Macro or Micro, Blinder Can’t Sell Bidenomics

Published in The Wall Street Journal.

Mr. Blinder wants to compare Mr. Biden to former President Franklin Roosevelt, but the current president doesn’t display the supreme deviousness and talent for manipulation, wrapped in rhetorical brilliance, of Roosevelt. There is, however, an important parallel.

In 1944, the Democratic Party bosses knew that whoever got nominated for vice president had a high probability of becoming the president, as indeed happened when Roosevelt died three months into his new term. They forced sitting Vice President Henry Wallace to be replaced on the new ticket by Harry Truman, luckily for the country and the world. Are the current Democratic bosses as smart and as responsible as the old pols of 1944?

At AEI, a Monetary Panel Expressed Pessimism About Inflation

Published in Real Clear Markets.

“While their conjectures are as speculative as any vulnerability identified in an official financial stability report, unlike official financial stability reports, they have the freedom to identify government policies and regulatory shortcomings as vulnerabilities,” Kupiec said.

The first panelist to speak was Alex Pollock, distinguished senior fellow at R Street Institute, a free market think tank in Washington, DC. Pollock mentioned several possible causes of the next financial crisis, including errors in judgment by the world’s central banks, a housing-market collapse, a future pandemic, or war. He cautioned that a crisis could be caused by a factor that “nobody sees coming,” which would inevitably hamper state response.

“If the next crisis is again triggered by what we don’t see, the government reaction will again be flying by the seat of their pants, making it up as they go along,” Pollock said.

Read the rest here.

Financial Triangle

Published in Barron’s.

Henry Kaufman, as quoted by Randall W. Forsyth in “Where Wall Street’s ‘Dr. Doom’ Sees Danger Now” (Up & Down Wall Street, March 12), is so right that we have a “dangerous dependency on the Fed” and that “the central bank and the Treasury are ‘joined at the hip.’ ” Of course, a core mandate of every central bank is to finance, as needed, the government of which it is a part, although you won’t find this in the Federal Reserve’s public-relations materials. The close link of the Fed and the Treasury goes back to the Fed’s 1913 chartering act, which originally made the secretary of the Treasury automatically the chairman of the Federal Reserve Board.

But now, the joining at the hip is even tighter than Kaufman suggests, because it includes the mortgage market, too. With its $2.1 trillion and growing mortgage portfolio, the Fed owns about 20% of all residential mortgages. It buys mortgage securities with the guarantee of Fannie Mae and Freddie Mac; but with virtually no capital of their own, the value of Fannie and Freddie’s guarantees is completely dependent on the Treasury. Moreover, the Treasury is their principal owner.

Thus, the real joining at the hip is not only the Fed and the Treasury, but also the Fed and the Treasury and Fannie/Freddie—a gigantic government financial triangle.

The unstable stability council

From American Banker’s Bankshot Podcast:

R Street’s Alex Pollock appears on the most recent Bankshot Podcast. At first the Financial Stability Oversight Council wanted to target individual nonbanks that pose a risk to the economy. Now it wants to target activities rather than firms. Is that a good idea or a political ploy? 

Click here to listen to the pull podcast.

Is Dodd-Frank council evolving, or throwing in the towel?

Published in the American Banker.

“In my judgment at the time” the FSOC was established was that “it was not well constructed,” said Alex Pollock, a senior fellow at the R Street Institute. “It’s set up to be naturally a logrolling operation among bureaucratic agencies. It’s a very hard kind of structure to get to work well, because everybody wants to defend his own territory from encroachment by somebody else.” 

Pollock said the council’s ability to prevent crises should not be the sole criteria for judging the shift toward an activities-based approach, because the alternative of designating firms one by one might not succeed, either. “I think it’s worth a try.”

Hume’s Timely Political Advice from 1741

Published by the R Street Institute.

I am neither surprised nor upset by the divisive partisanship of current times. Emotional partisanship is nothing new in the world. But we certainly must condemn the bad manners it now engenders.

David Hume, the great philosopher, economist and historian, reflected calmly on partisan passions in 1741, in his Essays Moral and Political. Here are some relevant excerpts (with ellipses deleted):

“There are enow of zealots on both sides who kindle up the passions of their partisans, and under pretense of public good, pursue the interests and ends of their particular faction.

“Those who either attack or defend a minister in such a government as ours, where the utmost liberty is allowed, always carry matters to an extreme, and exaggerate his merit or demerit. His enemies are sure to charge him with the greatest enormities, both in domestic and foreign management, and there is no meanness or crime, of which in their account, he is not capable. On the other hand, the partizans of the minister make his panegyric run as high as the accusations.

“When this accusation and panegyric are received by the partizans of each party, no wonder they beget an extraordinary ferment on both sides, and fill the nation with violent animosities.”

Hume included this excellent and timely advice for us, reading it 277 years later:

“For my part, I shall always be more fond of promoting moderation than zeal. Let us therefore try, if it be possible to draw a lesson of moderation with regard to the parties into which our country is at present divided.”

Good manners should control our behavior, whatever our feelings may be inside, and moderation frees the mind to think. Like Hume, let us be fond of promoting it.

When a bureaucracy is so independent it’s unconstitutional

Published in the Federalist Society.

In a conceptually important opinion, the 5th U.S. Circuit Court of Appeals has ruled the governance structure of the Federal Housing Finance Agency (FHFA) to be unconstitutional. This powerful agency is the conservator and regulator of the giant mortgage firms Fannie Mae and Freddie Mac, which combined have more than $5 trillion in assets, and is also the regulator of the Federal Home Loan Banks, which have more than $1 trillion in assets. That gives the FHFA broad power over $6 trillion of mortgage financing.

To meet the fundamental constitutional requirement, says the court, all elements of the government must reflect the separation of powers, or checks and balances, among the three main branches of legislative, executive and judicial. Without question, this principle is central to the constitutional order. Therefore, while agencies in the federal bureaucracy can be set up with varying degrees and modes of independence, the court finds, there is a limit to how independent they may be.

When do they have too much independence?  The answer is when “independence” of an executive bureaucracy becomes “insulation” or “isolation” from presidential control. Thus:

If an independent agency is too insulated from executive branch oversight, the separation of powers suffers…excessive insulation impairs the president’s ability to fulfill his Article II [of the Constitution] oversight obligations…

For these reasons, agencies may be independent, but they may not be isolated.

According to the circuit court, what pushes the FHFA over the constitutional line is no one factor, but multiple factors in their combined effect. These factors include:

• There is a single director of the FHFA.

• The director cannot be removed by the president except “for cause,” that is for failure to perform the job, criminal behavior or moral turpitude. The director cannot be fired for normal reasons, including taking actions contrary to the policy of the president.

• There is no bipartisan commission structure overseeing the agency.

• Its funding escapes the congressional appropriations and the power of the purse and is outside the federal budget process.

• There is an oversight board but it has no authority, only an advisory role.

Putting all of this together, the court writes:

We hold that Congress insulated the FHFA to the point where the executive branch cannot control the FHFA or hold it accountable.

That is presumably what Congress was trying to do when it created the FHFA amidst the growing financial crisis of 2008. But under the Constitution, they are not allowed to do it. So:

We conclude that the FHFA’s structure violates Article II. Congress encased the FHFA in so many layers of insulation…that the end result is an agency that is not accountable to the president… his ability to execute the laws—by holding his subordinates accountable for their conduct—has been impaired. In sum, while Congress may create an independent agency as a necessary and proper means to implement its enumerated powers, Congress may not insulate that agency from any meaningful executive branch oversight.

Considering this conclusion, another bureaucratic agency leaps to mind: the Consumer Financial Protection Bureau, or as it is now known, the Bureau of Consumer Financial Protection. It is surely unconstitutional on the same grounds!

But no, says the court, and differentiates the two cases, therefore not contradicting the recent judgment of the D.C. Circuit that the CFPB structure is constitutional. The distinction is the partial oversight of the CFPB, but not the FHFA, by the Financial Stability Oversight Council. In my opinion, the distinction is not convincing, and both bureaucracies are excessively insulated and fail the relevant test. But that is not how the opinion turned out.

The court limits its conclusions to the FHFA, finding that it is a unique case:

The FHFA is sui generis, and its unique combination of insulating features offends the Constitution’s separation of powers.

To remedy the problem, says the court, the provision limiting removal of the FHFA Director to “for cause” situations must be deleted from the chartering act, the Housing and Economic Recovery Act of 2008 (HERA). Then the life of the FHFA can go on, although its director’s job tenure becomes less secure and more subject to the judgment of the president.

“We leave intact,” the court concludes, “the reminder of HERA and the FHFA’s past actions … In striking the offending provision from HERA, the FHFA survives as a properly supervised executive agency.”

Thus the final outcome is quite narrow, though important, but the concepts of how to assess whether a federal agency exceeds its allowable independence seem possibly to open broader considerations.

Designation of Fannie Mae and Freddie Mac as SIFIs

Published by the R Street Institute.

Dear Secretary Mnuchin:

The Treasury Department has just issued a new review of “Financial Stability Oversight Designations,”[1] and we are writing to you in your capacity as Chairman of the Financial Stability Oversight Council (FSOC) that is responsible for implementing financial stability oversight designations. In the context of FSOC’s responsibility to address systemic financial risk, we would like to address a major omission in its past work, and make three fundamental points:

1. Fannie Mae and Freddie Mac are two of the largest and most highly leveraged financial institutions in the world. Fannie Mae is larger than JPMorgan or Bank of America; Freddie Mac is larger than Wells Fargo or Citigroup. They fund trillions of dollars of mortgages and sell trillions of dollars of mortgage-backed securities and debt throughout the financial system and around the world. The U.S. and the global economy have already experienced the reality of the systemic risk of Fannie Mae and Freddie Mac. When their flawed fundamental structure, compounded by mismanagement, caused them both to fail in September 2008, there can be no doubt that without a bailout, default on their obligations would have greatly exacerbated the financial crisis on a global basis.

2. We respectfully urge that Fannie Mae and Freddie Mac be designated as Systemically Important Financial Institutions (SIFIs) so that the protective capital and regulatory standards applicable to SIFIs under the law can also be applied to them. These two giant mortgage credit institutions clearly meet all of the criteria specified by the Dodd-Frank Act and implementing regulations[2] for designation as a SIFI. They also meet the international criteria of the Financial Stability Board for designation as a Global SIFI (G-SIFI).

3. Fannie Mae and Freddie Mac continue to operate in “conservatorship” and now have an even greater market share than before, based on an effective guarantee of all their obligations and mortgage-backed securities by the U.S. Treasury. Conservatorship status obligates the federal government, absent a change in the law, to return them to shareholder control after they have been stabilized financially. The Congress has, with much accompanying debate but no action so far, considered a variety of legislative reform measures with respect to the two companies. Whether or not Congress changes the law, we believe it is essential for Fannie Mae and Freddie Mac to be designated as SIFIs.

Why is Richard Cordray voting on FSOC?

Published by the R Street Institute.

The Financial Stability Oversight Council (FSOC) just made the good decision to remove the designation of the insurance company American International Group as a “SIFI” or “systemically important financial institution.” This was a good idea, because the notion that regulators meeting as a committee should have the discretion to expand their own power and jurisdiction was a bad idea in the first place – one of the numerous bad ideas in the Dodd-Frank Act. The new administration is moving in a sensible direction here.

The FSOC’s vote was 6-3. All three opposed votes were from holdovers from the previous Obama administration. No surprise.

One of these opposed votes was from Richard Cordray, the director of the Consumer Financial Protection Bureau (CFPB). Wait a minute! What is Richard Cordray doing voting on a matter of assessing systemic financial risk? Neither he nor the agency he heads has any expertise or any responsibility or any authority at all on this issue. Why is he even there?

Of course, Dodd-Frank, trying to make the CFPB important as well as outside of budgetary control, made him a member of FSOC. But with what defensible rationale? Suppose it be argued that the CFPB should be able to learn from the discussions at FSOC. If so, its director should be listening and by no means voting.

Mr. Cordray, and any future director of the CFPB attending an FSOC meeting, should have the good grace to abstain from votes while there.

And when in the course of Washington events, the Congress gets around to reforming Dodd-Frank, it should remove the director of the CFPB from FSOC, assuming both continue to exist, and from the board of the Federal Deposit Insurance Corp. while it is at it, on the same logic.

FSOC is too political to be taken seriously

Published in American Banker.

The Financial Stability Oversight Council is a political body masquerading as an analytical one. A dubious creation of the Dodd-Frank Act, it reflects that law’s urge to expand the power of bureaucrats, in turn reflecting the implausible credo that they can control “systemic risk” because they know the financial future better than other people. They don’t.

The expected result of a committee of heads of federal agencies chaired by the Treasury secretary is a politicized process. This was undoubtedly the case with the council’s attempt to designate MetLife as a “systemically important financial institution.” It should not be surprising that a U.S. District Court judge threw out the designation, ruling that it was “arbitrary and capricious,” and “hardly adhered to any standard when it came to assessing MetLife’s threat to financial stability.” In dissenting from the council’s action on MetLife, S. Roy Woodall — the FSOC’s statutorily required independent member with insurance expertise — said the designation relied on “implausible, contrived scenarios.”

Decisions concerning “systemic risk,” an unclear term in any case, cannot be purely analytical and objective. They involve generalized and debatable theories. They are, to a significant extent, inherently judgmental, subjective and political. The FSOC effectively sits as a miniature, unelected legislature. That is a bad idea.

The fundamental problem is the structure of the FSOC as designed by Dodd-Frank. To begin with, it is chaired by the Treasury secretary, a senior Cabinet member who always has major partisan interests at stake. No company can be considered for SIFI status without the Treasury secretary’s approval. This means that, by definition, the FSOC’s work is not a disinterested, analytical process. An administration is positioned to pick winners and losers. Under the Obama administration, MetLife was in the crosshairs, but Fannie Mae, Freddie Mac and Berkshire Hathaway were off-limits.

Meanwhile, most other FSOC members are heads of independent regulatory agencies, strongly motivated by bureaucratic self-interest to defend their jurisdictional turf from intrusions by the others, and to defend their regulatory records from criticism.

This conflicts with the ostensible purpose of the FSOC: to provide the combined substantive deliberation and development of insights into evolving risks from a diverse group of officials. The expectation that that purpose could be achieved was naive. When I asked one former senior FSOC official from the Obama administration if the meetings of the FSOC members had ever provided a new insight, he gave me a candid answer: No. One can hypothesize that the authors of Dodd-Frank were in fact not naive — that they welcomed another way to expand the reach of the administrative state.

The FSOC’s decision-making authority grants significant regulatory power to Treasury, as well as to members who help decide which firms are SIFIs and which are not. But that’s only the beginning, since the designation process also grants enormous power to the Federal Reserve. If an insurance company becomes designated by the FSOC, it falls under the Fed’s supervisory authority, even though the Fed has little or no experience in insurance regulation. Every head of the central bank who participates in FSOC designations is an interested and conflicted party in discussions that result in expanding the Fed’s authority. The politicization also leads the FSOC to ignore companies that more objectively deserve the SIFI label. The most egregious case of this, of course, is the council’s utter failure to address Fannie Mae and Freddie Mac, which are without question very systemically risky. On top of being huge, they are incarnations of these systemic risk factors: highly leveraged real estate and the moral hazard created by government guarantees.

Dodd-Frank assigns the FSOC the task of “eliminating expectations on the part of shareholders, creditors and counterparties that the Government will shield them from losses.” But Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses. But the staff of the FSOC was ordered not to study them—a bankruptcy of the FSOC’s intellectual credibility.

It appears that the FSOC has so much baggage that the best approach is simply to scrap it. If a truly independent, analytical systemic risk regulator is desired, it should be created outside of the Treasury’s political control.

Pollock before Oversight Subcommittee

Here’s more from R Street Distinguished Senior Fellow Alex Pollock’s testimony before the House Committee on Financial Services on the arbitrary and inconsistent non-bank SIFI designation process.

A flawed process generated by a flawed structure

Published by the R Street Institute.

Testimony to the Subcommittee on Oversight and Investigations
U.S. House Committee on Financial Services

Madam Chairman, Ranking Member Green and members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I spent 35 years in banking, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago, and then 11 years as a fellow of the American Enterprise Institute, before joining R Street last year. I have both experienced and studied numerous financial crises and financial cycles, including the political contributions to their creation and the political reactions afterward, and my work includes the issues of banking systems, central banking, risk and uncertainty in finance, housing finance and government-sponsored credit, and extensive study of financial history.

To begin, let me compliment the committee staff for their detailed, specific paper on the FSOC’s non-bank designation process. The paper embodies a very good analytical idea: it “compares the FSOC’s evaluation memoranda [of various companies] against one another to measure the consistency of the FSOC’s analysis.” This comparison, as documented in the paper, results in the conclusions that the treatment of different companies is not consistent, that FSOC did not follow its own formal guidance, and in summary, that the evaluations upon which companies either were or were not designated as systemically risky (as “SIFIs”) “have been characterized by multiple inconsistencies and anomalies on key issues.”

The paper says that “These examples cast doubt on the fairness of the FSOC’s designation process.” They do, but in my opinion, the more important point than fairness, is that the observations cast doubt on the objectivity of the FSOC’s work. Were these evaluations impartial analyses looking for disinterested conclusions, or were they rationalizations for conclusions already reached in political fashion?

As we all know, U.S. District Judge Rosemary Collyer, in her decision on the lawsuit MetLife brought against FSOC, found for MetLife and ruled that FSOC’s action was “arbitrary and capricious.” I want to focus on one of the reasons stressed by the judge: the assumptions FSOC made to arrive at its proposed designation.

Considering hypothetical losses resulting from MetLife, Judge Collyer’s Opinion pointedly observes that: “FSOC assumed that any such losses would affect the market in a manner that ‘would be sufficiently severe to inflict significant damage on the broader economy.’ …These kinds of assumptions pervade the analysis; every possible effect of MetLife’s imminent insolvency was summarily deemed grave enough to damage the economy.” [italics mine]

But the judge continued: “FSOC never projected what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result.” [original italics]

Further, “FSOC was content…to stop short of projecting what could actually happen if MetLife were to suffer material financial distress.” FSOC’s work appears pretty pathetic in this light, doesn’t it?  FSOC “hardly adhered to any standard when it came to assessing MetLife’s threat to U.S. financial stability,” the judge found.

This sound and sensible judicial decision was appealed by the previous administration. I believe the current Treasury Department should immediately request the Department of Justice to withdraw the appeal, and that Justice should do so as soon as possible.

Recall that the point of designation of insurance companies as SIFIs is to give significant regulatory jurisdiction over them to the Federal Reserve Board, an institution with little or no experience in insurance regulation and which certainly cannot be considered expert in it. The Independent Member of FSOC Having Insurance Expertise, Roy Woodall, who indubitably is a true expert in the insurance business and its regulation, voted against the SIFI designation of MetLife. Coming again to FSOC’s assumptions, he objected:  “The analysis relies on implausible, contrived scenarios” [my italics], which moreover, include “failures to appreciate fundamental aspects of insurance and annuity products.”

Mr. Woodall continued that “the central foundation for this designation” is the assumption of “a sudden and unforeseen insolvency of unprecedented scale [and] of unexplained causation.” He reasonably added, “I simply cannot agree with such a premise.” Can anybody?

Voting against the earlier designation of Prudential Financial as a SIFI, Mr. Woodall similarly pointed out that “Key aspects of [FSOC’s] analysis are not supported by the record or actual experience,”  that it presumes “an unfathomable and inexplicable simultaneous insolvency and liquidation of all insurance companies” among its “misplaced assumptions.”

Ed DeMarco, a distinguished financial regulator who was at the time the acting director of the Federal Housing Finance Agency and thus the conservator of Fannie Mae and Freddie Mac, joined the dissent on Prudential and also observed the lack of evidence presented in the FSOC’s evaluation. FSOC proceeded “despite the acknowledgment that no institution has as disproportionally large exposure to Prudential”; it “does not fully take account of the stability of Prudential’s liabilities”; it assumes that “withdrawals at Prudential could lead to runs at other insurance companies without providing supporting evidence.” Once again, FSOC was operating on assumptions.

Of course, Messrs. Woodall and DeMarco were in the minority. But did the majority address their serious and substantial objections?  Was there a meaningful, substantive exchange among FSOC members about the conceptual issues and the relevant evidence, as would be appropriate, before voting the proposal in?  I am told that there was not.

Why not?  The whole point of the existence of FSOC is supposed to be the combined substantive deliberation and development of insights by this committee of the heads of financial regulatory agencies. But it doesn’t seem to happen. So the designation process does not work well not only at the staff level, but also at the level of the FSOC as a corporate body.

I directly asked one former senior FSOC insider from the previous administration if the meetings of FSOC members had ever provided a new insight into financial issues. After thinking a moment, he gave me a candid answer: “No.”

Why is this?  The Milken Institute, in a recent paper, proposed idealistically that although FSOC is currently nothing like this, “policy makers should convert the FSOC into a truly cooperative working group of regulators focused on risks.” To anyone familiar with the ways of Washington, this will seem an unlikely outcome.

The underlying problem, it seems to me, is the structure of FSOC itself. The shortcomings of the designation process reflect the underlying problems with the fundamental design. To begin with, FSOC is primarily a group of individuals each representing a regulatory agency, with turf to protect from intrusions by the others, and a regulatory record to defend from criticism, as principal bureaucratic concerns.

It is a big group, with 15 official members, but in addition, they all bring along helpers and allies. At the FSOC meeting of Dec. 18, 2014—which approved the MetLife SIFI designation—there were, according to its minutes, 46 people present. It’s pretty hard, indeed impossible, to imagine a real, open, give-and-take and “truly cooperative” discussion with 46 people.

Moreover, FSOC is chaired by the secretary of the Treasury, a necessarily very political, powerful senior government actor with major partisan and institutional interests always in play. No company can be taken up for systemic risk study by the SIFI staff without the approval of the secretary. Does this suggest a disinterested analytical process?

The Federal Reserve is a special case in the structural design of FSOC, because it stands to expand its power every time FSOC makes a SIFI designation. Does the Federal Reserve like power?  Would it like to acquire a big new jurisdiction?  Of course, and it is a party at interest in every SIFI discussion. I think it is not unreasonable to suggest that, given the Fed’s major conflict of interest, it should recuse itself from any SIFI votes.

With this context, it is easier to see why the FSOC’s SIFI evaluations had to rely on big assumptions and tended to make inconsistent analyses of different companies. It was because the decisions being made were inherently judgmental, with inherently subjective elements, made amid competing interests—that is to say, unavoidably political.

The shortcomings of the FSOC evaluations appear at least consistent with the theory that the evaluations were meant to rationalize decisions already made. Where might the pressure for such decisions have come from?

One publicly debated possibility is that commitments were already made in the setting of the international Financial Stability Board, in which two of the FSOC members, it is sometimes suspected, made deals with foreign central bankers and regulators about which companies were “global systemically important insurers.” There is dispute about whether the FSB discussions were really agreements, and whether they were thought to be binding. But there is no dispute that the international discussions and the naming of “Global SIIs” preceded the Prudential and MetLife designations of the FSOC. Roy Woodall reflected: “While the FSB’s action should have no influence, I have come to be concerned that the international and domestic processes may not be entirely separate.” A related question is whether the Treasury and Federal Reserve FSOC members felt personally committed by their international discussions. If they did, it seems that they should have disclosed that and recused themselves from the FSOC decisions. Did they feel committed to follow the FSB?  Only they know.

During their research for the study of the FSOC designations process, the committee staff asked the FSOC’s executive director, Patrick Pinschmidt, what “significant damage on the broader economy” meant, in their assessments. Mr. Pinschmidt replied: “It’s up to each voting member of the council to decide for him or herself what constitutes a significant threshold.” That sounds like depending on subjective judgments to me.

I agree that it is a naturally good idea for financial regulatory agencies to get together and share information, ideas and experiences (to the extent that they will really share). But what is a committee of heads of regulatory agencies, who are acting as individuals and not even on behalf of the relevant boards or commissions, doing making political decisions?  If Congress wants to have the Federal Reserve Board regulate big insurance companies, it can make it so in statute, using whatever subjective judgments it wants. In my view, FSOC is a distinctly inappropriate body to act as a little legislature.

The staff paper of FSOC’s evaluations of possible SIFIs, those recommended for designation and those not, details the inconsistencies in treatment. But these differences pale beside the huge discrepancy of those companies chosen for evaluation and those companies not evaluated at all, because the previous Treasury Secretary did not approve their being studied. The FSOC staff did not even analyze them, because of some higher, prior, political judgment. I think this could fairly be characterized as desperately wanting to “see no evil” when it comes to the systemic financial risk of some entities.

The most egregious cases are Fannie Mae and Freddie Mac, which are obviously systemically important and without question systemically very risky. To document that is simple, starting with their combined $5 trillion in credit risk, virtually zero capital and ubiquitous interconnectedness throughout the country and world. Two of the biggest causes of systemic risk are leveraged real estate and the moral hazard created by the government—Fannie and Freddie are both of these combined and to the max.

The Dodd-Frank Act gives a key assignment to FSOC:  “To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties that the Government will shield them from losses in the event of failure.” Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses, not only as a hypothetical, but as a vast fact. They operate entirely on the government’s credit. They represent the very essence of the problem that FSOC was supposedly created to address. But FSOC doesn’t even study them—instead, the staff was ordered not to study them.

That is an inconsistency raised to the nth power – in my view, a bankruptcy of FSOC’s intellectual credibility as run by the previous administration.

A recent article claims that “the next financial crisis that rocks America…will be driven by pension funds that cannot pay what they promised.” Whether or not it triggers the next crisis, there is no doubt that this is a looming huge risk.

In the very center of this risk is an insurance company absent from FSOC’s evaluation as a SIFI: the Pension Benefit Guaranty Corp. The PBGC is not only on the hook as guarantor of unpayable pensions nationwide, but is already insolvent itself with, according to its own books, a deficit net worth of $76 billion. Might PBGC represent a systemic risk?  Yes. Do the creditors of the PBGC think “the Government will shield them from losses”?  Yes. Does the FSOC staff evaluate the PBGC?  Nope.

In sum, it appears that the flawed process of FSOC’s SIFI designations is generated by the flawed structure of FSOC itself.

In my opinion, structural reform of FSOC is needed as part of larger the Dodd-Frank reform legislation. But here are a few recommendations for improvements which could be implemented by the new administration in the short run:

• FSOC should have regular meetings of principals only with substantive discussions of major issues and explorations of disagreements. No helpers, no staff.

• The secretary of the Treasury should immediately instruct the FSOC staff to undertake systemic risk evaluations of Fannie Mae and Freddie Mac.

• The secretary of the Treasury should immediately instruct the FSOC staff to undertake a systemic risk evaluation of the Pension Benefit Guarantee Corporation.

• The Treasury Department should immediately request the Department of Justice to withdraw the government’s appeal in the MetLife v. FSOC suit and the Department of Justice should immediately do so.

• FSOC staff should be encouraged to come up with new ideas on evolving risks for discussion among the FSOC principals.

• Any SIFI evaluation should strictly follow the rules and guidance approved by FSOC, with analysis performed in a strictly consistent manner.

• Assumptions about macro reactions and assumptions of implausible and contrived scenarios should be clearly identified as judgments and guesses.

• International discussions and actual decisions of FSOC should be kept strictly separate. Any international agreements, even if informal, made by FSOC members, should be fully disclosed.

Again, my appreciation to the committee staff for their productive study of the inconsistent FSOC designation process and the very important issues it raises.

And thank you very much for the chance to share these views.

Taking on Leviathan

Published in the Thomas Hobbes (1588-1679), the great philosopher of the authoritarian state, in a famous metaphor portrayed the government as a dominating giant or Leviathan, animated by absolute sovereignty, and passing out rewards and punishments as it saw fit. It alone could control the unruly passions of the people and create stability and safety.

Today’s “administrative state”—or government bureaucracy, acting simultaneously as sovereign legislator, executive, and judge—brings Hobbes’ image of the giant vividly to mind.Nowhere is his metaphor more apt than in the government’s attempts at “systemic financial stability.” Hobbes’ 21st century acolytes include former Senator Chris Dodd (D-Conn.) and former Congressman Barney Frank (D-Mass.), whose Dodd-Frank Act sought to prevent financial crises, as Hobbes sought to prevent civil wars, by enlarging the giant. Now, as then, how to control the unruly passions, lust for power, and misguided enthusiasms of the state itself is left unanswered.

However, Congressman Jeb Hensarling (R-Tex.), who chairs the House Financial Services Committee, is now taking on Leviathan in the financial system with the proposed Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs (CHOICE) Act. If it seems unlikely that he could fell the giant altogether, perhaps he could limit and better control and confine it, at least with respect to banking and the people’s money. If he succeeded, the federal government would place more emphasis on competitive markets and less on the diktats of the central bank and regulatory bureaucrats whom Dodd-Frank made sovereign.

Writing his book Leviathan in 1651, in the wake of the English Civil War and the beheading of King Charles I, Hobbes had this to say: “By art is created that great LEVIATHAN called a COMMONWEALTH or STATE (in Latin, CIVITAS), which is but an artificial man, though of much greater stature and strength.”

He went on:

sovereignty is an artificial soul, as giving life and motion to the whole body; the magistrates and other officers of judicature and execution, artificial joints; reward and punishment (by which fastened to the seat of the sovereignty, every joint and member is moved to perform his duty) are the nerves.

Moreover,

Salus Populi (the people’s safety) its business; counsellors, by whom all things needful to know are suggested unto it, are the memory; equity and laws, an artificial reason and will; concord, health; sedition, sickness; and civil war, death.

Writing four decades before the founding of the Bank of England, Hobbes can be forgiven for not mentioning the central bank, which has since become a key element of sovereignty. We need to extend his metaphor to include it. We could say that the central bank is a kind of artificial heart pumping the circulating blood of credit and money, making sure to lend the government as much as it wants. It often pumps this blood of credit to an excessive extent, causing financial markets to inflate, be overly sanguine, then bust, constrict their flows and suffer the heart attacks of financial panics.

Three centuries or so after Hobbes, Leviathan developed a new capability: that of constructing vast shell games guaranteeing huge quantities of other people’s debt and taking vast financial risks, while pretending that it wasn’t doing this, and keeping this debt off the books. I refer to the  invention of government-sponsored enterprises like Fannie Mae and Freddie Mac, and to related schemes such as government-sponsored insurance companies, like the Federal Savings and Loan Insurance Corporation and the Pension Benefit Guaranty Corporation. All serve as Leviathan’s artificial stomach and gluttonous appetite for risk, causing in time obesity, flatulence, indigestion, and finally the heartburn of publicly admitted insolvency.

Although financial panics temporarily render Leviathan stunned and confused, in short order it resumes its energetic activity and ambitious pursuit of greater power. Writing legislation in 2010, in the wake of the financial crisis of 2007 to 2009, Senator Dodd and Representative Frank ordered Leviathan to make deep expansions into the financial sector. The people’s financial safety and concord became defined as a new supreme demand for “compliance” with the orders of government bureaucrats, who were assumed to know the right answers.

The Dodd-Frank Act was passed in 2010 on party line votes at a time of insuperable Democratic majorities in both houses of Congress. Shortly after voting it in, the Democrats suffered stinging losses in that year’s congressional elections. No subsequent Congress would ever have dreamed of passing anything remotely resembling Dodd-Frank, but financial Leviathan had already been put on steroids and unleashed.

Now comes Chairman Hensarling to try to bring financial Leviathan back under control. The CHOICE Act would reform Leviathan’s activity in a wide swath of financial areas. It would:

• Remove onerous Dodd-Frank burdens on banks that maintain a high tangible capital ratio (defined as 10 percent of total assets), thus creating a simple rule instead of the notoriously complex ones now in force.

• Force the Financial Stability Oversight Council into greater transparency by cutting back the power of this committee of regulators to make opaque decisions in secret.

• Correct the egregiously undemocratic governance of another bureaucratic invention, the Consumer Financial Protection Bureau, by giving it a bipartisan board and subjecting it to the congressional oversight and appropriations process that every federal agency should have.

• Require greater accountability and transparency from Leviathan’s heart, the Federal Reserve.

• Require cost-benefit analysis for new regulations and a subsequent measurement of whether they achieved their goals—imagine that!

• Repeal the “Chevron Doctrine” that leads judges to defer to federal agencies. This is essential, as bureaucrats make ever-bolder excursions beyond their legal authority.

• Take numerous steps to relieve Leviathan’s heavy hand on small businesses and small banks.

The CHOICE Act will likely be taken up by the House Financial Services Committee this fall—and be ready for further consideration if, as is forecast by most people, Republicans retain control of the House of Representatives in the upcoming election. The debates about the bill will be contentious and sharply partisan, with vehement opposition from those who love Leviathan. How far the reform bill can go depends on how other parts of the election turn out.

Will financial Leviathan grow ever fatter, more arrogant, and more intrusive? Or can it be put on a long-term diet by constraining its arrogance, correcting its pretensions, imbuing its artificial soul with behavior befitting a republic, and put in the service of a limited government of checks and balances?

The CHOICE Act is a good start at this daunting and essential project.