Macro or Micro, Blinder Can’t Sell Bidenomics

Published in The Wall Street Journal.

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

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

The Fed Doesn’t Know the Natural Rate of Interest

Published in The Wall Street Journal.

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

Alex J. Pollock

Senior fellow, Mises Institute

Lake Forest, Ill.

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

No ‘Pat on the Back’ for the Federal Reserve

Published in The Wall Street Journal.

Mr. Cochrane writes that “the Fed can costlessly buy bonds and issue interest-paying money.” To the contrary, by following exactly this formula, the Fed has so far accumulated net losses of about $130 billion for itself, the Treasury and the taxpayers, and there are unavoidably tens of billions in losses still to come.

This “costless” formula meant the Fed took massive interest-rate risk, investing very long and borrowing very short, thereby also imposing that risk on the Treasury and the taxpayers. For the Fed as for anybody else, taking interest-rate risk isn’t costless. It has proved far more costly than the Fed ever expected.

Alex J. Pollock

Senior fellow, Mises Institute

Why the Fed’s Unprecedented Losses Matter

Published in The Wall Street Journal.

The Federal Reserve’s risky policy has backfired.

Mr. Furman excuses the Fed’s unprecedented losses, which have surpassed $100 billion on their way to $200 billion or more, suggesting taxpayers shouldn’t care. To the contrary, taxpayers should care that the Fed will spend, without authorization, $200 billion or more that will be added to their future taxes.

These Fed losses are the result of a radical and exceptionally risky Fed choice to build a balance sheet resembling a giant 1980s savings and loan. In the process, it stoked bubbles in bonds, stocks, houses and cryptocurrencies, in addition to inducing enormous interest-rate risk in the banking system. Those risks have now come home to roost.

Mr. Furman argues that the Fed’s negative capital position doesn’t matter. If so, why cook the books to avoid reporting it? The Fed books its cash losses as a “deferred asset” so that it can obscure its true negative capital position. The Fed changed its own previous accounting rules precisely so it could do so. We know what would happen if Citibank tried that.

Who authorized the Fed to take an enormous interest-rate bet, risking taxpayer money? Nobody but the Fed itself. Does “independence” give the Fed the right to spend hundreds of billions of taxpayer dollars without congressional approval? That question needs to be debated.

Alex J. Pollock and Paul H. Kupiec

Mises Institute and AEI

Lake Forest, Ill., and Washington

The New Bank Bailout

Taxpayers are covering Federal Reserve losses, for which member banks are supposed to be liable.

Published in the Wall Street Journal with Paul H. Kupiec.

Taxpayers are bailing out Federal Reserve member banks—institutions that own the stock of the Fed’s 12 district banks—and hardly anyone has noticed. For more than 100 years, our central-banking system has made a profit and reliably remitted funds to the U.S. Treasury. Those days are gone. Sharp rate hikes have made the interest the Fed pays on its deposits and borrowing much higher than the yield it receives on its trillions in long-term investments. Since September 2022, its expenses have greatly exceeded its interest earnings. It has accumulated nearly $93 billion in cash operating losses and made no such remittances.

The Fed is able to assess member banks for these losses, but it has instead borrowed to fund them, shifting the bill to taxpayers by raising the consolidated federal debt. That tab is growing larger by the week. Under generally accepted accounting principles, the Fed has $86 billion in negative retained earnings, bringing its total capital to around negative $50 billion.

Each of the Fed’s 12 district banks, except Atlanta, has suffered large operating losses. Accumulated operating losses in the New York, Chicago, Dallas and Richmond, Va., district banks have more than consumed their capital, making each deeply insolvent. A fifth district bank, Boston, is teetering on insolvency. At the current rate of loss, five others will face insolvency within a year and the taxpayers’ bill will grow by more than $9 billion a month until interest rates decline or the Fed imposes a capital call or assessments on its member banks.

The Federal Reserve Act requires that member banks subscribe to the shares issued by their district bank in a dollar value equal to 6% of a member institution’s “capital” and “surplus”—the definitions of which depend on the depository institution’s charter. Member banks must pay for half their subscribed shares, while the remaining half of the subscription is subject to call by the board.

The act empowers the Fed to compel member banks to contribute additional funds to cover their district reserve bank operating losses up to an amount equal to the value of their membership subscription. The provision reads: “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” (emphasis added).

In the century when district banks were reliably profitable, these provisions posed only a remote risk to Fed shareholders. The central bank didn’t need member banks to make any additional contributions. As district banks’ consolidated losses approach $100 billion, however, the risks to Fed stockholders have risen. If called on, member banks are legally responsible to make these payments. At a minimum, they should disclose this potential liability.

The risk is that the more than 1,400 Fed-shareholder banks could receive a call on their resources equal to as much as 9% of their capital and surplus—a call for a 3% additional equity investment and 6% cash payment to offset district bank losses. Member banks could be on the hook to contribute three times the capital they currently own in their district bank, or $108 billion in total for the central-bank system.

The Securities and Exchange Commission requires every registered firm to include in its annual 10K reports “an explanation of its off-balance sheet arrangements.” The provision applies to securities issued by banks and bank holding companies that are traded on national exchanges, but enforcement is delegated to the federal regulatory agencies that aren’t requiring Fed member banks and their holding companies to disclose the Fed’s contingent resource claim as a material risk or as a contingent liability.

Consider the Goldman Sachs Group, which includes at least two Fed member banks. The company’s 10K for 2022 includes page after page devoted to discussion of the group’s regulatory, market, competition, operational, sustainability and climate-change risks. Not included in that list is the risk of being compelled to recapitalize and share in the losses of its Fed district banks.

The larger of the two is a member of the New York Federal Reserve Bank, a district bank with accumulated losses of nearly $62 billion, or more than four times its $15 billion stated capital. A smaller Goldman Sachs Trust bank is a member of the Philadelphia Fed, a bank with $821 million in accumulated losses.

Goldman’s member banks had almost $44 billion in capital and surplus, according to our analysis of its June regulatory-call report data. Applying the 3% equity-investment and 6% cash-payment requirements, we calculate that Goldman would face a maximum contingent call of approximately $4 billion—a sum that would exceed the combined 2022 income of its two Fed member banks.

Those sums aren’t mere rounding errors, and they shouldn’t be placed on taxpayers’ tab. Federal bank regulators should require Fed member banks that are registered with the SEC and their holding companies to disclose their risks of being called on to prop up the finances of their Federal Reserve district banks.

How High Interest Rates Turn ‘Paper Losses’ Into Real Ones

If you borrowed money to invest in bonds, waiting for them to mature will cost a bundle.

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to a sharp rise in interest rates since March 2022, the financial system is facing eye-popping mark-to-market losses on its fixed-rate assets. These include more than $1 trillion of market-value losses on the Federal Reserve’s portfolio of bonds and mortgage securities—and according to some estimates, a $2 trillion market-value loss on the fixed-rate securities and loans of the banking system.

Central-bank officials suggest that we needn’t worry, because these unrealized “paper” losses won’t translate to cash losses if the underwater investments are held to maturity. Though the market price is down today, the thinking goes, an institution will receive 100 cents on the dollar if it holds its security to maturity and thus won’t incur a loss.

The argument is appealing yet superficial. The notion that these are “simply paper losses” doesn’t hold up in the real banking world, where investments are financed with short-term borrowing. Even when underwater investments are held to maturity, a mark-to-market loss is a forecast of future high cash interest costs on the funds borrowed to finance the investment.

Suppose that in 2021, when the Fed had kept short-term interest rates near zero, you borrowed money to buy a seven-year $10,000 U.S. Treasury note yielding 2%. In 2023, when the note had five years remaining, the central bank raises the interest rate to 5%. The market price of your note drops from $10,000 to about $8,700, for an unrealized loss of $1,300 and a 13% decline in market value. This is about the same as the year-end mark-to-market discount the Fed has disclosed on its long-term investments.

Like the Fed, you may believe this $1,300 unrealized loss is merely a paper loss since the note will be held to maturity, when it will pay $10,000. But that neglects that you, like the Fed, funded the note with short-term borrowing that must be continually renewed at a cost of 5%.

If interest rates stay at 5% for the next five years, you will receive a 2% yield—or $200 a year in interest—but will pay 5%, or $500 a year, in interest on your debt. Holding the note costs 3% of $10,000, or $300 a year. Over the next five years, the total cash loss to carry this note to maturity will be $1,500, or a loss of 15% of your original investment, even though you never sold your Treasury note and it matured at par. This is a net cash loss with the cash gone forever.

This example is no doubt simplified by assuming a flat yield curve and ignoring fluctuating interest rates. But it nevertheless correctly demonstrates the economics of large mark-to-market losses on leveraged fixed-rate assets held by the Fed and many banks. The soaring costs of financing underwater held-to-maturity investments will generate large operating losses on these investments. If short-term interest rates continue to rise, the loss will be larger. Lower rates would stem the bleeding, but as long as they exceed 2%, holding the note in our example will generate a cash operating loss.

For the Fed and commercial banks, there are some funding sources that impose no or minimal interest costs. The central bank can issue paper currency that bears no interest but in amounts limited by the public’s demand for paper money. Banks can fund some of their investments with transaction deposits, which pay little or no interest to the account holder but impose deposit insurance and other operating costs on the bank. In both cases, though, these funding sources reduce the cost of carrying an underwater asset.

Now, let’s apply this analysis to the Fed’s investments in Treasury and mortgage securities, which totaled about $8.4 trillion as of year-end 2022. These investments have an average yield of about 2%. About $7.2 trillion have a remaining maturity of more than one year, $4 trillion of which have remaining maturities of over 10 years. These long-term securities account for most of the Fed’s reported $1 trillion in mark-to-market losses.

On the liability side, the Fed has about $2.3 trillion in outstanding currency—i.e., dollar bills—that can be used to fund part of the $7.2 trillion in long-maturity assets. The remaining $4.9 trillion are financed with floating rate deposits and reverse-repurchase-agreement borrowings on which the Fed now pays about a 4.9% interest rate.

The zero-interest-bearing paper currency that funds the $2.3 trillion of these 2% fixed-rate assets generates about $46 billion in annual net interest income for the Fed. The remaining $4.9 trillion in assets also yield 2%, but this income is more than offset by the 4.9% cost of financing these assets and, on balance, cost the Fed $142 billion. Combined, its fixed-rate held-to-maturity investments cost the central bank $96 billion annually. Adding its $9 billion in noninterest expenses, the Fed can expect an annual operating loss of about $105 billion.

A $105 billion annual loss equates to an average monthly loss of $8.7 billion. This estimate mirrors reality. The Fed’s actual net loss year-to-date through March 30 has averaged $8.7 billion per month.

If any institution, including the central bank, borrows short-term to finance long-term fixed-rate investments, large mark-to-market losses aren’t merely “paper” losses. They’re a forecast that holding investments to maturity is going to be extremely expensive.

Don’t Let Colleges Off the Hook for Loan Debt

Published in The Wall Street Journal:

Mitch Daniels makes many insightful points in his indictment of the utterly failed and, as he says, “bankrupt” system of federal student loans (“Student Loans and the National Debt,” op-ed, Sept. 2). Among the most important is that the colleges “encouraged students to borrow.” The colleges played the same role in this credit disaster as subprime-mortgage brokers did in the housing bubble: inducing excessive debt while sticking somebody else with all the risk.

Alex J. Pollock

Biden’s Pension Bailout Is a Giveaway to Unions

Most plans were insolvent long before the pandemic.

Published in The Wall Street Journal.

By Howard B. Adler and Alex J. Pollock

President Biden boasted last week about his administration’s bailout of union multiemployer pension plans, enacted in the American Rescue Plan supposedly to address pandemic-related problems. “Millions of workers will have the dignified retirement they earned and they deserve,” he said July 6 in Cleveland. In fact, the American taxpayer will bear the cost of union plans that were insolvent long before the pandemic. The bailout all but guarantees future insolvency or another bailout and constitutes a massive giveaway to labor unions.

Multiemployer pension plans are a creation of unions. They are defined-benefit retirement plans, maintained under collective-bargaining agreements, in which more than one employer contributes to the plan. These plans are typically found in industries such as trucking, transportation and mining, in which union members do work for multiple companies.

As of 2019, there were 2,450 multiemployer plans with 15 million participants and beneficiaries. Many were insolvent well before the Covid pandemic. The Pension Benefit Guaranty Corp. estimated total unfunded liabilities of PBGC-guaranteed multiemployer plans at $757 billion for 2018. According to 2019 projections, 124 multiemployer pension plans declared that they would likely run out of money over the next 20 years.

Read the rest here.

Asset Managers Should Not Vote Shares They Don’t Own

Published in The Wall Street Journal.

“Maybe it is time for the SEC to require index funds to poll their investors and vote their shares only as specifically directed,” say Phil Gramm and Michael Solon (“Enemies of the Economic Enlightenment,” op-ed, April 16). They are so right, except it is not “maybe,” it’s time, period.

Asset managers should not be able to vote the shares they do not own to pursue their political notions or business purposes. Instead, they should be able to vote only when instructed by the real owners. That means voting by the principals, not by the agents. In this way, the asset managers would be treated exactly like the broker-dealers who control huge numbers of shares registered in street name, but must ask the real owners how to vote. It is indeed high time for the SEC to fix this very troubling anomaly in corporate governance.

The Fed should be accountable for its results

Published in The Wall Street Journal.

“Vote Brings Uncertainty for Fed” (U.S. News, Nov. 10) says that President-elect Donald Trump might work with Congress to rewrite the laws governing the Fed’s structure. Good idea. It is of course decried by the Federal Reserve as a threat to its independence.

We should hope that the new president does proceed with this project. The Fed needs to be made accountable, as every part of the government should be. The notion that any part of the government, especially one as powerful and dangerous as the Fed, should be granted independence of checks and balances is misguided. Naturally, all bureaucrats resent being subject to the elected representatives of the people, but this doesn’t exempt them from their democratic accountability to the legislature that created them and may uncreate them.

The Fed is still carrying out emergency monetary experimentation seven years after the end of the crisis. It is busy robbing savers to benefit borrowers and leveraged speculators—a political act. It is imperative to figure out how best to make the Fed accountable to the Congress and to correct the evolved imbalance between its power and its accountability.