Can the Federal Reserve Buy Gold? Should It?

Published in Law & Liberty with Paul H. Kupiec.

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

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was severed in the early 1970s and all legal prohibitions against US persons buying, selling, and holding gold were repealed shortly thereafter.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

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

The History of Gold and the US Dollar

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

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

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

President Roosevelt soon exercised this power.

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

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

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

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

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

Central Banks and Gold

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

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

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

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

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

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

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

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

Can the Fed Own Gold Today?

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

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

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

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

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

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

If the Fed Can Own Gold, Should It?

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

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

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

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

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

Can the Fed Fund the CFPB?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How to Recapitalize the Federal Reserve

Published in Law & Liberty with Paul H. Kupiec. Also published in RealClear Markets.

The Federal Reserve starts the new year with capital, properly accounted for, of negative $92 billion. How can that be? How can the world’s greatest central bank, the issuer of the world’s dominant reserve currency, be technically insolvent—and by such a huge number?

The answer is that the Fed has accumulated immense operating losses, which by January 3, 2024, totaled $135 billion. Since September 2022, the Fed has been paying out more in interest expense to finance its more than $7 trillion securities portfolio than it receives in interest income. The losses continue into 2024 at the rate of over $2 billion a week. When you subtract the Fed’s accumulated losses, which are real cash losses, from the Fed’s stated capital of $43 billion, you get the Fed’s true consolidated capital, that is: $43 billion in starting capital minus $135 billion in losses equals the current capital of negative $92 billion. This balance sheet math is straightforward and unassailable under generally accepted accounting principles (GAAP).

The Federal Reserve System includes 12 regional Federal Reserve Banks (FRBs), each one a separate corporation with its own shareholders, customers, and balance sheet. Considered on their own, with proper accounting, 8 of the 12 FRBs start 2024 with negative capital. This means their accumulated cash operating losses exceed 100% of their capital. Two others have lost more than 80% of their capital and will exhaust their capital in 2024. Only two FRBs have their capital intact. Their operating losses have been limited because these banks have an especially high proportion of their funding supplied by the paper currency (Federal Reserve Notes) they issue—currency does not pay interest and thus results in lower overall interest expense. Under commercial bank rules, 10 of the 12 FRBs would be classified as severely undercapitalized, as would the entire consolidated Federal Reserve System. As of January 3, 2024, the FRBs true capital numbers are:

Source: Federal Reserve H.4.1 January 4, 2024, and authors’ calculations.

At the current rate the Fed is losing money, its negative capital will exceed $100 billion by February 2024.

You will not find the Fed’s true capital position reported on the Fed’s official consolidated balance sheet or on the individual FRBs’ balance sheets. This is because the Fed—unbelievably—does not subtract its losses from its retained earnings. Instead, it pretends that its growing losses are an asset. “Ridiculous!” you may exclaim. The kindest way to describe this Fed accounting is that it is non-standard, but Congress has allowed the Federal Reserve to determine its own accounting rules. Since its accumulated operating losses have made the actual liabilities of the Fed larger than its assets, the Fed created a new “asset” because it doesn’t want to show that it has negative capital. We do not suggest you try this accounting sleight-of-hand if you are a private bank, a business, or filling out a home loan application.

The Fed claims that, even if it does have negative capital, it doesn’t matter because it can always print all the money it needs. However, there are, in fact, limits to its ability to print paper currency. But even if there were no limits, the Fed’s large negative capital, growing ever more negative each week, certainly makes the Fed look bad—incompetent even—and calls its credibility into question. While it is not widely understood, the deposits in FRBs are unsecured liabilities of each individual FRB. When an FRB has negative capital, the presumed risk-free status of its deposits hinges on a belief that the deposits are implicitly guaranteed by the US Treasury.

Maintaining market confidence in the Federal Reserve System and FRBs is critical. As the Fed’s losses continue to rapidly accumulate, it would be sensible for Congress to recapitalize the Fed and bring it back to positive capital with assets greater than, instead of less than, its liabilities, and restore it to technical solvency. This could be done with four steps, which would fit well with and expand Pollock’s proposals for Reforming the Federal Reserve:

• Suspend FRB dividends

• Exercise the Fed’s existing capital call on its stockholders

• Assess the stockholders to offset Fed losses, as provided in the Federal Reserve Act (FRA)

• Have the US Treasury buy stock in the Federal Reserve, consistent with the original FRA.

Suspend Dividends

When banks or any other corporations are suffering huge losses, especially if they have negative retained earnings, let alone negative total capital, a typical and sensible reaction is to stop paying dividends. Indeed, the Federal Reserve in its role as a bank regulator would insist on this for the banks and holding companies it regulates. The same logic should apply to the Fed itself. The central bank of Switzerland is an instructive example. Like the Fed, the Swiss National Bank is now facing losses but, unlike the Fed, it still has significant positive capital. Nonetheless, the Swiss National Bank has stopped paying dividends for the last two years. When the Fed is losing over $100 billion per year, there is scant justification for it to be paying $1.5 billion in dividends to its member bank shareholders annually.

However, to stop a technically insolvent Fed from paying dividends, Congress has to get involved and amend the Federal Reserve Act. The FRA currently provides that the Fed’s dividends are cumulative. This provision reflects the former belief that the Fed would always make profits. With today’s reality of massive losses, the Federal Reserve Act should be revised to make dividends noncumulative and to prohibit FRB dividend payments if such payments would result in negative retained earnings (“surplus” in Fed terminology) on a GAAP basis.

Exercise the Fed’s Existing Capital Call on its Stockholders

Section 2.3 of the Federal Reserve Act requires every bank that is a member of a Federal Reserve Bank to subscribe to shares of the FRB in an amount tied to the member bank’s own capital. The member-stockholders, however, are required to pay in and have paid in only half of the amount subscribed. The other half is subject to call by the Federal Reserve Board, and if called, must be paid in by the member bank.

The total paid-in capital of the Fed is $36 billion. An additional $36 billion in FRB capital could be raised if the Federal Reserve Board simply exercised its existing statutory call. This would reduce the Fed’s negative capital as of January 3, 2024, by 39%. If the Federal Reserve Board balks at exercising the capital call, Congress should instruct it to do so.

Under our recommended changes to Fed dividend policy, the newly paid-in shares would not receive dividends until FRBs return to positive GAAP retained earnings (“surplus”).

Assess the Stockholders to Offset Fed Losses, as Provided for in the Federal Reserve Act

In a very little-known but very important provision of the FRA, which goes back to its original 1913 enactment, Federal Reserve Bank shareholders are made liable in addition to their subscription to Fed stock, for another amount equal to that subscription, which they may be assessed to cover all obligations of their FRB; in other words, to offset negative capital. A member bank assessment would be a cash contribution to their FRB, not an investment in more stock. Says the FRA, “The shareholders of every Federal reserve bank shall be held individually responsible … to the extent of the amount of their subscriptions to such stock at the par value thereof in addition to the amount subscribed.” (Italics added.)

The total subscriptions to Fed stock are twice the outstanding paid-in capital of $36 billion, so the subscriptions total $72 billion, and the maximum possible assessment on the Fed member banks is thus $72 billion. Since two FRBs, Atlanta and St. Louis, still have their capital intact, the available assessment would be on the other ten FRBs. The maximum assessments would be these FRBs’ paid-in capital of $34 billion times 2, or $68 billion. By comparison, the Fed paid $177 billion in interest and dividends to its member banks in 2023.

The original Federal Reserve Act, as enacted in 1913, provided for the US Treasury to buy Federal Reserve Bank stock, if necessary.

With the maximum assessment on the members of these ten FRBs in addition to calling the unpaid half of the stock subscriptions for all the FRBs, the total raised would be $104 billion ($36 billion in new stock plus $68 billion in assessments). This amount would offset the Fed’s year-end capital deficit of $92 billion and would cover about six weeks of additional losses at the current rate of $2 billion a week.

Doubtless the Fed’s member banks would be exceedingly unhappy with these actions to shore up the capital of the Federal Reserve. But member banks, as the sole shareholders in the FRBs, have a clear statutory obligation to financially support FRBs that will soon have consolidated true negative capital in excess of $100 billion.

Judging by public financial statements disclosures, few—if any—Fed member banks have seriously considered the large statutory contingent liability that membership in the Fed brings. Taking into account FRBs’ financial condition and their shareholders’ clear legal obligations, it seems that FRB member banks should be disclosing this material contingent liability.

Have the US Treasury Buy Stock in the Federal Reserve, Consistent with the Original Federal Reserve Act

Suspending FRB dividends, calling the rest of the member banks’ stock subscriptions, and assessing FRB stockholders the maximum amount would make the Fed’s capital positive again until mid-February 2024. After that, continuing losses will put it back into negative territory and the Fed back into technical insolvency. Given the fact that the Fed is stuck with long-term fixed-rate investments yielding a mere 2%, and that $3.9 trillion of its investments have more than ten years left to maturity, the Fed’s very large cash losses will most likely continue for quite a while.

Another source of recapitalization is needed.

The original FRA as enacted in 1913 provided for the US Treasury to buy Federal Reserve Bank stock, if necessary. (It also provided for possible sale of FRB stock to the public, which did not happen and could not happen under today’s circumstances.) Section 2.10 of the FRA, which has never been amended, empowers an FRB to issue shares to the Treasury to raise needed capital:

Should the total subscriptions … to the stock of said Federal reserve banks, or any one or more of them, be, in the judgment of the organization committee [the Secretary of Treasury, the Secretary of Agriculture, the Comptroller of the Currency], insufficient to provide the capital required therefor, then and in that event the said organization committee shall allot to the United States such an amount of said stock as said committee shall determine. Said United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated, and shall be held by the Secretary of the Treasury, and be disposed of… as the Secretary of the Treasury shall determine.

In a 1941 opinion, the Federal Reserve Board argued: “As originally enacted, the Federal Reserve Act provided for a Reserve Bank Organization Committee … [and] was authorized to allot Federal Reserve Bank stock to the United States in the event that subscriptions to such stock … were inadequate. However, subscriptions by member banks were adequate. … Accordingly, [this section] is now of no practical effect.”

However, the Fed’s financial condition has dramatically changed since 1941. In 2024, the subscriptions to the capital of the FRBs are grossly inadequate—the FRBs cannot maintain positive capital. Allocation of Fed stock to the United States would now be of very significant practical effect.

In light of the Fed’s technical insolvency, ongoing huge losses, and massively negative capital, Congress could sensibly amend Section 2.10 to read as follows:

Should the total subscriptions to the stock of the Federal reserve banks and the further assessments of the shareholders be insufficient to maintain positive capital as measured by GAAP for any one or more of the Federal reserve banks, then the Board of Governors of the Federal Reserve shall allot to the United States such an amount of said stock as the Board shall determine will bring the capital as measured by GAAP of these Federal reserve banks to not less than $100 million and maintain the consolidated capital of the Federal Reserve System as measured by GAAP at not less than $1.2 billion. The United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated and shall be held by the Secretary of the Treasury. Said stock may be repurchased at par by a Federal reserve bank or banks at any time, provided that after the repurchase, the capital of each Federal reserve bank as measured by GAAP shall be not less than $100 million and that the consolidated capital of the Federal Reserve System as measured by GAAP shall be not less than $1.2 billion.

The stock purchased by the Treasury would be non-voting, since the FRA provides that “Stock not held by member banks shall not be entitled to voting power.”

If over the next 15 months the Fed loses the same $135 billion as it has in the last 15 months, the Treasury would own about $123 billion in par value of FRB stock by March 31, 2025, and the member banks would own $72 billion after the capital call. The Treasury would thus own about 62% of the consolidated Fed stock but could not vote its shares. Over the long-term future, the FRBs would repurchase the Treasury’s shares as their finances permit.

With these four steps, the recapitalization of the Federal Reserve would be complete. Our proposed consolidated capital of $1.2 billion compared to the Fed’s beginning of 2024 total assets of $7.7 trillion, would give the Fed a leverage capital ratio of 0.016%—small indeed, but always positive. In other words, this revised section of the Federal Reserve Act would mean that the Treasury would, as it does for Fannie Mae and Freddie Mac, ensure that over time, the most important central bank in the world would never again be technically insolvent, no matter how big its losses.

"The Most Important Price of All"

Published in Law & Liberty.

In The Price of Time, Edward Chancellor has given us a colorful and provocative review of the history, theory, and profound effects of interest rates, the price that links the present and the future, which he argues is “the most important price of all.” 

The history runs from Hammurabi’s Code, which in 1750 BC was “largely concerned with the regulation of interest,” and from the first debt cancellation (which was proclaimed by a ruler in ancient Mesopotamia) all the way to our world of pure fiat currencies, the recent Everything Bubble (now deflating), cryptocurrencies (now crashing), and the effective cancellation of government debt by inflation and negative interest rates.

The intellectual and political debates run from the Old Testament to Aristotle to John Locke and John Law, to Friedrich Hayek and John Maynard Keynes, to Xi Jinping and Ben Bernanke, and many others.  

As for the vast effects of interest rates, a central theme of the book is that in recent years interest rates were held too low for too long, being kept “negative in real terms for years on end,” with resulting massive financial distortions for which central banks are culpable. 

The Effects of Low Interest Rates

Chancellor chronicles how over the centuries, many writers and politicians have favored low interest rates. They have in mind an image of the Scrooge-like lender, always a usurer lending at excessive interest, grinding down the impoverished and desperate borrower—not unlike contemporary discussions of payday lending. For example, Chancellor quotes A Discourse Upon Usury, written by an Elizabethan judge in 1572, which describes the usurer as “hel unsaciable, the sea raging, a cur dog, a blind moul, a venomus spider, and a bottomless sacke…most abominable in the sight of God and man.” Presumably, the members of the American Bankers Association and of the Independent Community Bankers of America would object to this description.

In fact, the roles of lender and borrower have often been and are in large measure today the opposite of the traditional image. This was already clear to John Locke, as Chancellor shows us. The great philosopher turned his mind in 1691 to “Some Considerations of the Lowering of Interest Rates” and “saw many disadvantages arising from a forced reduction in borrowing costs” and lower interest rates paid to lenders. For who are these lenders? Wrote Locke: “It will be a loss to Widows, Orphans, and all those who have their Estates in Money”—just as it was a loss in 2022 to the British pension funds when these funds got themselves in trouble by trying to cope with excessively low interest rates. Moreover, who would benefit from lower interest rates? Locke considered that low interest rates “will mightily increase the advantages of bankers and scriveners, and other such expert brokers … It will be a gain to the borrowing merchant.” Lower interest rates, Chancellor adds, would also benefit “an indebted aristocracy.”

In Chancellor’s summary, “Locke was the first writer to consider at length the potential damage produced by taking interest rates below their natural level.” Locke’s position in modern language includes these points:

•           Financiers would benefit at the expense of ”widows and orphans”

•           Wealth would be redistributed from savers to borrowers

•           Too much borrowing would take place

•           Asset price inflation would make the rich richer

Just so, over our recent years of too-low interest rates, ordinary people have had the purchasing power of their savings expropriated by central bank policy and leveraged speculators of various stripes made large profits from overly cheap borrowing, while debt boomed and asset prices inflated into the Everything Bubble.

The central bankers knew what they were doing with respect to asset prices. Chancellor quotes a remarkably candid statement in a Federal Open Market Committee meeting in 2004, in which, as a Federal Reserve Governor clearly put it:

[Our] policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of the distortion is deliberate and a desirable effect if the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand.

That boosting asset prices was “deliberate” is correct; that it was “desirable” seems mistaken to Chancellor and to me. “The records show that the Fed had used its considerable powers to boost the housing market,” he writes (I prefer the phrase, “stoke the housing bubble”). What is worse, the Fed did it twice, and we had two housing bubbles in the brief 23 years of this century. In 2021, the Fed was inexcusably buying mortgage securities and suppressing mortgage rates while the country was experiencing a runaway house price inflation (now deflating).

In general, “Wealth bubbles occur when the interest rate is held below its natural level,” Chancellor concludes.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes.

Bad Press

On a different note, he mentions that suppression of interest rates could lead to “Keynes’ long-held ambition for the euthanasia of the rentier,” using Keynes’ own memorable, if unpleasant, phrase. The recent long period of nearly zero interest rates, however, led to huge market gains on the investments of the rentiers, and caused instead the euthanasia of the savers—or at least the robbing of the savers.

Our recent experience has shown again how borrowers may be made richer by low interest rates, as were speculators, private equity firms, and corporations that levered up with cheap debt. “It is clear that unconventional monetary policies…had a profound impact on inequality,” Chancellor writes, “the greatest beneficiaries from the Fed’s policies [of low interest rates] were the financial elite, who got to enhance their fortunes with cheap leverage at a time when asset values were driven higher by easy money.”

Historically there was a question of whether there should be interest charged at all. “Moneylenders have always received a bad press,” Chancellor reflects, “Over the centuries… the greatest minds have been aligned against them”—Aristotle, for example, thought charging interest was “of all modes of making money…the most unnatural.” The Old Testament restricted charging interest, but as Chancellor points out, the Book of Deuteronomy makes this important distinction: “You shall not lend upon interest to your brother, interest on money, interest on victuals, interest on anything,” but “To a foreigner you may lend upon interest.” This raises the question of who is my brother and who is a foreigner, but does seem to be an early acceptance of international banking. It also makes me think that anyone who has made loans from the Bank of Dad and Mom at the family interest rate of zero, will recognize the intuitive distinction expressed in Deuteronomy.

Needless to say, loans and investments bearing interest prevail around the globe in the tens of trillions of dollars, the moneylenders’ bad press notwithstanding. This is, at the most fundamental level, because interest rates reflect the reality of time, as Chancellor nicely explains. One thousand dollars ten years from now and one thousand dollars today are naturally and inescapably different, and the interest rate is the price of that difference, which gives us a precise measure of how different they are.

A perpetually intriguing part of that price is how interest compounds over long periods of time. “The problem of debt compounding at a geometrical rate has never lost its fascination,” Chancellor observes, and that is certainly true. “A penny put out to 5 percent compound interest at our Savior’s birth,” he quotes an 18th-century philosopher as calculating, “would by this time [in 1773]… have increased to more money than would be contained in 150 millions of globes, each equal to the earth in magnitude, all solid gold.”

The quip that compound interest is “the eighth wonder of the world” is often attributed to Albert Einstein, but Chancellor traces it to a more humble origin: “an advertisement for The Equity Savings and Loan Company published in the Cleveland Plain Dealer” in 1925. “Compound interest… does things to money,” the advertisement continued, “At the Equity it doubles your money every 14 years.” This meant the savings and loan’s deposits were paying 5% interest—the same interest rate used in the preceding 1773-year calculation, but that case represented 123 doublings.

The mirror image of sums remarkably increasing with compound interest is the present value calculation, which reduces the value of future sums by compound interest running backward to the present, a classic tool of finance. Just as we are fascinated, as the Equity Savings and Loan knew, by how much future sums can increase, depending on the interest rate that is compounding, so we are also fascinated by how much today’s market value of future sums can shrink, depending on the interest rate. 

If the interest rate goes from 1% to 4%, about what the yield on the 10-year Treasury note did in 2021-2022, the value of $1,000 ten years from now drops from $905 to $676, or by 25%. You still expect exactly the same $1,000 at exactly the same time, but you find yourself 25% poorer in market value.

Central Bank Distortions

In old British novels, wealth is measured by annual income, as in “He has two thousand pounds a year.” One role of changing interest rates is to make the exact same investment income represent very different amounts of wealth. If interest rates are suppressed by the central banks, it makes you wealthier with the same investment income; if they are pushed up, it makes you poorer. If they change a lot in either direction, the change in wealth is a lot. The math is elementary, but it helps demonstrates why interest rates are, as Chancellor says, the most important price. 

In the 21st century, “The Federal Reserve lowered interest rates to zero and sprayed money around Wall Street.” But if the interest rate is zero, $1,000 ten years in the future is worth the same as $1,000 today, a ridiculous conclusion, and why zero interest rates are only possible in a financial world ruled by central banks.

More egregious yet is the notion of negative interest rates, which were actually experienced on trillions of dollars of debt during the last decade. “The shift to negative interest rates comprised the central bankers’ most audacious move,” Chancellor writes. “What is a negative interest rate but a tax on capital—taxation without representation.” With negative interest rates, $1,000 ten years in the future is worth more than $1,000 today, an absurd conclusion, likewise proof that negative interest rates can only exist under the rule of central banks.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes. In his ideal world, expressed on the book’s last page, “central banks would no longer be able to pursue an active monetary policy,” and “guided by the market’s invisible hand, the rate of interest would find its natural level.” Given all the mistakes central banks have made, with the accompanying distortions, this is an attractive vision, but unlikely, needless to say.

Reforming the Federal Reserve

Published in Law & Liberty.

The Federal Reserve creates and manipulates the dominant fiat currency of the world. It produces the inflation of its supply and the continuous depreciation of its purchasing power. It manipulates dollar interest rates and the cost of debt, makes elastic the availability of credit (especially during financial crises), finances the government, and monetizes federal deficits in amounts limited only by the statutory debt ceiling. It is often imagined to be “managing the economy,” although, in fact, no one can successfully do that. It is a central bank not only to the United States, but to the entire dollar-using world. In short, the Fed is the most powerful financial institution there is or ever has been. That such a power is concentrated in a single, unelected institution is a problem for the constitutional order of the American republic.

Equally fundamental is that the Fed is always subject to deep uncertainty. It has clearly demonstrated its inability (like everyone else’s) to predict the economic or financial future, and it is inherently unable to know what the results of its own actions will be. Its remarkable power combined with its inescapable lack of knowledge of the future makes it the most dangerous financial institution in the world. This is true no matter how intelligent or brilliant its officers may be, however good their intentions, however many hundreds of economists they hire, or however complex the computer models they build. 

At the famous Jackson Hole central banking conference in August 2023, Fed Chairman Jay Powell, with admirable candor, pointed out some essential uncertainties in the current Federal Reserve debates. “We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty” about monetary policy, which is “further complicated by uncertainty about the duration of the lags” with which the policy operates and the “changing dynamics [that] may or may not persist.” He continued, “These uncertainties, both old and new, complicate our task.” They certainly do, and this is true of the Fed’s monetary issues at all times.

Powell used an apt metaphor in this respect: “We are navigating by the stars under cloudy skies.” The President of the European Central Bank, Christine Lagarde, used a different metaphor: “There is no pre-existing playbook for the situation we are facing.” But the former Governor of the Bank of England, Mervyn King, in his book, The End of Alchemy, drew a blunter conclusion from it all: “If the future is unknowable, then we simply do not know and it is pointless to pretend otherwise.”

All this should increase our skepticism about how much independent power central banks should have, and whether there is a meaningful path for reform.

Uncertainty and Big Losses 

A good example of the results of uncertainty is the Fed’s own dismal financial performance and growing technical insolvency. The Federal Reserve made net losses of $105 billion as of September 27, 2023 since September 2022. That shocking number is getting rapidly bigger. The Fed continues to lose money at the rate of about $9.5 billion a month or $114 billion a year and the losses may continue for a long time. The accumulated losses are already more than double the Fed’s total capital of $43 billion—indeed, the losses had shriveled its capital, when properly measured under Generally Accepted Accounting Principles (GAAP), to negative $50 billion when Chairman Powell was speaking at Jackson Hole. The Fed’s properly measured capital is likely headed for a negative $100 billion or worse by early 2024. The Fed finances this negative capital by borrowing, which increases the consolidated government debt and is a cost to taxpayers. 

The scale of the losses it is suffering doubtless came as a surprise to the Fed. This is apparent from the woefully inaccurate forecasts of continued “lower for longer” interest rates which it made while amassing trillions of investments in long term, fixed-rate Treasury and mortgage securities with very low yields—including, for example, the 1.25% Treasury bond not maturing until 2050—and funding them with floating rate liabilities. In doing so, the Fed created for its own balance sheet a $5 trillion interest rate risk position similar to that of a giant savings and loan. Such a position would inevitably produce huge losses if interest rates rose to anything like historically normal levels of 4% or 5%. They did, and the losses have followed.

It is impossible to believe that the leadership of the Federal Reserve planned and consciously intended to lose over $100 billion. (As you read this, ask yourself if you believe it.) Fed officials knew they had created a very large interest rate risk position, but as an old boss told me long ago, “Risk is the price you never thought you would have to pay.” The combination of the unknowable future with great financial power joined forces to put this massive cost on the taxpayers without a vote of the Congress.

An Independent Power?

Should the Fed have been able unilaterally to commit the country to perpetual inflation and perpetual depreciation of the dollar’s purchasing power at the rate of 2% per year? The correct answer is “no.”

The media is full of references to “the Fed’s” 2% inflation target—but it should be “the country’s” target. The Fed’s proposal about the nature of the people’s money should have been presented to the elected representatives of the people for approval. The U.S. Constitution provides among the powers of the Congress: “To coin Money [and] regulate the Value thereof.” Regulating the value of the national money and deciding whether it should be stable, or perpetually depreciating, and if so, at what rate, involve inherently political questions. 

Let us review the always-striking math of compound growth rates and apply it to inflation. Stable prices imply a long-run average inflation of approximately zero. At 1% inflation, average prices will more than double in a lifetime of 80 years. At 2% inflation, prices will quintuple. At 3%, they will go up by 10 times. At 4% inflation, prices in a lifetime will go up by 23 times. Which would the sovereign people through their representatives choose? William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” How about “You shall not drown mankind in a flood of fiat money”? This is not up to the Federal Reserve to decide on its own.

The Federal Reserve Act specifies “stable prices” as an institutional Fed goal. The concept of “stable prices” is not the same as “a stable rate of inflation,” which the Fed now calls “price stability,” a misleading rhetorical shift.

It is often claimed, especially by the Fed itself, that the Federal Reserve is, or at least ought to be, “independent.” Supporters of the Fed, especially academic economists, join this chorus. Earlier generations of Fed leaders were more realistic. They spoke of the Fed as “independent within the government”—that is, not really independent. In this context, we may recall that the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board.

“Independent” might mean independent of the U.S. Treasury, so that the Treasury cannot require the Fed to print up money to finance its deficits. However, the Fed has had significant experience as the willing servant of the Treasury. This was especially prominent during wars, such as when the Fed committed to buy however many long-term Treasury bonds it took to keep their yield down to 2.5% during World War II. Similarly, the Fed’s “quantitative easing” artificially lowered the cost of financing Treasury deficits for years. In financial crises, as it did in the Covid crisis, the Fed works hand in glove with the Treasury to finance bailouts.

Alternately, “independent” might mean independent of the Congress. In this sense, the Fed should not be independent. As a matter of fundamental government design, it should be in a system of effective checks and balances to which the Congress is essential. 

Since the original Federal Reserve Act in 1913, there have many amendments to the act, with notable Federal Reserve reform legislation in the 1930s and in 1977–78. After its unprecedented actions in the twenty-first century so far, I suggest that it is time again for serious reform of the Federal Reserve.

Reforming the Fed

With the foregoing problems in mind, I recommend eight specific reforms to promote responsibility to the elected representatives of the people in a system of Constitutional checks and balances, bring greater emphasis on genuine price stability, and align expectations with the realities of limited knowledge and pervasive uncertainty.

1. First and foremost, the Congress should amend the Federal Reserve Act to make it clear that the Fed does not have the authority unilaterally to decide on the nature of U.S. money, an essential public question. The revised act should provide that the maintaining or setting of any “inflation target” requires review and approval by Congress. This would make it consistent with the practice of other democratic countries, notably the father of the inflation targeting theory, New Zealand, where the inflation target has to be an agreement between the central bank and the parliamentary government. The original New Zealand target was zero to 2%. But no long-term target for depreciating the money the government provides and imposes on the people should be set without legislative approval.

A true public discussion of the “Money Question,” as they called it in the long debates that ultimately gave birth to the Federal Reserve, would be salutary.

In contrast to those historic debates, how in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? A new reform would straighten it out on that, establishing that the Fed is not a committee of independent economic philosopher-kings, but “independent within the government,” subject to the checks and balances reflecting a constitutional republic.

2. Consistent with the first reform, the Congress should cancel the 2% inflation target set unilaterally by the Fed until it has approved that or some other guidance. For better guidance, I recommend price stability, or a long-run average target inflation of approximately zero, cyclically varying in a range of perhaps -1% to +1%. This would be a modern form of “sound money.” A range is needed, because it is entirely unrealistic to think the inflation rate should be the same at all times, when every other economic factor is always changing. As an interim step, one could live with New Zealand’s original range of zero to 2%. 

3. From 1913 to 2008, the Fed’s investments in mortgages were exactly zero, reflecting the fundamental principle that the central bank should not use its monopoly money power to subsidize specific sectors or interests. The Fed’s buying mortgage securities was an emergency action in a housing finance crisis that has now been over for more than a decade. Its mortgage investments should go back to zero. The Fed made itself into the world’s biggest savings and loan; its mortgage portfolio totaled $2.5 trillion in August 2023. So the run-off will take a long time, but the Fed’s mortgage investments should finally go to zero and stay there, at least until the next mortgage finance crisis.

4. The fundamental structure of the Fed’s consolidated balance sheet, and the balance sheets of the 12 individual Federal Reserve Banks, should be reviewed by Congress, including their capitalization. An iron principle of accounting is that operating losses are subtracted from retained earnings and therefore from capital. Unbelievably, the Fed’s accounting does not follow this principle, but embarrassingly pretends that its operating cash losses are an intangible asset. This is in order to avoid reporting its true capital. Properly measured, using GAAP, at the end of August 2023, the Fed’s consolidated capital was negative $52 billion.

All Federal Reserve member banks have bought only one-half of the Fed stock to which they have subscribed, and the other half is callable at any time by the Federal Reserve Board. The Fed could raise $36 billion in new capital by issuing a call for the other half. It should do this, with due notice, to bolster the depleted or exhausted capital of the various Federal Reserve Banks.

In addition, the Fed is authorized by the Federal Reserve Act to assess the member bank shareholders up to 6% of the member’s own capital and surplus to offset Federal Reserve Bank losses. Since these losses otherwise become costs to the taxpayers, the Fed should discuss with Congress whether it should proceed to make such assessments.

5. The Fed should be required to use standard U.S. GAAP accounting in reporting its capital. It would not have to go as far as the Central Bank of Switzerland, which by law reports its earnings and capital on a mark-to-market basis, making its earnings and capital reflect the realities of market prices. The Fed’s mark-to-market loss as of June 2023 is over $1 trillion. Recognizing the Fed’s argument that these are “paper losses,” the Fed could continue to disclose them but not book them into capital. However, operating cash losses like the Fed is experiencing without question reduce capital and the Fed should be instructed to adopt GAAP in this respect. As Bishop Joseph Butler said, “Things and actions are what they are. … Why then should we desire to be deceived?”

 6. Dividends on Fed stock should be paid only out of Federal Reserve Bank profits. The Federal Reserve Banks pay attractive dividends, defined by the Federal Reserve Act, to their member bank shareholders: 6% dividends to small banks and the 10-year Treasury note rate, now over 4%, to larger banks. This is fine as long as the Fed is making money, but, as is little known, the act does not require profits to pay dividends and also makes the dividends cumulative, so they have to be paid, now or in the future. These statutory provisions obviously never contemplated that the Federal Reserve would someday be making gigantic losses. If Federal Reserve Banks have lost so much money that they have negative retained earnings, let alone negative total capital, they should not be paying dividends, and any dividends should not be cumulative. Otherwise, such dividends are being paid in effect by the taxpayers. 

7. Congress should revoke the Fed’s payment of the expenses of the Consumer Financial Protection Bureau. When the Fed is losing more than $100 billion a year, it is ridiculous for it to be paying over $700 million a year in the expenses of an unrelated entity for which it has no management responsibility. Far worse than ridiculous, it is against the Constitutional structure of the U.S. government, depriving Congress of its essential power of the purse. This issue may be decided by the Supreme Court in a current case involving whether the CFPB’s funding by the Fed violates the U.S. Constitution. It seems obvious to many of us that it does, and that whatever amount of money the Congress wants to spend on the Consumer Financial Protection Bureau, it ought to be appropriated in the normal way.

8. In general and throughout all considerations of the Federal Reserve, all parties, including the Congress and the Fed itself, should be realistic about the inherent inability of the Fed to reliably forecast the economic or financial future or to “manage the economy” or to know what the results of its own actions will be. In the memorable phrase of F. A. Hayek’s Nobel Prize Lecture, there should be no “pretense of knowledge” about central banking.

These proposed reforms reflect the lessons of the Federal Reserve’s eventful twenty-first-century career so far. As it heads for its 110th birthday, they would move the Fed, with its power and with its danger, toward operating more effectively in the context of our Constitutional republic.

Mandating Mortgage Taxes

Published in Law & Liberty.

The Federal Housing Finance Agency (FHFA) is the regulator of Fannie Mae and Freddie Mac. On top of that, it has controlled them as their Conservator since 2008, amazingly for nearly 15 years, since reform of Fannie and Freddie has proved politically impossible. As Conservator, FHFA can exercise the power of their boards of directors. It is therefore not only the regulator, but also the boss of both of these giant providers of mortgage finance. Fannie and Freddie together represent more than $7 trillion in mortgage credit and dominate the mortgage market. FHFA also regulates the $1.6 trillion Federal Home Loan Bank System. Thus, the FHFA has impressive centralized power over the huge US mortgage market, although most people have probably never heard of it.

Housing finance is always political, and a housing finance regulator is always sailing in strong political winds, in addition to the cyclical storms of housing finance crises. The American housing finance system has collapsed twice in the last 40 years, in the decades of the 1980s and the 2000s, with corresponding regulatory reorganizations. The FHFA is a second-generation successor to the unlamented Federal Home Loan Bank Board (FHLBB), the cheerleader-regulator of the savings and loan industry. It presided over the 1980s savings and loan industry collapse, a collapse which also caused the government’s Federal Savings and Loan Insurance Corporation to go broke. The FHLBB was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision (OTS) to regulate savings and loans and the Federal Housing Finance Board (FHLB) to regulate the Federal Home Loan Banks.

Beginning in the 1990s, the federal government made the disastrous mistake of promoting and increasing the amount of risky mortgage loans in the pursuit of increasing home ownership, notably requiring Fannie and Freddie to buy more and more such loans. The riskier loans were promoted as “innovative” mortgages by the Clinton administration. That push was a major contributor first to the housing bubble and then to the housing finance collapse of 2007–09. The homeownership percentage temporarily went up and then fell back to where it had been before. After the crisis, Congress abolished OTS. FHFB was also abolished, with its operations merged into the newly created FHFA. Less than two months after its creation in 2008, FHFA became the Conservator of Fannie and Freddie, which it remarkably remains to this day.

The housing politics and the enjoyment of its power seem to have gone to the FHFA’s head. Now, carrying out instructions from the White House, one imagines, or at a minimum with White House approval, it is trying once again to encourage riskier mortgage loans in Fannie and Freddie. Moreover, it proposes to act as if it were the Congress, trying by its own rule to mandate what are effectively taxes on mortgage borrowers with good credit, in order to provide subsidies to riskier borrowers with poor credit. The FHFA is thus de facto legislating to create in the nationwide mortgage market a welfare and income transfer operation through mortgage pricing. However misguided an idea this is, it could be done by the power of Congress, but the last time we checked, the FHFA wasn’t the Congress. Its project here is remarkable bureaucratic overreach.

In this case, the FHFA wants to politically manipulate Fannie and Freddie’s Loan-Level Price Adjustments (LLPAs). The LLPAs are meant to be credit risk-based adjustments, which reflect fundamental factors in the credit risk of a mortgage loan, to the price of getting Fannie or Freddie to bear the credit risk of the loan. They are an adjustment to the cost of the loan to the borrower, supposed to be based on objective measures of risk. As one mortgage guide says:

A loan-level price adjustment is a risk-based fee assessed to mortgage borrowers … [and] adjustments vary by borrower, based on loan traits such as loan-to-value (LTV), credit score, loan purpose, occupancy, and number of units in a home. Borrowers often pay LLPAs in the form of higher mortgage rates. … Similar to an auto insurance policy, a person loaded with risk will typically pay a higher premium.

Considering the key risks of smaller down payments (higher LTVs) and lower credit scores, there is no doubt that these factors statistically result over time in higher delinquencies, more defaults, and greater credit losses. Simply put, they are riskier loans. The AEI Housing Center has shown that default rates in times of stress differ dramatically based on these factors. For mortgage loans acquired by Fannie and Freddie in 2006–07, for example, the subsequent credit experience was “among borrowers with 20% down payments and credit scores between 720 and 769, the default rate was between 4.2% and 8.8%. Among borrowers with less than 4% down payments and credit scores between 620 and 639, the default rate was between 39.3% and 56.2%.”

Many commentators have pointed out that the FHFA project to manipulate the LLPAs for a political purpose is a distinctly bad idea. It is an “Upside Down Mortgage Policy … against every rational economic model, while encouraging housing market dysfunction and putting taxpayers at risk”; it signals to well-qualified borrowers, “Your credit score is excellent, so prepare to be penalized”; it is income redistribution by bureaucratic fiat; it will encourage the growth of riskier loans in Fannie and Freddie, just as the government disastrously did leading up to the great housing bust of 2007–09; it reduces the incentives to make significant down payments and for establishing a good credit rating—a notably dumb housing credit policy. This is the kind of thing Ed Pinto and I predicted in 2021 that a Biden administration FHFA would do, anticipating “the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.”

The rule is also ethically challenged. As Jeff Jacoby wrote in the Boston Globe, the policy is not only backwards credit logic: “First and foremost, it is egregiously unfair to creditworthy borrowers. … The new mortgage fees amount to a tax on responsible behavior.” In short, “You shouldn’t be punished for having done the right thing.” This seems incontrovertible.

The Congress long ago set up by law a very large, specialized government agency to enable subprime mortgage loans, the Federal Housing Administration (FHA). FHA mortgage loans outstanding total about $1.4 trillion. The FHA provides subsidized mortgage credit, allowing mortgage loans with down payments of as little as 3.5%. The FHA and its sister organization, Ginnie Mae, which guarantees securitized FHA loans, both operate with explicit government support and with direct risk to the taxpayers. The FHFA should not be trying to compete with the FHA for subprime mortgage financing.

The FHFA’s political initiative on loan-level adjustments is a bad idea on the merits, but there is an even more fundamental issue: the creation of a tax and mortgage subsidy program which increases risk to the taxpayers is a question for the Congress to decide—it is not the purview of the FHFA.

Very belatedly, FHFA announced it would issue a “Request for Input” from the public, which would include consideration of LLPAs. This announcement, however, did not alter FHFA’s egregious LLPA changes, which are being imposed long before the “input” will be received.

If the FHFA wanted to pursue its initiative in a constitutional way, it would withdraw its new rule and bring its proposal to Congress, requesting that a bill be introduced to authorize charging those with good credit more on their mortgage loans in order to subsidize those with riskier credit. I imagine that such a bill would not make much progress among the elected representatives of the People.

A Frightening Solution to the Debt Ceiling Crunch

Published in Law & Liberty by Alex J. Pollock and Paul H. Kupiec.

Could the debt ceiling crunch be avoided by the Federal Reserve forgiving treasury debt? Let's hope not.

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Alex J. Pollock is a Senior Fellow at the Mises Institute and was the principal deputy director of the office of financial research of the U.S. Treasury Department, 2019-21. He is author of Finance and Philosophy—Why We’re Always Surprised and co-author of Surprised Again!—The COVID Crisis and the New Market Bubble.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies systemic risk and the management and regulations of banks and financial markets. Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC) and director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

"The Most Important Price of All"

Published in Law & Liberty:

In The Price of Time, Edward Chancellor has given us a colorful and provocative review of the history, theory, and profound effects of interest rates, the price that links the present and the future, which he argues is “the most important price of all.” 

The history runs from Hammurabi’s Code, which in 1750 BC was “largely concerned with the regulation of interest,” and from the first debt cancellation (which was proclaimed by a ruler in ancient Mesopotamia) all the way to our world of pure fiat currencies, the recent Everything Bubble (now deflating), cryptocurrencies (now crashing), and the effective cancellation of government debt by inflation and negative interest rates.

The intellectual and political debates run from the Old Testament to Aristotle to John Locke and John Law, to Friedrich Hayek and John Maynard Keynes, to Xi Jinping and Ben Bernanke, and many others.  

As for the vast effects of interest rates, a central theme of the book is that in recent years interest rates were held too low for too long, being kept “negative in real terms for years on end,” with resulting massive financial distortions for which central banks are culpable. 

The Effects of Low Interest Rates

Chancellor chronicles how over the centuries, many writers and politicians have favored low interest rates. They have in mind an image of the Scrooge-like lender, always a usurer lending at excessive interest, grinding down the impoverished and desperate borrower—not unlike contemporary discussions of payday lending. For example, Chancellor quotes A Discourse Upon Usury, written by an Elizabethan judge in 1572, which describes the usurer as “hel unsaciable, the sea raging, a cur dog, a blind moul, a venomus spider, and a bottomless sacke…most abominable in the sight of God and man.” Presumably, the members of the American Bankers Association and of the Independent Community Bankers of America would object to this description.

In fact, the roles of lender and borrower have often been and are in large measure today the opposite of the traditional image. This was already clear to John Locke, as Chancellor shows us. The great philosopher turned his mind in 1691 to “Some Considerations of the Lowering of Interest Rates” and “saw many disadvantages arising from a forced reduction in borrowing costs” and lower interest rates paid to lenders. For who are these lenders? Wrote Locke: “It will be a loss to Widows, Orphans, and all those who have their Estates in Money”—just as it was a loss in 2022 to the British pension funds when these funds got themselves in trouble by trying to cope with excessively low interest rates. Moreover, who would benefit from lower interest rates? Locke considered that low interest rates “will mightily increase the advantages of bankers and scriveners, and other such expert brokers … It will be a gain to the borrowing merchant.” Lower interest rates, Chancellor adds, would also benefit “an indebted aristocracy.”

In Chancellor’s summary, “Locke was the first writer to consider at length the potential damage produced by taking interest rates below their natural level.” Locke’s position in modern language includes these points:

• Financiers would benefit at the expense of ”widows and orphans”

• Wealth would be redistributed from savers to borrowers

• Too much borrowing would take place

• Asset price inflation would make the rich richer

Just so, over our recent years of too-low interest rates, ordinary people have had the purchasing power of their savings expropriated by central bank policy and leveraged speculators of various stripes made large profits from overly cheap borrowing, while debt boomed and asset prices inflated into the Everything Bubble.

The central bankers knew what they were doing with respect to asset prices. Chancellor quotes a remarkably candid statement in a Federal Open Market Committee meeting in 2004, in which, as a Federal Reserve Governor clearly put it:

[Our] policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of the distortion is deliberate and a desirable effect if the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand.

That boosting asset prices was “deliberate” is correct; that it was “desirable” seems mistaken to Chancellor and to me. “The records show that the Fed had used its considerable powers to boost the housing market,” he writes (I prefer the phrase, “stoke the housing bubble”). What is worse, the Fed did it twice, and we had two housing bubbles in the brief 23 years of this century. In 2021, the Fed was inexcusably buying mortgage securities and suppressing mortgage rates while the country was experiencing a runaway house price inflation (now deflating).

In general, “Wealth bubbles occur when the interest rate is held below its natural level,” Chancellor concludes.

Bad Press

On a different note, he mentions that suppression of interest rates could lead to “Keynes’ long-held ambition for the euthanasia of the rentier,” using Keynes’ own memorable, if unpleasant, phrase. The recent long period of nearly zero interest rates, however, led to huge market gains on the investments of the rentiers, and caused instead the euthanasia of the savers—or at least the robbing of the savers.

Our recent experience has shown again how borrowers may be made richer by low interest rates, as were speculators, private equity firms, and corporations that levered up with cheap debt. “It is clear that unconventional monetary policies…had a profound impact on inequality,” Chancellor writes, “the greatest beneficiaries from the Fed’s policies [of low interest rates] were the financial elite, who got to enhance their fortunes with cheap leverage at a time when asset values were driven higher by easy money.”

Historically there was a question of whether there should be interest charged at all. “Moneylenders have always received a bad press,” Chancellor reflects, “Over the centuries… the greatest minds have been aligned against them”—Aristotle, for example, thought charging interest was “of all modes of making money…the most unnatural.” The Old Testament restricted charging interest, but as Chancellor points out, the Book of Deuteronomy makes this important distinction: “You shall not lend upon interest to your brother, interest on money, interest on victuals, interest on anything,” but “To a foreigner you may lend upon interest.” This raises the question of who is my brother and who is a foreigner, but does seem to be an early acceptance of international banking. It also makes me think that anyone who has made loans from the Bank of Dad and Mom at the family interest rate of zero, will recognize the intuitive distinction expressed in Deuteronomy.

Needless to say, loans and investments bearing interest prevail around the globe in the tens of trillions of dollars, the moneylenders’ bad press notwithstanding. This is, at the most fundamental level, because interest rates reflect the reality of time, as Chancellor nicely explains. One thousand dollars ten years from now and one thousand dollars today are naturally and inescapably different, and the interest rate is the price of that difference, which gives us a precise measure of how different they are.

A perpetually intriguing part of that price is how interest compounds over long periods of time. “The problem of debt compounding at a geometrical rate has never lost its fascination,” Chancellor observes, and that is certainly true. “A penny put out to 5 percent compound interest at our Savior’s birth,” he quotes an 18th-century philosopher as calculating, “would by this time [in 1773]… have increased to more money than would be contained in 150 millions of globes, each equal to the earth in magnitude, all solid gold.”

The quip that compound interest is “the eighth wonder of the world” is often attributed to Albert Einstein, but Chancellor traces it to a more humble origin: “an advertisement for The Equity Savings and Loan Company published in the Cleveland Plain Dealer” in 1925. “Compound interest… does things to money,” the advertisement continued, “At the Equity it doubles your money every 14 years.” This meant the savings and loan’s deposits were paying 5% interest—the same interest rate used in the preceding 1773-year calculation, but that case represented 123 doublings.

The mirror image of sums remarkably increasing with compound interest is the present value calculation, which reduces the value of future sums by compound interest running backward to the present, a classic tool of finance. Just as we are fascinated, as the Equity Savings and Loan knew, by how much future sums can increase, depending on the interest rate that is compounding, so we are also fascinated by how much today’s market value of future sums can shrink, depending on the interest rate. 

If the interest rate goes from 1% to 4%, about what the yield on the 10-year Treasury note did in 2021-2022, the value of $1,000 ten years from now drops from $905 to $676, or by 25%. You still expect exactly the same $1,000 at exactly the same time, but you find yourself 25% poorer in market value.

Central Bank Distortions

In old British novels, wealth is measured by annual income, as in “He has two thousand pounds a year.” One role of changing interest rates is to make the exact same investment income represent very different amounts of wealth. If interest rates are suppressed by the central banks, it makes you wealthier with the same investment income; if they are pushed up, it makes you poorer. If they change a lot in either direction, the change in wealth is a lot. The math is elementary, but it helps demonstrates why interest rates are, as Chancellor says, the most important price. 

In the 21st century, “The Federal Reserve lowered interest rates to zero and sprayed money around Wall Street.” But if the interest rate is zero, $1,000 ten years in the future is worth the same as $1,000 today, a ridiculous conclusion, and why zero interest rates are only possible in a financial world ruled by central banks.

More egregious yet is the notion of negative interest rates, which were actually experienced on trillions of dollars of debt during the last decade. “The shift to negative interest rates comprised the central bankers’ most audacious move,” Chancellor writes. “What is a negative interest rate but a tax on capital—taxation without representation.” With negative interest rates, $1,000 ten years in the future is worth more than $1,000 today, an absurd conclusion, likewise proof that negative interest rates can only exist under the rule of central banks.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes. In his ideal world, expressed on the book’s last page, “central banks would no longer be able to pursue an active monetary policy,” and “guided by the market’s invisible hand, the rate of interest would find its natural level.” Given all the mistakes central banks have made, with the accompanying distortions, this is an attractive vision, but unlikely, needless to say.

Profligacy in Lockstep

Published in Law & Liberty and re-published in RealClear Markets with Paul Kupiec:

The Swiss National Bank’s (SNB) financial statements for the nine months ending September 30, 2022, show a bottom-line loss of US$150 billion.* A number to get your attention!

Under the strong financial discipline of its charter act, the SNB must mark its investments to market, and reflect any market value loss or profit in its income statement and capital account. From having capital of $221 billion at the end of 2021, the SNB’s capital has been reduced by 73% to $59 billion on September 30 due to falling market prices. Still, the SNB has a capital ratio—a bank’s equity to its total assets—over 6%.

In contrast, the Federal Reserve’s reported capital ratio, which does not reflect the Fed’s massive mark-to-market losses, is 0.5%. The Federal Reserve Bank of New York, by far the largest of the Federal Reserve Banks, has a reported capital ratio of 0.3%—again not counting its market value losses. “It helps the credibility of the central bank to be well capitalized,” said the Vice Chairman of the SNB in October 2022. Presumably, the Fed does not agree.

With Swiss candor, the Chairman of the SNB observed, also in October 2022, that many central banks “brought down longer-term interest rates by buying government and corporate bonds. This increased central banks’ balance sheets and the risks they bear.” (italics added) They certainly did run up their risk, all together, and now the big risks they assumed are turning into losses all around the central bank club.

The Reserve Bank of Australia announced in September that losses on its investments caused its capital to drop to a negative $8 billion on June 30. Its Deputy Governor admitted that “If any commercial entity had negative equity… [it] would not be a going concern,” but maintained, “there are no going concern issues with a central bank in a country like Australia.” Nonetheless, it’s pretty embarrassing to have lost more than all of your capital.

The Bank of England joined “the club of major central banks showing negative net worth” if its investments are marked-to-market, Grant’s Interest Rate Observer reported. Thus far, the Bank has lost $230 billion on its bond investments, 33 times the Bank’s capital of $7 billion as of February 2022, its fiscal year-end. Fortunately for the Bank, it has an indemnity from His Majesty’s Treasury—that is, the taxpayers—to cover the losses. “I am happy to reaffirm…that any future losses incurred by the Asset Purchase Fund will be met in full by the Government,” wrote a Chancellor of the Exchequer. In July 2022 the Financial Times summed it up: “With an indemnity provided by HM Treasury the Bank of England need not fret.” But should the taxpayers who bear the loss fret?

The Bank of Canada carries most of its investments at market value, and its financial statements reflect market value losses of $26 billion as of November 2022. These mark-to-market losses would render the bank’s capital negative were it not for a formal indemnity agreement it has with the Government of Canada. The Canadian government has contractually agreed to make up any realized losses on the Bank’s bond purchase programs. That’s a good thing for the Canadian central bank, since its capital ratio is only 0.1%.

While the Bank of Canada’s financial statements do show that its investment losses put the taxpayers at risk, you have to read the financial statement footnotes carefully to understand what the accounting means. The Bank carries an asset called “Derivatives: Indemnity agreements with the Government of Canada.” This asset is the amount that the government is on the hook for—in other words, it equals $26 billion in mark-to-market losses. Since the Bank’s total reported capital is only about $0.5 billion, the real capital of the Bank is its claim on Canadian taxpayers to reimburse its losses.

Now having created the same risks together, the world’s central banks are suffering big losses together.

The European Central Bank (ECB) has assets of over $9 trillion and a capital ratio of 1.3%. How do its mark-to-market losses compare to its $119 billion in capital? It’s hard to tell, but a German banking colleague wrote us, “ECB is not really transparent, [but] you can guess… Expect price losses in its portfolio of about $800 billion.” If his informed guess is accurate, the ECB has negative capital of about $680 billion on a mark-to-market basis. As our colleague also pointed out, many of the ECB’s investments are low-quality sovereign bonds. It will be interesting indeed to see how these ECB problems play out.

In September, the Governor of the Dutch central bank, De Nederlandsche Bank (DNB), formally wrote to the Ministry of Finance to discuss the Bank’s looming losses, and how “a situation may arise in which the DNB is faced with negative capital.” This is without considering the mark-to-market of its bond portfolio, because the DNB uses accounting conventions, like the Federal Reserve, that do not recognize mark-to-market losses on its QE investments.

“In an extreme case,” the letter continued, “a capital contribution from the shareholder may be necessary.” The sole shareholder is the Dutch government, so once again the cost would be transferred to the taxpayers.

In this unattractive situation the DNB has plenty of company: “All central banks implementing purchase programs, both in the euro area and beyond, are facing these negative consequences,” the Governor observed, adding that these included the Federal Reserve, the Swedish Riksbank, and the Bank of England.

Then, in an October television interview, the Governor brought up the old-fashioned idea of gold. The DNB’s negative capital problem could be ameliorated or avoided he said, by counting as capital the large unrealized profit on its gold. The Bank does mark its 19.7 million ounces of gold to market but keeps the appreciation in a separate $33 billion accounting “reserve,” which is not included in its capital account.

Although it is against the current rules of the Euro system, it would make perfect sense to include the market value of the gold when calculating the DNB’s capital, as the Swiss National Bank does. (This idea would not help the Federal Reserve, because it owns no gold.) It is no small irony that, to bolster their capital, modern fiat currency central banks would consider turning to the value of the “barbarous relic” of gold, against which their own currencies have over time so greatly depreciated.

Coming to the world’s leading central bank, the mark-to-market loss on the Federal Reserve’s investments, as we have previously written, is huge—estimated at a remarkable $1.3 trillion loss as of October 2022. This is 30 times the Fed’s total capital of $42 billion. More immediately pressing, the Fed is now running operating losses that it does recognize in its profit and loss statement of $1 billion or more a week, or annualized losses of $50 to $60 billion. Not counting the mark-to-market losses on its investments, the Fed’s operating losses at this rate will exceed its capital in less than a year.

Complicating the problem, the shares of the Federal Reserve Banks are owned not by the government, but by Fed member commercial banks. Under the Federal Reserve Act, the Fed’s shareholders are required to be assessed for a portion of any losses, but the Fed has thus far seemed to ignore the law and is sharing its operating losses with the taxpayers instead.

“Major central banks tend to move together,” as economist Gary Shilling pointed out recently. We believe this is because the major central banks are a coordinating elite club. They do not and cannot know the financial and economic future, and they must act based on highly unreliable forecasts. They face, and know they face, deep and fundamental uncertainty. Under these circumstances, intellectual and behavioral herding is natural and to be expected. Now having created the same risks together, they are suffering big losses together. In many cases, the accumulating losses will exceed central bank capital and be borne by the taxpayers.

*All currencies have been translated to US dollars at mid-November exchange rates.

Economic Truths, Perennially Forgotten

A review of Surprised Again! The Covid Crisis and the New Market Bubble, written by William M. Briggs and published in Law & Liberty.

In 2021, Treasury Secretary Janet Yellen assured Americans that recent inflation was “transitory.” Back in 2017, Yellen, then Chairman of the Federal Reserve Board, hinted there would not be another financial crisis “in our lifetimes.”

Maybe she got that idea from Morgan Stanley boss James Gorman, who in 2013 put the chance of a crisis “in our lifetime” as “close to zero” as he could imagine. Well, imagination, as the song says, is crazy. “Your whole perspective gets hazy.”

These two experts, as Alex J. Pollock and Howard B. Adler tell us in Surprised Again! The Covid Crisis and the New Market Bubble, are far from alone. Economic experts, they confirm, have a collective accuracy that would embarrass a busload of blind golfers. Not one expert, they remind us, saw the Great Depression coming. And none foresaw the Calamitous Coronadoom Panic of 2020. Which lasted until now.

What is fascinating is that being wrong in no way dents the awesome armor of assurance donned by our experts. Whatever they do when given power, they do it boldly and without doubt. Whether this lack of humility is caused by amnesia or hubris can be debated. But no one can doubt  the astonishing effects of the economic “solutions” foisted upon us by a string of experts during the panic, each trying to correct the ill effects of the other “solutions.”

Read the rest here.

Applying Volcker's Lessons

Published in Law & Liberty:

The year 2022 has certainly been a tough one for the Federal Reserve. The Fed missed the emergence of the runaway inflation it helped create and continued for far too long to pump up the housing bubble and other asset price inflation. It manipulated short- and long-term interest rates, keeping them too low for too long. Now, confronted with obviously unacceptable inflation, it is belatedly correcting its mistake, a necessity that is already imposing a lot of financial pain. 

Sharing the pain of millions of investors who bought assets at the bloated prices of the Everything Bubble, the Fed now has a giant mark-to-market loss on its own investments—this fair value loss is currently about $1 trillion, by my estimation. It is also facing imminent operating losses in its own profit and loss statement, as it is forced to finance fixed-rate investments with more and more expensive floating rate liabilities, just like the 1980s savings and loans of Paul Volcker’s days as Fed Chairman.

In short, the Fed, along with other members of the international central banking club, sowed the wind and is now reaping the whirlwind. Comparing the current situation with the travails of the Volcker years grows ever more essential.

Samuel Gregg, Alexander Salter, and Andrew Stuttaford have provided highly informed observations about the past and present, and offer provocative recommendations for the future of the “incredibly powerful” (as Gregg says) Federal Reserve—the purveyor of paper money not only to the United States, but also to the dollar-dominated world financial system. 

Stuttaford considers the issue of “Restoring the Fed’s Credibility?” with a highly appropriate question mark included. He points out that Volcker did achieve such a restoration of credibility and ended up bestriding “the [wide] world like a colossus,” although, we must remember, not without a lot of conflict, doubt, and personal attacks on him along the way.

But is it good for the Fed to have too much credibility? Is it good for people to believe that the Fed always knows what it is doing, when in fact it doesn’t—when it manifestly does not and cannot know how to “manage the economy” or what longer-run effects its actions will have and when? Is it good for financial actors to believe in the “Greenspan Put,” having faith that the Fed will always take over the risk and bail out big financial market mistakes? It strikes me that it would be better for people not to believe such things—for the Fed not to have at least that kind of “credibility.”

Stuttaford elegantly and correctly, as it seems to me, suggests that “the price of a fiat currency is—or more accurately, ought to be—eternal vigilance against inflation.” Such eternal vigilance requires that we should never simply trust in the Fed and poses the central question of who is to exercise the eternal vigilance.

It is often argued, especially by economists and central bankers, that central banks should be “independent,” thus presumably practicing by themselves the vigilance against inflation, making them something like economic philosopher-kings. Indeed, inside most macro-economists and central bankers there is a philosopher-king trying to get out. But the theory of philosopher-kings does not fit well with the theory of the American constitutional republic.

Those who support central bank independence always argue that elected politicians are permanently eager for cheap loans and printing up money to give to their constituents, so can be depended on to induce high inflation and cannot be trusted with monetary power. But if the central bank also cannot be trusted, what then? Suppose the central bank purely on its own commits itself to perpetual inflation—as the Fed has! Should that be binding on the country? I would say No. The U.S. Constitution clearly assigns to the Congress, to the elected representatives, to the politicians, the power “to coin money [and] regulate the value thereof.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Salter suggests we should follow this constitutional logic. “The Fed should have a single mandate,” he recommends, that of price stability, and “Congress should pick a concrete inflation target.” The Fed wouldn’t get to set its own target: “Since the Fed can’t make credible commitments with a self-adopted rule, the target’s content and enforcement must be the prerogative of the legislature, not the central bank.” In sum, “As long as we’re stuck with a central bank, we should give it an unambiguous mandate and watch it like a hawk. Monetary policymakers answer to the people’s representatives, in Congress assembled.” 

Along similar lines, I have previously recommended that Congress should form a Joint Committee on the Federal Reserve to become highly knowledgeable about and to oversee the Fed in a way the present Banking committees are not and cannot. I argued:

“The money question,” as fiery historical debates called it, profoundly affects everything else and can put everything else at risk. It is far too critical to be left to a governmental fiefdom of alleged philosopher-kings. Let us hope Congress can achieve a truly accountable Fed.

This still seems right to me. As I picture it, however, neither the Federal Reserve nor the Congress by itself would set an inflation target. Rather, on the original “inflation target” model as invented in New Zealand, the target would be a formal agreement between the central bank and the elected representatives. New Zealand’s original target was a range of zero to 2% inflation—a much better target than the Fed’s 2% forever. Since an enterprising, innovative economy naturally produces falling prices through productivity, we should provide for the possibility of such “good deflation.” Hence my suggested inflation target is a range of -1% to 1%, on average about the same target Alan Greenspan suggested when he was the Fed Chairman, of “Zero, properly measured.”

In his insightful history of the Fed, Bernard Shull considered how the Fed is functionally a “fourth branch” of the U.S. government. The idea is to put this additional branch and the Congress into an effective checks-and-balances relationship.

Among other things, this might improve the admission of mistakes and failures by the Fed, and thus improve learning. As Gregg observes, “Admitting mistakes is never something that policymakers are especially interested in doing, not least because it raises questions about who should be held accountable for errors.” And “central bankers do not believe that now is the time for engaging in retrospectives about where they made errors.” Of course they don’t.  But are you more or less credible if you never admit to making the mistakes you so obviously made?

Gregg is skeptical of the ability to control central banks by defined mandates, since we are always faced with “the ability of very smart people to find creative ways around the strictest laws (especially during crises).” The politicians, he points out, often want the central banks to use creative rationales for stretching and expanding their limits, and this is especially true during crises. As a striking example, “the European Central Bank has engaged in several bailouts of insolvent states and operated as a de facto transfer union.” But “governments…say as little as possible about such ECB interventions (and never question their legality),” and this “has everything to do with European governments wanting the ECB to engage in such activities.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Another Roman, Velleius Paterculus, expressed another fundamental central banking problem: “The most common beginning of disaster was a sense of security.” It is most dangerous when the public and the central bankers become convinced of the permanent success of the latest central banking fashion, especially, as Volcker pointed out in his autobiography, if that involves accommodating ever-increasing inflation.

We can conclude our review by stressing that the price of having fiat money is indeed eternal vigilance against inflation. But we don’t know very well how to carry out that vigilance and we can’t count on a new Volcker appearing in time to prevent the problems, or belatedly to address them, or appearing at all.

Restoring The Fed's Credibility?

Published in Law & Liberty by Andrew Stuttaford.

If any central banker, both literally and figuratively, bestrode, in Shakespeare’s phrase, “the…world like a colossus,” it was the 6-foot-7 Paul Volcker.  But, perversely, the giant shadow he cast helps explain our not-so-transitory inflationary mess.

Alex Pollock offers a brisk, deft analysis of Volcker’s battle against inflation. He sets the stage with a 1979 speech by Arthur Burns, Volcker’s not quite immediate predecessor as Fed Chairman. In what Pollock describes as an “agonizing reappraisal,” Burns conceded (he could hardly do otherwise) that central banks had failed to rein in inflation. Running through his lament was an acknowledgment that the Fed had gone along with “the philosophic and political currents that were transforming American life and culture,” currents that had also swept away traditional notions of fiscal and monetary discipline.

Read the rest here.

Volcker and the Great Inflation: Reflections for 2022

Published in Law & Liberty and also in RealClear Markets.

The celebrated Paul Volcker (1927-2019) became Chairman of the Federal Reserve Board 43 years ago on August 6, 1979. The 20th-century Great Inflation, stoked by the Federal Reserve and the other central banks of the day, was in full gallop in the U.S and around the world. In the month he started as Chairman, U.S. inflation continued its double-digit run—that August suffered a year-over-year inflation rate of 11.8%. On August 15, the Federal Reserve raised its fed funds mid-target range to 11%, but that was less than the inflation rate, so a nominal 11% was still a negative real interest rate. How bad could it get? For the year 1979, the December year-over-year inflation was an even more awful 13.3%. At that compound rate, the cost of living would double in about five years.

Everybody knew they had an inflationary disaster on their hands, but what could be done? They had already tried “WIN” (“Whip Inflation Now”) buttons, but inflation was whipping them instead. In this setting, “The best professional judgment among leading economists was that Americans should view the problem of inflation as being…intractable,” wrote Volcker’s biographer, William Silber. Leading Wall Street forecaster Henry Kaufman, for example, was pessimistic in 1980, opining “that he had ‘considerable doubt’ that the Fed could accomplish its ultimate objective, which is to tame inflation. He added for good measure that the Fed no longer had ‘credibility in the real world.”

Those days are now most relevant. Although Silber could write in 2012, “Inflation is ancient history to most Americans,” today it is upon us once again. What can we re-learn?

From Burns to Volcker

In September 1979, Arthur Burns, who had been Fed Chairman from 1970 to 1978, gave a remarkable speech entitled “The Anguish of Central Banking.” Discussing “the reacceleration of inflation in the United States and in much of the rest of the word,” “the chronic inflation of our times,” and “the world wide disease of inflation,” he asked, “Why, in particular, have central bankers, whose main business one might suppose is to fight inflation, been so ineffective?”

We may observe to the contrary that they had been very effective—but in producing inflation instead of controlling it, just as their 21st-century successors were effective in producing first the asset price inflation of the Everything Bubble, which is now deflating, and then destructive goods and services inflation, much to their own surprise. In both centuries, inflation was not an outside force attacking them, as politicians and central bankers both then and now like to portray it, but an endogenous effect of government and central bank behavior.

In what one might imagine as a tragic dramatic soliloquy, Burns uttered this cri de coeur: “And yet, despite their antipathy to inflation and the powerful weapons they could wield against it, central bankers have failed so utterly in this mission in recent years. In this paradox lies the anguish of central banking.”

I suspect the central bankers of 2022 in their hearts are feeling a similar anguish. Their supporting cast of government economists should be, too. “Economists at both the Federal Reserve and the White House were blindsided,” as Greg Ip wrote. “Having failed to anticipate the steepest inflation in 40 years,” he mused, “you would think the economics profession would be knee-deep in postmortems”—or some confessions of responsibility. But no such agonizing reappraisals as Burns’ speech seem forthcoming.

Reflecting that “Economic life is subject to all sorts of surprises [which] could readily overwhelm and topple a gradualist timetable,” in 1979 Burns announced that “I have reluctantly come to believe that fairly drastic therapy will be needed to turn the inflationary psychology around.” This was correct except for the modifier “fairly.” But, Burns confessed, “I am not at all sure that many of the central bankers of the world…would be willing to risk the painful economic adjustments that I fear are ultimately unavoidable.”

In our imagined drama of the time, enter Volcker, who was willing. He proceeds with firm steps to center stage. Burns fades out.

“If Congress had doubts about Volcker’s intentions,” says Allan Meltzer’s A History of the Federal Reserve, “they should have been dispelled by his testimony of September 5 [1979]”—one month after he took office. “Unlike the Keynesians, he considered the costs [of inflation] higher than the costs of reducing inflation.” Said Volcker to Congress, “Our current economic difficulties…will not be resolved unless we deal convincingly with inflation.”

In a television interview later that month, he was equally clear: “I don’t think we can stop fighting inflation. That is the basic, continuing problem that we face in this economy, and I think until we straighten out the inflation problem, we’re going to have problems of economic instability. So it’s not a choice….”

But what would it take to put into reverse the effects of years of undisciplined money printing, which accompanied oil supply and price shocks and other bad luck? Under the cover of restricting the growth in the money supply, Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%.

It is not clear whether Volcker ever took seriously the monetarist doctrine of focusing on the money supply, which he later abandoned, or simply used it as a pragmatic way to do what he wanted, which was to stop the runaway inflation. It is clear that he firmly rejected the Keynesian Phillips Curve approach of trying to buy employment with inflation. That had led central banks into inflationary adventures and resulted in simultaneous high inflation and high unemployment—the “stagflation” of the late 1970s, to which many think we risk returning in 2022.

The Double Dip Recessions

The Volcker program triggered a sharp recession from January 1980, five months after he arrived, to July 1980, and then a very deep and painful recession from July 1981 to November 1982—“double dip recessions.” Both hit manufacturing, goods production, and housing particularly hard, and generated the hard times of the “rust belt.” In 1982, unemployment rose to 10.8%, worse than the “Great Recession” peak unemployment of 10.0% in 2009.

“The 1981-82 recession was the worst economic downturn in the United States since the Great Depression,” says the Federal Reserve History. “The nearly 11% unemployment reached in late 1982 remains the apex of the post-World War II era [until surpassed in the Covid crisis of 2020]…manufacturing, construction and the auto industries were particularly affected.”

There were thousands of business bankruptcies. “The business failure rate has accelerated rapidly,” wrote the New York Times in September 1982, “coming ever closer to levels not seen since the Great Depression.” The total of over 69,000 business bankruptcies in 1982 was again worse than in the “Great Recession” year of 2009, which had 61,000.

The extreme interest rates wiped out savings and loan institutions, formerly the backbone of American mortgage finance, by the hundreds. The savings and loan industry as a whole was insolvent on a mark-to-market basis. So, in 1981, was the government’s big mortgage lender, Fannie Mae. A friend of mine who had a senior position with the old Federal Home Loan Bank Board recalls a meeting with Volcker at the time: “He was telling us he was going to crush the savings and loans.” There were securities firm and bank failures and then the massive defaults on the sovereign debt of “less developed countries” (“LDCs” in the jargon of the time), starting in August 1982. These defaults put the solvency of the entire American banking system in question.

This was a really dark and serious downer, but Volcker was firm about what he was convinced was the long-run best interest of the country. Was it debatable? Certainly.

There was plenty of criticism. Volcker wrote: “There were, of course, many complaints. Farmers once surrounded the Fed’s Washington building with tractors. Home builders, forced to shut down, sent sawed-off two-by-fours with messages…. Economists predictably squabbled.… Community groups protested at our headquarters….My speeches were occasionally interrupted by screaming protestors, once by rats let loose in the audience….” And “the Fed insisted I agree to personal security escort protection.”

In the government, Congressman Henry Reuss “reminded Volcker that the Constitution gave the monetary power to Congress”—as it does. “Congressman Jack Kemp called for Volcker’s resignation.” At the U.S. Treasury, “Secretary Donald Regan, a frequent critic, considered legislation restoring the Treasury Secretary to the [Federal Reserve] Board.” “Senator [Robert] Byrd introduced his bill to restrict Federal Reserve independence by requiring it to lower interest rates.” Inside the Federal Reserve Board, Governor Nancy Teeters, citing failures, the economy, high long-term interest rates, and high unemployment, objected in May 1982, “We are in the process of pushing the economy not just into recession, but into depression…I think we’ve undertaken an experiment and we have succeeded in our attempt to bring down prices…But as far as I’m concerned, I’ve had it.”

The minutes of the Federal Open Market Committee consistently display the intense uncertainty which marked the entire disinflationary project. “Volcker expressed his uncertainty frequently,” Meltzer observes, as he told the FOMC, for example: “I don’t know what is going to happen in the weeks or months down the road, either to the economy or to the aggregates or these other things,” or as he told Congress, “How limited our ability is to project future developments.” To his perseverance, add honesty. The same deep uncertainty will mark the Fed’s debates and actions in 2022 and always.

The 1982 recession finally ended in November. Inflation in December 1982 was 3.8% year-over-year. The fed funds rate was 8.8%. The year 1982 also saw the start of the two-decade bull market in stocks, and the 40-year bull market in bonds.

Meltzer speculated that the recession was more costly and “probably lasted longer than necessary.” Could a less severe recession have achieved the same disinflation? About such counterfactuals we can never know, but the current Fed must certainly hope so.

In 1983, President Ronald Reagan reappointed Volcker as Fed Chairman. In 1984, Reagan was re-elected in a landslide, the economy was booming, and inflation was 3.9%.

When Volcker left office in August 1987, inflation was still running at 4%, far from zero, but far below the 13% of 1979 when he had arrived as Fed Chairman. Real GDP growth was strong; fed funds were 6.6%. “The Great Inflation was over, and markets recognized that it was over.” Endemic inflation, however, was not over.

Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent.

Volcker’s Legacy

On top of the pervasive uncertainty, the Federal Reserve worried constantly during the Volcker years, as it must now, about its own credibility. Meltzer believed Volcker’s lasting influence was to “restore [the Federal Reserve] System credibility for controlling inflation.” But a generation after Volcker, the Fed committed itself to perpetual inflation at the rate of 2% forever. At the 2% target rate, prices would quintuple in an average lifetime. That is obviously not the “stable prices” called for in the Federal Reserve Act, but the Fed kept assuring everybody it was “price stability.” Volcker made clear his disagreement with this 2% target, writing of it in 2018, “I know of no theoretical justification. … The real danger comes from encouraging or inadvertently tolerating rising inflation.”

The classic monetary theorist Irving Fisher had warned, as have many others, that “Irredeemable paper money has almost invariably proved a curse to the country employing it.” Silber reflects that “The 1970s nearly confirmed Irving Fisher’s worst fears.” I would delete the word “nearly” from that last sentence.

The inflationary problems of Volcker’s days and ours are fundamentally linked to the demise of the Bretton Woods system in 1971, when the United States reneged on its international commitment to redeem dollars in gold. This put the whole world on pure fiat money instead, with fateful results. According to Brendan Brown, “Volcker considered the suspension of gold convertibility…’the single most important event of his career.’”  Indeed, it created the situation which put him on the road to future greatness. Ironically, Volcker began as a strong supporter of the Bretton Woods system, but then helped dismantle it. Of course, he was always an ardent anti-inflationist. “Nothing is more urgent than the United States getting its inflation under control,” he had already written in a formal Treasury presentation in 1969.

“Inflation undermines trust in government,” Volcker said. That it does, and such loss of trust is justified, then and now. Putting the thought another way, Volcker deeply believed that “Trust in our currency is fundamental to good government.” Throughout his life, he did his best to make the U.S. dollar trustworthy.

In retrospect, Volcker became “an American financial icon.” He elicits comments such as this one: “I knew Paul Volcker (who slew the Great Inflation). Volcker stopped inflation in the 1980s….” Or: “Volcker was the Federal Reserve knight who killed inflation.” Or: “Volcker and his FOMC…did what they thought was necessary, generating enormous pain but finally stamping out inflation. I hope Jerome Powell will find his inner Volcker.” As we have seen, Volcker didn’t actually stop or kill or stamp out inflation, but he brought it down from runaway to endemic.

His successor as Fed Chairman, Alan Greenspan, said “We owe a tremendous debt of gratitude to Chairman Volcker and the Federal Open Market Committee for…restoring the public’s faith in our nation’s currency.”

In 1990, Volcker spoke in the same Per Jacobsson Lecture series which had been the site of Arthur Burn’s anguish eleven years before. A similar audience of central bankers and finance ministers this time was treated to “The Triumph of Central Banking?” This included “my impression that central banks are in exceptionally good repute these days.”

However, he pointed out the question mark. “I might dream of a day of final triumph of central banking, when central banks are so successful in achieving and maintaining price and financial stability that currencies will be freely interchangeable at stable exchange rates” (shades of his earlier commitment to Bretton-Woods). “But that is not for my lifetime—nor for any of yours.” About that he was right, and also right about a more important point: “I think we are forced to conclude that even the partial victory over inflation is not secure.” There he was wiser than his many eulogists, as is obvious in 2022.

In discussions of the current inflation, including similarities to the 1970s, references to Volcker are frequent and laudatory. For example, “Federal Reserve Chairman Jerome Powell has taken of late to praising legendary Paul Volcker, as a signal of his new inflation-fighting determination.” Or “Powell tried to engage in some plain speaking, by telling the American people that inflation was creating ‘significant hardship’ and that rates would need to rise ‘expeditiously’ to crush this. He also declared ‘tremendous admiration’ for his predecessor Paul Volcker, who hiked rates to tackle inflation five decades ago, even at the cost of a recession.”

No Permanent Victories

With the model of Volcker in mind, will we now experience parallels to the 1981-82 recession, as well? This is the debate about whether a “soft landing” is possible from where the central banks have gotten us now. If we repeat the pattern of the 1980s, it will not be a soft landing and the cost of suppressing inflation will again be high, but worth it in the longer run. It should rightly be thought of as the cost of the previous central bank and government actions that brought the present inflation upon us.

Silber concluded that in the 1980s, “Volcker rescued the experiment in fiat currency from failure.” But experimentation with fiat currency possibilities has continued, including the creation of a giant portfolio of mortgage securities on the Fed’s own balance sheet, for example. When politicians and central bankers are hearing the siren song of “just print up some more money”—a very old idea recently called modern in “modern” monetary theory— in whatever guise it may take, who will provide the needed discipline, as Volcker did? Under various versions of the gold standard, it might be a matter of “what” provides monetary discipline, but in the fiat currency world of Volcker’s time and now, it is always and only a question of “who.”

Volcker wrote that “Bill Martin [William McChesney Martin, Fed Chairman 1951-70]… is famous for his remark that the job of the central bank is to take away the punch bowl just when the party gets going.” Unfortunately, Volcker continued, “the hard fact of life is that few hosts want to end the party prematurely. They wait too long and when the risks are evident, the real damage is done”—then it is already too late and the problem has become a lot harder. Like now.

As has been truly said, “In Washington, there are no permanent victories.” Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent. In 2021-22, we are back to disastrously high inflation, recognize the need to address it, and feel the costs of doing so. And Chairman Powell is citing Chairman Volcker.

But are there factors, four decades later, making the parallels less close? For example, international investor Felix Zulauf “thinks the Powell Fed is quite different from the Volcker Fed, and not just because of the personalities. It’s in a different situation and a different financial zeitgeist [and different political zeitgeist]. He doesn’t think the Fed, or any other central bank can get away with imposing the kind of pain Volcker did and will stop as soon as this year.” (italics added)

Suppose that is right—what then? Then the pain will come from continued inflation instead. There is now no avoiding pain, which will come in one way or the other.

A similar, though more strident, argument from June 2022 is this: “It will be politically impossible to raise rates enough to stop inflation. … Volcker raised rates to 19%. There is no way the Fed is going anywhere near that.…You may recall the Fed not long ago said they…were just talking about raising rates.” And echoing Henry Kaufman in 1980, “None of them has any credibility anymore.”

We must admit that the current fed funds rate of 1.75% with an inflation of 8.5%, for a real fed funds rate of negative 6.75%, is hardly Volckeresque. Indeed, there is nothing Volkeresque yet. Interest rates in 1980-81 went far higher than most people imagined possible—perhaps they will again go higher than now thought possible and maybe we will even see positive real interest rates again.

Chairman Powell was a Fed Governor and Chairman while the wind of the present inflation was being sown, and he is there to reap the whirlwind. Will the Fed under his leadership tame it and at what cost, as all the maladjustments and the financial dependence of both the government and private actors on negative real rates and cheap leverage during the last decade must now be corrected?

We might imagine a hypothetical case in which Paul Volcker was 40 years younger, and with his unyielding commitment to trustworthy money and his insistence that achieving it is worth the cost, had become the new Fed Chairman in 2022. We can speculate about what he would be and could be doing now.

But in the real case, just as Volcker did beginning in 1979, Chairman Powell has now stepped to center stage in the current drama. We cannot yet say whether his future valedictory lecture will be about the Anguish or the Triumph of central banking.

The Fed’s Tough Year

Published in Law & Liberty and republished in RealClear Markets.

The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:

• It has failed with inflation forecasting and performance;

• It has giant mark-to-market losses in its own investments and looming operating losses;

• It is under political pressure to do things it should not be doing and that should not be done at all.

Forecasting Inflation

As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.

The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25%, so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.

In short, the Federal Reserve cannot reliably forecast economic outcomes, or what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.

It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.

We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended “QE” strategy in 2012 as “a shot in the proverbial dark.” That was an honest admission, although unfortunately he admitted it only within the Fed, not to the public.

The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing.” Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.

Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.

Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.

A Mark-to-Market Insolvent Fed

Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of March 31, 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330 billion on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8 trillion of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200 billion in round numbers, bringing the Fed’s total MTM loss to over $500 billion.

Compare this $500 billion loss to the Fed’s total capital of $41 billion. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question—most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?

The Fed’s first defense of its huge MTM loss is that the loss is unrealized, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5 trillion of floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come, if the higher short-term interest rates implied by current market prices come to pass.

The Fed’s second defense is that it has changed its accounting so that realized losses on securities or operating losses will not affect its reported retained earnings or capital. Instead, the resulting debits will be hidden in a dubious “deferred asset” account. Just change the accounting! (This is exactly what the insolvent savings and loans did in the 1980s, with terrible consequences.)

What fun it is to imagine what any senior Federal Reserve examiner would tell a bank holding company whose MTM losses were 12 times its capital. And what any such examiner would say if the bank proposed to hide realized losses in a “deferred asset” account instead of reducing its capital!

Here is a shorthand way to think about the dynamics of how Fed operating losses would arise from their balance sheet: The Fed has about $8 trillion in long-term, fixed-rate assets. It has about $3 trillion in non-interest-bearing liabilities and capital. Thus, it has a net position of $5 trillion of fixed rate assets funded by floating rate liabilities. (In other words, inside the Fed is the financial equivalent of a giant 1980s savings and loan.)

Given this position, it is easy to see that pro forma, for each 1% rise in short-term interest rates, the Fed’s annual earnings will be reduced by about $50 billion. What short-term interest rate would it take to wipe out the Fed’s profits? The answer is 2.7%. If their deposits and repo borrowings cost 2.7%, the Fed’s profits and its contribution to the U.S. Treasury will be zero. If they cost more than 2.7%, as is called for in the Fed’s own projections, the Fed starts making operating losses.

How big might these losses be? In the Fed staff’s own recent projections, in its most likely case, the projected operating losses add up to $60 billion. This is 150% of the Fed’s total capital. In the pessimistic case, losses total $180 billion, over 4 times its capital, and the Fed makes no payments to the Treasury until 2030.

In such cases, should the Fed’s shareholders, who are the commercial banks, be treated like normal shareholders and have their dividends cut? Or might, as is clearly provided in the Federal Reserve Act, the shareholders be assessed for a share of the losses? These outcomes would certainly be embarrassing for the Fed and would be resisted.

The central bank of Switzerland, the Swiss National Bank (SNB), did pass on its dividends in 2013, after suffering losses. The SNB Chairman gave a speech at the time, saying in effect, “Sorry! But that’s the way it is.” Under its chartering act, the SNB—completely unlike the Fed—must mark its investment portfolio to market in its official profit and loss statement. Accordingly, in 2022 so far, the SNB has reported a net loss of $31 billion for the first quarter and a net loss of $91 billion for the first six months of this year.

The Swiss are a serious people, and also serious, it seems, when it comes to central bank accounting and dividends.

In the U.S., the Federal Reserve Bank of Atlanta did pass its dividend once, in 1915. As we learn from the Bank’s own history, “Like many a struggling business, it suspended its dividend that year.” Could it happen again? If the losses are big and continuing, should it?

A third Fed defense is that its “mandate is neither to make profits nor to avoid losses.” On the contrary, the Fed is clearly structured to make seigniorage profits for the government from its currency monopoly. While not intended by the Federal Reserve Act to be a profit maximizer, it was also not intended to run large losses or to run with negative capital. Should we worry about the Fed’s financial issues, or should we say, “Pay no attention to the negative capital behind the curtain!”

The Fed is obviously unable to guarantee financial stability. No one can do that. Moreover, by trying to promote stability, it can cause instability.

What the Fed Can and Can’t Do Well

The Federal Reserve is also suffering from a push from the current administration and the Democratic majority in the House of Representatives to take on a politicized agenda, which it probably can’t do well and more importantly, should not do at all.

This would include having the Fed practice racial preferences, that is, racial discrimination, and as the Wall Street Journal editors wrote, “Such racial favoritism almost certainly violates the Constitution. So does the [House] bill’s requirement that public companies disclose the racial, gender identity and sexual orientation of directors and executives.” The bill would “politicize monetary policy and financial regulation.” A lot of bad ideas.

Moreover, the Federal Reserve already has more mandates than it can accomplish, and its mandates should be reduced, not increased.

As has been so vividly demonstrated in 2021 and 2022, the Fed cannot accurately forecast economic outcomes, and cannot know what the results of its own actions, or its “shots in the proverbial dark,” will be.

Meanwhile, it is painfully failing to provide its statutory mandate of stable prices. Note that the statute directs the goal of “stable prices,” not the much more waffly term the Fed has adopted, “price stability.” It has defined for itself that “price stability” means perpetual inflation at 2% per year.

The Fed cannot “manage the economy.” No one can.

And the Fed is obviously unable to guarantee financial stability. No one can do that, either. Moreover, by trying to promote stability, it can cause instability, an ironic Minskian result—Hyman Minsky was the insightful theorist of financial fragility who inspired the slogan, “stability creates instability.”

There are two things the Fed demonstrably does very well.

The first is financing the government. Financing the government of which it is a part is the real first mandate of all central banks, especially, but not only, during wars, going back to the foundation of the Bank of England in 1694. As the history of the Atlanta Fed puts it so clearly:

During the war [World War I], the Fed was introduced to a role that would become familiar…as the captive finance company of a U.S. Treasury with huge financing needs and a compelling desire for low rates.

This statement is remarkably candid: “the captive finance company of [the] U.S. Treasury.” True historically, true now, and why central banks are so valuable to governments.

The second thing the Fed does well is emergency funding in a crisis by creating new money as needed. This was its original principal purpose as expressed by the Federal Reserve Act of 1913: “to furnish an elastic currency,” as they called it then. This it can do with great success in financial crises, as shown most recently in 2020, and of course during wars, although not without subsequent costs.

However, the Fed is less good at turning off the emergency actions when the crisis is over. Its most egregious blunder in this respect in recent years was its continuing to stoke runaway house price inflation by buying hundreds of billions of dollars of mortgage securities, continuing up to the first quarter of 2022. This has severe inflationary consequences as the cost of shelter drives up the CPI and erodes the purchasing power of households. Moreover, it now appears the piper of house price inflation is exacting its payment, as higher mortgage rates are resulting in falling sales and by some accounts, the beginning of a housing recession.

Among the notions for expanding the Fed’s mandates, the worst of all is to turn the Fed into a government lending bank, which would allocate credit and make loans to constituencies favored by various politicians. As William McChesney Martin, the Fed Chairman 1951-1970, so rightly said when this perpetual bad idea was pushed by politicians in his day, it would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

It is a natural and permanent temptation of politicians to want to do just that—to use the money printing power of the central bank to give money to their political supporters without the need for legislative approval or appropriation, and to surreptitiously finance it by imposing an inflation tax without legislation.

One way to achieve this worst outcome would be to have the Fed issue a “central bank digital currency” (CBDC) that allows everybody to have a deposit account with the Fed, which might then become a deposit monopolist as well as a currency monopolist.

Should that happen, the Fed would by definition have to have assets to employ its vastly expanded deposit liabilities. What assets would those be? Well, loans and securities. The Fed would become a government lending bank.

The global experience with such government banks is that they naturally lend based on politics, which is exactly what the politicians want, with an inevitable bad ending.

On top of that, with a CBDC in our times of Big Data, the Fed could and probably in time would choose to know everybody’s personal financial business. This could and perhaps would be used to create an oppressive “social credit system” on the model of China which could control credit allocation, loans, and payments. Given the urge to power of any government and of its bureaucratic agencies, that outcome is certainly not beyond imagining, and is, in my view, likely.

The current push to expand the Fed’s mandates is consistent with Shull’s Paradox, which states that the more blunders the Fed makes, the more powers and prestige it gets. But we should be reducing the Fed’s powers and mandates, not increasing them. Specifically:

• The Fed should not hold mortgage securities or mortgages of any kind. It should take its mortgage portfolio not just to a smaller size, but to zero. Zero was just where it was from 1914 to 2008 and where it should return.

• The Fed should not engage in subsidizing political constituencies and the proposed politicized agenda should be scrapped.

• Congress should definitively take away the Fed’s odd notion that the Fed can by itself, without Congressional approval, set a national inflation target and thereby commit the country and the world to perpetual inflation.

• Congress should repeat its instruction to the Fed to pursue stable prices. As Paul Volcker wrote in his autobiography, “In the United States, we have had decades of good growth without inflation,” and “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”

• The Fed should be required to have sound accounting for its own financial statements, with no hiding losses in the former savings and loan style allowed. This requires taking away from the Fed the power to set its own accounting standards, which nobody else has.

• The Fed should be prohibited from buying TIPS (Treasury Inflation-Protected Securities), because this allows it to manipulate apparent market inflation expectations.

• The funding of the Consumer Financial Protection Bureau expenses out of Fed profits should be terminated. This is an indefensible use of the Fed to take away the power of the purse from Congress and to subsidize a political constituency. It would be especially appropriate to end this payment if the Fed is making big losses.

• Finally, and most important of all, we must understand the inherent limitations of what the Federal Reserve can know and do. There is no mystique. We must expect it to make mistakes, and sometimes blunders, just like everybody else.

Knowing this, perhaps the 2020s will give us the opportunity to reverse Shull’s Paradox.

This paper is based on the author’s remarks at the American Enterprise Institute conference, “Is It Time to Rethink the Federal Reserve?” July 26, 2022.

Are Cryptocurrencies the Great Hayekian Escape?

Published in Law & Liberty. Also republished in RealClear Markets.

Practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people,” wrote the great economist Friedrich Hayek. He meant that when governments want to run big deficits, they can take the people’s money through currency depreciation and inflation, without having to pass any tax legislation. For governments to do this, having a central bank is very handy.

To finance government deficits, central banks with a fiat currency monopoly create as much money as desired, whether by literal printing or metaphorical printing by accounting entries, thus, as it is called, monetizing government debt. Since the 1960s, this has led to endemic inflation and continuous depreciation of the currency, sometimes fairly slowly (what used to be called “creeping inflation”), and sometimes very rapidly—like now. This is in sharp contrast to honest or sound money, which would have a stable value on average over time. 

In response, can the people escape the government’s currency monopoly with cryptocurrencies? Cryptocurrencies try to create competitive alternatives to depreciating central bank fiat money. Their development has set off an instructive dialectic between money as a government monopoly and possible private forms of money. 

A fundamental text for the concept of domestic monetary competition is Hayek’s notable essay, “Choice in Currency: a Way to Stop Inflation.” Published in 1976, in the wake of the collapse of the Bretton-Woods monetary system and during the great 1970s inflation, Hayek’s discussion included these provocative thoughts:

What is so dangerous and ought to be done away with is not governments’ right to issue money but the exclusive right to do so and their power to force people to use it.…Why should we not let the people choose freely what money they want to use? … If governments and other issuers of money have to compete in inducing people to hold their money…they will have to create confidence in its long-term stability… I hope it will not be too long before complete freedom to deal in any money one likes will be regarded as the essential mark of a free country.

These ideas or similar ones are echoed by supporters of all the cryptocurrencies that have appeared since the introduction of Bitcoin in 2009, which have had their own truly remarkable bull market. However, are today’s cryptocurrencies true alternatives to government fiat currency of the sort Hayek envisioned?

In 1976, Hayek was not thinking of the cryptocurrencies that have appeared in the last decade. He was thinking about gold. He wondered whether there might still be a rebirth for gold as money, although the last vestiges of the gold standard had just disappeared with the death of Bretton-Woods. This is apparent from the following section of his essay:

Where I am not sure is whether in such a competition for reliability any government-issued currency would prevail, or whether the predominant preference would not be in favor of some such units as ounces of gold. It seems not unlikely that gold would ultimately re-assert its place as ‘the universal prize in all countries’…if people were given complete freedom to decide what to use as their standard.

 One of the great marketing and public relations triumphs of recent years was Bitcoin’s success in convincing people, especially the media, to refer to it as a “coin,” and to publish articles about Bitcoin constantly accompanied by pictures of gold coins with a “B” in the form of a dollar sign stamped on them–just like the picture at the top of this essay. This was PR genius, a psychological reminder of the preference Hayek had expected. But obviously, a nonredeemable electronic entry in a computerized ledger bears no resemblance to an actual gold coin, with or without a ‘B’ stamped on it. The essential fact about Bitcoins is that there is no promise to redeem them with anything—in that sense, they are just like Federal Reserve dollars.

The price of Bitcoins has reached astronomical levels, accompanied in its flight by the idea of trying to escape from the Federal Reserve dollar (and all other central bank fiat currencies). In this way, buyers of Bitcoins and gold are similar. The well-known billionaire investor and speculator Stanley Druckenmiller was reported as explaining that “he finally realized what problem Bitcoin aims to solve—and that problem was called ‘central banks.’” Said Druckenmiller, without excess diplomacy:

The problem was Jay Powell and the world’s central bankers going nuts and making fiat money even more questionable than it already has been when I used to own gold.

Bitcoin, or any other cryptocurrency modeled on it, is equally a fiat currency. In these cryptocurrencies we see the radical attempt to create a private fiat currency. They are tied to no asset and no cash flow, and by definition, have no tie to government power. This is what makes them so intriguing. 

In contrast, the U.S. national bank notes of the 19th and early 20th centuries were tied to U.S. Treasury bonds as collateral, and state bank notes to the general assets of the issuing bank. It seems dubious that with no tie at all to any assets or cash flow, you can get a private currency reliably useful for ordinary exchange and as store of value. (Even with the infamous tulip bubble, there was a real tulip bulb involved. Although you might have lost a lot of money, at least you could still grow a tulip.) 

Nonetheless, the Bitcoin model has, without doubt, created a fascinating intangible object of speculation which displays extreme price volatility, with startling ascents and free-fall drops. It is often said, which seems right to me, that this volatility makes it unsuitable or unusable for ordinary, legal, everyday payments and exchange, since you have no idea from day to day what its value will be. Therefore, cryptocurrencies on the Bitcoin model create, as the Bank for International Settlements put it in 2021, “speculative assets rather than money.” While notably successful at becoming speculative assets, they thus fail to be a Hayekian competitor to central bank fiat money as money.

Trying to solve the problem of price volatility led to the development of a variety of stablecoins, which target a constant value in terms of the U.S. dollar (or other national currency), are backed by a “reserve” of dollar-denominated assets held by the issuer to support the value, and promise to various extents redemption in dollars. It is apparent, as many financial regulators have observed, that such a stablecoin looks very much indeed like a deposit in a bank, backed by the assets of the bank, and is equally dependent on the quality, riskiness, and liquidity of those assets for the ability to redeem it at par value.

But in terms of the grand objective of creating a Hayekian competitor to central bank fiat currency, there is a much more fundamental problem. A moment’s thought makes the deeper issue obvious: if the stablecoin gives itself stability and currency by linking itself to the U.S. dollar (or any other national currency), it has completely failed to escape the government’s central bank, and is instead entirely dependent on it.

If the Federal Reserve steadily depreciates the purchasing power of the dollar, the purchasing power of the stablecoin automatically goes down accordingly. If the dollar suffers rapid inflation, so will the stablecoin. If the dollar succumbs to hyper-inflation, so will the stablecoin. Thus, the stablecoin may represent a variation or perhaps an improvement on payments technology, but it does not, and cannot by design, represent a new currency. As long as it is linked to a national currency, it is part of the central bank fiat currency system, just as a bank deposit is, and fails to be a Hayekian competitive currency.

In a striking historical irony, the libertarian idea to free people from central bank monopoly money through cryptocurrencies has dialectically given rise to the idea of a central bank issuing its own cryptocurrency, with the more dignified name of “central bank digital currency.” If this should happen the central bank could become the bank for everyone, with the potential to be the monopolist of deposits, loans, and personal financial information, as well as the monopolist of money. This highly undesirable dialectical reversal would make the monetary system vastly more centralized and the central bank vastly more powerful than before. China, and more recently Canada, have shown us the direction that political control of your personal account can take. This would certainly be a non-Hayekian outcome!

Can there be a true alternative in Hayek’s sense to central bank fiat currencies, other than currency redeemable in gold? One of my friends has suggested a digital currency in which the unit is a real dollar—that is, a dollar adjusted for changes in the Consumer Price Index, so that the central bank cannot dilute its purchasing power (at least as captured by the CPI). It would resemble in this sense the Series I U.S. savings bond, which today pays its holders whatever the increase in the CPI turns out to be. But unlike the savings bond, the real dollar currency would need to be freely exchangeable, and available in large amounts. It would be an echo of the 1920s proposal of Irving Fisher, a famous economist in his day, to have a “compensated dollar,” which would automatically increase in value to offset inflation.

With today’s financial technology, would it be possible to create such a collateralized private currency, redeemable in inflation-adjusted dollars of steady purchasing power? Could an asset portfolio to back it be designed? Perhaps not, but it is an interesting thought experiment, in the spirit of Hayek, while we keep looking for a form of money to compete with the constantly depreciating, and now rapidly depreciating, Federal Reserve dollar and other central bank fiat currencies.

Federal Housing Regulators Have Learned and Forgotten Everything

Published in Law & Liberty and in Real Clear Markets.

Should the government subsidize buying houses that cost $1.2 million? The answer is obviously no. But the government is going to do it anyway through Fannie Mae and Freddie Mac. The Federal Housing Finance Authority (FHFA) has just increased the size of mortgage loans Fannie and Freddie can buy (the “conforming loan limit”) to $970,080 in “high cost areas.” With a 20% down payment, that means loans for the purchase of houses with a price up to $1,212,600.

Similarly, the Federal Housing Administration (FHA) will be subsidizing houses costing up to $1,011,250. That’s the house price with a FHA mortgage at its increased “high cost” limit of $970,800 and a 4% down payment.

The regular Fannie and Freddie loan limit will become $647,200, which with a 20% down payment means a house costing $809,000. The median U.S. price sold in June 2021 was $310,000. A house selling for $809,000 is in the top 7% in the country. One selling for $1,212,600 is in the top 3%. To take North Carolina for example, where house prices are less exaggerated, an $809,000 house is in the top 2%. For FHA loans, the regular limit will become $420,680, or a house costing over $438,000 with a 4% down payment—41% above the national median sales price.

Average citizens who own ordinary houses may think it makes no sense for the government to support people who buy, lenders that lend on, and builders that build such high-priced houses, not to mention the Wall Street firms that deal in the resulting government-backed mortgage securities. They’re right.

Fannie and Freddie, which continue to enjoy an effective guarantee from the U.S. Treasury, will now be putting the taxpayers on the hook for the risks of financing these houses. Through clever financial lawyering, it’s not legally a guarantee, but everyone involved knows it really is a guarantee, and the taxpayers really are on the hook for Fannie and Freddie, whose massive $7 trillion in assets have only 1% capital to back them. FHA, which is fully guaranteed by the Treasury, has in addition well over a trillion dollars in loans it has insured.

By pushing more government-sponsored loans, Fannie, Freddie, its government conservator, the FHFA, and sister agency, the FHA, are feeding the already runaway house price inflation. House prices are now 48% over their 2006 Housing Bubble peak. In October, they were up 15.8% from the year before. As the government helps push house prices up, houses grow less and less affordable for new families, and low-income families in particular, who are trying to climb onto the rungs of the homeownership ladder.

As distinguished housing economist Ernest Fisher pointed out in 1975:

[T]he tendency for costs and prices to absorb the amounts made available to prospective purchasers or renters has plagued government programs since…1934. Close examination of these tendencies indicates that promises of extending the loan-to-value ratio of the mortgage and extending its term so as to make home purchase ‘possible for lower income prospective purchasers’ may bring greater profits and wages to builders, building suppliers, and building labor rather than assisting lower-income households.

The reason the FHFA is raising the Fannie and Freddie loan-size limits by 18%, is that its House Price Index is up 18% over the last year. FHA’s limit automatically goes up in lock step with these changes. These increases are procyclical acts. They feed the house price increases, rather than acting to moderate them, as a countercyclical policy would do. Procyclical government policies by definition make financial cycles worse and hurt low-income families, the originally intended beneficiaries.

The contrasting countercyclical objective was memorably expressed by William McChesney Martin, the longest-serving Chairman of the Federal Reserve Board. In office from 1951 to 1970, under five U.S. presidents, Martin gave us the most famous of all central banking metaphors. The Federal Reserve, he said in 1955, “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Long after the current housing price party has gotten not only warmed up, but positively tipsy, the Federal Reserve of 2021 has, instead of removing the punch bowl, been spiking the punch. It has done this by, in addition to keeping short term rates at historically low levels, buying hundreds of billions of dollars of mortgage securities, thus keeping mortgage rates abnormally low, and continuing to heat up the party further.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more.

In fact, the government has been spiking the housing party punch in three ways. First is the Federal Reserve’s purchases of mortgage securities, which have bloated its mortgage portfolio to a massive $2.6 trillion, or about 24% of all U.S. residential mortgages outstanding.

Second, the government through Fannie and Freddie runs up the leverage in the housing finance system, making it riskier. This is true of both leverage of income and leverage of the asset price. It is also true of FHA lending. Graph 1 shows how Fannie and Freddie’s large loans have a much higher proportion of high debt-to-income (DTI) ratios than large private sector loans do. In other words, Fannie and Freddie tend to lend more against income, a key risk factor.

Graph 1: Percent of loans over 43% DTI ratio

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Fannie and Freddie also make a greater proportion of large loans with low down payments, or high loan-to-value (LTV) ratios, than do corresponding private markets. Graph 2 shows the percent of their large loans with LTVs of 90% or more—that is, with down payments of 10% or less—another key risk factor.

Graph 2:  Share of loans with LTV ratios over 90%

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Now—on top of all that– the FHFA, by upping the loan sizes for Fannie and Freddie, is bringing to the party a bigger punch bowl. That the size limit for Fannie and Freddie is very important in mortgage loan behavior, we can see from how their large loans bunch right at the limit, as shown by Graph 3.

The third spiking of the house price punch bowl consists of the government’s huge payments and subsidies in reaction to the pandemic. A portion of this poorly targeted deficit spending money made its way into housing markets to bid up prices.

A key housing finance issue is the differential impact of house price inflation on lower-income households. AEI Housing Center research has demonstrated how the spiked punch bowl has inflated the cost of lower-priced houses more than others. This research shows that rapid price increases crowd out low-income potential home buyers in housing markets. Thus, as Ernest Fisher observed nearly 50 years ago, government policies that make for rapid house price inflation constrain the ability to become homeowners of the very group the government professes to help.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more. The question of upping the size of Fannie and Freddie loans, and correspondingly those of the FHA, is part of a larger picture of what the overall policy for them should be. Should we favor making their subsidized, market distorting, taxpayer guaranteed activities even bigger than the combined $8 trillion they are already?  Should they become even more dominant than they are now?  Or should the government’s dominance of the sector and its risk be systematically reduced?  That would be a movement toward a mortgage sector that is more like a market and less like a political machine.

In short, what about the future of the government mortgage complex, especially Fannie and Freddie: Should they be even bigger or smaller?  We vote for smaller.

How might this be done? As a good example, Senator Patrick Toomey, the Ranking Member of the Senate Banking Committee, has introduced a bill that would eliminate Fannie and Freddie’s ability to subsidize loans on investment properties, a very apt proposal. It will not advance with the current configuration of the Congress, but it’s the right idea. Similarly, it would make sense to stop Fannie and Freddie from subsidizing cash-out refis, mortgages that increase the debt on the house. Another basic idea, often proposed historically, but of course never implemented, would be to reduce, not increase, the maximum size of the loans Fannie and Freddie can buy, and by extension, FHA can insure.

In the meantime, the house price party rolls on. How will it end after all the spiked punch?  Doubtless with a hangover.

Alex J. Pollock is a senior fellow at the Mises Institute and the author of Finance and Philosophy: Why We're Always Surprised. His five decades of financial experience include being the Principal Deputy Director of the U.S. Treasury’s Office of Financial Research and the president and CEO of the Federal Home Loan Bank of Chicago.

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Edward J. Pinto is an American Enterprise Institute (AEI) senior fellow and director of AEI’s Housing Center. The Center monitors the US markets using a unique set of Housing Market Indicators. Active in housing finance for over 40 years, he was an executive vice president and chief credit officer for Fannie Mae until the late 1980s.

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Risk, Uncertainty and Profit 100 Years Later

Published in Law & Liberty. Also appears in AIER.

The year 2021 marks the 100th anniversary of Frank Knight’s great book, Risk, Uncertainty and Profit (RU&P), which established uncertainty as a fundamental idea in economics and finance, and as a key to understanding enterprise, entrepreneurship, cycles of booms and busts, and economic growth. Viewed from the present, it also explains why faith in economic management by central banks will be disappointed, and why any idea that economies or financial markets are governed by “mechanisms” is deluded. Its ideas open the way to seeing that economies and financial markets are a different kind of reality than are machines, and thus why the econometric equations that seem so plausible in some times, at other times fail.

Knight lived from 1885 to 1972; RU&P was published in 1921 when he was 35. Although he subsequently had a long and distinguished career at the University of Chicago, where he influenced numerous future economists including Milton Friedman, RU&P is far and away his magnum opus, a book that “ended up changing the course of economic theory” and established Knight “in the pantheon of economic thinkers.” It might also be called “the most cited economics book you have never read.” Indeed, it is long, complex, and often difficult, but contains brilliant insights which do not go out of date. We may enjoy the irony that it arose from a contest by the publishers in 1917 in which its original text won second, not first, prize.

RU&P is most and justifiably famous for its critical distinction between Uncertainty and Risk, with the term “Knightian Uncertainty” immortalizing the author, at least among those of us who have thought about it. Although in common language, then and now, “It’s uncertain” or “It’s risky” might be taken to mean more or less the same thing, in Knight’s clarified concepts, they are not only not the same, but are utterly different, with vast consequences.

Knight set out to address, as he wrote in RU&P, “a confusion of ideas which goes down deep into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein.” So “the answer is to be found in a thorough examination and criticism of the concept of uncertainty, and its bearings upon economic processes.”

“But,” Knight continued, “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated”—until RU&P in 1921, of course. They are “two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different.”

Specifically, risk means “a quantity susceptible of measurement,” but uncertainty is “unmeasurable,” and “a measurable uncertainty is so far different from an unmeasurable one that it is not in effect an uncertainty at all.” It is only a risk.

Another way of saying this is that for a measurable risk, you can know the odds of outcomes, although you don’t know exactly what will happen in any given case. With uncertainty, you do not even know the odds, and more importantly, you cannot know the odds.

When facing risk, since you can know the odds, you can know in a large number of repeated events what the distribution of the outcomes will be. You can know the mean of the distribution of outcomes, its variation, and the probability of extreme outcomes. With fair pair of dice, you know that rolling snake eyes (one spot on each die) has a reliable probability of 1/36. We know that the extreme outcome of rolling snake eyes three times in a row has a probability of about 0.00002—roughly the same probability of flipping a fair coin and getting tails 16 times in a row. Of course, even that remote probability is not zero.

With risk, by knowing the odds in this fashion, and knowing how much money is being risked, you can rationally write insurance for bearing the risk when it is spread over a large number of participants. It may take specialized skill and a lot of data, but you can always in principle calculate a fair price for insuring the risk over time, and the ones taking the risk can accordingly buy insurance from you at a fair price, solving their risk problem.

Faced with uncertainty, however, you cannot rationally write the insurance, and the uncertainty bearers cannot buy sound insurance from you, because nobody knows or can know the odds. Therefore, they do not and cannot know the fair price for bearing the uncertainty.

In short, an essential result of Knight’s logic is that risk is in principle insurable, but uncertainty is not.

Of course, you might convince yourself that the uncertainty is really risk and then estimate the odds from the past and make calculations, including complicated and sophisticated calculations, manipulating your guesses about the odds. There is often a strong temptation to do this. It helps a lot in selling securities, for example, or in making subprime loans. You can build models using the estimated odds, creating complicated series of linked probabilities for surviving various stress tests and for calculating the required prices.

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it.

Your analysts will certainly solve the mathematical equations in the models properly; however, under uncertainty, the question is not doing the math correctly, but the relationship of the math to the unknown and unknowable future reality. In the uncertainty case, your models will one day fail, because in fact you cannot know the odds, no matter how many models you run. The same is true of a central bank, say the Federal Reserve, running a complex model of the whole economy and employing scores of economists. Under uncertainty, it may, for example, in spite of all its sophisticated efforts, forecast low inflation when what really is about to happen is very high inflation—just as in 2021.

There is no one to ensure against the mistake of thinking Uncertainty is Risk.

Let us come to the P in RU&P: Profit. Every time Knight writes “profit,” as in the following quotations, and also as used in the following discussion, it does not mean accounting profit, as we are accustomed to seeing in a profit and loss statement, but “economic profit.” Economic profit is profit in excess of the economy’s cost of capital. When economic profit is zero, then the firm’s revenues equal its costs, including the cost of capital and the cost of Risk, so the firm has earned exactly its cost of capital.

In a theoretical world of perfect competition, prices, including the price for insuring Risk, would adjust so that revenues always would equal cost. That means in a competitive world in which the future risks are insurable, there should be no profit. We obviously observe large profits in many cases, especially those earned by successful entrepreneurs. Knight concludes that in a competitive economy, Uncertainty, but not Risk, can give rise to Profit.

It is “vital to contrast profit with payment for risk-taking,” he wrote. “The ‘risk’ which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis,” and “the only ‘risk’ which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured.” Thus, “profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated…a probability calculation in regard to them is impossible and meaningless.” Loss also arises from the same brute fact, of course. We are again reminded that human activity is a different kind of reality than that of predictable physical systems.

Economic progress, or a rising standard of living for ordinary people, depends on creating and bearing Uncertainty, but this obviously also makes possible many mistakes. These include, we may add, the group mistakes which result in financial cycles. We don’t get the progress without the uncertainty or without mistakes. “The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress.” The paradox of economic progress is that there is no progress without Uncertainty, and no Uncertainty without mistakes.

To have Uncertainty, there must be change, for “in an absolutely unchanging world the future would be accurately foreknown.” But change per se does not create an unknowable future and Uncertainty. Change which follows a known law would be insurable; so “if the law of change is known…no profits can arise.” Profits in a competitive system can arise “only in so far as the changes and their consequences are unpredictable.”

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it. He takes the “ultimate responsibility” of bearing uncertainty in business.

Knight clearly enjoyed summing up “the main facts in the psychology of the case” of the entrepreneurs, when the uncertainties “do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance.” The entrepreneurs may have “an irrational confidence in their own good fortune, and that is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves.” They are “the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.” This suggests that a kind of irrational faith is required for progress.

A former student of philosophy, Knight always was a very philosophical economist. On the last page of RU&P comes this true perspective on it all: “The fundamental fact about society as a going concern is that it is made of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. . . . Life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out.” We need to be reminded of this as we in our turn strive to increase the great funds of inheritance for those who will carry on into the ever-uncertain future.

For it is as true now and going forward as when RU&P was published one hundred years ago that, as Knight wrote, “Uncertainty is one of the fundamental facts of life.”

Seven Possible Causes of the Next Financial Crisis

Published in Law & Liberty.

The great financial historian, Charles Kindleberger, pointed out in the 1970s that over several centuries, history showed there was a financial crisis about once every ten years. His observation still holds. In every decade since his classic Manias, Panics and Crashes of 1978, such crises have indeed continued to erupt in their turn, in the 1980s, 1990s, 2000s, 2010s, and again in 2020. What could cause the next crisis in this long, recurring series? I suggest seven possibilities:

1. What Nobody Sees Coming

A notable headline from 2017 was “Yellen: I Don’t See a Financial Crisis Coming in Our Lifetimes.” The then-head of the Federal Reserve was right that she didn’t see it coming; nonetheless, well within her and our lifetimes, a new financial crisis arrived in 2020, from unexpected causes.

It has been well said that “The riskiest stuff is what you don’t see coming.” Especially risky is what you don’t think is possible, but happens anyway.

About the Global Financial Crisis of 2007-09, a former Vice Chairman of the Federal Reserve candidly observed: “Not only didn’t we see it coming,” but in the midst of it, “had trouble understanding what was happening.” Similarly, “Central banks and regulators failed to see the bust coming, just as they failed to anticipate its potential magnitude,” as another top central banking expert wrote.

The next financial crisis could be the same—we may take another blindside hit for a big financial sack.

In his memoir of the 2007-09 crisis, former Secretary of the Treasury Henry Paulson wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.” If the next financial crisis is again triggered by what we don’t see coming, the government reactions will once again be flying by the seat of their pants, making it up as they go along.

2. A Purely Malicious Macro-Hack of the Financial System

We keep learning about how vulnerable to hacking, especially by state-sponsored hackers, even the most “secure” systems are. Here I am not considering a hack to make money or collect blackmail, or a hack for spying, but a purely malicious hack with the sole goal of creating destruction and panic, to cripple the United States by bringing down our amazingly complex and totally computer-dependent financial information systems.

Imagine macro-hackers attacking with the same destructive motivation as the 9/11 terrorists. Suppose when they strike, trading and payments systems can’t clear, there are no market prices, no one can find out the balances in their accounts or the value of their risk positions, and no one knows who is broke or solvent. That is my second next crisis scenario.

3. All the Central Banks Get It Wrong Together

We know that the major central banks operate as a tight international club. Their decisions are subject to vast uncertainty, and as a result, they display significant cognitive and behavioral herding.

I read somewhere the colorful line, “Central banks have become slaves of the bubbles they blow.” Whether or not we think that, there is no question that the principal central banks have all together managed to create a gigantic global asset price inflation.

Suppose they have also managed to set off a disastrous, runaway general price inflation. Then ultimately interest rates must rise, and asset prices fall. This will be in a setting of stretched asset prices and high debt. As asset prices fall, speculative leverage will be punished. “Every great crisis reveals the excessive speculations of many houses which no one before suspected,” as Walter Bagehot said. The Everything Bubble of our time would then implode and the crisis would be upon us. Huge government bailouts would ensue.

We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

4. A Housing Collapse Again

A particularly notable asset price inflation is, once again, that in the price of houses, which are the biggest investment most households have and are the mortgage collateral for the biggest loan market in the world. House prices are now rising in the U.S. at the unsustainable rate of more than 18% a year, but this is also global problem. Many countries, about 20 by one reckoning, face extreme house price inflation. Said one financial commentator, “This is now a global property bubble of epic proportions, never before seen by man or beast, and it has entrapped more central banks than just the Fed.”

House prices depend on high leverage and are, as is well known, very interest rate sensitive. What would an actual market-determined mortgage rate look like, instead of the Federal Reserve-manipulated 3% mortgage rate the U.S. has now? A reasonable estimate would begin with a 3% general inflation, and therefore a 4.5% 10-year Treasury note. The long-term mortgage rate would be 1.5% over that, or 6%. That would more or less double the monthly payment for the same-sized mortgage, house prices would fall steeply, and our world record house price bubble implode. Faced with that possibility, so far the Federal Reserve’s choice has been to keep pumping up the bubble.

Overpriced, leveraged real estate is a frequent culprit in financial crises. Maybe once again.

5. An Electricity System Failure

Imagine a failure, similar to our financial system macro-hack scenario, resulting from an attack maliciously carried out to bring down the national electricity system, or from a huge solar flare, bigger than the one that took down the electric system of Quebec in 1989.

Physically speaking, the financial system, including of course all forms of electronic payments, is an electronic system, utterly dependent upon the supply of electricity. Should that fail, it would certainly be good to have some paper currency in your wallet, or actual gold coins. Bank accounts and cryptocurrencies will not be working so well.

6. The Next Pandemic

It feels like we have survived the Covid pandemic and the crisis is passing. Even with the ongoing problem of the Delta variant, we are certainly more relaxed than at the peak of the intense fear and the lockdowns of 2020. Instead of financial markets being in free fall as they were, they are booming.

But what about the next pandemic? We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

How soon could a new pandemic happen? We don’t know.

Might that new pandemic be much more deadly than Covid? Consider Professor Adam Tooze: “One thing 2020 forces us to come to terms with is that this wasn’t a black swan [an unknown possibility]. This kind of pandemic was widely and insistently and repeatedly predicted.” What wasn’t predicted was the political response and the financial panic. “In fact,” Tooze continues, “what people had predicted was worse than the coronavirus.”

If the prediction of an even worse and more deadly new pandemic becomes right, perhaps sooner than we might think, that might trigger our next financial crisis.

7. A Major War

By far the most important financial events of all are big wars.

A sobering talk I heard a few years ago described China as “Germany in 1913.”

This of course brings our mind to 1914. The incredible destruction then unleashed included a financial panic, and the war created huge, intractable financial problems which lasted up to the numerous sovereign defaults of the 1930s.

What if a big war happened again in the 21st century? If you think that is not possible, recall the once-famous book, Norman Angel’s The Great Illusion, which argued that a 20th-century war among European powers would be so economically costly that it would not happen. In the event, it was unimaginably costly, but nonetheless happened.

One distinguished scholar, Graham Allison of Harvard, has written: “A disastrous war between the United States and China in the decades ahead is not just possible, but much more likely than most of us are willing to allow.” A particular point of tension is the Chinese claim to sovereignty over Taiwan.  Might a Chinese decision to end Taiwan’s freedom by force be the equivalent of the German invasion of Belgium in 1914?

Would anyone be crazy enough to start a war between China and the United States? We all certainly hope not, but we should remember that such a war did already occur: most of the Korean War consisted of battles between the Chinese and American armies. In his history of the Korean War, David Halberstam wrote, “The Chinese viewed Korea as a great success,” and that Mao “had shrewdly understood the domestic benefits of having his county at war with the Americans.”

If it happened again it would be a terrific crisis, needless to say, with perhaps a global financial panic thrown in.

Overall, we can say there is plenty of risk and uncertainty to provide the possibility of the next financial crisis.

Based on remarks at an American Enterprise Institute teleconference, “What might cause the next financial crisis?” on June 29, 2021.

The Many Faces of Government Default

Published in Law & Liberty.

Although government debt is a favored investment class all over the world, it has a colorful history of over 200 defaults in the last two centuries, which continue right up to the present time.

This record reflects a perpetual political temptation, memorably described by the sardonic observer of sovereign defaults, Max Winkler in 1933. Of “the politicians in the borrowing countries,” he wrote, “from Abyssinia to Zanzibar”—which we may update to Argentina to Zambia, both governments having defaulted again in 2020—“Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures . . . and exchange favors by the misuse of the public treasury. In order to enjoy the present, they cheerfully mortgage the future.” Of course, we can’t read this without thinking of the Biden $1.9 trillion project to spend, borrow, and print.

Often enough, historically speaking, booming government debt has resulted in “national bankruptcy and default” around the world. Winkler chronicled the long list of government defaults up to the 1930s. He predicted that future investors would again be “gazing sadly” on unpaid government promises to pay. He was so right. Since then, the list of sovereign defaults has grown much longer.

A Short Quiz: Here are six sets of years. What do they represent?

1. 1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014, 2020

2. 1828, 1898, 1902, 1914, 1931, 1937, 1961, 1964, 1983, 1986, 1990

3. 1826, 1843, 1860, 1894, 1932, 2012

4. 1876, 1915, 1931, 1940, 1959, 1965, 1978, 1982

5. 1826, 1848, 1860, 1865, 1892, 1898, 1982, 1990, 1995, 1998, 2004, 2017

6. 1862, 1933, 1968, 1971

All these are years of defaults by a sample of governments. They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

6. The United States.

In the case of the United States, the defaults consisted of the refusal to redeem demand notes for gold or silver, as promised, in 1862; the refusal to redeem gold bonds for gold, as promised, in 1933; the refusal to redeem silver certificates for silver, as promised, in 1968; and the refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.

With the onset of the Civil War in 1861, the war effort proved vastly more costly than previously imagined. To pay expenses, Congress authorized a circulating currency in the form of “demand notes,” which were redeemable in precious metal coins on the bearer’s demand and promised so on their face. Secretary of the Treasury Salmon Chase declared that “being at all times convertible into coin at the option of the holder . . . they must always be equivalent to gold.” But soon after, by the beginning of 1862, the U.S. government was no longer able to honor such redemptions, so stopped doing so. To support the use of the notes anyway, Congress declared them to be legal tender which had to be accepted in payment of debts. About issuing pure paper money, President Lincoln quoted the Bible: “Silver and gold have I none.”

In 1933, outstanding U.S. Treasury bonds included “gold bonds,” which unambiguously promised that the investor could choose to be paid in gold coin. However, President Roosevelt and Congress decided that paying as promised was “against public policy” and refused. Bondholders sued and got to the Supreme Court, which held 5-4 that the government can exercise its sovereign power in this fashion. Shortly before, when running for office in 1932, Roosevelt had said, “no responsible government would have sold to the country securities payable in gold if it knew that the promise—yes, the covenant—embodied in these securities was . . . dubious.” A recent history of this failure to pay as agreed concludes it was an “excusable default.”

In the 1960s, the U.S. still had coins made out of real silver and dollar bills which were “silver certificates.” These dollars promised on their face that they could be redeemed from the U.S. Treasury for one silver dollar on demand. But when inflation and the increasing value of silver induced people to ask for redemptions as promised, the government decided to stop honoring them. If today you have a silver certificate still bearing the government’s unambiguous promise, this promise will not be kept—no silver dollar for you. The silver in that unpaid silver dollar is currently worth about $20 in paper money.

An underlying idea in the 1944 Bretton Woods international monetary agreement was that “the United States dollar and gold are synonymous,” but in 1971 the U.S. reneged on its Bretton Woods agreement to redeem dollars held by foreign governments for gold. This historic default moved the world to the pure fiat money regime which continues today, although it has experienced numerous financial and currency crises, as well as endemic inflation. Since 1971, the U.S. government has stopped promising to redeem its money for anything else, and the U.S. Treasury has stopped promising to pay its debt with anything except the government’s own fiat currency. This prevents explicit defaults in nominal terms, but does not prevent creating high inflation and depreciation of both the currency and the government debt, which are implicit defaults.

Winkler related a pointed story to give us an archetype of government debt from ancient Greek times. Dionysius, the tyrant of Syracuse, was hard up and couldn’t pay his debts to his subjects, the tale goes. So he issued a decree requiring that all silver coins had to be turned in to the government, on pain of death. When he had the coins, reminted them, “Stamping at two drachmae each one-drachma coin.” Brilliant! With these, he paid off his nominal debt, becoming, Winkler said, “the Father of Currency Devaluation” and thereby expropriating real wealth from his subjects.

Observe that Dionysius’s stratagem was, in essence, the same as that of the United States in its defaults of 1862, 1933, 1968, and 1971. In all cases, like Dionysius, the U.S. government broke a promise, depreciated its currency, and reduced its obligations at the expense of its creditors. Default can have many faces.

So convenient it is to be a sovereign when you can’t pay as promised.

Inflation Comes for the Profligate

Published in Law & Liberty.

Printing money to finance wars with resulting inflation is the most time-honored monetary policy. It can also be used for other crises thought of as analogies to wars, like to finance the massive expense of bridging the Covid 19-triggered bust of 2020.

In these situations, the central bank necessarily becomes the Treasury’s partner and servant, stuffing its balance sheet with government debt and correspondingly inflating the supply of money. This captures an essential mandate of every central bank, though it is not one you will find in the Federal Reserve’s public relations materials, namely lending money to the government of which it is a part.

Now, as the economic recovery from the Covid bust strengthens, soaring government debt is still being heavily monetized in the Federal Reserve’s balance sheet, which has now expanded to a previously unimagined $7.6 trillion, in a classic Treasury-Fed cooperation. The printing (literal and metaphorical) continues and the new administration wants to expand it even more. Isn’t accelerating inflation on the way?

The distinguished former Secretary of the Treasury, economist Larry Summers, recently suggested that it may be. “There is a chance,” he wrote, that government actions “on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.” I believe this is correct.

If we agree that there is such “a chance,” how big a chance is it? With political delicacy, Summers’ essay does not address this question. Instead, he carefully points out the “enormous uncertainties” involved. While the fog of uncertainty always obscures the economic future, it looks to me like the answer is that the chance is substantial. It would not be at all surprising to see inflation move significantly higher.

“There is the risk,” Summers writes, “of inflation expectations rising sharply.” Well, inflation expectations are already rising among bond investors and analysts, giving rise to such commentaries as these:

“According to the Bank of America’s January fund manager survey, some 92% of respondents expect rising inflation.” (Almost Daily Grant’s Newsletter, February 10, 2021)

“Bonds Send Message that Inflation is Coming” (Barron’s, February 5, 2021)

“For those of us not inclined to believe in free lunches, the funding of large deficits with printed money is another source of inflation and financial stability concerns” (Barron’s, February 12, 2021)

“A new worry now is whether the tremendous spending plans…can really be done without prompting a historic inflation.” (Don Shackelford, Proceedings newsletter)

“With growth in unit labor costs surging and a range of survey indicators also pointing to rising price pressures, we think inflation will be much stronger over the rest of this year.” (Andrew Hunter in Capital Economics)

“Inflation Worries Drive Platinum Up” (Wall Street Journal)

“The rat the Treasury market is smelling is consumer price inflation.” (Wolf Street, February 13, 2021).

Reflecting these concerns, the yield on the 10-year Treasury note, while still low, has risen meaningfully of late, to about 1.4 percent from 0.7 percent six months ago. This move has imposed serious losses on anybody who bought long-term Treasuries last summer and held them. The price of the iShares Treasury Bond ETF, for example, is down about 18 percent since the beginning of August.

In contrast to the views just quoted, Summers observes “administration officials’ dismissal of even the possibility of inflation.” Who is right, the investors or the politicians? Whose assessments of inflation risk do you believe? Politicians may be expected to deny an economic result that would get in the way of their intense desire to spend newly printed money.

As has frequently been discussed, a notable inflation has already been running for some time—the inflation in asset prices. Monetary expansion, needing to go somewhere, has gone into the prices of equities, bonds, houses, gold, and Bitcoin. The “Everything Bubble” stoked by the Federal Reserve and the other principal central banks has taken asset prices to historically extreme, and in the case of Bitcoin, amazing, valuations. Financial history presents an essential recurring question: How much can the price of an asset change? It also provides the answer: More than you think.

U.S. house prices have been and are inflating rapidly. They are substantially over their Housing Bubble peak of 2006. According to December’s Case-Shiller index, they are rising at an annualized rate of 10 percent, and AEI’s December Home Price Appreciation Index shows a year-over-year increase of 11 percent. This is abetted by the Fed’s monetization of long-term mortgages, of which it owns, including unamortized premiums, a striking $2.3 trillion—a sum 2.6 times its total assets in 2007—and which it continues to buy in size. This huge monetization of mortgages by the institution they created would greatly surprise the founders of the Federal Reserve, could they see it, and displease them. Instead of taking away the punch bowl as the party warms up, the Fed is now pouring monetary vodka into the housing finance punch. Reflecting on this inversion of the famous metaphor, Ed Pinto of the American Enterprise Institute has reasonably asked if they couldn’t at least stop buying mortgages. But it appears this will not happen anytime soon.

Of course, as a base line, we have endemic inflation of goods and services prices. The Federal Reserve has moreover formally committed itself to perpetual inflation. The Covid bust notwithstanding, the Consumer Price Index increased 1.4 percent year-over-year in January, 2021, and over the two months of December-January at an annualized rate of 3.1 percent. We are told frequently by the Fed about its “2% target” and hear it endlessly repeated by a sycophantic chorus of journalists. Since the Constitution unambiguously gives the power of regulating the value of money to the Congress, I believe the Federal Reserve acted unconstitutionally in announcing on its own, and carrying out without the approval of the Congress, a commitment to perpetual depreciation of the purchasing power of the U.S. currency.

Last year it formally added a new willingness to let inflation go higher than 2 percent for a while. How much higher and for how long nobody knows, including the Fed itself, but this willingness is consistent with a greater chance of accelerating inflation.

How much inflation is a sustained 2 percent? At that rate, average prices quintuple in a lifetime. The global movement among central banks, including the Fed, to trying for 2 percent inflation is a notable example of the changing intellectual fashions of central bankers. When serving as Federal Reserve Chairman, Alan Greenspan suggested the right inflation target was zero, correctly measured, and an inflation rate of zero was the long-term goal of the Humphrey-Hawkins Act of 1978. The distinguished economist, Arthur Burns wrote in 1957 that “our economy is faced with a threat of gradual or creeping inflation over the coming years.” He was right about that, except that gradual unexpectedly became galloping in the 1970s (ironically, when he was Fed Chairman).

“It is highly important that we try to…stop the upward drift of the price level,” Burns argued. Over time, “even a price trend that rises no more than 1 percent a year will cut the purchasing power of the dollar”—so much the more would 2 percent, he added. How ideas have changed. . Since the 1970s, we never are told about “creeping inflation” anymore. While Burns in the 1950s attacked 1 or 2 percent inflation, our current monetary mandarins strive for 2 percent forever and more than 2 percent for now. This increases the risk, consistent with Summers’ observations, that they will get more than they are bargaining for.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

At 3 percent inflation, prices would multiply by 11 times in the course of a lifetime. We are always a little surprised at the result over time of relatively small changes in a compound growth rate like the average rate of inflation.

One of the key Keynesian arguments for inflation was that wages are sticky downwards, so that if real wages economically need to fall, you can make then go down by inflation instead. Over the decade prior to the Covid crisis, average U.S. hourly earnings for all employees were rising first at about 2 percent and later 3 or 3.5% percent a year. So a 2 or 3 percent inflation would sharply cut or wipe out real wage gains, at the same time as it imposes negative real returns on savers. Other items you will never see in the Federal Reserve’s public relations materials are its potent abilities to reduce real wages and punish savers.

“Throughout history, there’s absolutely no currency in the world that has maintained its value,” international fund manager Mark Mobius pronounced. The U.S. dollar certainly has not, losing 96 percent of its purchasing power since the creation of the Federal Reserve and losing 98 percent of its value in terms of gold since 1971. (That was when the U.S reneged on its Bretton Woods commitments and led the world into a pure fiat currency regime.) Increasing inflation going forward from here would be consistent with history.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

With the opinion farthest from mine, we have the cheerleaders for monetizing a lot more debt and practicing “What, me worry?”—these are the proponents of “MMT” or Modern Monetary Theory. Of course, it should be written “M”MT, or “Modern” Monetary Theory, since solving your problems by printing up money and forcing the people to accept the depreciating currency is a very old financial idea. The City of Venice used it in 1630, for example, to spend with inflationary result during an attack of bubonic plague. Alternately, we could consider calling it “WMT” or “ZMT” for Weimar Monetary Theory or Zimbabwe Monetary Theory. Even better would be “JLMT” for John Law Monetary Theory.

John Law was the creative, persuasive theorist of risk and paper money, “secretary to the King of France and controller general of His Majesty’s finances,” who presided over first the inflation and then the panicked collapse of the Mississippi Bubble of 1720. A main theme, then as now, was how to produce paper assets to cover the government’s debts, but his history also provides a precedent for our house price discussion: “Thanks to Law’s money-printing, land and houses were expensive.”

Like the close ties of John Law to the French monarchy, the question of debt monetization and its inflationary risks is closely tied to the question of what kind of government we want. Should the federal government’s power be limited or expansive and dominant? What the proponents of “M”MT really long for is a vastly expanded and more powerful government, with themselves in charge. If debt can be indefinitely expanded by bloating the central bank, then you don’t have to tax much in order to spend forever. Thus one of the most important limits on the power of Leviathan to dominate the society can be removed. We see that much more is involved than a monetary theory.

Are those desiring to wield the expanded power willing to cause much higher inflation to get it? This is the political meaning of the monetary question.