Fed ‘independence’ is a slippery slope

Published in American Banker, The Federalist Society, The American Conservative, and Live Trendy News.

Many observers, like Captain Renault in Casablanca, were “shocked, shocked!” at President Trump’s sharp criticism of the Federal Reserve and his attempt to influence it against raising interest rates, inquiring whether the president can fire the Fed chairman.

Yet many presidents and their administrations have pressured the Fed, going back to its earliest days, when the Woodrow Wilson administration urged it to finance bonds for the American participation in the First World War. The Fed compliantly did so, proving itself very useful to the U.S. Treasury.

That was not surprising, since the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board, and the board met in the Treasury Department.

In the decades since then, lots of presidents have worked to influence the Fed’s actions. Their purpose was usually to prevent the Fed from raising interest rates, exactly like Trump. It was also often to cause the Fed to finance the U.S. Treasury and to keep down the cost of government debt, just as “quantitative easing” does now.
But has a president ever fired a Federal Reserve Board chairman?

Yes, in fact. President Truman effectively fired Fed Chairman Thomas McCabe in 1951. “McCabe was informed that his services were no longer satisfactory, and he quit,” Truman said. Being informed by the president that your performance is not satisfactory is being fired, I’d say. One might argue that McCabe didn’t have to resign, but he did.

The background to McCabe’s departure was a heated and very public dispute between the Truman administration, including Truman personally, and the Fed about interest rates and financing the Korean War. Truman had even summoned the entire Federal Reserve Open Market Committee to the White House, where he made plain what he wanted, which was straightforward. Since the Second World War, the Fed, as the servant of the Treasury, bought however many Treasury bonds it took to keep their interest rate steady at 2.5% — this was the “peg.” In the middle of the Korean War, Truman understandably wanted to continue it.

The Fed, on the other hand, was understandably worried about building inflation, and wanted to raise interest rates. As the two sides debated in January 1951, American military forces were going backwards down the Korean peninsula, in agonizing retreat before the onslaught of the Chinese army. Although financial historians always tell this story favoring the Fed, I have a lot of sympathy for Truman.

By now we have been endlessly instructed, especially by the Fed itself, that the Fed is and must be “independent,” and this has become an article of faith, especially for many economists. However, the opposite opinion has often been prominent, including when the Fed and the Treasury completely coordinated their actions during the financial crisis of 2007-2009 — as they should have.

What exactly does Fed “independence” mean? Allan Sproul, a long-time and influential president of the Federal Reserve Bank of New York, maintained that the Fed “is independent within the government.” That is masterfully ambiguous. It expresses a tension between the executive branch, Congress and the Fed, searching for an undefined political balance.

When McCabe resigned, Truman appointed, he thought, his own man, William McChesney Martin from the Treasury Department. Martin is often viewed as the hero of establishing Fed independence — correspondingly, Truman later considered him a “traitor.” But Martin’s understanding of what Fed “independence” means was complex: He “was always careful to frame his arguments in terms of independence from the executive branch, not from Congress,” a history of Fed leadership says.

“It is clear to me that it was intended the Federal Reserve should be independent and not responsible to the executive branch of the Government, but should be accountable to Congress,” Martin testified in 1951. “I like to think of a trustee relationship to see that the Treasury does not engage in the natural temptation to depreciate the currency.”

Seven decades later, how accountability to Congress should work is still not clear, and Martin would certainly be surprised that the current Fed has formally committed itself to the perpetual depreciation of the currency at 2% per year.

Martin stayed as Fed chairman until 1970, which allowed him to experience pressure from five different administrations. The most memorable instance was the personal pressure applied by President Johnson. In late 1965, the Fed raised interest rates with the war in Vietnam, domestic spending and government deficits expanding.

“Johnson summoned the Fed Chairman to his Texas ranch and physically shoved him around his living room, yelling in his face, ‘Boys are dying in Vietnam and Bill Martin doesn’t care!’” one history relates.

That’s quite a scene to imagine.

One may wonder whether Fed independence is a technical or a political question. It is political. The nature and behavior of money is always political, no matter how much technical effort at measuring and modeling economic factors there may be.

For example, the Fed over the last decade systematically took money away from savers and gave it to leveraged speculators by enforcing negative real interest rates. Taking money from some people to give it to others is a political act. That is why the Fed, like every other part of the government, should exist in a network of checks and balances and accountability.

There is also a fundamental problem of knowledge involved in the idea of independence. How much faith should one put in the judgments of the Fed, which are actually guesses? The answer is very little — about as much faith as in any other bunch of economic forecasts, given that the Fed’s record is as poor as everybody else’s. The Fed’s judgments are guesses by sophisticated, intelligent and serious people, but nonetheless guesses about an unknowable future.

Arthur Burns, the Fed chairman from 1970 to 1978, observed that among the reasons for “The Anguish of Central Banking” is that “in a rapidly changing world the opportunities for making mistakes are legion. Even facts about current conditions are often subject to misinterpretation.”

Very true — and moreover, the world is always changing.

In the light of the political reality of Federal Reserve history, a completely independent Fed looks impossible. In the light of the unknowable future, it looks undesirable.

Bigger, Fewer, Riskier: The Evolution of U.S. Banking Since 1950

Published in The American Interest.

The total assets of JPMorgan Chase, the biggest U.S. bank, are now about $2.6 trillion. The total assets of the entire American commercial banking system in 1950 were $167 billion. In nominal dollar terms, Morgan by itself is more than 15 times as big as all the banks in the country together were in 1950, when Harry Truman was President and the United States was enjoying an economic boom after the cataclysms of the Depression and the Second World War. The fourth largest bank today, Wells Fargo, with $1.9 trillion in assets, is 11 times as big as the whole banking system was then.

Of course, there has been a vast price inflation and depreciation of the dollar over that time, so that a dollar today is worth about what a dime was in 1950. Adjusting the 1950s number for total banking assets to 2018 dollars brings it to $1.7 trillion. Thus in inflation-adjusted terms Morgan alone is still about 1.5 times as big—and Wells Fargo 1.1 times as big—as the whole banking system in the 1950s. Are these banks “too big to fail”? Of course they are. But so were the biggest banks in 1950.

On average over the past seven decades, banking assets and loans have grown more rapidly than the U.S. economy. In 1950, total banking assets were 56 percent of a GDP of $300 billion. Now at about $16.5 trillion, they are more than 80 percent of a GDP topping $20 trillion. Total bank loans relative to GDP grew even faster than banking assets did, from 18 percent of GDP in 1950 to 45 percent today.

Thus banking both in absolute terms and relative to the economy has gotten much bigger over the decades, but there are many fewer banks than there used to be.

“Ours is a country predominantly of independent local banks,” approvingly said Thomas McCabe, then Chairman of the Federal Reserve, in a commencement address in 1950. As McCabe observed, banking was then mostly a local business. There were at that point 13,446 commercial banks. The U.S. population was 153 million. Now there are 4,774 commercial banks for a population of 329 million. So as the American population has more than doubled, the number of commercial banks dropped by 64 percent.

In 1950, there were also 5,992 savings and loan institutions. Today there are 703, so the total of insured depositories fell from 19,438 in 1950 to 5,477 today, or by 72 percent. The previous multitude of banks was the result of unique American politics in which agrarian interests protected small, local institutions.  The reduced numbers have moved closer to what a market outcome would ordain. We can expect the consolidation to continue.

As to risk, in the entire decade of the 1950s, there were a mere 28 commercial bank failures—only 0.2 percent of the average number of banks. But banking got a lot riskier as time went on, particularly in the financially disastrous 1980s. In that decade, 1,127 commercial banks failed—40 times the failure rate of the 1950s. Maybe the bankers hadn’t gotten smarter, although they certainly employed more MBAs. State and Federal regulators didn’t appear any smarter either.

In addition to the bank failures, 909 savings and loans failed in the 1980s, bringing the total depository failures for the decade to 2,036—about four per week over ten years. Tough times! When the savings and loan industry collapsed, its government deposit insurer, the Federal Savings and Loan Insurance Corporation, also went broke, triggering a $150 billion taxpayer bailout.

The 1990s were not as bad as the 1980s, but 442 commercial banks (16 times as many as in the 1950s) and 483 savings and loans failed, for a total of 925.

The Federal Reserve optimistically announced that the 21st century heralded a new, stable era—“The Great Moderation.” Soon after that, however, came financial crisis and panic, showing once again that bankers and regulators have not gotten smarter, despite the addition of many PhDs in mathematics and science to the ranks of the MBAs in the finance industry. Ben Bernanke, then Chairman of the Federal Reserve, judged in 2006 that “banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.” That was just before the 2007-09 financial crisis. Apparently they hadn’t made such big strides after all.

Since 2000, 573 depository institutions have failed, of which 486 have been commercial banks. There would have been more failures without the government’s emergency TARP investments in banks, improvised government guarantees, and other forms of bailouts. These include the bailouts of the insolvent Fannie Mae and Freddie Mac, much of whose debt was held by banks, as was encouraged by regulation.

Should we want a banking system with no failures, as was virtually the case in the 1950s? Of course not. As the distinguished economist Alan Meltzer put it, “Capitalism without failure is like religion without sin.” Economic growth requires risk-taking and hence the failures that go with it. But we don’t want too much systemic risk, or for the banking system to collapse from time to time. Since 1950, the United States has experienced both extremes. No one knows how to achieve the golden mean.

We can see how much American banking has changed in the course of one lifetime. But one thing did not change: the tight connection between banking and the government. As banking scholar Charles Calomiris has convincingly summed it up, all banking systems are a deal between the politicians and the bankers.

Of course, the details of the deal shift over the decades. Congress frequently legislates about banking (as detailed further below).  One watershed banking enactment was the Federal Reserve Act of 1913, which created the U.S. central bank, the proper role of which was still being debated in 1950. At the time of its origin, it was thought that the Federal Reserve would end financial crises and panics: obviously it didn’t and relative to this hope the act was a failure.  But the act was a definite success at creating what it called an “elastic currency”—the ability of the Federal Reserve to create more money and allow banks to expand.  This ability in its original form was subject to the gold standard, which meant keeping dollars freely convertible to gold. We today can hardly imagine then-prevailing idea that you could go to your bank any time and turn in your paper dollars for gold coins minted by the United States at a fixed parity rate. This idea was only a memory by 1950, but under the 1944 Bretton-Woods agreement, the U.S. government was still promising to foreign governments that they could redeem dollars for gold.

In 1971, after various dollar crises, the government reneged on this commitment, which was the last vestige of the gold standard.  With that, the dollar became far more elastic than the authors of the Federal Reserve Act could ever have imagined. The Federal Reserve became able to expand the currency and the credit base of banking by as much as it wanted. It could either print up more paper dollars, or more directly, simply credit the deposit accounts banks have with it to expand the supply of money.  This can be done without limit except for the Federal Reserve’s own judgment and the extent of political controversy it is willing to endure.

Since 1950, an essential banking system development is that the Federal Reserve has grown ever more prominent, more prestigious and more powerful. Whether a republic should trust such immense money power to the judgment (which is actually the guessing) of its central bank is a fundamental political question to which the answer is uncertain.

But it is certain that the banking system, including the central bank as a key component, is highly useful to governments, especially to finance wars. A well-developed banking system that can lend large sums of money to the government is a key military advantage. This is a classic element in banking. The deal between politicians and bankers that created the Bank of England in 1694 was that the new bank would lend the government money to finance King William’s wars, in exchange for monopoly currency issuing privileges. U.S. national banks were created in 1863 to finance the Union armies in the Civil War; they bought government bonds and in exchange got to issue a national currency. The Federal Reserve first established its importance by lending money for the purchase of government bonds to finance American participation in the First World War. The young Fed “proved in war conditions an extremely useful innovation,” as a 1948 study of American banking observed.

The banks of 1950 were stuffed with Treasury securities as a result of their having helped finance the Second World War. At that time, the Federal Reserve was buying as many Treasury bonds it took to keep the interest rate on long bonds at 2.5 percent, to keep down the interest cost to the government. This was also meant to keep the market price of the banking system’s huge bond portfolio steady.

At that point, the banks in total owned more Treasury securities than they had in loans. Treasuries were 37 percent of their total assets—an unimaginably high proportion now. Total loans were only 31 percent of assets—now unimaginably low. These proportions made the balance sheet of the banking system very safe. In remarkable contrast, banks today have merely 3 percent of their assets in Treasury securities (see graph 3).

In the banking system of 1950, reflecting the experience of the 1930s, the government was intent on protecting the banks by reducing competition for and among them. Arthur Burns, who was Chairman of the Federal Reserve 1970-78, looked back from 1988 in The Ongoing Revolution in American Banking to explain the 1950s banking regime:

The legislation suppressed competition not only among banks but also between banks and other financial institutions. The ability of banks to compete with one another geographically was limited by rules on chartering and branching. No new bank could set up business without acquiring a national or state charter, and the authorities were disinclined to grant a charter if existing banks would suffer. . . . The ability of banks to compete with one another for demand deposits was limited by a prohibition against payment of interest on such deposits. . . . Banks could offer interest on time and savings deposits . . . but the amount they could pay was limited by a regulation known as Reg Q. . . . Competition between banks and other financial institutions was limited by restrictions on the kind of services each could offer.

In short, the government restricted competitive entry and limited price and product competition. The design was to promote safety by effectively having a banking cartel, with the government as the cartel manager.

This cartel idea was removed step by step in succeeding decades. The Regulation Q price controls, a big political deal in their day, proved a painful problem in the severe “credit crunches” of 1966 and 1969. They were obviously outdated by the time interest rates went into double digits in the 1970s and 1980s, and were belatedly removed. As the 1960s became the 1970s, U.S. banking had become more competitive, innovative, international and interesting, but also riskier. Banking scholars could discuss “the heightened entrepreneurial spirit of the banking industry” in 1975. Of course, there cannot be a competitive market without failures, in banking as in everything else, and we have observed the failures of the 1980s, 1990s and 2000s. But the tight link between banking and the government continued.

By the 1950s, banks had become accustomed to depending on having a lot of their funding guaranteed by the government in the form of deposit insurance. Although many banks had originally opposed the idea as promoting weak and unsound banking, they became and remain today absolutely hooked on it. It has come to seem part of the natural financial order.

But government guarantees of deposits, as is known to all financial economists, tend to make banks riskier, although it simultaneously protects them against bank runs. This combination of effects is because their depositor creditors no longer have to worry about the soundness of the bank itself. Consequently, unsound banking ventures can still attract plenty of funding: This is called “moral hazard,” and its importance in every financial crisis of recent decades can hardly be overstated. To try to control the risk to itself generated by moral hazard, the government must regulate more and more—but its attempt to control risk in this fashion has often failed.

Nonetheless, the extent of deposit insurance has been increased over time. The year 1950 saw a doubling in the amount of deposit insurance per depositor from $5,000 to $10,000. Since then, it has grown 25 times larger in nominal terms, to $250,000, and three times bigger in real terms. These increases are shown below.

As Arthur Burns observed, banks were formerly forbidden to pay interest on demand deposits (checking accounts). In 1950, these deposits comprised the great majority of the banks’ funding—75 percent of the total liabilities of the banking system. That meant that by law 75 percent of the funding had zero interest cost. I well remember as a bank trainee in 1970 having an old banker explain to me: “Remember that banks succeed or fail according to this one number—demand deposits.”

Those days are gone. Demand deposits now are only 11 percent of bank liabilities, and banks can pay interest on them. The graph below shows the historical decline of demand deposits in bank balance sheets.

One of the riskiest classes of credit are real estate loans, which are central to most banking crises. In 1950, real estate loans were only 26 percent of the total loans of the banks. But since then, having accelerated in the 1980s, they have grown to be the predominant form of bank credit, reaching 57 percent of all loans in 2006, just before the real estate collapse. They are now 47 percent of all bank loans, and in the majority of banks, those under $10 billion in total assets, are 72 percent of loans.

We still use the term “commercial banks,” but a more accurate title for their current business would be “real estate banks.”

We may consider together the trends of reduction in the lowest-risk assets, the decline of demand deposit funding, and the shift to riskier real estate credit by combining graphs 3, 4 and 5 into graph 6. The balance sheet of the banking system from 1950 to now has utterly changed.

During these seven interesting banking decades, Congress has been busy legislating away. This is natural: As long as the close connection of the government and banks continues, so will their dynamic interaction through politics, and so will congressional attempts to direct or improve the banking system, or to fix it after the busts that recur in spite of repeated attempted fixes.

Below is a list of the remarkable amount banking legislation since 1950. The mind boggles at the vast volume of congressional hearings, lobbyist meetings, and political speeches all this legislation entailed.

• Federal Deposit Insurance Act of 1950

• Bank Holding Company Act of 1956

• Bank Merger Act of 1960

• Bank Merger Act of 1966

• Bank Holding Company Act Amendments of 1966

• Interest Rate Adjustment Act (1966)

• Financial Institutions Supervisory Act of 1966

• Fair Housing Act (1968)

• Truth in Lending Act of 1968

• Emergency Home Finance Act of 1970

• Fair Credit Reporting Act (1970)

• Bank Holding Company Act Amendments of 1970

• Equal Credit Opportunity Act (1974)

• Real Estate Settlement Procedures Act of 1974

• Home Mortgage Disclosure Act of 1975

• Fair Debt Collection Practices Act (1977)

• Community Reinvestment Act (1977)

• Federal Reserve Reform Act of 1977

• International Banking Act of 1978

• Financial Institutions Regulatory and Interest Rate Control Act of 1978

• Depository Institutions Deregulation and Monetary Control Act of 1980

• Garn-St Germain Depository Institutions Act of 1982

• Competitive Equality Banking Act of 1987

• Financial Institutions Reform, Recovery, and Enforcement Act of 1989

• Federal Deposit Insurance Corporation Improvement Act of 1991

• Housing and Community Development Act of 1992

• Riegle Community Development and Regulatory Improvement Act of 1994

• Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

• Economic Growth and Regulatory Paperwork Reduction Act of 1996

• Gramm-Leach-Bliley Act of 1999

• International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001

• Sarbanes-Oxley Act of 2002

• Check Clearing for the 21st Century Act (2003)

• Fair and Accurate Credit Transactions Act of 2003

• Federal Deposit Insurance Reform Act of 2005

• Financial Services Regulatory Relief Act of 2006

• Housing and Economic Recovery Act of 2008

• Emergency Economic Stabilization Act of 2008

• Helping Families Save Their Homes Act of 2009

• Credit CARD Act of 2009

• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

• an Act to instruct the Inspector General of the Federal Deposit Insurance Corporation to study the impact of insured depository institution failures (2012)

• Reverse Mortgage Stabilization Act of 2013

• Money Remittances Improvement Act of 2014

• Credit Union Share Insurance Fund Parity Act (2014)

• an act to enhance the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, increase individual savings, and for other purposes (2014)

• American Savings Promotion Act (2014)

• FAST Act (this cut Federal Reserve dividends to large banks) (2015)

• Economic Growth, Regulatory Relief and Consumer Protection Act (2018)

In conclusion, we may consider three different perspectives on long-term banking change.

In the 1980s an old employee was retiring after 45 years with the Bank of America, so the story goes. The chairman of the bank came to make appropriate remarks at the retirement party, and thinking of all the financial developments during those years, asked this long-serving employee, “What is the biggest change you have seen in your 45 years with the bank?” His reply: “Air conditioning.” Arthur Burns summed up 1950s banking in this way: “This was a simple system, operating in a simple financial world.” But that is not how it seemed at the time, or at any time. As William McChesney Martin, Chairman of the Federal Reserve 1951-70, said in a 1951 speech to the American Bankers Association: “We are all painfully aware today of the manifold and overpowering complexities of our modern life.”

That feeling characterizes all the years from then to now.

Changes to capital rules should be part of GSE overhaul

Published in American Banker.

Changes to capital rules should be part of GSE overhaul

Acting Federal Housing Finance Agency Director Joseph Otting has certainly gotten the mortgage market’s attention.

To the great interest of all concerned, but especially to the joy of the speculators in Fannie and Freddie’s shares, he recently told agency staff that the FHFA and the Treasury would be working on a plan to soon take Fannie and Freddie out of their 10 years of government conservatorship. Their share prices jumped.

The joy — and the share prices — have since moderated, after more careful comments from the White House. Still, it appears that any near-term change would have to be done by administrative action, since there is zero chance that the divided Congress is going to do so by legislation.

The FHFA and Treasury can do it on their own. They put Fannie and Freddie into conservatorship and constructed the conservatorship’s financial regime. They can take them out and implement a new regime.

But should they? Only if, as part of the project, they remove the Fannie and Freddie capital arbitrage which leads to the hyper-leverage of the mortgage system.

Running up that leverage is the snake in the financial Garden of Eden. As everybody who has been in the banking business for at least two cycles knows, succumbing to this temptation increases profits in the short term but leads to the recurring financial fall.

Leverage is run up by arbitraging regulatory capital requirements in order to cut the capital backing mortgages. Before their failure, when they had at least had some capital, Fannie and Freddie still served to double the leverage of mortgage risk by creating mortgage-backed securities.

Here’s the basic math. The standard risk-based capital requirement for banks to own residential mortgage loans is 4% — in other words, leverage of 25 to 1. Yet if banks sold the loans to Fannie or Freddie, then bought them back in the form of mortgage-backed securities, Fannie and Freddie would have capital of only 0.45% and the banks only 1.6%, for a total of 2.05%, due to lower capital requirements for the government-sponsored enterprises. Voila! The systemic leverage of the same risk jumped to 49 from 25. This reflected the politicians’ chronic urge to pursue expansionary housing finance. Now that Fannie and Freddie have virtually no capital, even the 0.45% isn’t there.

The risks of the assets are the same no matter who holds them, and the same capital should protect the system no matter how the risks are moved around among institutions — from a bank to Fannie or Freddie, for example. If the risk is divided into parts, say the credit risk for Fannie or Freddie and the funding risk for the bank, the sum of the capital for the parts should be the same as for the asset as a whole.

But the existing system abysmally fails this test.

If 4% is the right risk-based capital for mortgages, then the system as a whole should always have to have at least 4%. If the banks need 1.6% capital to hold Fannie and Freddie mortgage-backed securities, then Fannie and Freddie must have 2.4% capital to support their guarantee, or about 5 times as much as their previous requirement. If Fannie and Freddie hold the mortgages in portfolio and thus all the risks, they should have a 4% capital requirement, 60% more than their former requirement.

The FHFA is working on capital requirements and has the power to make the required fix.

Bank regulation also needs to correct a related mistake. Fortunately, Mr. Otting is also Comptroller of the Currency. Banks were encouraged by regulation to invest in the equity of Fannie and Freddie on a super-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a risible 1.6%, since changed to a still risible 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (Your broker’s margin desk wouldn’t let you do that!)

In short, the banking system was used to double leverage Fannie and Freddie. To fix that, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so it really would be equity from a consolidated system point of view.

All in all, if Treasury and the FHFA decide to end the conservatorships, that would be fine. That is, provided they simultaneously stop the systemic capital arbitrage and add the two highly-related reforms.

Fannie and Freddie will continue to be too big to fail, even without the capital arbitrage, and will continue to be dependent on and benefit enormously from the Treasury’s effective guarantee. They need to pay an explicit fee for the value of this taxpayer support. The fee should be built in to any revision of the existing senior preferred stock purchase agreements between them and the Treasury.

Finally, Fannie and Freddie are without question systemically important financial institutions. To address their systemic risk, Treasury and the FHFA should get them formally designated as the SIFIs they so obviously are.

How to Fix the Unhealthy Concentration of Corporate Voting Power In the U.S.

Published in Real Clear Markets.

The popularity of index and other mutual funds, combined with the current rules for voting shares of stock, has had an unexpected ill effect: concentration of corporate voting power in the hands of a few giant asset management companies.  Nobody did or would intend this outcome.  Fortunately, the voting rules can be changed. A great way for the SEC to start 2019 would be to take on and then fix this threat.

The asset managers holding the concentrated voting power are, economically speaking, mere agents.  They are not principals. One hundred percent of the risks and rewards of ownership belong to the beneficial owners of the funds: they are the economic owners.  The agent asset managers simply pass through these risks and rewards (minus their fees, course).  They have the stock registered in the fund name, but they are in no economic sense the owners.

They are in economic terms in exactly the same position as broker-dealers holding stock registered in street name, of which 100% of the risks and rewards (minus commissions) likewise belong to the customers.

The current voting rules for shares in mutual funds accelerate the famous “separation of ownership and control” in precisely the wrong direction: away from the substantive owners and into the hands of agents. As corporate governance scholar Bernard Sharfman has written to the SEC, “BlackRock, Vanguard, and State Street Global Advisors (the Big Three) now control enormous amounts of proxy voting power without having any economic interest in the shares they vote.”

The celebrated creator of index funds, John Bogle, rightly warned that “a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.”  In fact, the control would be exercised by a few senior employees of those institutions—the agents of the agents.  Said Bogle, “I do not believe that such concentration would serve the national interest.”  It certainly wouldn’t.

It also does not serve the interests of the economic owners, who are under current rules deprived of any ownership voting rights.  This contrasts strikingly with the case when investors economically own stock that is legally registered in their broker’s street name.  In that case, the rules work hard to align voting rights with economic ownership, as they should.

There is an additional problem with concentrating voting power in the hands of a few agents.  These highly visible organizations are subject to political pressure and influence on how they cast their votes.  They cannot fail to be tempted to take positions through voting on contentious issues which are politically and economically advantageous to themselves, doubtless accompanied by pious speeches, rather than to the principals. The temptation to signal political “virtue,” rather than vote the interests of the real owners, may be irresistible.  The severe agency problem is obvious.

What do the principals want?  You should ask them, just as the brokers have to do.

We are confronted with a problem of a concentration of not only economic, but also of political power, needing to be fixed, sooner rather than later.

The public discussion of the issue has included the charge that index funds, because they may own all the major public companies in an industry, will promote cartel and oligopoly behavior to favor the industry, not the individual competitors in it—an influence which, if true, is certainly not to be desired.  This led financial commentator Matt Levine to suggest that index funds “pose a problem under the antitrust laws.”

But the problem is not that these funds hold shares registered in their name on behalf of the beneficial owners.  The problem is that the funds are allowed to vote such shares without instructions, to suit themselves.  It’s not the surface “ownership,” it’s the voting power that must be addressed.  They don’t need to have anti-trust laws applied, just to have their voting rules fixed.

The analogy is compelling: in economic substance, the status of the shares held by a mutual fund and that of the shares held by a broker in street name is exactly the same.  They should have exactly the same rules for voting the related proxies.

So the fix is quite straightforward:  Apply the same proxy voting rules to asset managers as already exist in well-developed form for brokers voting shares held in street name.  In short, the asset managers could vote uninstructed shares for routine matters, just like brokers, assuring the needed quorums.  But for non-routine matters, including the election of corporate directors, they could vote only upon instructions from the economic owners of the shares.   Thus the economic owners of shares through brokerage accounts and through mutual funds would be treated exactly the same.  The intermediary agents would be treated exactly the same.

Of course, the asset managers would whine about the trouble and expense of getting mutual fund holders to vote their proxies.  But the brokers already have the same problem.  Overall operating efficiency would be enhanced by allowing the real owners to provide revocable standing instructions to both asset managers and to broker-dealers for non-routine matters with a choice like this:

1.       Vote my shares only upon specific instructions from me.

2.       Vote my shares for the recommendations of the board of directors of each company.

3.       Vote my shares for whatever the asset manager or broker-dealer decides.

It would be gigantic mistake to let a handful of big asset managers amass discretionary voting dominance of the whole U.S. corporate sector, including pursuit of political agendas, all without having any economic interest in the shares they vote.  We should instead create instead a governance structure which ensures that the principals control the votes.

In Finance, the Blind Spots Will Always Be With You

Published in Law & Liberty.

“Where are our blind spots?” is an excellent question to ask about systemic risk, one I recently was asked to speak on at the U.S. Treasury. Naturally, we don’t know where the blind spots are, but they are assuredly there, and there will always be darkness when it comes to the financial future.

Finance and Politics

The first reason is that all finance is intertwined with politics. Banking scholar Charles Calomiris concludes that every banking system is a deal between the politicians and the bankers. This is so true. As far as banking and finance go, the 19th century had a better name for what we call “economics”—they called it “political economy.”

There will always be political bind spots—risk issues too politically sensitive to address, or which conflict with the desire of politicians to direct credit to favored borrowers. This is notably the case with housing finance and sovereign debt.

The fatal flaw of the Financial Stability Oversight Council (FSOC) is that being part of the government, lodged right here in the Treasury Department, it is unable to address the risks and systemic risks created by the government itself—and the government, including its central bank—is a huge creator of systemic financial risk.

For example, consider “Systemically Important Financial Institutions” or SIFIs. It is obvious to anyone who thinks about it for at least a minute that the government mortgage institutions Fannie Mae and Freddie Mac are SIFIs. If they are not SIFIs, then no one in the world is a SIFI. Yet FSOC has not designated them as such. Why not? Of course the answer is contained in one word: politics.

A further political problem with systemic financial risk is that governments, including their central banks, are always tempted to lie, and often do, when problems are mounting. The reason is that they are afraid that if they tell the truth, they may themselves set off the financial panic they fear and wish at all costs to avoid. As Jean-Claude Juncker of the European Union so frankly said about financial crises, “When it becomes serious, you have to lie.”

Uncertainty and the Unknowable

We often consider “known unknowns” and “unknown unknowns.” Far more interesting and important are “unknowable unknowns.” For the financial future is inherently not only unknown but unknowable: in other words, it is marked by fundamental and ineradicable uncertainty. Uncertainty is far more difficult to deal with and much more intellectually interesting than risk. I remind you that, as famously discussed by Frank Knight, risk means you do not know what the outcome will be, but you do know the odds; while uncertainty means that you do not even know the odds, and moreover you cannot know them. Of course, you can make your best guess at odds, so you can run your models, but that doesn’t mean that you know them.

Needless to say, prices and the ability of prices to change are central to all markets and to the amazing productivity of the market economy.

But a price has no sustainable existence. As we know so well with asset prices in particular, the last price, or even all the former prices together, do not tell you what the next price will be.

With housing finance audiences, I like to illustrate the risk problem with the following question: What is the collateral for a mortgage loan? Most people say, “The house, of course.” That is wrong. The right answer is that it is the price of the house. In the case of the borrower’s default, it is only through the price of the house that the lender can collect anything.

The next question is: How much can a price change? Here the answer is: More than you think. It can go up more in a boom, and down a lot more in a bust than you ever imagined.

One key factor always influencing current asset prices is the expectation of what the future prices will be, and that expectation is influenced by what the recent behavior of the prices has been. Here is an important and unavoidable recursiveness or self-reference, and we know that self-reference generates paradoxes. For example, the more people believe that house prices will always rise, the more certain it is that they will fall. The more people believe that they cannot fall very much, the more likely it is that they will fall a lot.

The Nature of Financial Reality

Financial reality is a fascinating kind of reality. It is not mechanical; it is inherently uncertain, not only risky; it is not organic; it is full of interacting feedback relationships, thus recursive or reflexive (to use George Soros’ term); unlike physics, it does not lend itself to precise mathematical predictions.

Therefore we observe everybody’s failure to consistently predict the financial future with success. This failure is not a matter of intelligence or education or diligence. Hundreds of Ph.D. economists armed with all the computers they want do not succeed.

The problem is not the quality of the minds that are trying to know the financial future, but of the strange nature of the thing they are trying to know.

Another troublesome aspect of financial reality is its recurring discontinuous behavior. “Soft landings” are continuous, but “hard landings” are discontinuous. Finance has plenty of hard landings.

From this odd nature of financial reality there follows a hugely important conclusion: Everybody is inside the recursive set of interacting strategies and actions. No one is outside it, let alone above it, looking down with celestial perspective. The regulators, central bankers and risk oversight committees are all inside the interactions along with everybody else, contributing to the uncertainty. Their own actions generate unforeseen combinations of changes in the expectations and strategies of other actors, so they cannot know what the results of their actions will be.

Another way to say this is that there are no financial philosopher-kings and there can never be any, in central banks or anywhere else. No artificial intelligence system can ever be a philosopher-king either.

Odin’s Sight

We can conclude that blind spots are inevitable, because of politics, and because of the unknowability of the outcomes of reflexive, expectational, interacting, feedback-rich combinations of strategies and actions.

I will close with a story of Odin, the king of the Norse gods. Odin was worried about the looming final battle with the giants, the destruction of Valhalla, and the twilight of the gods. Of course he wanted to prevent it, and he heard that the King of the Trolls had the secret of how to do so. Searching out this king by a deep pool in a dark forest, he asked for the secret. “Such a great secret has a very high price,” the troll replied, “one of your eyes.” Odin considered what was at stake, and decided to pluck out one of his eyes, which he handed over.

“The secret is,” said the King of the Trolls, “Watch with both eyes!”

When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one.

The Fed is technically insolvent. Should anybody care?

Published in American Banker.

As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?

The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.

If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.

The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.

And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?

All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.

Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.

People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.

About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?

Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.

When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.

It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.

It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?

India’s Central Bank Debates Remind Us the Fed Is Far From ‘Independent’

Published in Real Clear Markets.

Should central banks be “independent” from the elected parts of the government?  If so, should they be independent in all things, or just some things?  Or should they not be independent at all? These are classic questions.  Of course, central bankers themselves like the idea of independence, as do many economists, who believe they know better about economic and financial affairs than mere politicians.  Larry Summers, a leading economist, former Secretary of the Treasury and former contender for the office of Federal Reserve Chairman, recently wrote about President Trump’s criticism of Federal Reserve policy:

“No self-respecting central banker can be seen as yielding to pressure from a politician.”

Of course Professor Summers knows that there have been many instances over the decades of U.S. presidents and administrations exerting pressure on the Fed.  As Allan Meltzer wrote in his monumental A History of the Federal Reserve, “Missing from most explanations by economists is the political dimension.  By law the Federal Reserve was an independent agency.  In practice, it responded to political pressures.”

Interestingly, at the same time as President Trump’s criticisms, half a world away, the government of India’s Prime Minister Narendra Modi is putting much more pressure on India’s central bank, the Reserve Bank of India.

So India, a huge country with a big economy, a parliamentary democracy and a sophisticated central bank, has been having a highly interesting debate of the issue.  The Reserve Bank has maintained that its independence is a central principle, with its Deputy Governor Viral Acharya pronouncing that “Governments that do not respect the central bank’s independence will sooner or later…ignite economic fire and come to rue the day.”  Does this mean he thinks a central bank has no boss, no political accountability?

Under the original Federal Reserve Act of 1913, the executive branch was assumed to have an important voice in central bank affairs, since the Secretary of the Treasury was by law the Chairman of the Federal Reserve Board. This provision was removed in the Banking Act of 1935, which certainly pleased the new Fed Chairman, Marriner Eccles, when he assumed the role in that year.

In the Indian context, the Prime Minister’s government has a stronger hand than does a U.S. administration.  The central bank’s chartering act, the Reserve Bank of India Act of 1934, provides:

“The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

Although this power apparently has never been explicitly used, it could not be clearer: Have a discussion about the issues with the central bank, and then if you think it “necessary in the public interest,” tell the bank what to do and the bank has to do it.  While “the market and the banking system have been abuzz that the rift between the government and the RBI had reached a point of no return,” as India Today put it, the government has been forcefully and publicly reminding the Reserve Bank about this unambiguous provision of its chartering act.

Professor Summers, in the same essay as quoted above, added like a good two-handed economist, that on the other hand:

“There is a need for pragmatism regarding the independence of central banks.”  And: “It is foolish to suppose that a nation’s financial policies should be conducted independently of its elected officials.”

So the unelected central bankers should not be so independent, after all?  Arthur Burns, Chairman of the Fed in the inflationary 1970s, reportedly characterized such pragmatism, or political realism, in these memorable terms:  “We dare not exercise our independence for fear of losing it”!

What does the present Indian government consider necessary in the public interest?  First, it wants to get its hands on what it says are the “excess” retained earnings of the Reserve Bank, and more of the bank’s annual profit, in order to have the money to spend.

It may be of interest to compare the Federal Reserve’s situation in this respect.  The Congress has three times taken some of the retained earnings of the Federal Reserve Banks—half of their surplus in 1933 to fund the new Federal Deposit Insurance Corporation; $19 billion in 2015 to fund highways in a transportation act; and another $2.5 billion in 2018 to fill a gap in a budget deal.  Although it was “a raid on the capital base of the nation’s central bank,” as one critic said, it happened anyway.  As for profits, the Fed pays almost all of its annual profit, about 99%, right over to the U.S. Treasury.  The resulting consolidated Federal Reserve balance sheet has a trivial capital ratio of 0.9%.  Is that enough?  Who gets to say?

Prime Minister Modi’s idea of getting money to spend from the central bank’s reserves and profits is hardly a new idea.

Second, the Indian government wants the Reserve Bank to ease its regulatory constraints on banks which already have high ratios of bad loans, in order to promote more lending now, with as is often noted, an election coming up. That may be a bad idea, but who is the boss when it comes to financial regulation?  In the U.S., it is certainly the Congress, although the Fed and other regulators have significant discretion in interpretation.

After a marathon meeting of the Reserve Bank of India’s board on November 19, the bank agreed to reassess its policy on reserves and its rules for troubled banks. It does not seem too hard to guess what direction the “reassessment” will take.

While the immediate issues are about regulatory policy and helping out the government budget, the classic “independence” argument is that central banks should be independent in monetary policy, as their essential mandate. This aspect of independence has also been debated in India.  In contrast to its government’s preferences and to President Trump’s comments, recent Federal Reserve reform bills in the House of Representatives which would have subjected the Fed to significantly increased oversight, nevertheless always protected monetary policy independence.  Is that distinction a sacred principle or a sacred cow?  In U.S. history, the Truman administration, wanting the Fed to help finance the Korean War, certainly didn’t believe in it.  Will it be respected as the government of India continues to push the Reserve Bank?

It will be instructive to observe the continuing developments there, including the competing rationales and rhetoric.  As an example of the latter, “The independence of the central bank is still intact,” said one economist after the November board meeting—perhaps he proposes to redefine “independence.” “We don’t think that this issue has been fully solved yet,” said another.  For sure not–stay tuned.

Perpetual Inflation vs. Sound Money

Published in Law & Liberty.

Among the most important financial forces in the world are fashions in central bankers’ ideas. The dominant central bank fashion in recent years is the notion that they should create perpetual inflation at the rate of 2% per year—not 2% sometimes, but 2% always. If this indeed should happen, in a lifetime of 80 years, consumer prices on average will nearly quintuple. Current central banks’ rhetoric insists on calling this “price stability,” a striking instance of newspeak. They have converted the journalists, who earnestly report whether inflation is meeting the central bank “target,” simply taking it on faith that this target must be a good idea.

The central banking commitment to 2% inflation forever has become internationally widespread, including of course the Federal Reserve, which is the dollar-issuing central bank to the world, not only to the United States. The Fed adopted this debatable doctrine on its own and simply announced it in 2012, without the approval of the Congress, although Congress has the Constitutional duty to regulate the value of money.

Brendan Brown, London-based senior economist for Mitsubishi UFJ Bank and iconoclastic monetary thinker, attacks the 2% inflation fashion head on, as the title of his new book expresses: The Case Against 2 Per Cent Inflation. He argues instead for a regime of sound money (for his definition of what this means, see below).

This complex book first reviews the 2% inflation doctrine’s place in the history of shifting central banking ideas:

Since the fall of the full international gold standard in 1914, the fiat money ‘system’ has wandered through four successive stages…. The first three all ended in dismal failures…. The fourth [2% inflation] is headed in the same direction.

Following the destruction of the gold standard by the First World War and the related wild inflations, the stages have been, according to Brown:

• The gold exchange standard of the 1920s, meant to restore stability but ending with “the bust of the global credit bubble” of the late 1920s.

• 1930s disorders leading to the stabilization efforts of the Bretton Woods agreement of 1944. This system collapsed in 1971.

• Pure fiat currencies with floating exchange rates among them. This period featured the Great Inflation of the 1970s, but also monetarist doctrines, most notably in Germany and also temporarily in the U.S. It ended “most spectacularly” with “the bubble and bust in Japan” in 1989.

• Then “out of the monetarist retreat,” says Brown, “was born…a new stabilization experiment—the targeting of perpetual inflation at 2% p.a.,” the current theory. Since the Fed first formally adopted this idea in 2012 we have had a spectacular global asset price inflation—will it end with a bang or a whimper?

Surveying this history must prompt us to ask: is there is any eternal central banking truth?

The book quotes the changing central banking ideas over time as described by Stanley Fischer, formerly Vice Chairman of the Fed and Governor of the Bank of Israel:

Emphasis on a single rule as the basis for monetary policy implies that the truth has been found, despite the record over time of major shifts in monetary policy—from the gold standard, to the Bretton Woods fixed but changeable exchange rate rule, to Keynesian approaches, to monetary targeting, to the modern frameworks of inflation targeting….

This led Fischer reasonably to suggest that these matters need appropriate awareness of the “human frailty” and the “considerable uncertainties” involved.

Should we put our faith in the most recent central banking fashion of 2% inflation forever? Or will it also end up, as Brown thinks, in “the dustbin of monetary history” with the others?

The book addresses four key questions about the 2% theory:

1. Where did it come from?

2. What is its rationale?

3. Is the rationale convincing?

4. How does it contrast with sound money?

Where Did the 2% Doctrine Come From?

The answer, as the book explains, is that it came from New Zealand; specifically, an act of its Parliament: the Reserve Bank of New Zealand Act of 1989. The whole point of the original project was to get inflation downfrom its unacceptably high level, then about 5%. In its origin, it had nothing to do with making inflation go up. Very important in this context was that the original goal was not 2% inflation, but a range of zero to 2%, as agreed to between New Zealand’s Minister of Finance the Governor of the Reserve Bank. In subsequent international central banking evolution, the “zero” part seems to have been forgotten.

Similarly, the Humphrey Hawkins Act of 1978 in the United States held out the idea that by 1988 the inflation rate could be reduced to zero. We never hear this statutory provision discussed by the Federal Reserve.

Thus, New Zealand’s creation of what has become the international 2% doctrine began with an act of its legislature, followed by an agreement with the government, not an announcement of the central bank by itself. This is a striking contrast with American developments. Does the Fed have the authority to decide this essential question on its own, without the approval of Congress? I don’t think so, and neither did Alan Greenspan.

At the end of the 1980s, the book relates, then Fed Chairman Greenspan “had no inclination to adopt a formal 2% inflation target—seeing this as potentially irritating relations with Congress (here he feared that some members might question why inflation rather than price stability).” This was before the Federal Reserve rhetoric had redefined “price stability” to mean perpetual inflation.

Further, in a key 1996 discussion of whether there should be a specific inflation target, Greenspan argued that “The question is really whether we as an institution can make the unilateral decision to do that. I think this is a very fundamental question for this society. We can go up to the Hill and testify… but we as unelected officials do not have the right to make that decision.” A very sound point. But in 2012, the Federal Reserve on its own made a formal commitment to perpetual inflation at 2%, anyway.

What Is the Rationale for the 2% Doctrine?

One important argument is from the point of view of central bank power. With 2% inflation, it is easier for central banks to run negative real interest rates when needed, while still keeping nominal interest rates over zero. The argument is focused on how to avoid hitting the “zero lower bound” for nominal interest rates. We all know by now that nominal interest rates can in fact go below zero, but presumably not too far below. With 2% inflation, you just have to get nominal rates below 2% to make them negative in real terms. In the meantime, we are assured that 2% inflation is “low.”

This argument assumes that central banks should be in the business of setting of interest rates by discretion, the very thing that sound money advocates doubt or deny that central banks can successfully do. Do central bankers themselves share this doubt? They should.

A deeper economic argument for inflation (though not necessarily perpetual inflation) is that it allows real wages to fall while nominal wages do not, and thus enables required adjustment in real prices to take place, even though wages are “sticky.” This was the key argument that Janet Yellen made to the Fed’s Open Market Committee in the opening 2% target debate in 1996, and it will be recognized as a classic Keynesian idea. It does depend, however, as then-Governor Yellen herself said at the time, on people believing in nominal dollars rather than inflation-adjusted ones—in other words, in “money illusion,” though she did not use that term.

Making sure inflation is 2% runs another important theme, we will make sure that we will never have price deflation, assumed to be always bad. But is moderate deflation always and necessarily bad? Brown doesn’t think so, as explained below. Constant inflation with low or negative real rates also makes sure that debt is favored, strengthening its tendency to induce financial bubbles.

A clear and firm repetitive communication of the 2% target, it is further argued, will manage market and popular expectations of future inflation or deflation, “anchoring” them at about 2%. “I don’t see anything magical about targeting 2% inflation,” former Fed Chairman Ben Bernanke said later, “my advocacy…was based much more on the transparency and communication advantages.” Of course, central bankers can neither bind their successors, nor know that 2% is the perfect number now, let alone forever.

An additional argument is that standard government measures overstate the rate of inflation, so you have to make your inflation target high enough to offset this mistake.

Is the Rationale Convincing?

In a word, according to Brown: No. I agree. Celebrated central banker Paul Volcker has recently added his distinguished No to this discussion, as noted below.

Underlying Brown’s rejection of all perpetual inflation targets, including 2%, is his fundamental insight about the natural course of average prices in a free market, entrepreneurial economy. The natural course, he says, is not forever upwards, nor always stable. “In a well-functioning capitalist economy, sound money goes along with prices on average for goods and services which fluctuate upwards and downwards over considerable periods, with some tendency to revert to a mean over the long run.” [italics added] A natural rhythm of prices makes them sometimes go down, notably in periods of “spurts in productivity growth, resource abundance, or perhaps a change in product and labor market structure.” This kind of deflation is not a disaster to be fought at all costs by central banks because it shows that productivity is making real incomes rise. Combined with alternating periods of rising prices, in this currently non-existing scenario, prices on average tend to go sideways in the long term.

Instead, modern central banks keep attempting to manipulate prices to a different and “better” outcome—to rise constantly at the same 2% rate forever. But, Brown asks rhetorically (and convincingly to me), “Why should we believe these super claims about central bank wisdom and insight when the record suggests otherwise?” Why indeed?

Further, “Attempts of central banks to drive up prices when the natural rhythm is downwards end up with likely virulent asset price inflation (and eventual bust),” Brown argues. With modern central bank policies, asset price booms and busts are certainly what we experienced, followed by another remarkable asset price inflation.

“You will not find in the advocacy literature for monetarism or for the 2% inflation standard,” the book observes, “any mention of asset price inflation.” I recently read two presentations made at the Brookings Institution discussing whether the 2% doctrine should be changed. Neither mentioned asset price inflation. Certainly, no monetary theory or policy makes sense which does not address the issue of asset price inflation.

Concerning other defenses of 2% inflation forever, we may ponder: How much of central bank actions should be based on trying to fool the people with money illusion? And if your position is that you don’t believe the government’s inflation statistics, wouldn’t it be a superior approach to state, as Greenspan reasonably suggested, that the right inflation goal is “zero, if inflation is properly measured”?

Finally in this context, we note that Paul Volcker, in his new book, Keeping At It: The Quest for Sound Money and Good Government, provides these thoughts about the 2% theory: “I know of no theoretical justification,” and “All these arguments [for it] seem to me to have little empirical support.”

How Does 2% Forever Contrast with a Sound Money Regime?

Brown’s fundamental recommendation is for “a journey away from the 2% inflation standard to a sound money alternative.” What does he mean by “sound money”? Not, as we have seen, that price levels should be always the same, instead of price levels rising forever at 2% per year. His definition of sound money is rather this:

The guiding features of sound money are market determination of short- and long-term interest rates free of any official manipulation; the quality of money and consumer satisfaction with it are the lead objectives of the money suppliers; persistent moves of money prices of goods and services in one direction should not be expected; over the long run, there should be some tendency for prices to revert to the mean, but in no precise or assured manner; money must not be a tool of the sovereign usable towards funding expenditures without legislating tax rises or floating loans on the free market at non-manipulated rates; [or of] bailing out cronies including the banks.

This is a radically market-based doctrine. It retains no role for the central bank serving as the national price fixing committee to manipulate interest rates or prices generally. Although an amazing number of people naively accept the idea that central banks can successfully fix prices, Brown shows why we should reject that pretense. The book also rejects central bank policies of financial repression “levying inflation tax on the small and the weak” to finance the government’s deficits. It certainly does not flatter the ambitions of central bankers to “manage the economy” or the desire of governments for monetization of their debts and collection of inflation taxes. In short, it is not a doctrine to appeal to political elites.

How then shall you get some country to try it? Ay, there’s the rub. Perhaps some small country or countries might play the New Zealand of a new sound money monetary doctrine? Brown speculates about this possibility, but it does not seem too hopeful. Still, as has been wisely observed, “Many things which had once been unimaginable nevertheless came to pass.” Is it possible that the fashion in central bankers’ ideas will turn to sound money after the next crisis?

In sum, Brown has written an interesting history, thorough analysis, and penetrating criticism of the 2% inflation forever doctrine, and provided provocative food for thought about what in contrast a sound money regime would be like.

A Most Enjoyable History of a Most Remarkable Bank

Published in Real Clear Markets.

This is a colorful book, full of great stories and forceful (if not always admirable) personalities, who deserve to be remembered.  It gives us repeated lessons of how banking is a business always intertwined with the government, demonstrated in the long history of Citibank, a very important, very big, often quite creative, and sometimes very troubled bank.  It reminds us of the theory of Charles Calomiris that every banking system should be thought of as a deal between the bankers and the politicians.

According to then-Treasury Secretary Henry Paulson’s instructive memoir of our most recent financial crisis, on November 19, 2008:

“Just one week after I had delivered a speech meant to reassure the markets, I headed to the Oval Office to tell the president that yet another major U.S. financial institution, Citigroup, was teetering on the brink of failure.

‘I thought the programs we put in place had stabilized the banks,’ he said, visibly shocked.

‘I did, too, Mr. President.’”

This exchange led to the instructions from the President which appear on page 1 of Borrowed Time:

“Don’t let Citi fail.”

At this point, as the book tells us, “The Office of the Comptroller of the Currency and Citigroup guessed that Citibank would be unable to pay obligations or meet expected deposit outflows over the ensuing week.  Citigroup’s own internal analysis projected that ‘the firm will be insolvent by Wednesday, November 26.’”

“As ever,” the authors add, “the latest crisis in the banking sector caught many regulators by surprise.”

Now, if Citibank had failed and defaulted on its obligations, what would have happened?  Nobody wanted to find out.  Then-New York Federal Reserve President Tim Geithner forecast that it would be a “catastrophe,” the book relates, and quotes the then-head of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair: “We were all fearful.”

In their place would you, ladies and gentlemen, have been fearful, too?

Yes, you would have been.

Would you have decided on a bailout of Citibank, as they did?

Yes, you would have.

The FDIC had a special and very pointed reason to be fearful: a failure of Citibank would have busted the FDIC, too—this government insurance fund would itself have needed a taxpayer bailout.  As we learn from the book:

“The FDIC staff did a seat-of-the-pants calculation and estimated the agency’s potential exposure to Citibank to be in the range of $60 billion to $120 billion.  Even at the low end of that estimated range, losses would ‘exhaust the $34 billion or so in the [Deposit Insurance Fund].’”

So the FDIC would have been broke—just like the Federal Savings and Loan Insurance Corporation was twenty years before.  In short, the bailout of Citibank was an indirect bailout of the FDIC.  This insightful lesson is not made explicit in the book, but is a clear conclusion to draw from its account.

Going back in history to 147 years before these events of 2008, we find the situation interestingly reversed.  In 1861, at the beginning of the Civil War, City Bank—at that point spelled with a sensible “y” and not the marketing “i” of much later times—was helping save the government, as the U.S. Treasury scrambled to raise money for the army.

We learn from the book that Moses Taylor, then the head of City Bank, “played a leading role in gathering private and municipal funds to equip and sustain Union troops and also in managing the issuance of federal debt to pay for the war.”

In the summer of 1861, “Secretary of the Treasury Salmon Chase visited a group of New York bankers and told them he needed $50 million ‘at once.’  The bankers huddled, and the Tylor, speaking for the group, announced, ‘Mr. Secretary, we have decided to subscribe for fifty millions of the United States government’s securities that you offer, and to place the amount at your disposal immediately.’”

We can imagine how relieved and happy that must have made the Treasury Secretary.

As the Civil War dragged on and became vastly more expensive, one of the ways to finance it was the creation of the national banking system to monetize the government debt.  City Bank then became a national bank, as it still is.

However, the limitations of the national bank charter made it hard to be in the securities business.  How City Bank got around this in the boom of the 1920s makes interesting reading, including how it actively financed the stock market bubble of the decade.

Then came, of course, the collapse and the disaster of the 1930s, and that brought government investment in the preferred stock of City Bank by the Reconstruction Finance Corporation.  “The debate is over whether City really needed Washington’s money,” the book tells us, “or was persuaded to participate in a broader program intended to show that the government was shoring up the nation’s banking system.”  It continues, “Just as in 2008”—note how financial ideas as well as events repeat themselves—“federal officials in the 1930s wanted healthy banks to accept government investment so that the weak banks that really needed it would not be stigmatized.”  But which category was City Bank in?

The authors conclude that “it seems likely that City really did need the money.”

Citibank was and is a very international bank.  This has its advantages, but also its problems.  In the 1930s, City was in trouble from its international loans to, as the book relates, Chile, Cuba, Hungary, Greece and most importantly, Germany.

Germany had boomed in the 1920s and was the second largest economy in the world.  It had financed its boom with heavy international borrowing, especially from the United States.  By the 1930s, it was obvious that this had not been a good idea from the lenders’ point of view.

In the natural course of events, the costly 1930s experience became “ancient history,” and in the 1970s, Citi (now spelled with an “i”) was the vanguard of a great charge into international lending, in which a lot of other banks followed.

The leader and chief proponent of the charge was Walter Wriston, Citi’s CEO and the most innovative and best known banker of his day.  Says the book:

“Wriston’s most remarkable achievement at Citibank was persuading Washington that lending money to governments in developing countries was nearly risk-free.”

But the government was already cheering for these loans.  “There had for years been a tendency among many government officials to look with favor on loans to less-developed countries [LDCs].”

About these loans, Wriston notoriously said, “They’re the best loans I have.  Sovereign nations don’t do bankrupt.”

No, they don’t.  But they do default on their loans—and quite often, historically speaking.  And default many foreign governments did, starting in 1982.

At that point, the Chairman of the Federal Reserve was the famous Paul Volcker.  As the book discusses, his solution to the possibility the U.S. banking system had become insolvent was to mandate that the LDC loans not be called the bad loans they were, that no loan losses would be booked against them, and that the banks would indeed have to make new loans to keep the Ponzi scheme going.  In other words, the solution was to cook the books.

With this big gamble, as it turned out, things did keep going.  When LDC loans were finally charged off in the late 1980s, there was a new boom on: financing commercial real estate.  This boom in turn collapsed in the early 1990s.  We might say there is a theme and variations involved.

In 1981, just before the Wriston-led charge into LDC debt went over the cliff, the biggest ten banks in the United States, in order, were:

Bank of America (the one in San Francisco, long since sold)

Citibank

Chase Manhattan

Manufacturers Hanover

Morgan Guaranty

Chemical Bank

Bankers Trust

Continental Illinois

First National Bank of Chicago

Security Pacific

Consider this:  of the ten, only two still exist as independent companies.  Eight of the ten are gone.  To people not in the financial trade, or even to younger ones in it, these once-important names are probably unknown.  As a song written by one of my old banking friends goes:

“You were a big bank, Blink and now you’re gone!”

But Citibank, the subject of the eventful history related by Borrowed Time, is not gone—it is still here.

Which is the only other survivor of the former top ten?  Maybe you would like to guess?*

In short, if you have a taste for the adventures and evolving ideas, the ups and downs, the growth and reverses, and the innovations and blunders of banking over the years, you will enjoy this history of a most remarkable institution.

*The answer is Chemical Bank, although it has changed its name to JPMorgan.

It’s time for the Fed to be made accountable for its actions

Published in The Hill.

The U.S. Constitution assigns responsibility for the nature of money to the Congress. As Article I, Section 8 famously says, “Congress shall have Power…To coin Money [and] regulate the Value thereof.”

How can this be consistent with the idea that the Federal Reserve should be “independent,” as it is so often proclaimed, especially by the Fed itself? The answer is that it is not consistent.

Last week, the House Financial Services Committee approved the Federal Reserve Reform Act of 2018, H.R. 6741, which was sponsored by Rep. Andy Barr (R-Ky.), the chairman of the Subcommittee on Monetary Policy and Trade. The full committee passed the bill 30-21, with the vote along party lines.

This is an important effort to move toward the proper constitutional ordering of authority over money and regulating the value thereof, which we now call “monetary policy,” whatever the future of the bill may be.

Who should be in charge of money and its value? The Fed all by itself or the Fed as accountable to Congress? Almost all of the very many economists I know think that the Fed, a very large employer of economists, should be independent.

But that cannot be the right answer in a government whose essential character requires robust checks and balances.

I believe proponents of Fed independence tend to view it as a committee of economic philosopher-kings. But this fits neither its existence as part of a democratic government, nor the inherent uncertainties and limitations of its knowledge of the economic present, let alone the future.

Section 2 of the bill, Monetary Policy Transparency and Accountability, requires the Fed to discuss with Congress what the Fed is trying to do, in some specificity and in plain English, as distinct from “Fedspeak.”

The Fed would be required to discuss what its monetary strategy for each coming year is, how it plans to use the various instruments at its disposal, what monetary policy rules it has adopted and how these might change.

After the fact, it must discuss how the monetary strategy did change, if it did. This seems a pretty reasonable discussion for the Fed to have with the elected representatives of the people, who have the constitutional responsibility for the value of money.

Section 11 C (b) contains a nice definition of what money should mean in the pure fiat currency system we now have:

A generally acceptable medium of exchange that supports the productive employment of economic resources by reliably serving as both a unit of account and store of value.

This is what the bill instructs the Fed to produce. It is in notable contrast to the endemic inflation the Fed has presided over for the last several decades, which has resulted in a dollar today being worth what a dime was in 1950.

In the bill as originally proposed, a Section 12 would have changed the Fed’s so-called “dual mandate” of “maximum employment [and] stable prices” to simply “stable prices.” This vividly contrasts with the current Fed’s formal commitment to perpetual inflation. This provision did not make it into the committee’s approval, but is such an important idea that it deserves discussion.

The “dual mandate” was enacted in the 1970s, when people believed in the Phillips Curve theory that you would increase employment by running up inflation.

If it were up to me, on the next opportunity, I would write this new mandate somewhat differently, along these lines: “All Federal Reserve strategies are to be consistent with stable prices on average over the long run.”

This is because in an innovative, free-market economy with sound money, prices will rise sometimes and sometimes fall, but have a basically flat trend over the long run. It must not be forgotten that the Fed’s original 1913 mandate, “to furnish an elastic currency” to finance crises, is still there.

Section 3 (a) of the bill, “Returning to a Monetary Policy Balance Sheet,” would require the Fed’s investment portfolio to be essentially held in Treasury securities (with a few exceptions for gold certificates, foreign central bank obligations or the International Monetary Fund).

The real point is to take the Fed out of being a massive investor in real estate mortgage securities, thus out of being a promoter of house price inflation and out of effectively being a giant savings and loan vehicle. The Fed would have to give all non-qualifying investments to the U.S. Treasury in exchange for Treasury securities.

This is not as strict as the “Bills Only” policy adopted by the Fed under Chairman William McChesney Martin in the 1950s, but reflects similar ideas. Martin’s policy required that all Fed investments be in short-term Treasury bills.

To show how much things can change, the Fed for the last several years owned zero Treasury bills, and today, bills represent about 2 percent of its assets.

The Federal Reserve has grown over time to be an institution that combines immense power with a yearning for “independence.” Rep. Barr is right that, faced with this behemoth, the Congress should be improving its oversight and exercising its duty to define money and regulate its value.

Did Congress just settle for less than best plan to reform housing finance?

Published in The Hill.

House Financial Services Committee Chairman Jeb Hensarling (R-Texas) has long worked to move the American housing finance sector toward private and competitive markets and away from the distortions and disasters of government guaranteed debt with huge risks to taxpayers.

His previous policy direction, exemplified in his sponsorship of the Protecting American Taxpayers and Homeowners Act, was the correct one, both economically and philosophically. But up against the many well placed interests that feast on subsidies from the government dominated system, it could not succeed politically. The history of American mortgage lending should make us modest as a country. Our housing finance system has collapsed twice in the last four decades, first in the 1980s then again in the 2000s. We should certainly try to do better going forward.

Now Hensarling, working across the aisle with John Delaney (D-Md.) and Jim Himes (D-Conn.), has introduced a discussion draft of the Bipartisan Housing Finance Reform Act, which he hopes will prove a “grand bargain” to create a “sustainable housing finance system for the 21st century” after 10 years of a stalemate in Congress. But central to this new proposal is vastly increasing the government guarantee of mortgage backed securities by using Ginnie Mae, a wholly owned government corporation whose liabilities deliver the full faith and credit of the United States. Thus, the government and taxpayers would explicitly guarantee virtually the whole secondary mortgage market.

Has Hensarling given up on his principles? No, but he has decided that, with the best choice unavailable, he will settle for what may be the second best, arguing that it would be an improvement from where we are and where we have been stuck for a decade. The new bill requires private capital to bear a junior position in mortgage credit risk, taking losses ahead of Ginnie Mae, which is to say, ahead of taxpayers. It abolishes the federal charters of Fannie Mae and Freddie Mac, while allowing them to become private credit risk takers, among other such private institutions. It also allows the Federal Home Loan Banks to aggregate mortgage loans for their members. I especially like this last idea because my team developed it while I was running the Chicago Home Loan Bank.

Consider the following series of options. The best choice is a primarily private and competitive housing finance system, but it cannot happen politically. As a second best choice, a system is proposed that uses big government guarantees, but fits in as much private risk bearing and competition as it can. A third choice would be a bad decision to stay where we are now, with Fannie and Freddie perpetually in conservatorship but dominating the housing finance system nonetheless. Finally, the worst choice is to return to the old and failed Fannie and Freddie model.

Given where we are, is it better to wish for the best and never get it, or try to move toward a second best option, which might be politically feasible? This second best strategy is understandable and reasonable. But is the structure proposed in the new bill actually the second best available? That is debatable. For example, when it comes to the key idea of having private capital bear the principal credit risk, the bill unfortunately misses an essential principle that the best place for the junior credit risk to reside is with the institution that made the loan in the first place. That is the party with the most knowledge of the credit and the only one with direct knowledge of the borrower. Keeping the credit risk there provides by far the best possible alignment of incentives for a sound housing finance system. It also spreads the credit risk bearing across the country.

This is demonstrated by the unquestionably superior credit performance through the financial crisis of the mortgage portfolio built on this principle by the Federal Home Loan Banks in their mortgage partnership finance program, the first loan of which was completed by the Chicago Home Loan Bank in 1997. The risk principle in this program provides more than 20 years of instructive experience to draw on in moving toward a better housing finance system for the United States, even if, as Chairman Hensarling has concluded, we cannot attain the best.

Minneapolis Fed’s TBTF plan has some GSE-sized holes

Published in American Banker.

The Federal Reserve Bank of Minneapolis this winter finalized its “Minneapolis Plan to End Too Big to Fail” — that is, a plan intended to end the problem of “too big to fail” financial institutions, including both banks and nonbank financial companies.

But here is something remarkable: Fannie Mae and Freddie Mac, among the most egregious cases of “too big to fail,” appear nowhere at all in the plan.

Have the Federal Reserve Bank of Minneapolis authors forgotten how Fannie and Freddie blew masses of hot air into the housing bubble, then crashed, then got a $187 billion bailout from the U.S. Treasury? Have they not noticed that Fannie and Freddie remain utterly dependent on the credit guaranty of the Treasury, remaining TBTF to the core?

Since the plan focuses on excessive leverage as the fundamental cause of “too big to fail” risk, have they not considered that Fannie and Freddie each had capital of less than zero at the end of last year, so they had infinite leverage along with their $5.4 trillion in liabilities?

Defenders of Fannie and Freddie will cry that they can’t build capital when the Treasury takes all their profits every quarter. But whoever may be to blame does not change the overwhelming fact: the government-sponsored enterprises are “too big to fail.”

The Minneapolis plan notes that, under the current regime, firms “can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely.” This is true — and it is especially true of Fannie and Freddie. So the plan should say instead: “Under the current regime, banks and nonbank financial firms, including notably Fannie Mae and Freddie Mac with their $5 trillion in risk exposure, can continue as TBTF institutions potentially indefinitely.”

What should be done about the TBTF nonbank companies? According to the Minneapolis Fed, the answer is for the Congress to impose a “tax on leverage” that offsets the advantages of running at high leverage and low capital. This tax on leverage will apply to any company with more than $50 billion in total assets. Since Fannie has over $3 trillion of assets and Freddie over $2 trillion, it is safe to say they would qualify.

If the secretary of the Treasury certifies that the company in question does not pose systemic risk, the tax would be 1.2 percent of liabilities under the plan. It is certainly hard or impossible to imagine that any Treasury secretary could certify that Fannie and Freddie pose no systemic risk. So in their case the tax on leverage would be 2.2 percent of total liabilities — 2.2 percent of “anything other than high quality common equity.”

Among the types of firms that the plan would consider for the leverage tax are “funding corporations, real estate investment trusts, trust companies, money market mutual funds, finance companies, structured finance vehicles, broker/dealers, investment funds and hedge funds.” Again, and amazingly, Fannie and Freddie are not on the list.

But if this proposal applies to any these entities, or indeed to anybody at all, it certainly applies to Fannie and Freddie. That is especially true since the market arbitrages across capital requirements of different financial institutions. It sends mortgages to Fannie and Freddie, not because they are most skilled at managing risk, but rather because they have the highest leverage. This was true even before they crashed, since Fannie and Freddie had charters granting them far greater leverage than any other financial institutions.

We’ve calculated how much the proposed Minneapolis tax on leverage would cost these financial behemoths. For Fannie, total liabilities are $ 3.35 trillion, so the annual tax would be 2.2 percent times that, or $74 billion. Fannie’s profit before tax for the year 2017 was $18.4 billion, so the tax in the size proposed by the Minneapolis Plan would be four times Fannie’s total pretax profit.

For Freddie, the corresponding numbers are liabilities of $2.05 trillion and a leverage tax of $45 billion, which would be 2.7 times its 2017 pretax profit.

In short, instead of paying about 100 percent of their profits to the Treasury, Fannie and Freddie together would pay Treasury well over 300 percent of their profits. This would obviously cause them to operate at a huge pro forma loss.

As a first step, we make the much more modest proposal that Fannie and Freddie should be required to pay the Treasury for its credit support, which makes their existence possible, an annual fee of 0.15 percent to 0.20 percent. Such a fee would be consistent with what undercapitalized banks must pay for a government guarantee from the Federal Deposit Insurance Corp., which is also assessed on their total liabilities. Fannie and Freddie’s effective, though not explicit, guarantee from the Treasury is extremely valuable and should be paid for, without question. As is the intent of the Minneapolis plan, charging a fair price for it would significantly reduce the capital arbitrage the GSEs exploit, reduce the distortions and vulnerabilities they introduce into the mortgage market and reduce the massive taxpayer subsidies they have heretofore enjoyed.

As the foremost “too big to fail” institutions in the country — indeed, in the world — Fannie and Freddie must be included in any TBTF reform plan that is to be taken seriously.

A better way to assess disparate impact

Published in American Banker.

The Department of Housing and Urban Development is currently reviewing its disparate impact regulation, and it’s possible the courts, including the Supreme Court, could take the issue up once again.

Here’s the key issue: What if a lender applies the same credit underwriting standards to all credit applicants, but this results in different demographic groups having different credit approval-credit decline ratios? Is that necessarily a problem?

One position is that applying the same credit standards to everybody, regardless of demographic group, is exactly what every lender should be doing. Yet supporters of “disparate impact” argue that if there are different ratios for loan approvals versus loan declines among groups, it must mean there is some kind of hidden, even if entirely unintended, bias in the process.

Which side is right? There is a straightforward, data-based way to tell. It is simply to add to the report the default rates on the loans in question and compare them to the approval ratios by group.

Suppose, for example, that demographic Group A has a lower loan approval rate and therefore a higher decline rate than Group B. We must also compare their default rates. There are three possibilities: Group A either has the same, a lower or a higher default rate than Group B.

If Group A has the same default rate as Group B, then the underwriting procedure and the different approval-decline ratios were fair and appropriate, since they resulted in the same default outcome. Predicting and controlling defaults is the whole point of doing the credit analysis.

If the default rate of Group A is lower than Group B, however, that shows that it is experiencing a different credit standard, which may be a higher standard, or may be one biased one against Group A, even if it is not intended.

In the third possibility, if the default rate for Group A is higher than Group B, that shows that in spite of the fact Group A had a lower approval and higher decline ratio, it was nonetheless being given easier credit standards, or that the process was biased in its favor, even if not intended.

We need the facts of default rates to objectively and calmly address this issue. Why not simply provide them as part of the regular Home Mortgage Disclosure Act reports?

Some previous discussions of this issue have analyzed the different groups by factors such as household income or standard credit ratios. But such factors are merely attempted predictions of future default rates, not the reality of the actual default rates. It is much better to use the direct reality of defaults, since controlling defaults is the whole point of credit underwriting.

As HUD addresses the issue, a resolution based on fact should be adopted: Report the default rates on relevant loans and compare them to approval-decline rates, and then draw the logically necessary conclusions. If the question gets to the courts, judges should insist on the same fundamental logic being applied.

When a bureaucracy is so independent it’s unconstitutional

Published in the Federalist Society.

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

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

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

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

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

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

• There is a single director of the FHFA.

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

• There is no bipartisan commission structure overseeing the agency.

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

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

Putting all of this together, the court writes:

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

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

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

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

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

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

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

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

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

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

Who is the boss when it comes to Federal Reserve and Congress?

Published in The Hill.

In January 2008, Federal Reserve Chairman Ben Bernanke made this memorable announcement: “The Federal Reserve is not currently forecasting a recession.” This was a poor forecast indeed, since as we now know, a very deep and painful recession had already started by the time of this prediction that there would not be one.

But this is only one of many such errors. If you have the unrealistic belief that the Fed should somehow manage the economy, banking system, stock market, financial stability, interest rates, employment, inflation and risks, you run into a granite wall of a knowledge problem. The Fed does not know and cannot know enough to do all this.

The simple fact is that the economic and financial future of this great nation is not only unknown, but unknowable, for the Fed as it is for everybody else. It is not that our central bank is any worse than anybody else at knowing the future, including what the results of its own actions will be, but the Fed is just not any better than anybody else.

Yet, the Fed keeps insisting and has enshrined as part of its own confession of faith that it ought to be “independent” as an immensely powerful fiefdom answerable only to its own theories. Should the Fed be independent of Congress? Given the inherent human will to power, naturally those leading the central bank would like to be.

This desire to act as independent economic philosopher kings could be justified by a claim to superior knowledge. But the Fed demonstrably does not have such superior knowledge. Still, we cannot avoid observing that there is a strange and quite common faith in the Fed. For example, it is endlessly repeated in the media that an inflation rate of 2 percent a year must be good because that is the Fed target, apparently without wondering whether this target is a good idea or not.

Of course, some people have more skeptically considered the 2 percent question. Olivier Blanchard, formerly the chief economist of the International Monetary Fund, has stated, “There is no sound economic research that shows 2 percent to be the economically optimal inflation rate.” He was arguing for higher inflation. On the other hand, Alan Greenspan, when asked what the right inflation target was, said “zero” and added “if measured correctly,” a wonderfully famous hedge.

A remarkable thing about the current idea of a Fed inflation target is that it is a target in perpetuity at 2 percent a year forever. To commit for 2 percent a year forever means that in an expected lifetime of 82 years, average prices will quintuple. With a straight face, the Fed informs us that this is “price stability.” Should Congress have anything to say about whether it wants inflation of 2 percent a year forever?

The Fed often states that “price stability” is part of its statutory “dual mandate.” The reference is to the Federal Reserve Reform Act of 1977. But this law does not say “price stability.” It says “stable prices.” It does in particular not say a “stable rate of inflation.” It says “stable prices.” Does the term “stable prices” mean perpetual inflation? What did Congress mean by “stable prices” when it put that term into law?

We learn from the minutes of the Federal Open Market Committee that in 1996, when the Fed was discussing whether it should have an inflation target, one member of the committee dared to ask what Congress meant by the statutory language. This question was quickly passed over and not pursued. But it was a good question, was it not?

In fact, we have a good indication of what Congress meant by “stable prices.” The very next year, in the Humphrey Hawkins Act of 1978, Congress provided the “goal of achieving by 1988 a rate of inflation of zero.” Obviously, this was not achieved and somehow, we never hear the Fed discussing this goal as expressed in statute.

Bernanke advised Janet Yellen, his successor as head of the central bank, to remember that “Congress is our boss.” But does the Fed and those who work there really believe that Congress should be the boss? That these mere politicians, elected by the American people, should be in charge of the powerful economic and financial experts of the Fed?

William Proxmire, a former senator from Wisconsin, once put the case for Congress pretty bluntly in a hearing. He stated, “You recognize, I take it, that the Federal Reserve Board is a creature of Congress?” and “Congress can create it, abolish it, and so forth?” While that is certainly true, but short of abolishing it, what steps can be taken for greater accountability and more effective legislative governance of the Fed?

It seems the best model might be to think of Congress as the board of directors and Federal Reserve officers as the management of government operations in money. With this model in mind, the relationship of the Fed and Congress should evolve into a grown up and real discussion of issues, alternatives, strategies and risks. That would be quite a contrast to the media event that Fed testimony now represents.

Such discussions might even include the Fed asking Congress what it means by “stable prices” as a goal. Of course, the Fed could lay out all its arguments for 2 percent inflation and its thoughts on alternatives for legislative consideration. Can you imagine that? Perhaps you cannot, but as the long history of the Fed demonstrates, many things that were previously unimaginable nevertheless came to pass.

We won’t know the final lessons of QE until it’s over

Published in Real Clear Markets.

A justly famous line of John Maynard Keynes is:  “Soon or late, it is ideas…which are dangerous for good or evil.”

The first lesson from ten years of Quantitative Easing (QE) is that the ideas of those who run fiat currency central banks, as these ideas change over time and go in and out of central bank fashion, are extremely important for good or evil, on a very large scale.

Contrasting the ideas of QE to earlier governing ideas of the Federal Reserve is instructive.  In the 1950s under Chairman William McChesney Martin, the Fed adopted the “bills only” policy.  That meant the only investment assets from the Fed’s open-market operations were short-term Treasury bills.  The theory was that the Fed’s open market interventions should not operate directly on long-term interest rates and should never try to allocate credit among economic sectors.

This was clearly the opposite of the theory of QE.  It was not a policy directed at financial crisis, as QE originally was.  But the last crisis has now been over for a long time, and QE still amounts to $4.2 trillion on the balance sheet of the Fed.

How many Treasury bills does the Fed own today?  The answer is zero.

So over 50 years, the Fed has gone from believing in all Treasury bills to no Treasury bills.

Another lesson of QE:  Do not look for the ideas of central bankers to be eternal verities—they aren’t.  The times call forth the ideas, for better or for worse.

The Credit Crunch of 1966 was created by the Fed’s regulatory ceilings for interest rates—the Fed used to believe in those, too.  In that year, mortgage lending funds dried up, the savings and loan industry (then politically powerful, believe it or not) was unhappy, and many in Congress wanted the Fed to buy the bonds of Fannie Mae and the Federal Home Loan Banks in order to support housing and housing finance.

Chairman Martin did not agree.  Correctly pointing out that this would be credit allocation by the Fed, he found it a bad idea “to divert open market operations from general economic objectives to the support of specific markets for credit.”  This 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.”

In my judgment, Martin was right about this, but Congress loves nothing better than to subsidize and overleverage real estate.  Here was the consequent threatening message to the Fed sent by a future Banking Committee chairman, Senator Proxmire, in a 1968 hearing:

“You recognize, I take it, that the Federal Reserve Board is a creature of Congress?

The Congress can create it, abolish it, and so forth?

What would Congress have to do to indicate that it wishes the Board to change its policy and give      greater support to the housing market?”

If Proxmire were still alive, he would presumably be a fan of QE forever.

The new Fed Chairman, Arthur Burns, who arrived in 1970, decided that the Fed should “demonstrate a more cooperative attitude.”  So by the 1980s, the Fed’s bond portfolio came to include the debt of Fannie Mae, the Federal Home Loan Banks, the Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks for Cooperatives, the United States Postal Service, Ginnie Mae, the General Services Administration, the Farmers Home Administration, the Export-Import Bank, and even the Washington Metropolitan Area Transit Authority.  In other words, the Fed was helping fund the Washington DC Metro system!  That was along with funding Fannie Mae when it was insolvent on a mark-to-market basis, as well as the Farm Credit System when it was broke.

Still, at their peak, all these totaled about $9 billion—or about 0.2% of the current size of QE.

Let’s review where the Fed’s QE-dominated balance sheet is now.  As of May 30, 2018, it includes:

Treasury bills:                                                     zero

Longer term Treasury securities:               $2.4 trillion

Long-term mortgage-backed securities:   $1.8 trillion.

These MBS are funded with floating-rate deposits, which makes the Fed in effect the biggest savings and loan in the world.  Even if we needed the world’s biggest S&L in the crisis—do we now?

Total assets:                                                   $4.3 trillion

Total capital:                                                   $39 billion

This means the Fed is leveraged 110 to 1.

As we know, the immense QE portfolios are very slowly running off—not being sold.   Among the reasons for not selling is that the Fed does not want to face the very large losses in its super-leveraged balance sheet that it would probably realize when selling any meaningful part of its huge, unhedged QE position.

Another lesson: It is easier for a central bank to get into a QE portfolio than to get out.

Thus, the exit strategy is constrained to being very gradual, accompanied by the Fed’s intense hope that the ultimate adjustment in inflated house prices, and inflated stock and bond prices, will also be gradual.  This is especially true for house prices, which affect 64% of American households.

Here is a further QE lesson, this one fundamental:  In principle, a fiat currency central bank can make unlimited investments in anything, financed by monetization.

The Federal Reserve is the champion investor in mortgages.  The European Central Bank has invested in corporate bonds, government agencies, regional and local government debt, asset-backed securities, and covered bonds (which include mortgages). The Bank of Japan has bought asset-backed securities and equities, in addition to vast amounts of government debt.  The Swiss central bank has a huge portfolio of foreign currency bonds, a big position in U.S. equities, and also makes loans to domestic mortgage companies.

The Swiss central bank, by the way, is required by law to mark its investment securities to market, a discipline the Fed sedulously avoids.

All of these versions of QE involve credit allocation.  In the case of the Fed, its two favored allocations are housing and long-term financing of the government deficit.

The only limits to what a fiat currency central bank can finance and subsidize are: the law, politics, and the ideas of central bankers.  There are no intrinsic financial constraints.

Whether there will be new legal and political constraints in the future depends, I believe, on how the end of the QE experiments ultimately turn out.  In other words, will the correction of the QE-induced asset price inflations be a soft landing or a hard landing?  If the latter, you can easily imagine a legislature wanting to enact future constraints.

Ten years into QE, what should the Fed be doing now?  The distinguished expert on central banking, Charles Goodhart, recently wrote that it is “generally agreed” that “Where the QE involved directional elements, to support credit flows through critical but weak markets, e.g. the mortgage market in the USA, such assets should be entirely run off, and the assets left in the central bank’s balance sheet should be entirely in the form of government debt.”

With all due respect to Senator Proxmire, this seems correct to me.

But, as Goodhart continues, it does not answer a further question QE makes us ask: What is the optimal size of central bank balance sheets in normal times?  They have become so large—how much smaller should they get?

Other related questions include:  Will the central banks’ credit allocations become viewed in retrospect as misallocations?  And how should we understand the respective roles of the Treasury and the central bank?   Are they essentially one thing masquerading as two, as QE tends to suggest?

I conclude with a final lesson:  We won’t know what the final lessons are until after the exit from QE has been completed.  It ain’t over till it’s over.

The great waves of industrial innovation

Published in Law & Liberty.

How did the world of lord and serf, horse and carriage, superstition and disease, turn into the world of boss and worker, steam and steel, science and medicine?

Jonathan Steinberg asks us to ponder this in his lecture series “European History and European Lives: 1715 to 1914.” We can add to his question, among countless other things previously unimaginable, “and the world of jets and space probes, computers and Google searches, antibiotics and automatic washing machines, and sustained long-term economic growth per capita?” Relative to all previous human life, this new world, the one we live in, is truly astonishing. As Steinberg asks us to wonder, “How and why did what we call the modern world come about?”

The answer at the most fundamental level is through the creation and harnessing of scientific knowledge. Far and away the most important event in all of history was the invention of science based on mathematics by the geniuses of the seventeenth century. This is symbolized above all by Isaac Newton, whose masterwork, Philosophiae Naturalis Principia Mathematica, we may freely render into English as “Understanding Nature on Mathematical Principles.” The invention of mathematicized science was the sine qua non of the modern world. Other important modernizing developments in government, law and philosophy are handmaidens to it.

As Alexander Pope versified the impact:

Nature and Nature’s laws lay hid in night:

God said, Let Newton be! And all was light.

Of course, the translation to the modern world was not quite that direct. The new and multiplying scientific knowledge had to be transferred into technical inventions, those into economically useful innovations, those expanded into business ventures by entrepreneurial enterprise, and with the development of management processes for large-scale organizations, those spread around the world in great waves of industrial innovation.

We may picture these great waves over the last two and a half centuries like this:

Waves of Innovation

The result of these sweeping creations by the advantaged heirs of the Newtonian age is the amazing improvement in the quality of life of ordinary people like you and me. As measured by real GDP per capita, average Americans are about eight times better off than their ancestors of 100 years ago. (They in turn were far better off than their predecessors of the 18th century, when the modern world began to emerge.)

In 1897, average industrial wages per week have been estimated at $8.88. That was for a work week of about 60 hours (say six ten-hour days—and housewives had to work 70 hours a week to keep home life going). The industrial wages translate to 15 cents an hour. Correcting for inflation takes a factor of about 25, so 15 cents then is equivalent to $3.75 today. Current U.S. average hourly manufacturing wages are $21.49, adding benefits gives total hourly pay of over $30. In other words, real industrial hourly pay has multiplied about eight times. While this was happening, over the course of a century a lifetime’s average working time per day fell in half, while average leisure time tripled, according to estimates by Robert Fogel.

Along the way, of course, there were economic cycles, wars, recessions, depressions, revolutions, turmoil, crises, banking panics, muddling through and making mistakes. But the great waves of industrial innovation continued, and so did the improving standard of living on the trend.

Joseph Schumpeter memorably summarized the point of economic growth as not consisting in “providing more silk stockings for queens, but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort.” The Federal Reserve Bank of Dallas demonstrated how more goods for less effort indeed happened—showing how prices measured in hours and minutes of work at average pay dropped dramatically during the twentieth century. Their study, “Time Well Spent—The Declining Real Cost of Living in America,” is full of interesting details—here are a few notable examples. The time required to earn the price of milk fell 82%; of a market basket of food, 83%; of home electricity, 99%; of a dishwashing machine, 94%; of a new car, 71%; and of coast-to-coast airfare, 96%. Of course, no amount of work in the early twentieth century could have bought you an iPhone, a penicillin shot, a microwave oven, a ride on a jet across the Atlantic Ocean, or a myriad of other innovations.

These advances in the economic well-being of ordinary people are consistent with a famous prediction made by John Maynard Keynes in 1930.  In the midst of the great global depression, which might have led to despair about the future, Keynes instead prognosticated that the people of 2030, of 100 years from then, would be on average four to eight times better off due to innovation and economic growth. As 2030 approaches, we can see that his forecast will be triumphantly fulfilled near the top of its range.

How much can the standard of living continue to improve? In 1900, according to Stanley Lebergott, the proportion of Americans who had flush toilets was only 15%. Only 24% had running water, 1% had central heating, 3% had electricity, and 1% owned an automobile. The people of that time could not imagine ordinary life as it is now. Correspondingly, it is exceptionally difficult for us to imagine how hard, risky and toilsome the average life was then.

And if we try to imagine the ordinary life of 100 years into the future, can we think that people will once again be eight times better off than we are? Can the great waves of innovation continue? Julian Simon maintained that since human minds and knowledge constitute “the ultimate resource,” they can. “The past two hundred years brought a great deal of new knowledge relative to all the centuries before that time,” he wrote, “the past one hundred years or even fifty years brought forth more than the preceding one hundred years,” and we can confidently expect the future to continue to “bring forth knowledge that will greatly enhance human life.”

S. 2155 won’t end finreg debate, but it’s an important first step

Published in Real Clear Markets.

S. 2155 won’t end finreg debate, but it’s an important first step

The U.S. House reportedly will move next week to take up and pass a modest financial regulatory reform bill already approved by the Senate – S. 2155, the Economic Growth, Regulatory Relief and Consumer Protection Act.

This is not the fundamental reform of the bureaucracy-loving Dodd-Frank Act of 2010 one might once have hoped for, nor is it the much broader reforms proposed by the House Financial Services Committee in its Financial CHOICE Act. But everyone agrees the current political reality is that the latter bill cannot be enacted, while the current bill is a step forward that can actually be taken. A modest step forward is better than standing still.

Small banks and credit unions, defined in the bill as those with assets of less than $10 billion, will be the principal beneficiaries of its reforms, by reducing their compliance burdens with onerous regulations that were inspired by the political emotions of 2010 in the wake of the financial crisis. These lenders are less than 0.5 percent the size of JPMorgan Chase. The costs and burdens of complex and opaque regulation are disproportionately heavy for them.

Community banks and credit unions are enthusiastic supporters of the bill and its expected enactment will be an important victory for them. Small banks represent the vast majority of all banks. There are 5,670 federally insured depository institutions in the United States. Of these, 5,547 or 98 percent, have assets of less than $10 billion. On a still smaller scale, 4,920, or 87 percent of all banks, have assets of less than $1 billion, which makes them less than 0.05 percent the size of JPMorgan.

Among other regulatory de-complexification, the bill would provide small banks the option to have a high and simple leverage capital requirement (tangible equity as a percentage of total assets) replace the complicated risk-based capital calculations arising from the international negotiations known as the “Basel” rules (named after the city in Switzerland). It provides for this ratio to be set in a range of 8 percent to 10 percent. The similar idea of the CHOICE Act specified 10 percent. If combined with a simple liquidity requirement, this is an excellent idea.

A key improvement in the bill is that, for small banks, residential mortgage loans they make and keep for their own portfolio would be considered “qualified mortgages” for compliance with the Dodd-Frank Act. This recognition is essential; when a bank keeps the mortgage loan and all its risks, putting up its own capital as “skin in the game,” it is in a different financial world from those who make the loan and forthwith sell it, passing all the risk to somebody else. Much of the regulatory motivation of the Dodd-Frank Act was trying to deal with the moral hazard of the “originate and sell” mortgage model. That the “skin in the game” model is fundamentally different should have been obvious all along, but better late than never. A sad irony is that the “originate and sell model,” with the flaws that later became so evident, was strongly pushed by government policy, subsidies and regulation.

This regulatory reform bill is pretty complex. In draft form, it is 192 pages long, with many provisions devoted to particular constituency concerns, as you might expect from something that needed a bipartisan deal to get through the Senate. You might say it displays Madisonian balancing of competing concerns of interest groups (or as Madison would have put it, “factions”). Everybody cannot like everything in it.

A sampling of its various provisions includes:

• For big banks, increasing the level at which they are automatically considered “systemically important” from $50 billion to $250 billion in assets—subject to regulators’ ability to overrule in particular cases.

• A special deal on the leverage capital requirement for banks whose principal business is custody of assets (there are only a couple of them).

• More favorable treatment of investment grade municipal bonds for purposes of big bank liquidity requirements. In addition to helping big banks, this is naturally very popular with issuers of municipal securities.

• A regulatory simplification for closed-end mutual funds.

• A break on the treatment of certain brokered deposits, useful to some small banks.

• Easier treatment of some riskier commercial real estate loans. This is popular with real estate developers, of course. Since commercial real estate is often at the center of banking busts, this may be the most dubious of all the bill’s provisions.

• A choice for federal savings associations to have regulatory treatment just like national banks. This is a natural step in the gradual disappearance of a separate savings and loan industry. It is now hard to remember that a special savings and loan industry was in former days considered an important national financial priority.

• Not to be forgotten is an additional taking of the Federal Reserve Banks’ retained earnings, to help reduce the budget deficit.

And numerous other special provisions, displaying that the bill is indeed a product of a democratic legislative processes.

Taking the bill all in all, it should be enacted. But it should by no means be the end of regulatory reform. The House has a lot of ideas for additional steps, many with bipartisan support. We’ll see if anything else happens.

How does our ‘Great Recession’ compare to ones from the past?

Published in Real Clear Markets.

A prominent economist opened his book, The Great Recession, with this observation: “In the years ______, the world economy passed through its most dangerous adventure since the 1930s.”  This should sound familiar. “Its world-wide character and the associated bankruptcies and financial disturbances,” he added, “made this episode the long-awaited postwar economic crisis.”  But what years was Otto Eckstein in fact describing, so how do you fill in the blank in the first quotation?  The correct answer is the great recession of 1973-75. (How did you do on the quiz, esteemed Reader?)

“The capitalist process progressively raises the standard of life for the masses,” wrote the ever-provocative Joseph Schumpeter, but “It does so though a series of vicissitudes.”  Further, “Economic progress, in capitalist society, means turmoil.”  If Schumpeter is right that progressively raising the standard of living for ordinary people requires vicissitudes and turmoil, then cycles of booms and busts do not just happen, but are necessary in theory to economic progress.  They certainly do seem unavoidable so far.  Empirically, recessions are reasonably frequent.  In the last 100 years, there were 18 recessions in the United States, thus on average about once every 5 1/2 years. In the last 50 years, there have been seven recessions or on average once about every seven years.

Many recessions are shallower, but there are occasional great recessions.  How does “our” great recession—that of 2007-09– look relative to some of its predecessors?  Specifically, we compare it to the great recessions of 1981-82, 1973-75, and 1937-38.

The 2007-09 great recession led to a U.S. unemployment rate peak of 10.6%.  This was surely bad, but not as bad as the 11.4% which followed the 1981-82 bust.  The unemployment rate in 1973-75 got to 9.1%.  The great recession of 1937-38 was far worse, with unemployment peaking at about 20%.  (These unemployment rates are not seasonally adjusted.)

For 2007-09, 477 financial institutions failed in the five years from the onset of the great recession.  For 1981-82, the comparable number is 625 financial institution failures.  In the five years after 1973, there were 46 failures, but it is possible that the whole banking system was insolvent on a mark-to-market basis.  There were 262 failures in the five years after 1937.

In terms of peak-to-trough drop in real GDP, 2007-09 is the second worst of our examples.  In order of increasing severity the aggregate real GDP changes were:  1981-82, -2.8%; 1973-75, -3.1%; 2007-09, -4.2%; and estimated for 1937-38, -18%.

These great recessions had very different inflation experiences.  In 1973-75, in addition to the high unemployment, the U.S. suffered from painful double-digit inflation rates, with an annualized average of 10.9% on top of the other problems.  In 1981-82, the inflation rate was 5.2% along with recession, compared to 1.8% in 2007-09.  In 1937-38, they had deflation, or an inflation rate of -1.9%.

Then there is the cratering of the stock market in each case.  As measured by the peak to trough percentage drop in the Dow Jones Industrial Average, “our” great recession was the worst, with a 52% drop.  In 1937-38, the drop was 48%.   The DJIA fell 39% in 1973-75, and 20% 1981-82.  All painful, to be sure, especially if you were on margin.

Short-term interest rates fell dramatically in all four great recessions, but from very different levels.  Three-month Treasury bill yields started the 1981-82 great recession at the remarkable level of 15% and fell to 8.1%, the biggest change in number of percentage points.  The biggest drop measured as a percentage of the initial level was our 2007-09, in which three-month bill yields dropped from 3% to 0.18% or by 94%.  In 1973-75, these yields went from 7.8% to 5.5%, which sounds still very high to us now.  The lowest trough in rates was in 1937-38, when three-month bills went down to 0.05% from 0.41%.

In sum, the great recession of 2007-09 has predecessor great recessions.  These were worse in some ways, less bad in other ways, and present different combinations of painful problems.  All were severe downers.  But great recessions and ordinary recessions notwithstanding, on the trend the enterprising economy keeps taking income per capita ever higher, “progressively raising the standard of life for the masses” over time. If there is some way to do that without the cycles, it has yet to be discovered.

What you would have made if you bought big lenders in 2006

Published in Real Clear Markets.

Lending money is a risky business. Lending money when the lender is itself highly leveraged is more risky yet. How bad can the result of this simple fact be for investors in common stock? And have such investors yet recovered from the crisis of 2007-2009?

Suppose you had decided at the end of 2006, when it looked like lending businesses were booming, to invest $10,000 equally divided among the common stock of the dozen biggest U.S. lending institutions. Those would have been eight bank holding companies, two thrift holding companies and two government-sponsored enterprises. Specifically, ranked by total assets, that would have been: Citigroup, Bank of America, JPMorgan, Fannie Mae, Freddie Mac, Wachovia, Wells Fargo, Washington Mutual, U.S. Bancorp, Countrywide Financial, SunTrust and National City.

How would you have done? Your portfolio, bought for $10,000, would at the end of March 2018, eleven years later, been worth $5,960. You would be still be down more than 40 percent. Of course, you are now better off than at the bottom of the stock market in 2009, when it was worth $2,569, or down 74 percent. But the more than eight years since have not gotten you back to even, far from it. The unfortunate history of your big lender portfolio is shown in the following table.

S&P Global Intelligence

You are also in poor shape relative to the Standard & Poor’s 500 index. As of March 2018, you are about 68 percent behind the alternative of having put your $10,000 in the S&P. Your current $5,960 compares to the index’s current $18,620. The history of the relationship is shown in the following graph.

S&P Global

Of course, the performance over the whole period of the lenders’ individual stocks varies by a lot. From the virtually 100 percent loss in Washington Mutual, to the 98 percent losses in Fannie and Freddie, to the 88 percent loss in Citigroup and 44 percent loss in Bank of America, we find gains of 47 percent in Wells Fargo and 128 percent in JPMorgan. Overall, there are nine institutions with their value still down after more than 11 years and only three that are up versus 2006.

It is true that financial markets are always energetically looking forward with thousands of eyes, minds and computers. But despite the diligent efforts, they often don’t see forward very well. So indeed it was in 2006, with the stock prices of the biggest lending institutions at the top of the first (and assuredly not the last) great 21st century bubble.