Congress Must Take Control of Money Back From the Fed

Published in Real Clear Markets.

The question of Money is always political.  What is the definition of “money,” what is its nature, how is it created, and how are debts settled—these are questions that have been much debated over time, sometimes very hotly.  Recall, for example, William Jennings Bryan’s famous, burning rhetoric of 1896:

“You shall not press down upon the brow of labor this crown of thorns—you shall not crucify mankind upon a cross of gold”!

He was addressing the definition of money.

What the U.S. Constitution says about the definition of money is succinct.  Article I, Section 8 gives Congress the express power:

“To coin money [and] to regulate the value thereof.”

As writers on the subject have pointed out innumerable times, to “coin” is obviously not the same as to “print.”

How then does it come about that the American government issues irredeemable, fiat, paper money, and this is the only kind of money we have today?

The Constitution expressly prohibits the states from issuing such paper money, but is silent about the national government on this point.

Considering original intent through the Constitutional debates, the founding fathers were nearly unanimous in their strong opposition to paper money, as the Notes of the Debates in the Federal Convention make completely clear.  In general, they shared the view later expressed by James Madison about:

“The rage for paper money…or any other improper or wicked project.”

Although this was the dominant opinion of the members of the convention, and although they debated an express prohibition of national paper money, they decided not to include it.  Of course, neither was there an authorization.

In the discussion, George Mason explained:

“Though he had a mortal hatred to paper money, yet…he could not foresee all the emergencies” of the future and was “unwilling to tie the hands of the legislature.”

Paper money in this view is a matter only for emergencies.

The Constitutional result was the express power “to coin” and silence on “to print.”  Should one conclude that there is an implied power for the government to print pure paper money?  Further, is there an implied power to make it a legal tender in payment of debts, even if those debts had been previously contracted for and explicitly required payment in gold coin?

A lot of supreme judicial ink would later be devoted to debating and ultimately deciding this question.
In the Constitutional Convention debates, Gouverneur Morris:

“Recited the history of paper emissions and the perseverance of the legislative assemblies in repeating them, with all the distressing effects.”

He further predicted:

“If a war was now to break out, this ruinous expedient would again be resorted to.”

This prediction was proved right when the Civil War did break out, and the Lincoln administration soon turned to paper money to pay the costs of the Union Army.

In 1861, faced with the staggering expenses of the war, Congress authorized the issuance of paper money, or “greenbacks,” as they were called.  In 1862, it made them a legal tender.  Predictably, the greenbacks went to a large discount against gold—their value fluctuated with the military fortunes of the ultimately victorious Union.

As another war measure, national bank notes were created by the National Currency Acts of 1863 and 1864, which we now know as the National Bank Act.  The main point was to use the new national banks to monetize the Treasury’s debt.  Governments always like the power to monetize their deficits.

After the Civil War, the expedient of paper money as legal tender resulted in a series of Supreme Court cases in which:

First, making paper money a legal tender for debts previously contracted in gold was found unconstitutional in a 4-3 decision.

Then, soon afterwards, the Court reversed itself 5-4, after the addition of two new justices, finding that it was constitutional, after all.  The new majority stressed the sovereign right of a government to do what was necessary to preserve itself.

About the legal tender cases it has been said:

“Measured by the intensity of the public debate at the time, it was one of the leading constitutional controversies in American history.”

Yet they are now largely forgotten.

In one of the series of legal tender decisions, one later overruled, the Court wrote:

“Express contracts to pay in coined dollars can only be satisfied by the payment of coined dollars…not by tender of United States notes.”

That this decision did not stand was handy for the United States government later—in 1933, when it defaulted on its express promise to pay Treasury gold bonds in gold.  Instead it paid in paper money.

This action the Supreme Court upheld in 1935 by 5-4, although no one doubted the clarity of the promise to pay that was broken.  Among the majority’s arguments were the sovereign right of the government to default if it wanted to and the sovereign right of the national government to regulate money.

Coming to today: We have a pure fiat money system of the paper Federal Reserve notes in your wallet and bookkeeping entries on the books of the Fed.

This paper currency, the Federal Reserve on its own has committed to depreciate by 2% per year forever, in spite of the fact that the Federal Reserve Act instructs it to pursue “stable prices.”

By promising perpetual 2% inflation, the Fed keeps promising to make average prices quintuple in a normal lifetime.  (That is simply the math of compound interest.)

The Fed made this momentous, inherently political, decision on its own, without the approval of the Congress.  It did not ask Congress for legislative approval and no hearings on this debatable proposal about the nature of money were held.

Where, under the Constitution, did the Fed get this right to proceed without Congress?  That the Fed presumed to do this on its own authority was a highly questionable action of the administrative state.

I believe one could correctly argue that this was an unconstitutional violation of Article I, Section 8. Unfortunately, we have no lawsuit about it, so we can only observe it.

One scholar of the legal tender cases concluded:

“There remains the intriguing question of the Constitutional basis for today’s legal tender paper… today’s fiat money.”

Indeed there does.  But the political basis rules and life goes on.

Will the Federal Reserve have a monopoly in digital currencies?

Published in The Hill.

Cryptocurrencies started out with a libertarian desire to give people an alternative to national money, thereby escaping government power to depreciate their fiat currencies through inflation. Many governments, including the United States, have gone so far as to promise perpetual inflation, a key function of which is to help governments depreciate their own debt. Governments can also completely destroy the value of their currency through hyperinflation, as has happened throughout history.

To create a meaningful alternative to this government money monopoly was a noble intent, consistent with the classic proposal by Friederich Hayek in “Choice in Currency.” He asked, “Why should we not let people choose freely what money they want to use?” He argued, “Practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.” Cryptocurrency enthusiasts agreed. They were, however, too optimistic about how forcefully governments could react, first by imposing regulation and then by realizing that governments themselves could issue digital currency to the public.

The great irony here is that the idea of a digital alternative to national money can morph into an idea to expand and solidify the government money monopoly. According to a survey by the Committee on Payments and Market Infrastructure of the Bank for International Settlements, more than 60 central banks, representing 80 percent of the world population, are researching central bank digital currencies. More than half of them have moved on to actual experiments or more “hands on” activities.

The broadest form of government digital currency would be the central bank offering deposit accounts to the public at large, so individuals, businesses, corporations, nonprofit organizations, and municipal entities could have deposit accounts at the Federal Reserve instead of with a private bank. Then their financial transactions in the digital currency with each other would be settled directly by the accounting entries on the electronic books of the Federal Reserve. Efficient and risk reducing!

Such a centralization has happened before. Paper currency became monopolized by the Federal Reserve in the form of government notes in the early 20th century. Until then, private banks issued their own paper currency. I have a copy of a $3 bill issued in the 1840s by a previous banking employer. Needless to say, no such currency is used today.

Could money in the form of deposits, such as money in the form of paper currency, be monopolized by the central bank, given current technology? In principle that could be the case. Direct deposits at the Federal Reserve would be close to being default and liquidity risk free. No need to worry about whether your bank might fail, whether it might become illiquid or insolvent, or whether your deposit was over the insurance limit. You would have no need to withdraw cash if you were worried about banks in a crisis because you would be holding a direct Federal Reserve obligation. That would no doubt appeal to many holders of money and, in our electronic world, it is quite easy to imagine such a central bank digital currency.

Do we like the idea, however, that deposits would be concentrated in the government instead of spread among 5,000 private banks? How much of the deposit market the central bank could take over depends on whether it would pay interest on the deposits. If it paid zero interest, its market share would be much less. But the Federal Reserve can and does pay interest on deposits. There are $14 trillion in total deposits in the banking system. Suppose 50 percent of them moved to digital deposits with the Federal Reserve compared to the 100 percent market share the Federal Reserve has in paper currency. That would be a towering $7 trillion. The government money monopoly would become bigger and more powerful.

What would the Federal Reserve do with its new $7 trillion? It would have to invest it. It would become an even bigger allocator of credit. It might allocate a lot more credit to the government itself and its favored housing sector. Or it might get into corporate credit, displacing private investors and becoming a state commercial bank. The history of such banks has been generally pathetic because their credit decisions inevitably become politicized. The Federal Reserve could also more readily impose negative interest rates directly on the people, thereby expropriating their savings.

On top of all that, the government would also have financial Big Data extraordinaire. It would know almost everything about our financial lives. Digital currency would then have traveled from libertarian choice to Big Brother. If not strictly limited and controlled, central bank digital currency could turn out to be one of the worst financial ideas of the 21st century.

Should the Fed Be Run by Economists?

Published in Law & Liberty.

Tomorrow, November 2, marks two years since the nomination of Jerome Powell to be Chairman of the Federal Reserve. Leaving aside President Trump’s subsequent expressions of regret at his choice, the nomination represented an important institutional change for the Fed: the first Chairman in 30 years lacking a Ph.D. in economics.

The anniversary of Powell’s appointment offers us an opportunity to reflect: Was this a good thing, or should the Fed always be an “econocracy,” run by economists? Does other expertise matter?

In a 1977 conference at the American Enterprise Institute, Irving Kristol observed: “Most professors of economics genuinely believe they know how to run the economy and would very much like to have the chance to prove it.”

It does seem that inside every macroeconomist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king—or at least an assistant deputy philosopher king.

On the other hand, the will to power is hardly limited to economists. What kind of education and experience, we may wonder, helps us best moderate our natural ambitions, apply wisdom to our actions, and control, in Friedrich Hayek’s terms, the “fatal conceit” of “the pretense of knowledge”?

On the 100th anniversary of the creation of the Federal Reserve, I made a dozen predictions about the Fed’s next 100 years.[1] Among them was this:

An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of Chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro-economics is or can be a science.

I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.

This prediction was fulfilled much more quickly than I thought with the appointment of Chairman Powell, and I think it is a good thing for the Fed to move away from econocracy. Whatever the illusions in the past may have been, we not only no longer believe, but we all ought to know by now that macroeconomics is not a science. Moreover, in my view, it cannot ever be one. Therefore, it is healthy to move the chairmanship of the Fed around among various professional domains.

Chairman Powell was trained as a lawyer and has significant Wall Street experience in investment banking and private equity investing. This is a completely appropriate background, as it seems to me.

Speaking of lawyers, the first Chairman of the Federal Reserve Board was William G. McAdoo, who was at that time the Secretary of the Treasury. Under the original Federal Reserve Act, the Treasury Secretary was automatically the chairman. McAdoo was a lawyer and a businessman, who among other things built two tunnels under the Hudson River between Manhattan and New Jersey. As Treasury Secretary during the cataclysm of the First World War, he set out to and succeeded in helping New York displace London as the world financial center.

But the real power inside the Fed in its early days was Benjamin Strong, the president (they called it “Governor” at the time) of the Federal Reserve Bank of New York from 1914 to 1928. Strong was definitely one of Kristol’s “men of experience.” He went to work in banking right out of public high school—no college, let alone a graduate degree for him. He nonetheless became president of Bankers Trust Company and then took charge of the New York Fed.

If you were President of the United States, whom would you want to pick as chairman of the central bank to the dollar-based world? Here, by principal vocation, are the ones who did get picked in chronological order: Lawyer, banker, lawyer, banker, investment banker, banker, banker, corporate executive, financier, Ph.D. economist (we have reached Arthur Burns), corporate executive, economist without Ph.D. (that is, Paul Volcker), Ph.D. economist, Ph.D. economist, Ph.D. economist, financier (bringing us up to the present).

We may further consider that there are two major Federal Reserve buildings in Washington, DC. The first is the main Fed headquarters. This familiar, impressive temple to the importance of money is the Eccles Building, named for Marriner Eccles, who was chairman of the Fed from 1934 to 1948, and after that stayed on the Federal Reserve Board without being chairman until 1951. About Eccles, we read:

Although he neither attended college nor received any formal training in economics, Marriner S. Eccles became the intellectual force who led the Fed through financial crises during the Depression and World War II.

Eccles was a Salt Lake City banker who controlled two dozen banks, in addition to a number of other companies, and set up one of the first multiple bank holding companies. It is fair to say that this powerful Fed chairman bore little resemblance to an economics Ph.D.

The second main Federal Reserve building in Washington is the Martin Building. It is named for William McChesney Martin, who was chairman of the Fed from 1951 to 1970, which included serving under five U.S. presidents, and represents the record tenure in the job.

Martin’s highest academic degree was a B.A. in English from Yale, where he also studied Classics. Perhaps this prepared him to be, as Peter Conti-Brown has written, the Fed’s greatest creator of language. His most famous metaphor, of course, was “the punchbowl,” which the Fed must take away “just when the party was really warming up.”

Martin did take classes in economics in college, in which “he was astonished,” we are told, that the academic economists believed that his father, who was the president of the St. Louis Federal Reserve Bank, and other Fed bankers were “hopelessly out of date because of their misguided warnings about excessive speculation in the stock market” of the 1920s. Of course, his father and friends turned out to be right.

Among other things, Martin served as the president of the New York Stock Exchange. He did take some graduate classes in economics, too, but through his long tenure at the Fed, he remained highly skeptical of economic models and forecasts.

History does make clear that while having professional education in economics can be a relevant qualification for leading the Federal Reserve, it certainly isn’t the only one or a necessary one.

A very instructive book on whom you might want as Federal Reserve chairman is Donald Kettle’s Leadership at the Fed. Its final chapter, “The Chairman as Political Leader,” draws these insightful conclusions:

The Fed’s policymaking is inevitably political, and no institutional (or even constitutional) fix can change that. History demonstrated the folly of thinking that monetary management can be reduced to a process of technical adjustment, for any monetary policy has political implications and creates political conflicts. The very attempt to shield such inherently political decisions behind “technical” standards and legal “independence” is itself a political strategy.… In framing monetary policy, the chairman operates as a political leader. He seeks to craft a policy for which he can build political support (and deflect attack)… [while enmeshed in] the intricate and complex balance of political forces in the Fed’s constituencies.

These points seem to me correct and to reflect reality. They must make us think of Alan Greenspan, Chairman of the Fed from 1986 to 2006, who earned an economics Ph.D., but was not an academic, and repeatedly demonstrated his skills as a master politician and political leader. This took him all the way to being “The Maestro”—though even he could not sustain that exalted but unrealistic perception.

In sum, are we better off for having had at the Fed an econocracy of Ph.D.s for most of the last three decades? Forty years ago, Kristol mused: “I am not so sure the world has improved much since we began being governed by economic theories rather than by men of experience using some common sense.” As with other counter-factual speculations, we can never know what would otherwise have been.

Turning to the future, it is safe to predict that the Federal Reserve staff will continue to be full of economics Ph.D.s, whose advice and analysis any Fed chairman will want to consider.

But at the top of the Fed, will Chairman Powell be the start of a new phase, which returns to a model of financial experience and practical knowledge—like Eccles, Martin, McAdoo, and Strong? In my view, this would be a good addition to the Fed leadership mix over time. We should certainly not exclude economics Ph.D.s from the office, but they should most definitely not have an exclusive claim on this hugely powerful, globally impactful, systemically important job. The Fed should not be an econocracy.

Eliminating Fannie & Freddie’s Competitive Advantages by Administrative Action

Published in Real Clear Markets.

Among the strategic goals for reform of Fannie Mae and Freddie Mac specified by Treasury Secretary Steven Mnuchin in Congressional testimony on October 22 was: “Legislation could achieve lasting structural reform that…eliminates the GSEs’ competitive advantages over private-sector entities.” A good idea, except legislation won’t happen.

As the Secretary suggests, replacing the current government-dominated, duopolistic secondary housing finance sector with a truly competitive one is an excellent goal. But fortunately, it does not take legislation. It can be achieved with purely administrative actions—three of them, to be exact. These administrative actions are:

1. Set Fannie and Freddie’s capital requirements equal to those of private financial institutions for the same risks.

2. Have Fannie and Freddie pay the same fee to the government for its credit support that other Too Big To Fail financial institutions have to pay.

3. Set Fannie and Freddie’s g-fees at the level that includes the cost of capital required for private financial institutions to take the same risk.

The Same Capital Requirement

The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator, has full authority to set their capital requirements. FHFA simply has to set them in a systemically rational way: namely, so that the same risk requires the same capital across the system: the same for Fannie and Freddie as for private financial institutions.

Running at hyper-leverage was a principal cause of Fannie and Freddie’s failure and bailout. It naturally induced market actors to perform capital arbitrage and send credit exposure to where the capital was least—that is, into Fannie and Freddie—thereby sticking the taxpayers with the risk.

The capital for mortgage credit risk is still the least at Fannie and Freddie and the risk is still sent every day to the taxpayers by way of them. Even with the revised agreement between the FHFA and the Treasury announced on September 30, Fannie and Freddie will be able to in time increase their capital only to $45 billion combined. This is exceptionally small compared to their risk of $5.5 trillion: it would represent a capital ratio of less than 1%, still hyper-leverage.

Something like a 4% capital requirement would be more like the equilibrium standard required to eliminate the capital arbitrage, which would imply a total capital for the two government-backed entities of about $220 billion. I do not insist on the exact numbers, only that the FHFA should implement the right principle: same risk, same capital.

The Same Fee for Government Support

Fannie and Freddie are Too Big To Fail (TBTF). No one doubts or can doubt this. Their business and indeed their existence utterly rely on the certainty of government support. This means their creditors have immense moral hazard: they don’t have to worry about the credit risk of the trillions of Fannie and Freddie fixed income securities they hold. History has proved that the creditors are right to rely on government support—when Fannie and Freddie were deeply insolvent, the bailout assured that the creditors nonetheless received every penny of interest and principal on time.

What is this government support worth? A huge amount. There is widespread agreement that Fannie and Freddie should pay an explicit fee for it, but how much? The right answer is to remove their unfair competitive advantage by having them pay at the same rate as any other Too Big To Fail institution with the same leverage and the same risk to the government.

In other words, have the FDIC determine what the deposit insurance rate for a TBTF bank with Fannie and Freddie’s leverage and risk would be, and require them to pay that to the Treasury. Then they would be on the same competitive basis as private financial institutions.

Setting the right fee in exchange for the ongoing government support is within the power of the FHFA as Conservator and the Treasury, by the two of them amending their Fannie and Freddie Senior Preferred Stock Purchase Agreements accordingly.

The Same Guaranty-Fee Logic

The key action here, which the FHFA is already not only empowered but directed by Congress to take, is already in law—to be specific, in the Temporary Tax Cut Continuation Act of 2011. This statute requires the setting of Fannie and Freddie’s g-fees to include not only the risk of credit losses, but also “the cost of capital allocated to similar assets by other fully private regulated financial institutions.” The FHFA Director is instructed to make this calculation and increase the g-fees accordingly. The FHFA has egregiously not carried out this unambiguous instruction. It should do so now, thereby removing the third distorting competitive advantage which historically allowed Fannie and Freddie to drive out private capital.

Each of these administrative actions by itself would create a serious advance toward the stated goal. To take all three of them would settle the matter: game, set, match. No legislation needed.

Actually, Sovereigns Do Go Broke

Published in Law & Liberty.

The ballooning debt of the United States government is an especially large and interesting case of sovereign debt. One chronicler of sovereign debt’s long, global, colorful history, Max Winkler, concluded that “The history of government loans is really a history of government defaults.” More moderately, we may say that at least defaults figure prominently in that history.

In a vivid recent example, the government of Greece, in its 2012 debt restructuring, paid private holders of its defaulted debt 25 cents on the dollar, so these creditors suffered a 75 percent loss from par value. Greek government debt was at the vortex of Europe’s 21st century sovereign debt crisis. Various governments of Greece have defaulted seven times on their debt, which has been in default approximately half the time since the 1820s.

With such a record, how soon would the lenders be back this time?

Pretty soon, as usual. Defaults were the past; new loans proclaim a belief in the future. Thus in July, the print edition of the Financial Times informed us, “Greek debt snapped up as investors seek higher yields”! That’s a headline that would not have been predicted a few years ago—except by students of financial history who have observed the repeating cycles of sovereign borrowing, default, and new borrowing.

“Greece has seen vigorous demand for its latest bond sale,” read the Financial Times article. “The Mediterranean country received orders of more than €13 billion for the seven-year bonds, well above the €2.5 billion on offer.” And the “higher yield”? A not very impressive 1.9 percent. The recently again-defaulting Greek government has succeeded in borrowing at the same interest rate as the United States government was at the same time for the same tenor. Of course the currencies are different, but this is nonetheless remarkable.

Note the common but inaccurate figure of speech used in the article. It talks about the country borrowing, when it is in fact the government of the country that borrows. That these two are not the same is an important credit consideration. Governments can be overthrown and disappear, while the country goes on. Governments can and do default on their debt with historical regularity.

Breaking the Faith

Notorious in this respect is the government of Argentina, which has “broken good faith with its creditors on eight occasions since it declared independence from Spain in 1816,” as James Grant reminds us. That is a default on average about once every 25 years. Obviously the lenders reappeared each time—in 2017, they bought Argentine government bonds with a maturity of 100 years. That is long enough on average to cover four defaults. In August 2019, the Argentine government announced it would seek to restructure its debt once again, and its 100-year bonds at the end of the month were quoted at 41 cents on the dollar.

In contrast to this, an optimistic columnist for Barron’s pronounced in that same August that sovereign bonds “have minimal to no credit risk because they are backstopped by their governments.” This financially uneducated statement is reminiscent of the notorious Walter Wriston line that “countries don’t go bankrupt.” Wriston, then prominent in banking as the innovative chairman of Citicorp, was defending the credit expansion that would shortly lead to the disastrous sovereign debt collapse of the 1980s. While sovereign governments indeed do not go into bankruptcy proceedings, they nevertheless do often default on their debt.

The great philosopher, economist and historian, David Hume, famously argued two and a half centuries ago, “Contracting debt will almost infallibly be abused, in every government.”

Max Winkler shared a realistic appreciation of the risk involved, as he was writing during the sovereign debt collapse of the 1930s. His instructive and entertaining book, Foreign Bonds: An Autopsy (1933), provides a simple but convincing explanation for the recurring defaults. Considering “politicians in the borrowing countries, from Abyssinia to Zanzibar,” Winkler memorably observed:

The position they occupy or the office they hold is ephemeral. Their philosophy of life is carpe diem. . . . Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures, proposed by themselves and their temporary adherents. . . . In order to enjoy the present they cheerfully mortgage the future, and in order to win the favor of the voter they . . . exceed the taxable possibilities of the country.

This sounds familiar indeed. We only need to update Winkler’s A to Z country names—we could make it “from Argentina to Zimbabwe.” Otherwise, the logic of the politicians’ behavior he describes is perpetual. It applies not only to national governments but to the governments of their component states, cities, and territories, like over-indebted Illinois and Chicago; New York City, which went broke in 1975; and Puerto Rico, now in the midst of a giant debt restructuring, among many others.

The observation fits the governments of advanced, as well as emerging, economies. This political pattern includes the expanding debt of the United States government, although it has not defaulted since 1971. In that year, it reneged on its Bretton Woods agreement to pay in gold. The U.S. government also defaulted on its gold bonds in 1933. Then Congress declared that paying these bonds as their terms explicitly provided had become “against public policy.”

The always insightful Chris DeMuth, writing in The American Interest and pondering the long-term trend of rising U.S. government debt, proposes that we have seen “the emergence of a new budget norm.” This is “the borrowed benefits norm.” “Voters and public officials,” he writes, have forged “a new political compact: for the government to pay out benefits considerably in excess of what it collects in taxes, and to borrow the difference.” He points out that the benefits “are mainly present consumption and are not going to generate returns to pay off the borrowed funds. Borrowing for consumption leads to immoderation now, immiseration down the road.”

This scholarly language captures the same behavior Winkler described in more popular terms in 1933.

A Habit of Default that Few Seem to Have Noticed

How frequent are defaults on sovereign debt? In their modern financial classic, This Time Is Different (2009), Carmen Reinhart and Kenneth Rogoff counted 250 government defaults on their external debt between 1800 and 2006, or 12 sovereign defaults per decade on average (of course, there have been more since 2006). In addition, they found 70 defaults on domestic public debt over that period.

A study by the Bank of Canada finds that, since 1960, 145 governments “have defaulted on their obligations—well over half the current universe of 214 sovereigns.” That is on average 24 defaulting governments per decade.

The study considers “a long-held view among some market participants . . . that governments rarely default on local currency sovereign debt [since] governments can service such obligations by printing money.” It points out that “high inflation can be a form of de facto default on local currency debt.” Holders of U.S. Treasury bonds found that out in the Great Inflation of the 1970s, when the bonds became called “certificates of confiscation.” But not counting the inflation argument, the Bank of Canada still finds 31 sovereigns with local currency defaults between 1960 and 2017. “Sovereign defaults on local currency debt are more common than is sometimes supposed,” it concludes.

The Wikipedia “List of sovereign debt crises,” relying heavily on Reinhart and Rogoff, shows 298 sovereign defaults by the governments of 88 countries between 1557 and 2015.

“The regularity of default by countries on their sovereign debt” is how Richard Brown and Timothy Bulman begin their study of the Paris Club and the London Club. These are organizations of governmental and private creditors, respectively, to negotiate with over-indebted governments. The first Paris Club debt rescheduling was in 1956 for Argentina; the London Club’s first was in 1976 for Zaire. (A to Z again.) The clubs have been busy since then. “Reschedulings increased dramatically from 1978 onwards,” Brown and Bulman observed in 2006. The current webpage of the Paris Club reports that in total it has made 433 debt agreements with the governments of 90 debtor countries.

The cycle of sovereign borrowing, default, and new borrowing has a long and continuing history. “Defaults will not be eliminated,” Winkler wrote in 1933. He further predicted that “debts will be scaled down and nations will start anew,” and that “all will at last be forgotten. New loans will once again be offered, and bought as eagerly as ever.” He was entirely right about that, and now we observe once again “Greek debt snapped up.”

How far back in time do government defaults go? Over 2,300 years in Greece. As Sidney Homer, in A History of Interest Rates, tells us: “In 377-373 B.C., thirteen [Greek] states borrowed from the temple at Delos, and only two proved completely faithful; in all, four-fifths of the money was never repaid.”

Shall we expect the fundamental behavior of politicians and governments to change?

Unfunded Pensions: Watch out, bondholders!

Published in Real Clear Markets.

A reorganization plan for the debt of the government of Puerto Rico was submitted to the court Sept. 27 by the Puerto Rico Oversight Board. It covers $35 billion of general obligation and other bonds, which it would reduce to $12 billion.

On average, that is about a 66 percent haircut for the creditors, who thus get 34 cents on the dollar, compared to par. Pretty steep losses for the bondholders, but steep losses were inevitable given the over-borrowing of the Puerto Rican government and the previous over-optimism of the lenders. Proposed haircuts vary by class of bonds, but run up to 87 percent, or a payment of 13 cents on the dollar, for the hapless bondholders of the Puerto Rican Employee Retirement System.

In addition to its defaulted bonds, the Puerto Rican government has about $50 billion in unfunded pension obligations, which are equivalent to unsecured debt. But the pensioners do much better than the bondholders. Larger pensions are subject to a maximum reduction of 8.5 percent, while 74 percent of current and future retirees will have no reduction. Those with a reduction have the chance, if the Puerto Rican government does better than its plan over any of the next 15 years, to have the cuts restored.

The Oversight Board’s statement does not make apparent what the overall haircut to pensions is, but it is obviously far less than for the bondholders. “The result is that retirees get a better deal than almost any other creditor group,” as The New York Times accurately put it. This may be considered good and equitable, or unfair and political, depending on who you are, but it is certainly notable. The Times adds: “Legal challenges await the plan from bondholders who believe the board was far too generous to Puerto Rico’s retired government workers.”

The Puerto Rican debt reorganization plan demonstrates once again, in municipal insolvencies and bankruptcies, unfunded pension obligations are de facto a senior claim compared to any other unsecured debt, including general obligation bonds that pledge the full resources and taxing power of the issuing government. This is not because they are legally senior, but because they are politically senior.

By running up their unfunded pensions, municipalities have not only stressed their own finances, but have effectively subordinated the bondholders. When it comes to unfunded pensions, the Puerto Rico outcome, like that of Detroit and others, announces: Bondholders, Watch Out!

Have Fannie and Freddie Paid the Taxpayers Back Yet?

Published in the Real Clear Markets.

The distinguished judges of the U.S. Court of Appeals for the Fifth Circuit have considered how much Fannie Mae and Freddie Mac have paid the Treasury Department to compensate the taxpayers for the giant bailout which kept Fannie and Freddie in existence and business.  The court observed in its September 6 judgment:

“The net worth sweep transferred a fortune from Fannie and Freddie to Treasury.”  Specifically, “Treasury had disbursed $187 billion and recouped $250 billion.”

The “net worth sweep” is the dividend on the senior preferred stock in Fannie and Freddie acquired by the Treasury in the bailout.  Originally set at 10% per year in 2008, the dividend was changed in August 2012—in the “Third Amendment” to the governing agreement—to essentially, “just send in all your profit” each quarter, hence a “sweep.”  The Treasury then owned $187 billion of senior preferred stock acquired for cash, as the court suggested, and another $2 billion in exchange for the original credit support agreement, for a total of $189 billion.  (Now it owns $199 billion.)

Fannie and Freddie should, said the court, “of course…pay back Treasury for [their] draws on the funding commitment.” And “Treasury was also entitled to compensation for the cost of financing.”  No one could disagree.  “But the net worth sweep continues transferring [Fannie and Freddie’s] net worth indefinitely, well after Treasury has been repaid,” it critically points out.  This must make us ask: Have Treasury and the taxpayers been repaid at this point?  The answer is not obvious, as sometimes has been asserted, and requires a little arithmetic.

In short, does having been paid $250 billion vs. a $189 billion principal amount automatically mean full repayment?  As every banker knows, it doesn’t.

Consider a simple analogy.  Suppose you borrowed $1,000 at an interest rate of 10%, under a $5,000 commitment with a commitment fee of 1% per year.  Suppose you pay only the interest and the commitment fee, but never a penny of principal.  After ten years, you will have paid $1,500.   You could truly observe that “You lent me $1,000 and I have paid you $1,500.”  But how much principal do you still owe?  You still owe all $1,000, without a doubt.

We can apply the same logic to Fannie and Freddie and see what happens.

Let us go back to August 2012, and suppose that the Third Amendment and the “net worth sweep” had never happened.  There is outstanding $189 billion of senior preferred stock.  The dividend remains the original 10%.  That is a dividend of $18.9 billion a year.  In addition to the dividend, as the court rightly noted, the original deal provides for Treasury also to charge an ongoing commitment fee. This was to compensate the taxpayers for their continuing credit support, which backed up and continues to back up all Fannie and Freddie’s liabilities.  Nine Fifth Circuit judges in an accompanying opinion call this support “a virtually unlimited line of credit from the Treasury.”  It effectively guarantees liabilities totaling $5.5 trillion—you don’t get that for free.  With vast liabilities and effectively zero capital, Fannie and Freddie could not function for even a minute without taxpayer support.  The Housing Reform Plan just published by the Treasury clearly provides for Fannie and Freddie to pay a commitment fee—and they undoubtedly should.

What would be a fair price for the taxpayers’ credit commitment?  Based on what the FDIC would charge a severely undercapitalized bank for the credit guarantee which is called deposit insurance, I believe 0.18% of total liabilities per year is a good guess.  This credit support fee on $5.5 trillion in liabilities gives an annual fee of $9.9 billion.

Thus, going back to our hypothetical 2012 with no profit sweep, Fannie and Freddie should have been paying Treasury $18.9 billion plus $9.9 billion or a total of $28.8 billion a year.  That was seven years ago.  Had Fannie and Freddie been paying that instead of the profit sweep for seven years the aggregate payment for dividends and commitment fee only, would have been $202 billion.  That payment would provide no reduction of the $189 billion of principal.

But Fannie and Freddie paid $250 billion.  That is $42 billion more than $202 billion, which might fairly be used to retire some of the $189 billion principal.  If we credit Fannie and Freddie with the going rate of interest, say 2%, on this amount, we might make that $45 billion.  That gives us $189 billion less $45 billion, leaving $144 billion of principal still to be repaid.

Suppose you think my suggested commitment fee is too high.  Let us cut it in half, to 0.09 %.  Then by analogous math, Fannie and Freddie’s required payment of 10% dividends plus commitment fees would be $23.9 billion a year, or $167 billion in total for seven years.  That would leave $83 billion, or $88 billion with interest, for principal reduction.  Result: they would have $101 billion still to pay.

Even when we remove by hypothesis Treasury’s claim on the perpetual net worth sweep criticized by the court, it is far from the case that Treasury has been repaid.

These considerations must be taken into account as Treasury and the Federal Housing Finance Agency (as conservator for Fannie and Freddie) revise the Preferred Stock Purchase Agreement as part of the administration’s housing finance reform plan.

Lest We Forget

Published in Law & Liberty.

Fannie Mae and Freddie Mac, then staggering under huge losses from bad loans, were put into government conservatorship on September 6, 2008—eleven years ago today. Once considered financially golden and politically invulnerable, they were the lynchpins of the giant American housing finance market. But in 2008, instead of inspiring the fear and admiration to which they were previously accustomed, they were humiliated. “O what a fall was there, my countrymen!” This was an essential moment in the intensification of the 2007-2009 financial crisis. Naturally, Fannie and Freddie were bailed out by the U.S. Treasury. All the creditors got paid every penny on time, although the common stockholders from peak to trough lost 99%.

On the anniversary of Fannie and Freddie’s arrival in conservatorship, we consider Firefighting, the instructive and often quite personal memoir of the crisis and their own roles in it by three principal government actors—Hank Paulson, then Secretary of the Treasury; Ben Bernanke, Chairman of the Federal Reserve; and Tim Geithner, President of the Federal Reserve Bank of New York (and later, Paulson’s successor as Treasury Secretary).

To paraphrase the opening lines of the famous History of Herodotus from ancient Greece, using first names as they do in the book, “These are the memories of Hank and Ben of Washington and Tim of New York, which they publish in the hope of thereby preserving from decay the remembrance of what they have done, and of preventing the great and wonderful actions of the Treasury and the Federal Reserve from losing their due meed of glory; and withal to put on record what were the grounds of their actions.” This memoir will be able to be read usefully by future generations, if they are smart enough to study financial history.

The personal dimension of this account impresses us with the unavoidable uncertainty and the fog obscuring understanding, not to mention the emotions and then the exhaustion, which surround those who must act in a crisis. As they struggle to update their expectations and make decisions adequate to the threatened collapse, surprising disasters keep emerging in spite of their efforts.

As the authors reflect: “None of us was ever sure what would work, what would backfire, or how much stress the system would be able to handle.” So “We had to feel our way through the fog, sometimes changing our tactics, sometimes changing our minds, with enormous uncertainty.”

The pervasive uncertainty in part reflects the fact that crises “are products of human emotions and perceptions, as well as the inevitable lapses of human regulators and policymakers.” And “regulators and policymakers aren’t immune to those manias. Human beings are inherently susceptible to irrational exuberance as well as irrational fears.” This is not a new thought, to be sure, but certainly an accurate one.

In a crisis, all are faced with “the infinite expandability and total collapsibility of credit.” This wonderful phrase is from Charles Kindleberger, in his classic Manias, Panics, and Crashes. But how can those in responsible positions know when the collapsibility is going to be upon us? It may not be so easy to figure that out in advance.

“In the early phase of any crisis, policymakers have to calibrate how forcefully to respond to a situation they don’t yet entirely understand,” says the book. This seems right, but pretty delicately stated. A more honest wording would have been “have to guess how to respond to a situation they don’t understand.” While guessing, they are faced with this problem: “Governments that routinely ride to the rescue at the first hint of trouble can create. . . reckless speculation. . . . But underreacting can be even costlier and more damaging than overreacting.” Which is it to be? “Unfortunately, crises don’t announce themselves as either idiosyncratic brush fires. . . or systemic nightmares.” So, as the book describes, “Policymakers have to figure it out as they go along.”

As they strove to do so, “The three of us would work together as a team throughout the crisis, talking to one another every day, usually multiple times.” And talking to many financial executives, too: “Sometimes we just needed to hear how much fear was in their voices. Sometimes they professed confidence, sometimes they pleaded for assistance. Often they didn’t know that much about the risks ahead. We had to sort through all the confusion and self-interest.” In general, “Policymakers can’t trust everything they hear from market participants.” Of course.

Indeed, whose word can be trusted? Government officials worry that speaking truly about their fears may set off the very panic they are trying to avoid. “When it becomes serious, you have to lie,” said Jean-Claude Juncker about this aspect of the crisis in Europe. “The mere act of publicly advocating for [the] TARP [bailout] carried some risk,” write our authors. “Excessively alarmist rhetoric could end up inflaming the panic.” There seems to be no way to escape this dilemma.

Here is the authors’ confession: “Even in the months leading up to it, we didn’t foresee how the scenario would unfold”—how it would “unravel” would be a better term. This was not for lack of effort. “All three of us established new risk committees and task forces within our institutions before the crisis to try to focus attention on systemic threats. . . calling for more robust risk management and humility about tail risks.” But “none of us recognized how they were about to spiral out of control. For all our crisis experience, we failed to anticipate the worst crisis of our lifetimes.”

This experience leads the authors to a reasonable conclusion: such a lack of foresight is likely to repeat itself in the future. “For us,” they muse, “the crisis still feels like yesterday,” but “markets have short memories, and as history has demonstrated, long periods of confidence and stability can”—I would say almost certainly do—“produce overconfidence and instability.” So “we remain worried about the next fire.” This is perfectly sensible, although the book’s overuse of the “fire” metaphor becomes tiresome.

Failed foresight and future financial crises and panics are possible or probable. With that expectation and their searing experiences, the authors believe that it is essential to maintain the government’s crisis authorities and bailout powers. This includes the ability to invest equity into the financial system when it would otherwise go broke, and they deplore the Dodd-Frank Act’s having curtailed these powers.

To correct this, “Washington needs to muster the courage to restock the emergency arsenal with the tools which helped end the crisis of 2008—the authority for crisis managers to inject capital into banks, buy their assets, and especially to guarantee their liabilities.” This would hardly be politically popular with either party now, because it would be seen as favoring bailouts of big banks. It would increase moral hazard, but would also reflect the reality that government officials will intervene in future financial crises, just as in past ones. “The current mix of constraints on the emergency policy arsenal is dangerous for the United States,” conclude the most prominent practitioners of emergency financial actions of our time. Thus they end the book with their contribution to the perpetual debate of preparing for government intervention versus creating moral hazard.

In the meantime, they have related a history which, in the spirit of Herodotus, does deserve its due meed of remembrance.

Steering Central Banking Past Scylla and Charybdis (the Technocrats and the Politicians)

Published in Law & Liberty.

Napoleon was clear about why he set up the Bank of France in 1800: He wanted a bank to lend his government money when he needed it. As monetary economist George Selgin wrote, “The idea of credit which existed in the mind of General Bonaparte boiled down to this: that he might have all the credit he wanted, if only he could establish a bank he could control, and award it a monopoly of currency.” This nicely sums up one essential function of central banks: financing the government of which they are a part. If you want your government debt to be thought of as nearly risk-free, the central bank has to be willing to buy it at all times.

Somehow, the central banks don’t discuss this service of theirs in their brochures or their public statements. Nonetheless, it is a critical element of whether central banks are, or ought to be, “independent” as they wield their great financial and economic power. If independent, how they are to be accountable, and to whom? Upon the answers to these questions depends the legitimacy (or lack thereof) of these unelected wielders of power in a democracy.

A detailed consideration of what should be meant by central bank independence, accountability, and legitimacy may turn out to be quite complex, as Paul Tucker’s Unelected Power—The Quest for Legitimacy in Central Banking and the Regulatory State certainly is.

Sir Paul, knighted for his contributions to central banking and now a fellow at Harvard University, writes: “Unelected power is one of the defining features of modern governance,” and “central banks are, today, the epitome of unelected power.” He is unambiguous that “What we are dealing with here is power—who has it, for what purposes, and on what terms.”

In turn, this involves “the interconnectedness of events, beliefs, values, norms, laws, and institutions,” with not only domestic issues of economic growth and employment, attempts at financial stability, perpetual inflation (as is these days the central banks’ goal), financial regulation, government finance, and dealing with financial crises, but also necessarily involving international cooperation by central bankers, who thus may be perceived as part of a “transnational elite.”

Pondering Power

Over the last century, central banks have become a worldwide institution. In the 1920s, the League of Nations prescribed that “in countries where there is no central bank of issue, one should be established.” In the 1990s, “the International Monetary Fund and the World Bank began prescribing independent central banks and . . . inflation targeting.” In the most recent financial crisis, “central bankers were the leading players.” They “emerged from the crisis with more, not fewer, responsibilities and powers.” Reflecting on this dominant financial institution of our times, “the consolidation of power should make us ponder,” says Tucker. Indeed it should.

Central banks must operate in three interacting aspects of government, in Tucker’s terms: “The Fiscal State, the Regulatory State, and the Emergency State.” As Napoleon saw, the central bank is essential to the Fiscal State; it has become an essential regulator and hoped-for controller of risk for the Regulatory State; and it is essential to coping with financial emergencies and panics for the Emergency State. Central banks “are built to be emergency institutions,” Tucker writes, with emphasis—this is certainly the main reason why the Federal Reserve was created. At this high level of abstraction, the unavoidable complexity is already apparent.

Tucker is well-prepared through long practical experience, having risen to Deputy Governor of the Bank of England, and by much theoretical reflection, to ponder these matters. He spends the first 568 pages of the book carefully examining innumerable aspects of how and under what conditions central banks can legitimately have so much power. He does not sufficiently explore, in my opinion, the dilemma that central bankers can never have the knowledge of the future they would need to carry out their grand goals. Otherwise, the treatment is exhaustive.

The Central Banking Golden Mean

The author wants to avoid two extremes in his search for what might be thought of as the central banking golden mean.

The first extreme is having central banks and money completely controlled by the politicians currently in office, who are ready to manipulate and depreciate the currency in the pursuit of short-term political advantage. Then, as history demonstrates, the central bank can become subject to the government’s whims, as Martin Wolf recently described it. To direct the central bank is doubtless a natural desire of the executive.

President Trump and India’s Prime Minister Modi have both been explicit about this. So, notably, were Presidents Harry Truman, Lyndon Johnson and Richard Nixon, and the executive branch completely controlled the Federal Reserve during the Second World War. Tucker would like a central bank independent enough to resist this natural pressure, except of course, during a big war.

The opposite extreme is a central bank that is too independent, operated by a self-styled set of Platonic guardians who do not have to answer to any mere elected politicians (as they see it), and who by “their professional expertise would improve the welfare of the people.” President Woodrow Wilson helped negotiate and signed the original Federal Reserve Act in 1913. Purely independent central banks would represent Wilson’s theory that independent agencies would be “improved on scientific lines, occupying a sphere separate from politics.” Tucker knows that is not possible in a democratic government, nor is it desirable, leading as it would, in a favorite phrase of his, to “unelected overmighty citizens.” In historical context, Wilson’s “classic celebration of administration looked back to the same exemplars of executive government [as Hegel did]: the Prussian and Napoleonic states.”

Tucker sets out to define in detail a middle ground for central banks. This is to be achieved by conscious design, well considered institutional frameworks, ongoing oversight by the legislature, and informed public debate, which will avoid short-term political domination of central bank actions “without surrendering republican democracy in favor of technocracy.”

When we reach page 569 of this careful and thoughtful book, we find a four-page long list of all the principles needed to construct this central banking golden mean. Entitled “The Principles for Delegation to Independent Agencies Insulated from Day-to-Day Politics,” the list includes “Delegation Criteria,” “Design Precepts,” “Multiple-Constraints,” and “An Ethic of Self-Restraint.”

It’s a reasonable, if lengthy, set of requirements, though naturally some of its points are debatable. Tucker sums up his approach to framing monetary regimes as follows:

a clearly articulated regime, simple instruments, principles for the exercise of discretion,  transparency that is not deceptive, engagement with multiple audiences, and, most crucially, testimony to legislative committees; all directed at establishing and maintaining a reputation for reliable, legitimate authority.

Does any existing central bank meet all these criteria? Probably not, Tucker admits. This suggests the unfortunately missing chapter of the book: one that applies the principles to existing major central banks to see how they measure up and that identifies what institutional reforms would be indicated.

It would have been most interesting had Tucker added such an analysis of current central bank designs, judged against his principles. These studies could have included the Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, or the Swiss National Bank, for example.

Accountability?

In the case of the Federal Reserve, I believe the conclusion of such an exercise would be that the Fed could not legitimately, and should not have claimed to be able to, set a 2 percent inflation target on its own. This should instead have resulted from an extensive consultation with the legislature. In particular, to unilaterally set goal of having 2 percent inflation forever is of highly dubious legitimacy, when the law instructs the Fed to pursue “stable prices.”

Such an analysis would also lead one to question whether the United States meets Tucker’s standard that “the legislature has the capacity, through its committee system, properly to oversee” the central bank. Any fair consideration, I believe, would find that under current circumstances, the U.S. Congress does not. I have previously suggested that a specialized new joint committee, perhaps called the Committee on the Federal Reserve and the Currency, would have a better chance of carrying out what is, under Tucker’s principles, a mandatory legislative duty.

This is the essential question of the accountability of central banks, which is “the riddle at the heart of this book.” Tucker thinks that “sensible central bankers will want to invest in reasoned debate and criticism of their policies.” (Emphasis in original.) The responsibility of the legislature is “for the people’s representatives to fulfill their own role as higher-level trustees, setting clear objectives and constraints.” One might say in such a design that the central bank is the management of the monetary regime and the legislature is, or should be, the board of directors.

The Claim of Expertise

Supporters of pure central bank independence stress the Wilsonian claim of expertise, the technocratic argument. But although they are monetary and economic experts, do central banks have the requisite knowledge of the financial and economic future they would need for consistent success? It is apparent that they do not. Tucker rightly observes that “bad results are from time to time inevitable.” By analogy, you could be a great expert in the stock market but still be unable to say what stock prices will do today, let alone tomorrow.

Central bankers might have “unparalleled status, power and prestige” but, “as they well know, they, like the rest of us, have a more tenuous grasp of what is going on in the economy than anyone ever expected,” Tucker admits. Or in more informal terms (to quote Wolfgang Muenchau), “The proverbial monkey with a dartboard would have outperformed the ECB’s forecasting department in the past decade.” Hence it is no surprise, as Tucker writes, that we have “a world that combines market failure with government failure.” To expect otherwise would be foolish.

The Governor of the Bank of France, Francois Villeroy de Galhau, in a brilliant talk, pointed out how central banks face four fundamental uncertainties. In my paraphrased summary, these are:

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

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

3. They are affected by what others will do, but don’t know what the others will do.

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

The unelected power of central banks, however well designed for legitimacy, must always be understood as faced with such inescapable uncertainty.

So, as Tucker says, “Our central bankers are not a priesthood” nor are they “philosopher kings, maestros or celebrities . . . Nor, more modestly, is the chair of a central bank its country’s chief economist.” Not being elected, “they must work within clear democratic constraints and oversight.”

In short, we should be neither idealistic nor cynical about central banks and bankers, merely realistic.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Published in Real Clear Markets.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Members of Congress whose financial markets credo begins with “I believe in the Dodd-Frank Act,” experience severe cognitive dissonance when faced with the systemic financial risk created by Fannie Mae and Freddie Mac. Of course, this applies principally to Congressional Democrats. Here is the logic of their problem:

If you believe in the Dodd-Frank Act, you must believe in the concept of SIFIs (Systemically Important Financial Institutions).

If you believe in the Dodd-Frank Act, you must believe that SIFIs should be regulated by the Federal Reserve in addition to any other regulator, and that the Fed must be able to set “more stringent” regulations to reduce systemic risk.

If you believe in the concept of SIFIs, you cannot escape the obvious fact that Fannie and Freddie are SIFIs.

So if you believe in the Dodd-Frank Act, you must believe that Fannie and Freddie should be regulated by the Fed to address systemic risk.

But many politicians who wish to believe in the Dodd-Frank Act also wish to escape this inescapable conclusion. “Wait!” they say, “If the Fed regulates Fannie and Freddie, maybe that will hurt housing, so don’t do it!” There is the cognitive dissonance. Stating it in more candid terms, they fear that regulating the systemic risk of Fannie and Freddie in accordance with the Dodd-Frank Act would limit political schemes to run up mortgage risk, and likewise limit the ability to push all that risk onto the Treasury and the taxpayers. Indeed it would, especially recalling that Dodd-Frank authorizes “more stringent” regulations for SIFIs. Presumably, for starters, Fannie and Freddie would no longer be able to run at hyper-leverage.

The Dodd-Frank faithful cannot have it both ways. They cannot both believe in the Dodd-Frank Act and oppose the Fed as systemic risk regulator of Fannie and Freddie. It’s one or the other, not both.

Others do not have this logical problem. For example, my good friend, Peter Wallison of the American Enterprise Institute, opposes recognizing that Fannie and Freddie are SIFIs (thereby disagreeing with me), because he does not want to give the Fed any more power than it already has. Peter can do this with intellectual consistency because he doesn’t believe in the Dodd-Frank Act in the first place.

Another approach to opposing the Fed as systemic risk regulator of Fannie and Freddie would be to deny its supposed ability to regulate any systemic risk at all. This approach would observe the deep uncertainty of the financial future, which is constantly displayed, and argue that neither the Fed nor anybody else can have the knowledge to be a successful systemic risk regulator. But if you think this, you obviously do not believe in the Dodd-Frank Act.

Neither these nor any other arguments against making the Fed a Fannie and Freddie regulator are available to those who recite the Dodd-Frank creed. They must agree with the accuracy of this syllogism:

1. SIFIs must be regulated by the Fed.
2. Fannie and Freddie are obviously SIFIs.
3. Therefore, Fannie and Freddie must be regulated by the Fed.

If you believe in the Dodd-Frank Act, it is simply “Q.E.D.”

Fannie Mae and Freddie Mac need to be labeled as systemically important

Published by The Hill.

The Senate Banking Committee held a hearing this summer on whether Fannie Mae and Freddie Mac should be designated as systemically important financial institutions (SIFIs). Absolutely nobody there, no witness and no senator, tried to argue that Fannie Mae and Freddie Mac are not systemically important.

That would be a hopeless argument indeed, since Fannie Mae and Freddie Mac guarantee half the credit risk of the giant United States housing finance sector and have combined assets of $5.5 trillion. Fannie Mae is bigger than JPMorgan Chase and Bank of America, and Freddie Mac is bigger than Citigroup and Wells Fargo. They have already demonstrated that they can “pose a threat to the financial stability of the United States,” to use the words of the Dodd Frank Act. Are they systemically important? Of course. Are they financial companies? Of course. They are systemically important financial institutions, as a matter of simple fact.

This is true if you consider them as two of the largest and most highly leveraged financial institutions in the world, but it is equally true if you consider them as an activity that generates systemic risk. Guaranteeing half the credit risk of the biggest credit market in the world (second only to United States debt) is a systemically important and systemically risky activity. Leveraged real estate is, and has been throughout financial history, a key source of credit collapses and crises, as it was yet once again in 2007-2009. The activity of Fannie and Freddie is entirely about leveraging real estate. Moreover, they have been historically, and are today, themselves hyper leveraged.

The Financial Stability Board has stated this fundamental description of a SIFI: “the threatened failure of a SIFI — given its size, interconnectedness, complexity, cross-border activity or lack of substitutability — puts pressure on public authorities to bail it out using public funds.” Fannie and Freddie displayed in their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity, and lack of substitutability. As everybody knows, in 2008, federal authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out. In addition, they pledged the credit support from the Treasury which protected and continues to protect Fannie and Freddie’s global creditors. Fannie and Freddie remain utterly dependent on Treasury’s credit support.

As Treasury Secretary Henry Paulson recounted in his memoir of the financial crisis, “Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee.” Paulson instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.” He memorably added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the bailout he directed, Paulson’s assurances turned out to be true for all of Fannie and Freddie’s creditors, even holders of subordinated debt. In short, that Fannie and Freddie are SIFIs in reality no reasonable person can dispute. Yet so far, the Financial Stability Oversight Council has not designated them officially as such. Judging purely on the merits of the case, this is indefensible. Of course, Fannie and Freddie have an existing regulator, the Federal Housing Finance Agency (FHFA). But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system as a whole.

Fannie and Freddie are by definition 100 percent concentrated in the risks of leveraged real estate. A matching systemic risk is that their regulator is likewise devoted only to housing finance. Such an agency is always pushed by powerful political forces to become a cheerleader for housing credit. This brought down the old Federal Home Loan Bank Board, abolished in 1989, and also the Office of Thrift Supervision, abolished in 2010. It is easy to picture a future FHFA, under the appointments of a future administration, behaving similarly in that perpetual fount of systemic risk, leveraged real estate.

Designating Fannie and Freddie as SIFIs should not be delayed because they are in regulatory conservatorship. They are just as systemically important in conservatorship as out of it. The answer to the Senate Banking Committee’s excellent question is that it is high time to recognize reality and designate Fannie and Freddie as the SIFIs they so obviously are.

Congress Moves to Put Pension Benefit Guaranty Corporation On Taxpayer Dole

Published by Real Clear Markets.

The Ways and Means Committee of the House just approved a bill for a big taxpayer bailout of private multi-employer/union-sponsored pension plans.  Many of these plans are hopelessly insolvent.  In other words, they have committed to pay employee pensions far greater than they have any hope of actually paying. In the aggregate, the assets of multi-employer plans are hundreds of billions of dollars less than what they have solemnly promised to pay.

There is an inescapable deficit resulting from past failures to fund the obligations of these plans. This means somebody is going to lose; somebody is going to pay the price of the deficit.  Who?  Those who created the deficits? Or instead: How about the taxpayers? The latter is the view of the Democratic majority which passed the bill out of committee in a 25-17 straight partyline vote on July 10.

“Wait a minute!” every taxpayer should demand, “aren’t all these pension plans already guaranteed by an arm of the U.S. government?”  Yes, they are–by the government’s Pension Benefit Guaranty Corporation (PBGC). But there is a slight problem:  the PBGC’s multi-employer guarantee program is itself broke.  It is financially unable to make good on its own guarantees. The proposed taxpayer bailout is also a bailout ofthis deeply insolvent government program.

This was not supposed to be able to happen.  In creating the PBGC, the Employee Retirement Income Security Act (ERISA) required, and has continued to require up to now, that the PBGC be self-financing.  But it isn’t–not by a long shot. Its multi-employer program shows a deficit net worth of $54 billion.  The PBGC was not supposed ever to need any funds from the U.S. Treasury.  But it is now proposed to give it tens of billions of dollars from the Treasury, and the bill does not have any limiting number.

“ERISA provides that the U.S. government is not liable for any obligation or liability incurred by the PBGC,” says the PBGC’s annual report every year.  But here we have another of the notorious “implicit guarantees,” which pretend they are not guarantees until it turns out that they really are.  Consider that if the PBGC’s multi-employer program were a private company, any insurance commissioner would have closed it down long ago.  No rational customer would pay any premiums to an insurer which is demonstrably unable to pay its committed benefits in return.  Only the guarantee of the Treasury, “implicit” but real, keeps the game going.

Bailing out guarantees which were claimed not to put the taxpayers on the hook, but in fact did, is the familiar pattern of “implicit” guarantees.  They are originally done to keep the liability for the guarantees off the government’s books, an egregious accounting pretense, because everybody knows that when pushing comes to shoving, the taxpayers will be on the hook, after all.

In such “self-financing,” off-balance sheet entities, the government generally does not charge the fees which their risk economically requires. This is true even if their chartering acts theoretically require it.  Undercharging for the risk, politically supported by the constituencies who benefit from the cheap guarantees, allows the risk to keep increasing.  So in time, the day of the taxpayer bailout comes.

Notable examples of this are the bailouts of the Farm Credit System, the Federal Savings and Loan Insurance Corporation (FSLIC), Fannie Mae, and Freddie Mac.  However, the bailout of Farm Credit included serious reforms to the System, and the bailout of FSLIC, serious reforms to the savings and loan industry.  The bailouts of Fannie and Freddie were combined with putting them in conservatorship under the complete control of the Federal Housing Finance Agency, where they remain today.

Now for the PBGC, when we read all the way to the very last paragraph on the last page of the bill, page 40, we find that the PBGC’s multi-employer program, which was supposed never to need any appropriated funds, is to get generous taxpayer funds forever.  “There is appropriated to the Director of the Pension Benefit Guarantee Corporation,” says this paragraph, “such sums as may be necessary for each fiscal year.”  The multi-employer pensions would thus become an entitlement, on the taxpayer dole.  There is no limiting number or time.  Nor in the previous 39 pages is there any reform of the governance, operations, or ability of these pension plans to finance themselves on a sustainable basis.

In short, the bill passed by the Ways and Means Committee is a bailout with no reform.  But the governing principle for all financial bailouts should be instead: If no reform, then no bailout.

Multi-Employer Pension Bailout Needs a Good Bank/Bad Bank Strategy

Published in Real Clear Markets.

The stock market is high, unemployment is low, but many multi-employer, union-sponsored pension plans are hopelessly insolvent and facing their own financial crisis. So is the government’s program that guarantees those pensions through the Pension Benefit Guaranty Corporation (PBGC). “Insolvent” means that while they have not yet spent their last nickel of cash (although that day is coming), their liabilities are vastly greater than their assets, and all the liabilities simply cannot be paid. In short, many multi-employer pension plans are broke and so is their government-sponsored guarantor. Unsurprisingly, the idea of a taxpayer bailout arises, although its proponents do not wish to call it a bailout.

The PBGC’s multi-employer program has a net worth of a negative $54 billion, according to its September 30, 2018 annual report. It has assets of only $2.3 billion, and liabilities of $56 billion—it has $24 in liabilities for each $1 of assets. And this striking deficit only counts the probable losses for the next ten years, not the unavoidable further losses after that. PBGC estimates the total unfunded pension liabilities of the multi-employer plans at $638 billion. Making financial promises is so much more enjoyable than keeping them.

One of the causes of these deficits is the government guarantee itself, which can induce these pension plans to make bigger pension commitments than they funded or can fund, reflecting the expectation of a taxpayer bailout. This displays the moral hazard of getting the government to guarantee pensions, an unintended but natural risk of creating the PBGC in the first place.

The deficits in the insolvent pension plans and in the PBGC are facts. We know for certain that losses which already exist will necessarily fall on somebody. On whom? That is the question. From where we are now, there is no possible outcome in which nobody loses.

The Employee Retirement Income Security Act of 1974 (ERISA), in establishing the PBGC, specified that it would never take any money from the Treasury. As the PBGC annual report explains, “ERISA requires that PBGC programs be self-financing.” Whoops. Furthermore, “ERISA provides that the U.S. Government is not liable for any obligation or liability incurred by the PBGC.” Should we ever believe such protestations? The same provision was made for the debt of Fannie Mae and Freddie Mac, but they got bailed out anyway.

Last year, Congress set up the Joint Select Committee on Solvency of Multiemployer Pension Plans to figure out what to do. The name was nicely diplomatic, since the core issue was rather the “Insolvency” of these plans. The special committee held hearings and did its best, but disbanded without issuing its required report.

Now it inevitably occurs to many politicians that there should be a bailout to benefit the pensioners, unions, employers, and the PBGC, while moving losses to the taxpayers. A bill to this effect, the “Rehabilitation for Multiemployer Pensions Act,” was introduced this year and is headed to a mark-up in the Ways and Means Committee of the House.

Suppose you have decided that a taxpayer bailout is less bad than having pensions cut, unions embarrassed, employers faced with unaffordable pension contributions, and watching the PBGC’s multi-employer program head to default. How would a bailout best be structured? I suggest the following essential points:

Congress should be honest about what it is doing. You can’t think clearly about the principles and effectiveness of bailouts if you don’t face up to the fact that you are designing a bailout.

Congress should adapt for use in this case a globally tried and true method for dealing with hopelessly insolvent financial entities: the Good Bank/Bad Bank structure. This structure should be required for any pension plan receiving appropriated taxpayer funds in any form.

A fundamental principle is reform of the governance of bailed out entities. Those who ran the ship on the rocks should not be left in command. They should not be in charge of spending the money taken from other people to make up their deficits.

The Good Bank should contain what has a high probability of being a successful, self-sustaining entity going forward.

The Bad Bank should contain the deficits and unfunded obligations from past unsuccessful operations, plus the bailout funding. It should be run as a long-term liquidation. It will make clear the real cost of the bailout and dispense with the need for further bailouts in the future.

The Good Bank should begin and continue on a fully funded basis. The required contributions of the employers should be determined as a mathematical result of the committed pensions, not be a result of bargaining subject to the moral hazard of the government guarantee. This calculation should use the discount rates required for single-employer plans. Employers should have to book as their own liabilities their pro rata share of any underfunding which might occur. Finally, data and reporting should be revised to be made timely and more transparent.

The Bad Bank should have whatever assets, if any, are left over after forming the Good Bank, all the plan’s pension commitments already made but not funded, the obligations of employers for contributions to those commitments, and the bailout funding. It should purchase high quality annuities to meet its pension obligations, not try to run risky asset portfolios. In time, it would disappear, with remaining funds, if any, returned to the Treasury.

The Good Bank should be governed by a board of independent directors with fiduciary responsibility for the good management of the plan.

The Bad Bank should be run by a government-appointed conservator.

If you are going to have a bailout of the insolvent multi-employer pension plans, a Good Bank/Bad Bank structure along these lines would be highly advisable.

Give Fannie, Freddie the same capital standards as everybody else

Published in American Banker.

Taking up a key issue in housing finance reform, one within his control as the new director of the Federal Housing Finance Agency, Mark Calabria told a conference recently that Fannie Mae and Freddie Mac must in the future have a strong capital position.

He’s absolutely right. And this would be in vivid contrast to the 0.2% capital ratio they have now.

Calabria stated that “all large, systemically important financial institutions should be well capitalized,” specifically including Fannie and Freddie. “That would seem non-debatable at this point.”

Indeed it does. No one can plausibly disagree.

But what is the number? What is the explicit capital ratio which would implement Calabria’s excellent principle?

I believe his remarks in effect gave us the answer by asking the question in this pertinent way: “How do we level the playing field to where all large financial institutions have similar capital” so that Fannie and Freddie do not have “lower standards than everybody else?”

The answer to this well-framed question is obvious: Give the government-sponsored enterprises the same capital requirement for mortgage risk that everybody else has. In short, the answer is 4%. This is the internationally recognized standard for mortgage risk, which represents virtually all of Fannie and Freddie’s assets. The FHFA should, in my view, immediately establish a minimum capital requirement for Fannie and Freddie of tangible equity equal to 4% of total assets.

Considering them on a combined basis, 4% of Fannie and Freddie’s assets of $5.5 trillion results in a required capital of $220 billion between the two of them. That is 22 times their current capital and $210 billion more capital than they’ve got right now.

Naturally, Fannie and Freddie cannot retain or raise any more capital while subject to the “profit sweep” to the Treasury, but let us suppose the senior preferred stock purchase agreements between the Treasury and the FHFA as conservator could be renegotiated. This outcome would not be unreasonable, since the Treasury now has an internal rate of return on its preferred stock investment of about 12% — which is pretty good — and much better than the original 10% agreement. On top of that, Treasury still has warrants to acquire 79.9% of Fannie and Freddie’s common stock at an exercise price of virtually zero (0.001 cents per share). That could be a nice pop for the taxpayers on top of the 12% average annual return.

As President Trump’s March 27 memorandum on housing finance reform makes clear, as part of any renegotiation, Fannie and Freddie will need to pay the Treasury for its ongoing credit support, implicit or otherwise. This should absolutely be required.

How much in fees should they pay? That is debatable, to be sure, but definitely not nothing. We might consider that the lowest rated banks on the FDIC’s deposit insurance fee table pay a range of 16 to 30 basis points of total liabilities per year for their government guarantee. Let’s give the critically undercapitalized Fannie and Freddie the benefit of the doubt and assume the lowest end of that range: a fee to the Treasury of 16 basis points.

What kind of return on equity could a Fannie and Freddie capitalized at 4% then expect? Here’s one estimate. Fannie and Freddie’s combined net profits for the first quarter of 2019 were $3.8 billion. That annualized is $15.2 billion — let’s call it $16 billion. Subtract from that the 16 basis point fee to the Treasury assessed on liabilities, which after tax would be $7 billion. Add the fact that they would have $210 billion more cash worth 2.5%, or approximately $4 billion, after tax. In sum, that gives $13 billion in net profit pro forma, or an ROE of about 6%. If the fee to Treasury were dropped to 10 basis points, the pro forma ROE would rise to a little over 7%.

That seems like a reasonable starting range. It compares to the 5-year average ROE of U.S. banks of 9.6%. From the 6% to 7% range, there are lots of actions in pricing, greater efficiency and improved methods for management to pursue. But running at hyper-leverage as in the old days and in the conservatorship days would not be possible. That would move the mortgage market toward the more competitive state that Calabria correctly envisions.

What should happen next? The FHFA should set a 4% capital standard for Fannie and Freddie. The Financial Stability Oversight Council should designate Fannie and Freddie as the “systemically important financial institutions” they so obviously are, treating them the same as others of their size. The Treasury should exercise as a gain for the taxpayers its warrants for their common stock, removing any uncertainty about the warrants.

When capital has become sufficient, the FHFA should end the conservatorships and implement regulation which ensures that Fannie and Freddie’s credit risk stays controlled and tracks how the more competitive, less GSE-centric mortgage system evolves.

Congress does not have to do anything in this scenario. That is good, because it is highly unlikely that it will do anything.

What Does the Fed Know that Nobody Else Knows?

Published in Law & Liberty and in the Federalist Society.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Colleges need to have skin in the game to tackle student loan debt

Published in The Hill.

Republican Senator Lamar Alexander of Tennessee rightly wants to make colleges more accountable for the results of student loans. With these federal loans, the government lends with no credit underwriting, the students get in debt, but who gets all the money? The colleges. If the students fail to repay the loans, who takes the hit? The taxpayers. This is a perverse incentive structure. It leads to, as his committee report found, “nearly half of all borrowers not making payments on their student loans.”

Alexander proposes a “new accountability system for colleges based upon whether borrowers are actually repaying their student loans.” Great idea! In a similar vein, the annual White House budget correctly observes a “better system would require postsecondary institutions that accept taxpayer funds to share in the financial responsibility associated with student loans.” Indeed, each college should share the risk of whether its students repay the money they borrowed and the college spent. Nothing improves your behavior like having to share in the risk you are creating. In his book “Skin in the Game,” Nassim Nicholas Taleb wrote, “If you inflict risk on others, and they are harmed, you need to pay some price for it.”

In student loans, with their abysmal repayment rate, colleges play the same role as subprime mortgage brokers did in the infamous housing finance bubble. They promote the loans without regard to how they might be repaid, they make money from the loans, and they pass all the risk on to somebody else. In the housing finance case, the risk went ultimately to the taxpayers. In the student loan case, it goes directly to the taxpayers. Just as the flow of easy mortgage credit induces higher house prices then takes even more debt to pay the higher price, the flow of easy student credit induces higher college prices then takes even more debt to pay the higher tuition. It is a sweet deal for colleges that create the risk, keep all the money, and stick the taxpayers with all the losses.

A Brookings Institution research paper points out that with low repayment rates, the federal student loan program represents a “sizeable taxpayer funded transfer” to the colleges. It rightly asks how much of the taxpayer losses the college should have to pay back. It proposes that each cohort of college borrowers be measured at the end of five years of required payments, and each college has to pay at least 25 percent of the amount by which the actual principal reduction has fallen short of 20 percent of the total of the original loans after five years. The 20 percent principal reduction results from what would happen with a 15 year amortization of the loan pool as the standard used. That seems perfectly reasonable.

This proposal is a good stab at it, but I would say do not wait for five years to address the problem. Do it every year. Take the total loan pool of each borrower cohort of the college. Establish a 15 year amortization schedule for the principal of the pool. Measure every year how much principal has actually been paid in the pool as a whole. Each year the college should pay to the Treasury, I suggest 20 percent of any repayment shortfall against the standard. That would be a steady financial feedback loop.

After 15 years, the college will have reimbursed taxpayers for 20 percent of whatever loan principal was not paid. Of course, taxpayers would still be paying for 80 percent of the losses. The 20 percent loss participation would be enough to give the college the right incentives to improve its repayment performance and control instead of constantly bloating the debt of its students. Student loan borrowers, like mortgage borrowers, are hurt being saddled with thousands of dollars in debt they cannot pay.

Colleges should have maximum flexibility for how to work on this. They could increase efficiency, reduce their costs and their prices, or shorten the time to graduation to scale back the need for borrowing. They should make sure the students understand what loans mean and how they are expected to repay, consider their ability to pay, guide the students to programs with the most promising job prospects for them, and adjust their mix of programs. They can do all of the above plus other ideas and managing the tradeoffs involved. Colleges should no longer play the role of subprime mortgage brokers. They need some skin in the game now.

Federal Lending to Insolvent Pension Plans Is Code for Bailout

Published in Real Clear Markets.

Here’s a remarkable lending opportunity to consider:  Let’s make billions of dollars in loans to borrowers which “are insolvent” or in “critical or declining status.”  These loans would be unsecured and no payments of principal would be due for 30 years.  At that point, in case of default, the loans would be forgiven.  Would you make such a loan?  Obviously not, and neither would anybody else—except maybe the government.   This idea is one only politicians could love, since it gives them a way to spend the taxpayers’ money without calling it spending.

Making such loans is proposed in a bill before the House Ways and Means Committee, entitled “Rehabilitation for Multiemployer Pensions Act” (HR 397). The borrowers would be multiemployer (union) pension funds which are deeply underfunded, insolvent in the sense of having obligations much greater than their assets, and won’t have the money to pay the benefits they have promised.  A more forthright title for the bill would be the “Taxpayer Bailout of Multiemployer Pension Funds Act.”

The bill’s primary sponsor, Congressman Richard Neal (D-MA), who is Chairman of the Ways and Means Committee, has stated, “This is not a bailout.”  But a bailout by any other name is still a bailout.  “These plans would be required by law to pay back the loans they receive,” said Chairman Neal.  But the bill itself provides on pp.18-19:

          “(e) LOAN DEFAULT.—If a plan is unable to make any payment on a loan under this section when due, the Pension Rehabilitation Administration [PRA] shall negotiate with the plan sponsor revised terms for repayment, which may include…forgiveness of a portion of the loan principal.”

No limit is set on how big the “portion” may be.  Why not 100%?  Of course, all loans of all kinds are in principle required to be repaid, but are nonetheless not repaid if the borrower becomes insolvent, and pension funds demonstrably can go broke like anybody else.  As one actuary recently observed, “It seems very likely that the default rate on PRA loans will be significant.”  Indeed it does.

It is highly convenient for the politicians that under the bill no default on principal repayment could occur by definition until the balloon payment in 30 years.  Assuming defaults start to occur in 2050, a member of Congress who is now 60 years old would be 91, if still living.  “I’ll gladly pay you Tuesday for a hamburger today,” said the instructive cartoon character, Wimpy.  Likewise, “We’ll gladly pay in 30 years for a bailout today” is a natural human response to financial failure.

Chairman Neal said that with his bill, “The federal government is simply backstopping the risk.”  But the federal government is already backstopping the risk of these pension plans through its implicit guarantee of the Pension Benefit Guaranty Corporation (PBGC). 

How has that worked out?  The PBGC’s insurance program for multiemployer pension funds is itself broke.  Its net worth is a negative $54 billion, according to the PBGC’s 2018 annual report.  The net position of $54 billion in the hole is composed of total assets of only $2.3 billion and liabilities of $56 billion, thus the liabilities are 24 times the assets.  Since PBGC’s accounting only takes into account the budget window, its long term position is even worse.

So it is not a surprise that by the time you get to the last paragraph on the last page of the bill, you find it also includes a bailout of the PBGC’s failing multiemployer program:

     “(b) APPROPRIATIONS.—There is appropriated to the Director of the Pension Benefit Guaranty Corporation such sums as may be necessary for each fiscal year.” 

These sums are for direct financial assistance from the PBGC to “critical and declining” and “insolvent” multiemployer pension plans.  There is virtually no limit to the amount (“such sums as may be necessary”) or the time (“for each fiscal year”) of these appropriations.  They are for sending cash in addition to the loans from the bill’s proposed Pension Rehabilitation Administration.  Also on its last page, the bill provides that the PBGC “shall not require the financial assistance to be repaid before the date on which the [PRA] loan…is repaid in full.”  That may be never.  The Congressional Budget Office estimated the probable taxpayer cost of a similar previous bill at more than $100 billion.

In theory and under its Congressional charter, the PBGC was supposed to be a financially stand-alone, actuarially sound insurance company, not guaranteed by the government and never needing any appropriated funds.  As its annual report says, “PBGC receives no funds from taxpayer dollars.”  Not yet, anyway.  The PBGC has always had an implicit guaranty from the U.S. Treasury, and we can once again observe that implicit government guarantees tend to become bailouts.

In short, the bill is a convoluted way to a simple end: to have the taxpayers pay the pensions promised but not funded by the multiemployer plans.  If enacted, the bill will encourage other plans to make new unfunded promises in the very logical expectation of future additional bailouts.

To adapt a famous line of the great philosopher and economist, David Hume, “It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London than to give a politician the ability to guarantee pension plans.”

Thoughts on the Source of International Economic Advantage

Published in Real Clear Markets.

What are the possible sources of America’s international economic advantages and success at creating a superior standard of living for its people?  Each fundamental factor of production gives rise to a potential competitive advantage.  According to the classic list of Adam Smith, these factors are Land, Labor and Capital.  A more compete list would contain five fundamental factors:

1.       Natural Resources

2.       Labor

3.       Capital

4.       Knowledge

5.       Social Infrastructure.

In the revised list, Natural Resources is a more general version of Land.  Labor must be understood to include the essential element of education, as well as a crucial kind of labor: that of the entrepreneur.  Capital is what allows risks to be taken and economic growth to accumulate.  Knowledge most importantly means science and its offspring, technology of all kinds.  Knowledge also includes knowing how to manage large, complex organizations.  Social Infrastructure means the laws, property rights, financial practices, enforcement of contracts, culture friendly to enterprise, the lack of stifling or corrupt bureaucracy, and the essential political stability that together allow markets, including financial markets, to function well.

Historically, America had important advantages in all five fundamental factors, leading to its establishment by 1920, a hundred years ago, as the dominant economy in the world.  But global development, a very good thing for mankind in general, makes it harder to maintain America’s former advantages.  This suggests the U.S. political economy will be continuingly challenged at how to provide higher pay than elsewhere in the world—otherwise known as a higher standard of living.  It means we have less room than before for subsidizing political drag.

In the global competition of the ongoing 21st century, America no longer has as great an advantage as it previously did in the first four factors, but a continuing and central advantage in the fifth.  This advantage, however, can be weakened by unwise politics and bureaucracy.

Let us consider each of the factors in turn in a globalized world.

1. Natural Resources.  Commodities trade actively in world markets, move among countries with very low transportation costs, historically speaking, and are available almost everywhere.  Being a natural resources-rich country, as the U.S. is, matters less than before.  For example, making Land more productive by the scientific agriculture of the 19th century, as symbolized by the institution of land grant colleges, and by the continuing advances in agricultural science since then, is available everywhere in the world.

2. Labor.  The great historical revolution of public education has spread around the world, while the struggles of large parts of U.S. public education are well known.  The ability to organize and manage large, capital-intensive enterprises to make labor productive has also spread around the world.  Large pools of educated, technically proficient labor are increasingly available, notably in China and India.  Napoleon thought China a sleeping giant and recommended not waking it up.  Now we have two giants awake, as well as other countries, with increasingly educated labor.  If America wants to provide higher pay than they do for work with the same level of education, this must be based on a different fundamental advantage.

3. Capital.  Capital is essential to all risk-bearing, economic growth and productivity.  Savings available for investment as capital now flow quickly around the world, seeking and finding the best opportunities wherever they may be.  While capital is raised and employed in huge amounts in the U.S., we are not the leaders in savings.

4. Knowledge.  The incredible economic revolution of the last 250 years, or modernization, which empowered first Britain, then Western Europe and America with vast leadership advantages, has as its most fundamental source science based on mathematics.  Scientific Knowledge, turned to technology and harnessed to production by entrepreneurial energy, then matched with learning how to manage large organizations, created the modern world.  Mathematical science began as a monopoly of Europe and America, but is now the most cosmopolitan of human achievements.  America has world-leading research capabilities, including top research universities, but Knowledge is now available everywhere and incorporated into international scientific endeavor.

5. Social Infrastructure.  The political stability, clear property rights and safety of America have long served to attract investment as a safe haven and supported the role of the U.S. dollar as the dominant reserve currency.  By designing a stable political order which continued to work for an extremely large republic, the American Founding Fathers also created a powerful economic competitive advantage.  This advantage was augmented when Europe destroyed itself in the First World War, and New York replaced London as the center of world capital markets, and when Europe again destroyed itself in the Second World War.  This key advantage continues and helps explain how the U.S. can finance its continuous trade and budget deficits.  It may be an “exorbitant privilege” as viewed from France, but it is one earned by superior Social Infrastructure.

As John Makin instructively wrote a decade ago, “The fact that global savers accommodate U.S. consumers…is simply a manifestation of America’s competitive advantage at supplying wealth management services.”

This advantage in wealth storage, reflecting an advantage of Social Infrastructure, yields not only economic, but also large political and military benefits.  But no competitive strength is incapable of being lost over time, as former world economic leader Britain found out.  The strongest advantages can be weakened by political, bureaucratic, legal and regulatory drag.  The constant effort to maintain these advantages also maintains the ability to pay more for work than other countries do.

President makes the smart call for reforming housing finance system

Published in The Hill.

In a recent White House memorandum, President Trump said, “It is time for the United States to reform its housing finance system.” He is right about that. He is also right about principal elements of reform, as listed in the memorandum, notably reducing taxpayer risks, expanding the role of the private sector, establishing “appropriate” capital requirements for Fannie Mae and Freddie Mac, providing that the government is properly paid for its credit support of Fannie and Freddie, facilitating competition, addressing the systemic risk of Fannie and Freddie, defining what role they should have in multifamily mortgage finance, and terminating their conservatorships only when the other reforms are put in place.

In all this, the Treasury is instructed to distinguish between what can be done by administrative action and what would require legislation. This seems to set the stage for carrying out the former, even if Congress cannot agree on the latter, which it probably cannot. The memorandum provides that for “each administrative reform,” the Treasury housing reform plan will include a “timeline for implementation.” This timetable instruction represents a pretty clear declaration of intent to proceed.

Needless to say, the general directions can only be implemented after being turned into specifics. While that seems impossible for Congress to agree on, the executive branch can define the specific administrative actions it wishes to take. As the administration comes to decisions about the details, is there an appropriate model to consider for Fannie and Freddie? Is there some way to simplify thinking about the issues they present, which entails swarms of lobbying interests?

I think there is. The model should be too big to fail and systemically important financial institutions. Fannie is bigger than JPMorgan Chase. Freddie is bigger than Citigroup. There is no doubt Fannie and Freddie remain too big to fail. They are an essential point of vulnerability of American residential mortgage finance, the biggest credit market in the world except for Treasury debt. Should they implode, the government will again rush to the rescue of their global and domestic creditors.

Vast intellectual and political efforts have gone into lowering the odds that too big to fail banks will need bailouts or generate systemic crisis. We need to apply the results of that effort to Fannie and Freddie, which now run with virtually no capital. But before the crisis, they already ran at extreme leverage. Indeed, they leveraged up the whole housing finance system, making the system, as well as themselves, much riskier.

What about their capital requirements? Following our model, simply apply the risk based capital standards of systemically important banks to Fannie and Freddie. The same risks need the same capital, no matter who holds them. Fannie or Morgan? Freddie or Citi? The same risk and the same risk based capital. This would result in a required capital for the two on the order of $200 billion, or about $190 billion more than they have.

How much should they pay the government for its credit support? The same as the too big to fail banks pay. For them, this is called a deposit insurance premium. For Fannie and Freddie, you could call it a credit support fee, which would replace the profit sweep in their deal with the Treasury. Deposit insurance fees are assessed on total bank liabilities. Apply the same to Fannie and Freddie credit support fee and at the same level as would be required for a giant bank of equivalent riskiness.

I estimate this would be about 0.18 percent per year, but recommend the administration ask the Federal Deposit Insurance Corporation to run its big bank model on Fannie and Freddie and report on what level of fee results. Note that the Treasury stands behind the Federal Deposit Insurance Corporation, just as it stands behind Fannie and Freddie.

With such a serious amount of capital, Fannie and Freddie would need to charge guarantee fees that would allow greater competition in the private sector. This would be consistent with the law, which requires that their guarantee fees be set at levels that would cover the cost of capital of private regulated financial institutions. If they have the same risk based capital requirement, then that should follow for Fannie and Freddie.

With $200 billion in capital and a credit support fee of 0.18 percent, I estimate that Fannie and Freddie could sustain a return on total capital of 8 percent or so, which is quite satisfactory. The Treasury should exercise its warrants for about 80 percent of their common stock to share in this return until Treasury sells the stock, which will generate a large gain for the taxpayers. It seems to me that virtually all of this might be done by administrative action. Let us hope the administration will proceed apace.

The Inescapably Political World of Banking and Finance

Published in Law & Liberty.

Banking always involves political economy, as professor Mark Rose observes, or as we might more precisely say, political finance. This is the central lesson of Rose’s Market Rules. The book nicely shows how banking and politics have been constantly intertwined in the United States over the 50 years beginning in the 1960s, as much bigger banks have been created and the banking system has consolidated. (Although today there are 5,477 banks and savings associations in the United States, in 1950 there were 19,438.)

The book’s anecdotes of forceful personalities of American banking history, both those in the business and those in government during the times it covers, are engaging, at least to those of us in the trade, and fun to read. In addition, its theme has much broader application than the text suggests: namely to all countries in all times. As banking scholars Charles Calomiris and Stephen Haber have concluded, all banking systems reflect deals between bankers and politicians, which they call “the Game of Bank Bargains.” The study of this idea in their book, Fragile by Design—The Political Origins of Banking Crises and Scarce Credit(2014), covers a number of countries in detail and a long history going back to the 17th century. This gives us a wider framework in which to view the arguments and events related by Rose and reinforces his local variations on the theme that banking is politically entwined.

However, unlike Fragile by Design, don’t read Market Rules for economic or financial concepts or for careful economic or financial arguments. They aren’t there. Likewise, don’t read it for theoretical insights into politics or banking systems. Its discussion of political finance is journalistic, with a left-of-center slant. The book displays a pronounced bias against markets and competition, repeatedly dismissing them as “market talk.” “Citing markets” is characterized as a “rhetorical obsession.” There is throughout a positive bias for governments and for government control.  Discussing the financial crisis bailouts, for example, Rose reflects that “For that moment at least, government authority and prestige were in the ascendance”—just the way he likes it. Still, the book’s rendition of banking debates and developments is interesting and useful, describing how the economically critical banking sector evolved over five decades.

A more balanced view of banks and governments than the book conveys would stress that both banks and governments are made up of human beings, and that both demonstrate the aspirations, insights, and achievements always mixed with the failures, mistakes and hypocrisy natural to mankind. We should not be surprised that these same attributes appear in their interaction and the deals they make with each other. Moreover, both banks and governments often make big mistakes at forecasting the economic and financial future and cannot know what the long-term results of their own actions will be.

We naturally observe this mix of strengths and weaknesses in all parties in the course of banking history. Nothing human is perfect, or even close. The pursuit of profit, subject to competition and innovation, will on average get much better economic results for the people than will the pursuit of bureaucratic power using the government’s monopoly of force and coercion. Rose is right, however, that in banking we always find some combination of the two.

Market Rules brings out in what remarkable fashion banking times and ideas change, and how what seems like a great issue at one point, becomes difficult to remember at some later point. In discussing the Hunt Commission, appointed by President Richard Nixon to consider how to improve the American financial system, the book says:

Hunt and his commissioners determined not to explore in detail the boldest question of all, which is whether the nation needed a separate and distinct group of S&Ls [savings and loans] and another group of separate and distinct commercial banks.

That was the boldest question of all? It seems hard for us to believe, but in 1970, the S&Ls were a political force to be reckoned with. They had their own powerful trade association, the U.S. League for Savings, and their own cheerleading regulator, the Federal Home Loan Bank Board. Those names are probably unfamiliar, because both have long since disappeared and been merged into the respective banking organizations. Of course, at the time of this debate, the 1980s collapse of the S&L industry was more than a decade in the future.

The Hunt Commission did propose numerous reforms, but “criticism of Hunt’s report arrived hard and fast,” Rose relates. One of the commissioners arose “to denounce the ‘blurring of distinctions between financial institutions.’” “Blurring of distinctions” hardly sounds like a stirring battle cry, or even a clear thought, but since it really meant “protect me from competition,” it was.

A similar thought arose in the 1990s: “Large and small bankers alike feared that insurance companies like State Farm would purchase a thrift [S&L] charter and use it to offer bank services.” In Rose’s phrase, this was a “horrifying prospect.” By now, State Farm has operated its S&L, which is called State Farm Bank, for two decades. I have an account there. It doesn’t seem too horrifying.

Another big battle of past years was that over the then well-known “one-quarter point.” To any readers under the age of 50: does that mean anything to you? Probably not. The context is that in the 1960s and 1970s, the U.S. government practiced national price fixing for the interest rates that banks and S&Ls could pay on deposits. The point of this 1930s idea was to limit competition, so that deposit banking was a cartel with the government as cartel manager. The “quarter point” meant that the price fixing rules allowed the maximum rate the S&Ls could pay to be 0.25 percent higher than what commercial banks could pay their depositors.

As the book relates, “Insiders knew the government’s ability to determine interest rates paid to savers by its official name, the Federal Reserve’s Regulation Q,” commenting that it was “curiously named.” So it was, but famous in banking at the time. I well remember an old banking lawyer explaining to me that “Reg Q,” as it was called, was a permanent and unchangeable part of the American banking system. A bad prediction, as it turned out, since Reg Q has now disappeared from the memory of all but financial historians. Nonetheless it was a big deal in its day.

The book further explains: “In 1966, President Johnson and the Congress approved the Interest Rate Control Act, which authorized S&L executives to pay a higher rate of interest to savers than banks paid them. Nervous S&L officers had urged this action.” Rose does not mention that they had urged it because the government’s interest-rate fixing had brought on the Credit Crunch of 1966. “Federal Reserve officers in turn approved a 0.25 percent differential.” Then S&Ls were “passionate in defending the regulation…as a vital protection to their firms and to American home construction.”

Passionate? Vital? A quarter-point? Reg Q? Times change.

One of the most instructive examples of intertwined finance and government is the history of Fannie Mae and Freddie Mac. Fannie and Freddie played a large role in inflating the disastrous housing bubble of the 2000s. The most important thing about them is that they were government-sponsored, government-promoted and government guaranteed, while having their stock privately owned—a fundamental conflict which turned out to have bankrupting results. Fannie and Freddie were known by the acronym, “GSEs,” for “government-sponsored enterprises.” In 2008, they also became majority government-owned.

But in its less than one-page treatment of them, Market Rules describes Fannie and Freddie as “privately owned firms,” without mentioning their GSE status or the tight political connections and political clout they enjoyed in their glory days. Fannie was a Washington bully, including attacking the individual careers of those who dared to criticize or oppose them, and inspired genuine fear. James Johnson, its 1990s CEO and a highly influential political insider and operator, presided over a huge institution which seemed at the time an unstoppable colossus, both financial and political. Although he is a most impressive example of its main thesis, he rates not even a mention in the book.

Many other interesting characters do appear. Featured roles are given to James Saxon, William McChesney Martin, Wright Patman, Walter Wriston, Arthur Burns, Bill Simon, Hugh McColl, Don Regan, Gene Ludwig, Robert Rubin, Phil Gramm, Sandy Weill, Paul Volcker. If you are interested in political finance but you don’t know who all these gentlemen are, you should. Also appearing is a whole series of U.S. presidents from John Kennedy on.

Of everybody in this history, my favorite is James Saxon, the comptroller of the currency from 1961-1966, who on Rose’s telling got the whole ball rolling of introducing more competition into a financial system previously designed to suppress competition.

“Saxon, often intemperate in his public language,” Rose writes, “asserted that investment bankers’ control of revenue bonds constituted a ‘full-fledged monopoly.’” To be exact, it was an oligopoly, but of course Saxon was basically right.

“In March 1964, Saxon told members of the Senate Banking Committee that the Federal Reserve’s regulation of the interest rates that banks paid savers amounted to price fixing.” Rose comments primly, “Presidential appointees did not speak in that fashion about the Federal Reserve.” My reaction is, “Saxon was absolutely right!”

Being right may not be popular: Saxon “had thrown state-chartered bankers into a more competitive environment, which they resisted.” And Saxon had “encouraged powerful enemies” who demanded his ouster. Rose does not like him either and writes with satisfaction of how President Lyndon Johnson declined to reappoint him in 1966, so that “Saxon returned to anonymity.” Like we all do, but it seems to me he had a great run.

In conclusion, as this book illustrates with lots of examples, political finance it is.

When my successor as president of the Federal Home Loan Bank of Chicago asked me for advice, I told him, “Remember that this job is 50 percent banking and 50 percent politics.” That seems to sum it up.