Pity FOMC Members Trying to Divine a Future They Can’t Know

Published in Real Clear Markets.

Pity the poor members of the Federal Open Market Committee! These Federal Reserve Board Governors and Federal Reserve Bank Presidents all know in their hearts, for sure, each one, that they do not and cannot know the financial and economic future—that they do not and cannot know, among other things, how bad the current hot inflation is going to get, or how long it will last.

Yet they are forced to make forecasts and statements published all over the world about things they cannot know.  Their statements move markets and influence behavior, so they have to guess and worry about not only about what will happen, but about what others will do based on what they say.  They cannot know for sure what the results of their own actions will be, or what actions others will take, no matter how sincerely they try to make their best guesses.  And of course, they have to worry about what the politicians will say or demand.

How seriously should we take the Fed’s forecasts?  Last December, they projected inflation for 2021 at 1.8%.  Half way through the year, this looks to have been wildly wrong.  The rapid inflation of 2021, with the Consumer Price Index increasing year to date at well over 6% annualized, clearly surprised them. I am speaking of the inflation as experienced only in 2021, with no comparison to the crisis time of 2020 or “base effect.”  You might say this was a blind side hit on the FOMC quarterbacks.

On June 16, FOMC members upped their guess for this year’s inflation to 3.4%–an 89% increase in their expected inflation rate, best thought of as the rate of depreciation in the dollar’s purchasing power, of your wages and of your savings.  This revised expectation came with an essential hedge: “Inflation could turn out to be higher and more persistent than we expect”– a sensible and true statement by Fed Chairman Powell.

Powell also made this sound observation: “We have to be humble about our ability to understand the data.”  Just like the rest of us!  But the rest of us are not assigned a part in the public drama of the FMOC.  “All the world’s a stage,” but the FMOC is an especially challenging stage.  The Fed is no better at economic and financial forecasting than anybody else, but the show must go on.

The FMOC continues to characterize the current high inflation as mostly “transitory.”  Well, paraphrasing J.M. Keynes, we may observe that in the long run, everything is transitory.  In the process of transitioning, a lot can happen.  FMOC members are now hoping and making estimates for inflation to fall back to around 2% by the end of 2022—a long forecasting way away.  There is a self-referential problem here: what inflation does depends on what the FOMC does. So the poor FOMC members must forecast their own behavior under future, unknown circumstances.

In particular, future inflation depends on whether the Fed keeps up its historic, giant monetization of government debt and mortgages, and on how big it bloats its own balance sheet, already over $8 trillion as of this week.  At its June meeting, the FMOC gave instructions to keep up the big buying, including buying more mortgages at the rate of $480 billion a year.

Consider that the housing market is in the midst of a runaway price inflation.  By March, using the Case-Shiller Index, house prices were up by 13% year over year.  The most current data indicates, according to the AEI Housing Center, house price inflation now running at over 15%.  Yet the Fed continues to stimulate and subsidize a market which is already red hot.  One is hard pressed to imagine any remotely plausible excuse for that.

We have to wonder what the poor FOMC members must feel in their own hearts about this issue.  Do they really believe in some rationale?  Is it a case of “We easily believe that which we wish to believe,” as Julius Caesar said?  Or in their private hearts, are the FOMC members only voting “yes” for monetizing more billions of mortgages with serious mental reservations and doubts?  I have to believe the latter is the case, but suppose we won’t know until their memoirs are published.

Meanwhile, the members of the FOMC are like the airmen in the old World War II song, “Comin’ in on a wing and a prayer!”  They have no alternative to that, so we must all wish them good luck.

A New Inflationary Era

Published in Law & Liberty.

In this provocative but calmly argued book, The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan predict a new era of widespread and lasting inflation. Goodhart, who has been a respected expert in financial, monetary, and central banking issues for decades, and Pradhan, a macroeconomist who studies global financial markets, express as their “highest conviction view” that “the world will increasingly shift from a deflationary bias to one in which there is a major inflationary bias.”

This conviction reflects their “main thesis” that “demographic and globalization factors were largely responsible for the deflationary pressures of the last three decades, but that such forces are now reversing, so the world’s main economies will, once again, face inflationary pressures over the next three or so, decades.”

The demographic factors include the end of the “positive supply shock” to the global supply of labor provided by China over the previous decades. That is because “China’s working age population has been shrinking, a reflection of its rapidly aging population,” and “the surplus rural labor supply no longer provides a net economic benefit through [internal] migration.” Thus, “China will no longer be a global disinflationary force” and it “no longer stands in the way of global inflation.”

A second key factor is that birth rates around the world continue to decline and longevity to increase, furthering the aging of society and increasing dependency ratios. In this context, the authors point out that the average fertility rate in advanced economies has fallen to well below replacement. This includes the U.S. For the foreseeable future, there will be an ever-lower ratio of active workers to the dependent elderly, with the huge expense of support and health care for the elderly stressing government budgets. They add this striking thought: “Our societies today are still relatively young compared to what is to come.”

These are longer-term, not short-term movements. The implication is that we may envision a slow, great cycling over decades of inflationary and disinflationary or deflationary periods. The 2020s swing to inflation would mark a great cycle reversal, with perhaps a book like The Death of Inflation of 1996 symbolizing the previous reversal.

In a different estimate of the duration of the coming inflationary era, Goodhart and Pradhan make it somewhat shorter: “The coronavirus pandemic… will mark the dividing line between the deflationary forces of the last 30-40 years, and the resurgent inflation of the next two decades.” But whether it’s two or three decades, the authors expect two or three decades, not two or three years, of significantly higher inflation.

The effects of such an inflation would be, they write, “pervasive across finance, health care, pension systems and both monetary and fiscal policies,” and they surely would be. For example, they suggest, “It will no longer be possible to protect the real value of pensions from the ravages of inflation.” Nominal interest rates will be higher, but “Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate,” so “negative real interest rates… will happen.” Here they should have written, “will continue,” since we already have negative real interest rates, the yield on the 10-year U.S. Treasury note now falling short of the year-over-year inflation rate.

Further, “The excessive debt amongst non-financial corporates and governments will get inflated away.” In other words, governments will implicitly default on their bloated debt through inflation, a classic strategy. Of the three alternatives the book cites for reducing excess debt, “inflation, renegotiation and default,” inflation is the easiest for a government with debt in its own currency.

As the authors say, “neither financial markets nor policymakers are prepared” for such an inflationary future world.

In a final chapter written in 2020, Goodhart and Pradhan conclude that the government deficits and debt created in response to the coronavirus pandemic have reinforced and accelerated the coming inflationary era. Government-mandated quarantines and lock-downs were “a self-imposed [negative] supply shock of immense magnitude.” To finance it, “the authorities quite rightly opened the floodgates of direct fiscal expenditures,” in turn financed by escalating debt and monetization.

“But,” they logically ask, “what then will happen as the lock-down gets lifted and recovery ensues”—as is now well under way—“following a period of massive fiscal and monetary expansion?” To this question, “The answer, as in the aftermaths of many wars, will be a surge in inflation.”

Directionally, I think this is a very good forecast. We are already seeing it play out in the first months of 2021.

How much inflation might there be? They suggest the inflation numbers will be high: “quite likely more than 5%, or even on the order of 10% in 2021.”

Is 5% inflation possible? Well, the U.S. Consumer Price Index rose from December 2020 to April 2021 at the annualized rate of 6.2% when seasonally adjusted, and 7.8% when not seasonally adjusted. Signs of increasing inflation are widespread.

It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

How about that 10%? Could we really go to a 10% inflation? It has happened before. The U.S. has been at 10% inflation or more in 1917-20, 1947, 1974, and 1979-81. Most of these followed inflationary financing of wars, but the fiscal deficits and money printing of late are as great as during a war.

The authors proceed to the question of “What will the response of the authorities then be?” and offer this prediction—made in 2020: “First and foremost, they will claim that this a temporary and one-for-all blip.” We already know that this prediction was correct.

Overall, is this theory of a new inflationary era plausible? It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

Speaking of the central bankers, Goodhart and Pradhan observe something important: “In recent decades Central Banks have been the best friends of Ministers of Finance [and Secretaries of the Treasury], lowering interest rates to ease fiscal pressures and to stabilize debt service ratios.” But what will happen “when inflationary pressures resume, as we expect”? Will the relationship become more tense or even hostile? To put it another way, might the disputes of 1951 between the U.S. Treasury and the Federal Reserve be re-played and the celebrated “Accord” between them come out in the opposite way: with the central banks more subservient? “Inevitably,” the authors rightly say, “central banks have to be politically agile.”

The book interestingly comments on an implied cycle in the standing of macroeconomics and macroeconomists. How credible are their pronouncements and forecasts? “From the Korean War until about 1973 was a transient golden age for macroeconomics.” The 1960s featured the misplaced confidence of macroeconomists that they could “fine tune the economy,” and control inflation and employment using the “Phillips Curve” they believed in. Sic transit gloria: “It all then went horribly wrong in the 1970s,” when they got runaway inflation and high unemployment combined. And “the second golden period for macroeconomics (1992-2008) [also] went horribly wrong.” That time the announcements of the “Great Moderation,” which central bankers gave themselves credit for, turned into a Great Bubble and collapse. The golden macroeconomic ideas of one era may seem follies to the next.

If the new inflationary era predicted by Goodhart and Pradhan becomes reality, the follies of the present will seem blatant. Should we adopt their “highest conviction” that this inflationary era is on the way? In my view, the economic and financial future is always wrapped in fog, but their argument is well worth pondering and entering into our considerations of the biggest economic risks ahead.

The Many Faces of Government Default

Published in Law & Liberty.

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

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

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

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

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

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

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

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

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

6. 1862, 1933, 1968, 1971

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

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

6. The United States.

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

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

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

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

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

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

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

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

The Oversight Board Keeps Working On Puerto Rico’s Record Insolvency

Published in Real Clear Markets.

The government of Puerto Rico continues to hold the all-time record for a municipal insolvency, having gone broke with over $120 billion in total debt, six times as much as the second-place holder, the City of Detroit.

Faced with this huge, complex, and highly politicized financial mess, and with normal Chapter 9 municipal bankruptcy legally not available, the Congress wisely enacted a special law to govern the reorganization of Puerto Rico’s debts. “PROMESA,” or the Puerto Rico Oversight, Management, and Economic Stability Act, provided for a formal process supervised by the federal courts, in effect a bankruptcy proceeding.  It also created an Oversight Board (formally, the Financial Oversight and Management Board for Puerto Rico) to coordinate, propose and develop debt settlements and financial reform.  These two legislative actions were correct and essential. However, the Oversight Board was given less power than had been given to other such organizations.  The relevant models are notably the financial control boards of Washington DC and New York City and the Emergency Manager of Detroit, all successfully called in to address historic municipal insolvencies and deep financial management problems.

It was clear from the outset that the work of the Puerto Rico Oversight Board was bound to be highly contentious, full of complicated negotiations, long debates about who should suffer how much loss, political and personal attacks on the Board and its members, and heated, politicized rhetoric.  And so it proved to be.  Since the members of the Oversight Board are uncompensated, carrying out this demanding responsibility requires of them a lot of public spirit.

An inevitable complaint about all such organizations, and for the Puerto Rico Oversight Board once again, is that they are undemocratic.  Well, of course they are, of necessity, for a time. The democratically elected politicians who borrowed beyond their government’s means, spent the money, broke their promises, and steered the financial ship of state on the rocks should not remain in financial control.  After the required period of straightening out the mess and re-launching a financial ship that will float, normal democracy returns.

It is now almost five years since PROMESA became law in June, 2016.   It has been, as it was clear it would be, a difficult slog, but substantial progress has been made.  On February 23, the Oversight Board announced a tentative agreement to settle Puerto Rico’s general obligation bonds, in principle the highest ranking unsecured debt, for on average 73 cents on the dollar.  This is interestingly close to the 74 cents on the dollar which Detroit’s general obligation bonds paid in its bankruptcy settlement.   If unpaid interest on these bonds is taken into account, this settlement results in an average of 63 cents on the dollar.  In addition, the bondholders would get a “contingent value” claim, dependent on Puerto Rico’s future economic success—this can be considered equivalent to bondholders getting equity in a corporate reorganization–very logical.

The Oversight Board has just filed (March 8) its formal plan of adjustment.  It is thought that an overall debt reorganization plan might be approved by the end of this year and that the government of Puerto Rico could emerge from its bankrupt state.  Let us hope this happens.  If it does, or whenever it ultimately does, Puerto Rico will owe a debt of gratitude to the Oversight Board.

We can draw two key lessons.  First, the Oversight Board was a really good and a necessary idea.  Second, it should have been made stronger, on the model of previous successes.  In particular, and for all future such occasions, the legislation should have provided for an Office of the Chief Financial Officer independent of the debtor government, as was the case with the Washington DC reform.  This was highly controversial, but effective. Any such board needs the numbers on a thorough and precise basis.  Puerto Rico still is unable to get its audited annual reports done on time.

A very large and unresolved element of the insolvency of the Puerto Rican government remains subject to a debate which is important to the entire municipal bond market.  This is whether the final debt adjustments should include some reduction in the almost completely unfunded government pension plans.  Puerto Rico has government pension plans with about $50 billion in debt and a mere $1 billion or so in assets.

There is a natural conflict between bondholders and unfunded pension claims in all municipal finance, since not funding pensions is a back door deficit financing scheme.  General obligation bonds are theoretically the highest ranking unsecured credit claims, and senior to unfunded pensions.  But the reality is different.  De facto, reflecting powerful political forces, pensions are the senior claim.  Pensions did take a haircut in the Detroit bankruptcy, but a significantly smaller one than did the most senior bonds.  In other municipal bankruptcies, unfunded pensions have come through intact.

What should happen in Puerto Rico?  The Oversight Board has recommended modest reductions in larger pensions, reflecting the utter insolvency of the pension plans.  Puerto Rican politicians have opposed any adjustment at all.  Bondholders of Illinois: take note of this debate.

I suggest a final lesson:  the triple-tax exemption of interest on Puerto Rican bonds importantly contributed to its ability to run up excess and unpayable debts.  Maybe there was a rationale for this exemption a hundred years ago.  Now Puerto Rico’s bonds should be put on the same tax basis as all other municipal bonds.

Inflation Comes for the Profligate

Published in Law & Liberty.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.