites, also set a long-term goal of zero inflation. What does the Fed think about that provision of the laws of the United States?

A true sound money regime has goods and services prices which average about flat over the long term. But being prices, they do fluctuate around their stable trend. The Fed, like other central banks, is in contrast committed to prices which rise always and forever. Discussing which of these two regimes we should want would focus consideration on where the goalposts should be.

Mackintosh worries that there may be a “loss of faith in the Fed’s ability.” On the contrary, I think a lack of faith in the Fed’s ability is rational, desirable, and wise.