How the Fed’s 2008 mortgage experiment fueled today’s housing crisis

Published in The Hill with Paul H. Kupiec.

How should Congress assess the Federal Reserve’s track record as an investor in residential mortgage-backed securities (MBS)?  Regardless of Fed spin, it merits a failing grade. 

The Fed’s COVID-era intervention in the mortgage markets fueled the second real estate bubble of the 21st century. The bubble ended when the Fed stopped purchasing MBS and raised rates to fight inflation. While time will tell whether recent increases in home prices are reversed, the end of the bubble has already cost the Fed over $400 billion in losses on its MBS investments.

From 1913 until 2008, the Fed owned precisely zero mortgage-backed securities. While the Fed’s monetary policy decisions still impacted conditions in the housing and mortgage markets, they did so indirectly through the influence the Fed’s purchases and sales of Treasury securities had on market interest rates. 

In a radical “temporary” policy response to the 2008 financial crisis, the Fed began intervening directly in the mortgage market. Through a series of MBS purchases, the Fed’s MBS portfolio ballooned from $0 to $1.77 trillion by August 2017. The Fed subsequently altered policy and slowly reduced its MBS holdings. By March 2020, it held about $1.4 trillion in MBS.

When the COVID crisis hit in March 2020, the Fed decided to reinstate its 2008 financial crisis rescue plan. It resumed purchasing MBS as well as Treasury notes and bonds. By the time it stopped its purchases in the spring of 2022, it owned $2.7 trillion in MBS. The Fed had become the largest investor in MBS in the world. By spring 2022, it owned nearly 22 percent of all 1-to-4 family residential mortgages in the U.S. By Sept. 30, the date of the last available quarterly Fed consolidated financial statement, the Fed had lost $438 billion on its MBS investments. These losses will increase if the fight to subdue inflation requires still higher interest rates.

Because most buyers borrow 80 percent or more of the purchase price of a home, house prices are sensitive to the level of mortgage interest rates. Low mortgage rates increase the pool of potential buyers, stimulating housing demand. If the interest rate stimulus is overdone, excess demand will push up home prices. High mortgage interest rates have the opposite effect. They dampen demand, dissipate upward pressure on home prices, and in some cases, lead to home price declines. 

As one might predict, the Fed’s massive MBS purchases coincided with large reductions in mortgage interest rates. During the Fed’s COVID MBS purchase campaign, the national average 30-year mortgage interest rate fell to a low of 2.65 percent in January of 2021. Today, with the Fed’s campaign of higher interest rates to battle inflation, 30-year mortgage interest rates are hovering around 7 percent. This change in the mortgage interest rate alone would cause monthly principal and interest payments on a same-sized mortgage loan to increase by 65 percent.

Predictably, the decline in mortgage interest rates stimulated housing demand and pushed up home prices. Government statistics report that, from January 2018 to this January, the median new home price in the United States rose from $331,800 to $467,700 — an increase of 41 percent. Interestingly, from January 2018 through March 2020, before the Fed renewed its MBS purchases, the median price of a new house actually declined to $322,600. From April onwards, the national median house price rose steadily, reaching a peak of $468,700 by the end of June 2022.

In 2018, purchasing a new median-price home with 20 percent down and the then prevailing average 30-year mortgage rate of 3.95 percent required $1,259 in monthly principal and interest payments. In January, purchasing the $467,700 median-priced new home with 20 percent down required monthly payments of $2,360 given the 6.48 percent rate on a 30-year mortgage. In only 5 years, because of house price inflation and higher mortgage interest rates, the monthly principal and interest payment needed to purchase a median-priced new house increased by 87 percent!   

The Fed’s foray into the MBS market will have a long-lasting impact on real estate markets. Not only has demand for homes been softened by home price inflation and 7 percent mortgage rates, but current homeowners with favorable mortgage interest rates are reluctant to sell, reducing the inventory of homes available for sale in a market that is already starved for listings. This unfavorable balance is clearly reflected in the National Association of Realtors housing affordability index which has fallen from a cyclic high of 180 in July 2021, to recent readings below 100, indicating affordability challenges not seen since the double-digit mortgage interest rates of the 1980s.

The end of Fed MBS purchases and the increase in Fed policy rates have put an end to the COVID housing bubble. While home prices are showing declines in some areas, prices in other areas remain elevated due to historically low inventories of homes for sale and strong job markets.

Any realistic review of the impact of the Federal Reserve’s experiment investing in MBS would conclude that the Fed should stop buying mortgages. Its decision to invest trillions of dollars in MBS has helped to push the cost of home ownership beyond the reach of many. Others will find themselves locked into homes they cannot afford to sell because of the artificially low rates on their current mortgages. 

From either perspective, the Fed’s MBS experiment has whipsawed housing markets and cost the Fed over $400 billion in MBS losses. It’s hard to see how this experiment merits anything but a failing grade.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute.  Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again!—The Covid Crisis and the New Market Bubble.” 

The Fed's Capital Is Rapidly Heading to Zero, and Below

Published in RealClear Markets.

Since September 2022, the Federal Reserve has lost about $36 billion.  A big number!—and notably big compared to the Fed’s stated capital of $42 billion. Thus the Fed has already run through about 85% of its capital and has only $6.6 billion (0.07 % of its total assets) left as of February 22. How long will it take to burn through that?  Less than three weeks.

So the Fed’s real capital will hit zero in mid-March. By April Fools’ Day, it will be proceeding into ever more negative territory.

What does negative capital mean for the world’s top central bank?  As for any entity, it means that its liabilities exceed its assets, and that it is technically insolvent.

Here we are dealing with the Fed’s real capital, in contrast to the stated capital its financial statements report.  For every organization, everywhere and necessarily, losses reduce retained earnings and thus total capital.  Nothing could be more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses of $36 billion. But the Fed wishes to exempt itself from this law of accounting, by treating its losses as an asset, which they aren’t.  It wishes us to believe that if it loses $100 billion, as it probably will in 2023, or $200 billion, or even $1 trillion, that its capital would always be the same.  “LOL,” as people text these days. The situation may make you think of the cynically realistic remark of Jean-Claude Juncker, when he was the head of the European finance ministers: “When it becomes serious, you have to lie.”

The Fed itself and most economists claim about the losses and the looming negative capital that “It doesn’t matter and no one cares.” They point out that the Fed can continue to print up more money to pay its obligations, no matter how much it has lost or how much less its assets are than its liabilities.  

Nonetheless, it is surely embarrassing to have lost all your capital, let alone twice or three times your capital, as the Fed will have done by the end of this year.  Whether it did this intentionally or unintentionally, it raises pointed questions about whether the Fed correctly anticipated such huge losses and how negative its capital would become, and, if it did, whether it informed Congress of what was coming.

A second argument the Fed and its supporters make is that “Central banks are not supposed to make profits.”  This is not correct.  All central banks, including the Fed, are designed precisely to make profits for the government through their currency monopoly.  They issue non-interest bearing currency, and make interest bearing investments.  This makes profits automatically and thereby reduces the Treasury’s deficit.  But no more.  The easy profits have been wiped out by the losses on the Fed’s $5 trillion risk position of investing long and borrowing short, now upside down.  The Fed has trillions of long-term “Quantitative Easing” investments it bought to yield 2% or 3 %, but the cost of funding them is now over 4 1/2%-- a guaranteed way to lose money.  And the Fed’s borrowing costs are likely headed still higher, making its losses still bigger. 

Thus the losses are the actualization of the immense financial risk the Fed knowingly took, while not knowing how bad the outcome would be.  The Fed’s losses now make its capital negative, increase the federal deficit and are a fiscal burden on the Treasury.

The Fed is not alone in this problem, since many central banks together set themselves up for losses. “Euro Area Braces for Era of Central-Bank Losses After QE Binge,” in the words of a recent Bloomberg headline. In Great Britain, His Majesty’s Treasury has committed to pay for losses of the Bank of England, and the Canadian Finance Ministry has entered into a contract with the Bank of Canada to offset any realized losses on the Bank’s QE bonds.  

Should the U.S. Treasury recapitalize the Fed by buying stock in the Federal Reserve Banks?  Unlike in most other countries, the U.S. government does not own the stock of its central bank— private banks do.  The Fed does have a formal call on the private banks to require them to buy more stock-- the half of their stock subscription they have not paid in.  This would raise about $36 billion in new capital.

But the Fed certainly does not want to be seen as needing to call this additional capital-- or needing to skip its dividend, as both the European Central Bank and the Swiss central bank have done this year.

Nor does the Fed wish its balance sheet to show its real capital.  But if, as the Fed argues, it doesn’t matter and no one cares, why go through the charade?  Why not simply report the true number?

Hemorrhaging losses, the Fed’s problems are now the taxpayer’s

Published in The Hill with Paul H. Kupiec.

When liabilities exceed assets, equity capital is negative and an entity is technically insolvent. Few institutions in that condition can continue operating at a loss indefinitely, and those that can usually benefit from an explicit government guarantee. Past special cases have included government-backed agencies like the U.S. housing GSEs. 

From mid-March 2023, there will be a new addition to the list of institutions that, while losing billions of dollars a month and technically insolvent, with the benefit of taxpayer support will still be able to issue billions in new interest-bearing liabilities. That institution is the Federal Reserve.

With large projected operating losses and liabilities already in excess of assets, existing creditors are unlikely to be repaid, let alone new creditors. No sensible fiduciary would lend under these conditions unless newly injected funds have seniority in bankruptcy or carry an explicit government guarantee.

Since mid-September, the Federal Reserve has lost about $36 billion and will continue to post billions of dollars a month in losses for many months if not years to come. Fed losses have already consumed about 85 percent of its stated capital of $42 billion. It will take less than 3 weeks for the Fed to burn through the $6.6 billion of its remaining capital. 

The Fed routinely creates new money by purchasing interest-bearing U.S. Treasury securities in exchange for newly created Federal Reserve notes or interest-bearing bank reserves. From mid-March on, the Fed will, for the first time in its history, pay for its accumulating losses by issuing new liabilities without acquiring any new interest-bearing assets. The Fed will pay its bills by printing new money — not just Federal Reserve Notes that pay no interest, but by issuing new reserve balances that pay banks an interest rate higher than can be earned in a savings account.

When the housing GSEs were insolvent and losing money hand-over-fist, the U.S. Treasury used congressional powers in the Housing and Economic Recovery Act of 2008 to inject enough new capital to save the GSEs from defaulting so they could continue to borrow and operate. How can a technically insolvent and loss-hemorrhaging Federal Reserve continue to operate without a similar congressionally-approved bail-out?  Do other central banks have the Fed’s seemingly magical power to continue operations while technically insolvent, and yet still issue billions in new interest-bearing liabilities to cover losses?

The “magic” begins with the fact that, regardless of the size of its accumulated losses, the Fed will always report positive equity capital. By any sensible accounting standard, losses reduce retained earnings and capital. Nothing is more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses. The Fed magically suspends this law of accounting by booking its accumulated losses as an asset. If Fed losses accumulate to $100 billion, as they probably will in 2023, or to $200 billion or more by 2024, the Fed will report that it still has $42 billion in equity capital. Magic.

The Fed and many economists believe that the Fed’s losses and its looming negative capital position are inconsequential. While other central banks shrug-off losses, they are not so cavalier with their accounting treatment of losses, nor do they contend that their capital position is of no consequence.

In reporting its recent losses, the European Central Bank canceled paying dividends and was careful to state that its losses were well covered by its reserves and so had no impact on its capital. The Swiss National Bank’s $143 billion loss in 2022 caused it to cancel its dividend payments and reduce its retained earnings. It still remains well-capitalized by central bank standards. In Great Britain, His Majesty’s Treasury explicitly agreed to offset losses of the Bank of England, and the Canadian Finance Ministry has a contract with the Bank of Canada to offset any realized losses on its QE bonds. Meanwhile, the Dutch central bank alerted its country’s Treasury of the possibility that the bank might need to be recapitalized. For all of these central banks, their equity capital position apparently does matter.

With negative real capital and massive losses accruing, how will the Fed still pay member banks a dividend, interest on their reserves balances, conduct monetary policy and pay its bills? With the benefit of an implicit government guarantee — a guarantee that has so far avoided any mention in congressional hearings.

On a consolidated government basis, the Fed’s accounting treatment — paying for accumulating losses by creating new interest-bearing liabilities — is equivalent to the U.S. Treasury selling new interest-bearing debt and remitting the proceeds to the Fed to cover its losses. If Fed losses were paid and accounted for in this way, the Fed’s losses would count against the Federal budget deficit and the new Treasury debt issued would add to the Federal government’s outstanding debt.

With the Fed counting its accumulating losses as a deferred asset, the losses do not reduce the Fed’s reported equity capital or increase the federal budget deficit. Moreover, the new interest-bearing liabilities the Fed issues to pay bank dividends, interest on bank reserves and to cover other Fed operating costs do not count as part of the U.S. Treasury’s outstanding debt.

The Fed’s accounting trickery allows the Fed to borrow taxpayer money to cover its losses without the borrowing or the losses appearing on the Federal government’s ledgers. The Fed itself decides how much to borrow from taxpayers without any explicit congressional authorization. The current arrangement inadvertently allows the Fed to appropriate, borrow and spend taxpayer dollars on its own authority — an issue that should be addressed in the Fed’s next semi-annual congressional appearance.

The Fed’s Operating Losses Become Taxpayer Losses

Published in the Federalist Society with Paul H. Kupiec.

The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?

How to pay all of the Treasury’s bills without raising the debt limit

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The news is filled with dire warnings of what will happen if Congress does not lift the debt ceiling and the U.S. Treasury defaults on its debt. 

Conservative House Republicans in the new Congress have promised to block any increase in the debt ceiling without an agreement to make cuts in the government’s massive deficit spending. President Biden has vowed not to negotiate and says Congress must pass a clean bill that only increases the debt ceiling. 

Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”

Voila! The Treasury has $494 billion more in cash with no additional debt. The president’s budget proposed a deficit of $1.2 trillion for fiscal 2023, so the additional funds should carry the Treasury from the current June deadline to easily past the end of fiscal 2023, giving the new Republican House majority, and the Democratic Senate majority, time to negotiate, in regular order, and pass a 2024 fiscal year budget with spending cuts as well as pass a new appropriately-sized debt ceiling to facilitate government funding in fiscal 2024 and beyond.

By merely recognizing the true market value of the Treasury’s gold holdings, the intense embarrassment to the administration and Congress of a looming default by the Treasury can be completely avoided. It is indeed ironic that in a world of inflated fiat currency and massive deficit finance, simply recognizing the true value of the government’s gold holdings can keep the government solvent. There are no budgetary tricks involved. It’s been done before and can work again.

Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again!—The Covid Crisis and the New Market Bubble. ” Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The Fed’s quantitative easing gamble costs taxpayers billions

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The year 2023 is shaping up to be a challenging one for the Federal Reserve System. 

The Fed is on track to post its first annual operating loss since 1915. Per our estimates, the loss will be large, perhaps $100 billion or more, and this cash loss does not count the unrealized mark-to-market losses on the Fed’s massive securities portfolio. An operating loss of $100 billion would, if properly accounted for, leave the Fed with negative capital of $58 billion at year-end 2023. 

At current interest rates, the Fed’s operating losses will impact the federal budget for years, requiring new tax revenues to offset the continuing loss of billions of dollars in the Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth-quarter operating loss of over $18 billion. The weekly Fed H.4.1 reports suggest that after December’s 50 basis point rate hike, the Fed is losing at a rate of about $2 billion a week. This weekly loss rate when annualized totals a $100 billion or more loss in 2023. If short-term interest rates increase further, operating losses will increase. Again, these are cash losses and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion on Sept. 30. 

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed-rate, low-yielding mortgage and Treasury securities with floating-rate liabilities. These are the net investments of non-interest-bearing liabilities — currency in circulation and Treasury deposits — thus investments financed by floating rate liabilities.

These quantitative easing purchases were a Fed gamble. With interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose — as they now have.

The return of high inflation required the Fed to increase short-term interest rates, which pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s savings and loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits (the dollars the Fed earns managing the money supply) in the future once its massive interest rate mismatch has rolled off. This may take a while since the Fed reports $4 trillion in assets with more than 10 years to maturity. During this time, future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for Federal tax revenues, will not be remitted. 

While not widely discussed at the time, the Fed’s quantitative easing gamble put taxpayers at risk should interest rates rise from historic lows. The gamble has now turned into a buy-now-pay-later policy — costing taxpayers billions in 2023, 2024 and perhaps additional years as new tax revenues will be required to replace the revenue losses generated by quantitative easing purchases. 

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did Congress understand the risk of the gamble? The Fed tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses something else: a “deferred asset.” The accumulated losses are assuredly not an asset but properly considered are a reduction in capital. The political fallout from these losses will be magnified by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest — if anything at all — on bank excess reserve balances. Besides, at the time, excess reserve balances were very small, so if Fed did pay interest on excess reserves, the expense would have been negligible.  

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds and other financial institutions while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits and contribute to Federal revenues. In 2023 and going forward, the Fed will negatively impact fiscal policy — something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the looming Fed losses are no big deal? 

Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again! — The Covid Crisis and the New Market Bubble.” Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

"The Most Important Price of All"

Published in Law & Liberty:

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

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

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

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

The Effects of Low Interest Rates

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

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

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

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

• Wealth would be redistributed from savers to borrowers

• Too much borrowing would take place

• Asset price inflation would make the rich richer

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

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

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

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

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

Bad Press

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

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

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

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

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

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

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

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

Central Bank Distortions

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

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

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

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

Among six proposals to regulate cryptocurrency, one is superior

Published in The Hill with Howard B. Adler:

In the wake of billions in losses suffered by investors from the failure of cryptocurrency exchange FTX and other crypto collapses, how to regulate cryptocurrencies is a hot topic the new Congress must address. Competing proposals for it to consider range from banning cryptocurrencies outright, to giving them government backing, to stifling them with regulatory bureaucracy, to letting them fail or succeed entirely on their own. 

Some urge that cryptocurrencies simply be banned. This is the approach taken by China in 2021 when it banned all private cryptocurrency transactions and imposed an official “digital yuan” to monitor its citizens even more. The Chinese approach reflects the belief that currency must be a state monopoly and the official currency must have no private competitors. After FTX, some commentators have asked whether cryptocurrency should be banned in the United States. While banning cryptocurrency may be a characteristic response by an absolutist state like China, we do not believe it is appropriate for the United States. 

A second approach, unsurprisingly advocated by Securities and Exchange Commission Chairman Gary Gensler, is to have the SEC take over cryptocurrency regulation primarily by using its existing powers to regulate securities. Gensler believes that “the vast majority” of crypto tokens are securities already within the SEC’s jurisdiction. Of course, the SEC failed to head off the FTX collapse or any of the other cryptocurrency debacles. A glaring problem with this approach is that it requires the SEC to first assert that a particular form of crypto is a security and then for this issue to be litigated — a slow, expensive and inefficient process. A former SEC chair conceded that Bitcoin, the archetypal and largest cryptocurrency by market cap, is not a security and many cryptocurrencies are structured similarly to Bitcoin. 

The Commodity Futures Trading Commission has proposed that it should be the principal cryptocurrency regulator. This is called for in the Digital Commodities Consumer Protection Act, a bill reportedly pushed by former FTX CEO Sam Bankman-Fried and other members of the cryptocurrency industry. The crypto industry is said to regard the CFTC as a less stringent regulator than the SEC. One proposal is for each cryptocurrency firm to get to choose either the SEC or the CFTC as its regulator.  

From a different perspective, a group of top U.S. financial regulators has put forward a banking-based regulatory approach. This would be applied to stablecoins, a type of cryptocurrency backed by or redeemable at par in dollars (or other government currencies), and intended to maintain a stable value with respect to the dollar. This approach, advanced by the Treasury and the President’s Working Group on Financial Markets, would require that stablecoin issuers be chartered as regulated, FDIC-insured banks. The rationale for this approach is that stablecoin issuers are functionally taking deposits, which is by definition a banking function.  

Regulation as a bank is the most invasive form of financial regulation and imposes very high compliance costs.  For the business models of many cryptocurrency issuers, this may be the functional equivalent of banning cryptocurrency.  (Perhaps this is the outcome actually intended.)  More importantly, the only good thing that can be said about FTX’s and other cryptocurrency failures is that they did not damage the wider financial system or result in taxpayer bailouts.  Requiring cryptocurrency issuers to be FDIC-insured puts them in the federal safety net and puts taxpayers on the hook for future losses.  In our view, creating taxpayer support is going in exactly the wrong direction. 

A fifth approach, in a bill introduced by Sen. Pat Toomey (R-Pa.), would authorize a new type of license from the Office of the Comptroller of the Currency for stablecoin issuers, presumably less onerous than a full banking license and not requiring FDIC insurance. Issuers would be subject to examination and required to disclose their assets and redemption policies. Most importantly, they would be required to provide quarterly “attestations” from a registered public accounting firm. 

As a further step, we believe that disclosure of full, audited financial statements is critical. Right now, most cryptocurrencies are not subject to any kind of accounting disclosure. But no one should ever invest money in an entity that does not provide audited financial statements without recognizing that their funds are at extreme risk. If a federal regulatory system for cryptocurrency is to emerge, financial statement requirements are essential. 

Sixth and finally, it has been proposed that cryptocurrency not be specially regulated at all. Instead, it should be treated like a “minefield,” with appropriate warnings that investors face danger and invest entirely at their own risk. Investors would be able to rely on the protections of general commercial law and existing anti-fraud and criminal laws, but if cryptocurrency ventures crash, they crash, and their debts are reorganized in bankruptcy with losses to the investors and creditors, but not to taxpayers.  

Since cryptocurrency originated as a libertarian revolt against the government monopoly on money, this approach is consistent with its founding ideas. If people want to risk their money, they ought to be allowed to do so. However, they must be able to understand what they are doing. All parties should clearly understand that Big Brother is not protecting them when they hold or speculate in cryptocurrency. 

We believe that this sixth approach is superior in philosophy, but that it needs to be combined with required full, audited financial statements and disclosures about risks and important matters such as assets and redemption policies. Such a combination is the most promising path forward for cryptocurrency regulation. 

Howard B. Adler is an attorney and a former deputy assistant secretary of the Treasury for the Financial Stability Oversight Council. Alex J. Pollock is a senior fellow of the Mises Insitute and former Principal Deputy Director of the Treasury’s Office of Financial Research. They are the coauthors of the newly released book,” Surprised Again! The COVID Crisis and the New Market Bubble.” 

Profligacy in Lockstep

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Fed is in the red: Should it still pay CFPB’s bills?

Published in The Hill with Paul Kupiec.

The Fifth Circuit Court of Appeals just ruled that the Dodd-Frank Act’s requirement that the Federal Reserve pays the expenses of the Consumer Financial Protection Bureau is unconstitutional. This important ruling adds to another problematic aspect of the CFPB’s funding scheme — the Federal Reserve no longer has enough earnings to cover the $692 million in checks the CFBP writes each year.

The CFPB’s 2022 “Budget Overview” states that “The CFPB’s operations are funded principally by transfers … from the combined earnings of the Federal Reserve.” But in the fall of 2022, this is not true. There are no such earnings, the Fed is losing money. Making the Fed pay the CFPB’s expenses simply makes those losses larger. It also keeps the CFPB’s expenses out of the federal budget deficit where the court ruling says they rightly belong.

Former Fed Chairman Ben Bernanke has just been awarded the Nobel Prize in economics, but the policy of quantitative easing he championed has left the Fed with market value losses of monumental proportions. We estimate that the Fed’s balance sheet as of mid-October suffers from a $1.3 trillion mark-to-market loss. That is 30 times the Fed’s total capital of $42 billion. To put the size of this loss in perspective, it is nearly equal to Spain’s GDP and larger than the GDP of Indonesia.

The Fed says these mark-to-market losses are not an issue, they are “merely” unrealized losses. It does not include them in the asset valuations or the capital it reports on its financial statements. Since the Fed does not intend to sell any of its underwater investments, it says there is no danger it will experience a cash loss. While the Fed can feign indifference to a $1.3 trillion market value loss on its investment portfolio, imagine your reaction if you opened your 401(k) statement and saw a very large unrealized loss. 

As short-term interest rates increase, the Fed is experiencing both unrealized mark-to-market losses and cash operating losses. Both will continue because of the Fed’s massive interest rate mismatch. The Fed’s investment portfolio has a net position of about $5 trillion of long-term fixed-rate investments, much of them with remaining maturities of more than 10 years. These investments are funded with floating rate liabilities. The Fed is the financial equivalent of a $5 trillion 1980s-vintage savings and loan. When short-term interest rates rise, its profits naturally shrink and then turn into losses.

We estimate that, in round numbers, for each 1 percent that short-term interest rates increase, the Fed’s annual net income falls by $50 billion. Since the interest rate on the Fed’s floating rate liabilities has increased by 3 percent (so far) in 2022, the Fed is now posting substantial losses and will continue to post losses going forward.

In May, we estimated that the Fed would begin losing money when short-term rates exceed 2.7 percent. With the last FOMC rate increase, the Fed is now paying about 3.1 percent on bank reserve balances so the Fed’s operating profits should already be in the red. A comparison of the Fed’s Oct. 19, H.4.1 Report with its report from mid-September shows that, over the past month, the Fed has accumulated an operating loss of about $5 billion. The loss appears in Table 6 in the account, “Earnings remittances due to the U.S. Treasury.” On Oct. 19, the account is negative, which means the Fed is now losing money.

A loss of $5 billion in a month annualizes to a loss of $60 billion. At current short-term interest rates, not only are there no Fed profits to cover the checks CFPB will be writing, but the Fed’s annual operating loss is on a path that will soon exceed the Fed’s total capital. If these operating losses were booked into retained earnings, as required by Generally Accepted Accounting Principles, within a year, the Fed would report negative capital. In other words, using normal accounting standards, the Fed will soon be technically insolvent.

But unlike the banks it regulates, the Fed will not report negative capital and it won’t go out of business as its losses continue to accumulate. In its accounting statements, the Fed will offset operating losses dollar-for-dollar by debiting an intangible (better said, an imaginary) asset account called a “deferred asset.” As long as the Fed has a deferred asset balance, which may be for years, it will make no payments to the Treasury. In the meantime, the Fed will print money to pay its bills, further contributing to inflation.

If interest rates continue to increase, as nearly everyone expects, Fed losses will grow. The Fed’s total cash losses could easily grow to $100 billion or more over time — maybe a lot more — before rates decline. Ironically, the more the Fed fights inflation by increasing short-term interest rates, the bigger its own loss becomes.

From its inception in 1913, the Fed has been structured to make profits from its money printing monopoly and required to send most of its profits to the Treasury to reduce the federal deficit. But today the Fed’s short-funded quantitative easing investments have resulted in losses that exceed its seigniorage profits.

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Accounted for properly, Fed losses increase the federal deficit that ultimately must be paid by future taxes — but Fed losses are currently not counted in federal deficit estimates. As the next Congress considers Fed reforms, it should also require that Fed operating losses also be included in the federal budget deficit.

While the CFPB’s expenses are clearly federal government expenditures, they are currently not counted in the federal budget and have hitherto been set by an unelected CFPB director and evaded congressional appropriations by making the Fed pay the CFPB’s bills. If the Fifth Circuit’s ruling prevails, these expenditures could be put into a normal democratic process, set by the elected representatives of the people in a constitutional fashion, and no longer be increasing the Federal Reserve’s already embarrassingly large losses.

Alex J. Pollock is the co-author of the newly published “Surprised Again!—The Covid Crisis and the New Market Bubble,” and a senior fellow at the Mises Institute.  Paul Kupiec is a senior fellow at the American Enterprise Institute.

The Political History of Money

Published in Law and Liberty:

Those who fail to study the intellectual debates of the past are condemned to repeat them,” is a variation on Santayana’s famous dictum particularly applicable to economics and monetary theory, where ideas cycle along with events. In The Currency of Politics, Stefan Eich has written a valuable and very interesting review of specific monetary debates in their historical settings during centuries of thought about the nature of money as it is entwined with politics. The author’s own recommendations, however, are sketchy and betray a naïve faith in governments. The historical survey does inexplicably leave out the intense debate of “the money question” at the end of the 19th century in the U.S., starring William Jennings Bryan, which we will fill in at the end of this review.

The Currency of Politics was published in 2022, well timed to be greeted by the Great Inflation in this country, and runaway inflation in other countries as well, which has given rise to a new global debate about central banking, money, and inflation, with the global club of money-printing central banks on the defensive—at least for now. The current arguments and monetary stresses must become a new chapter in any future second edition.

Eich’s principal overall theme is that “money is always already political.” This does seem obviously true. I often point out that the old title, “Political Economy,” was a more accurate term than the current “Economics.” We find economics without politics only in theory, never in reality. Likewise, there is no “Finance,” only “Political Finance.”

One reason this is true is the recurring cycles of financial crises, which inevitably trigger powerful political reactions.

A second reason is that the control of money is extremely convenient to governments, especially to have their own central bank to buy their debt when they are out of money. This was the reason for creating the archetypical Bank of England in 1694. It is an arrangement so advantageous to politicians that virtually every national government has its own central bank now. This is particularly useful in times of war, but also handy in general while running budget deficits.

As George Selgin observed in his 2017 study of the nature of money:

Governments have come to supply currency, and to restrict the private supply of currency and deposits, not to remedy market failures, but to provide themselves with seigniorage and loans on favorable terms. Government currency monopolies…can thus be understood as part of the tax system [and reflect] the preference of the fiscal authorities.

This ability of the government to use its control of money for fiscal purposes is precisely what appeals to practicing politicians when they want to spend more, and to a statist academic like Eich, who wants “more precisely political control over money” and “to reconceive of money as a malleable political institution,” in order to have “more democratic visions,” although the “visions” are fuzzy.

In support of his true, but hardly surprising, theme that money is political, Eich goes back to Aristotle. He says Aristotle thought that “money could be an institution that would contribute to the cohesiveness of the polis—but one that was insufficient, imperfect and laden with potentially tragic consequences.” Indeed, such tragic consequences have been experienced by every victim of the hyperinflations that numerous governments have visited on their populations, and as are being experienced today, for example, with Argentina’s reported 71% inflation rate in July 2022.

From Aristotle, the book leaps two thousand years ahead to another great philosopher, John Locke, and in my view, becomes more interesting. The setting is the debate about the great British recoinage of 1696, two years after the founding of the Bank of England, in which Locke was an original shareholder. Famous for his influential political philosophy and theory of knowledge, Locke, as Eich recounts, was also a key monetary thinker. (That was left out of my philosophy courses, and I’ll bet is equally news to many others. As Eich comments, “today political theorists rarely engage with his monetary writings”—bravo to Eich for doing so.) At the same time, the towering scientific genius, Isaac Newton, was also involved in monetary affairs, as he became Warden of the Royal Mint in 1696. He was made Master of the Royal Mint in 1699, a post he held until his death in 1727.

Locke becomes a principal intellectual antagonist in the book for proposing “that the government call in all the circulating currency [that is to say, coinage] and recoin it to affirm its official silver content as originally set in Elizabethan times,” a century before. Eich writes, “For Locke, a pound sterling was and had to remain neither more nor less than three ounces, seventeen pennyweights, and ten grains of sterling silver.” This was in order “to restore trust in the monetary and political system.” The historical outcome was that “to the surprise of many, Locke’s novel insistence on the unalterability of the [monetary] standard carried the day… Parliament passed the act in January 1696…clipped and worn coins were removed from circulation and replaced by newly minted coins with milled edges…[accompanied by] the new emphasis on coins’ inviolable intrinsic value.”

Eich considers this an attempt to “depoliticize” money, but fairly points out that “Locke’s intervention was itself political.” Indeed, sound money, like inflationary money, is itself a position in Political Economy about what monetary system is best.

After Locke, Eich moves on to the German Idealist and nationalist philosopher, Johann Gottlieb Fichte, a theorist more to his taste. Fichte “set out the most incisive plea for…the political and philosophical implications of the new possibilities of fiat money,” which he believed would require a “closed commercial state” which cuts itself off from all foreign trade “with external commerce banned,” and “commercial autarchy.” Further, it would be “a state that enjoyed the full trust of its citizens had at its disposal the full powers of modern money,” and—an expansive claim by Fichte—“it would ensure for all time the value of the money distributed by it.” Needless to say, in a world of monetary politics, the probability of that is zero. A permanent related question is whether it is ever wise to trust the government in monetary affairs.

Eich is well aware that others doubt (as I do) that the state can or should be so trusted. But could fiat currency work anyway? That it could, at least for a while, was shown by a key historical event: the suspension of the convertibility of its notes by the Bank of England in 1797, in order to help finance England’s war against Napoleon. (A hundred years before, the Bank of England had been set up to finance England’s wars against Louis XIV, and one hundred years later, the Federal Reserve first made its mark financing American participation in the First World War.)

Eich’s discussion of this period is extremely interesting to us denizens of the current pure fiat currency world. Like President Nixon on August 15, 1971, the British government on February 26, 1797 “issued a breathtaking proclamation…The Bank of England had suspended…The pound sterling, still in name referring to the weight measure of silver, had become a piece of paper backed only by the word of the state.” This was “a dramatic opening of a now largely forgotten episode in global monetary affairs…from 1797 until 1821, Britain experimented with the most advanced monetary practice in the world—pure fiat money,” Eich says, “and with it the politics of modern central banking. [This] challenged and transformed not only reigning conceptions of money, but also the nature and role of the modern nation state.”

Like the United States in 1971, Britain in 1797 had little choice about this dramatic move—they were both running out of the gold they had promised to pay on demand to their creditors. Here was the British situation:

“The latter part of 1796 had brought a new wave of failures of mercantile and banking houses all over the country. The apprehension of a French invasion heightened the alarm, and when in February 1797 a single French frigate actually landed 1,200 men in Fishguard in Wales, a run on the Bank of England started.” Think of that. According to Hayek, “[Prime Minister] Pitt, being informed of the state of affairs by a deputation from the Bank…forbade the directors, by an Order in Council [from] issuing any cash payments.” The prohibition lasted more than two decades.

Eich emphasizes that “for the first three years prices stayed almost completely stable.” But they didn’t stay that way after that. You have to go to footnote 85 of his Chapter 3 to find that “Over the next two decades…prices rose overall by about 80%.” Eich comforts himself with the thought that this was only “an annualized rate of less than 4 %.” He apparently did not do the math of compound growth rates. At an inflation rate of 4%, prices will multiply by 16 times in a lifetime of 72 years.

Eich hopes that his history will help “by providing a better language to capture the politics of money, including its promises and limitations.”

Likewise, in our own fiat currency days, after a period of central bank self-congratulation for “price stability,” prices have also not stayed stable, to say the least.

In the historic British case, “a lively debate ensued,” famous to students of monetary history. If we get to footnote 86 of Chapter 3, we find that “The most important English contribution to the debate… was that of Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.” Unfortunately, Thornton does not make it into the book’s main text or appear in its index. We may remedy this lack with two of Thornton’s essential conclusions:

That the quantity of circulating paper must be limited, in order to the due maintenance of its value, is a principle on which it is of especial importance to insist.

To suffer…the wishes of the government to determine the measure of the bank issues, is unquestionably to adopt a very false principle.

At the end of the classic monetary debate in which Thornton played an important part, and with Napoleon well and truly defeated, Britain went back to gold convertibility in 1821.

As the book proceeds, Eich devotes a chapter to his real hero, John Maynard Keynes, and one to the other principal intellectual antagonist of the book, Friedrich Hayek. These chapters have much history of interest—for example, how in 1925 Keynes rightly advised Chancellor of the Exchequer Winston Churchill not to go back on gold at the old, pre-War parity, because the War had destroyed the parities of the old gold standard for good. How Keynes proposed at the Bretton Woods Conference in 1944 the impractical creation of a global central bank and an international fiat currency, “Bancor,” but was representing Britain, which was by then a broke debtor nation and a loser in the argument. The world moved on to the Bretton Woods system based on the U.S. dollar with inter-government gold convertibility, which collapsed in 1971. And on the other side, how Hayek intellectually led “the devastatingly effective politics of the 1970s, which not only paved the way to disinflationary discipline, but also effectively buried Keynes, at least until…2008,” and how Hayek suggested “depriving governments of their monopolistic control of money.” Eich views that as the renewed heresy of “depoliticization” of money.

Eich likes Keynes’ 1930s proposal for zero interest rates which would bring “the euthanasia of the rentier.” However, when in our day central banks imposed zero interest rates, they brought instead the “euthanasia of the saver” and for the rentiers created giant profits by asset price inflation in their bond and stock portfolios.

In the Epilogue to the book, Eich explains, “Following past thinkers…is not meant to produce a catalogue of answers.” Still, he mentions a few suggestions, none spelled out and none, in my view, of much interest, like bringing back postal banking or making the Federal Reserve into a government lending bank. He wants “the greater democratization of money power,” but suggests the anti-democratic need to shield monetary decisions from “the whims of public opinion.”

As a summary thought, he hopes that his history will help “by providing a better language to capture the politics of money, including its promises and limitations.”

The most surprising thing about The Currency of Politics is that the great American monetary debate in which “the money question” dominated national politics, and particularly the presidential election of 1896 with the stirring oratory of William Jennings Bryan, gets not a single mention. Yet its focus was precisely the politics of money in a clear, dramatic, and historic fashion.

Bryan—“that Heaven born Bryan, that Homer Bryan, who sang from the West,” according to the poet Vachel Lindsay—thrilled the Democratic National Convention of 1896 with his “Cross of Gold” speech, the high-flying rhetoric of which was an attack on the gold standard and the promotion of an explicitly inflationist monetary program by the free coinage of silver. One commentator, with some exaggeration, calls it “the most famous speech in American political history.” It is surely the most famous American speech on monetary policy.

Says one history, Bryan “leaped to the speaker’s stand two steps at a time,” and “appeared like a Democratic Apollo.” He proclaimed “that the issue of money is a function of the government, and that the banks should go out of the governing business”—a proposition to which Eich would subscribe. After much more, which I wish we had space to quote, Bryan reached his unforgettable conclusion:

We shall answer their demands for a gold standard by saying to them, “You shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold!”

Bryan got three runs for the U.S. presidency and lost three times. Whatever your views on the substance of his ideas, he certainly gave us notable rhetoric. Eich might add it to his study while he searches for “a better language to capture the politics of money.”

Applying Volcker's Lessons

Published in Law & Liberty:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The government is not only spending trillions — it’s losing trillions

Published in The Hill with Paul Kupiec. Also in RealClear Markets.

Lately, no matter if the federal government is spending taxpayer dollars or losing them, it doesn’t mess around with small change.  

The government allocated $4.6 trillion just in COVID relief spending, tens of billions of which have been siphoned off by fraud. And when it comes to losing taxpayers’ hard-earned dollars, we’ve calculated that losses tallied at the Federal Reserve and Department of Education together will top $2 trillion. No telling how much it will cost when the government losses accumulate on the $370 billion green energy loan and loan guarantee programs included in the Inflation Reduction Act, but if Obama-era green energy loan guarantee costs are any guide, they will be large. 

Let’s start with Fed. By the end of May of this year, we estimated that the Fed’s mark-to-market loss on its huge portfolio of Treasury bonds and mortgage securities had grown to the staggering sum of $540 billion. The Fed’s losses have continued to build and today are, we now estimate, quickly approaching $1 trillion. Thus the Fed’s investing losses match the estimated loss the Department of Education is about to foist on U.S. taxpayers should President Biden’s student loan forgiveness plan survive legal challenges.

The government spends trillions of taxpayer dollars here and loses trillions more there, but it hardly seems to make the news. Congress has passed so many new giant spending bills in the past three years, much of it financed on the Fed’s balance sheet, that the public has become desensitized to the magnitude of the taxpayer dollars involved. 

Consider this: One million seconds is about 11.5 days; a billion seconds is about 32 years; a trillion seconds is 32,000 years!

In the footnotes of the Fed’s recently released financial statement of the combined Federal Reserve Banks for the second quarter of 2022, you can find this startling disclosure: The mark-to-market loss on the Fed’s system open market account portfolio on June 30 reached $720 billion, $180 billion more than our end-of-May estimate.

Since June 30, interest rates have continued rising and the market value of the Fed’s massive investment portfolio has shrunk even more. Using the interest rate sensitivity that the market value of the Fed’s portfolio displayed over the first six months of 2022, we estimate that the market value loss since June 30 has increased by $275 billion, bringing the Fed’s total investment portfolio mark-to-market loss to about $995 billion, which is 17 times the Federal Reserve System total capital. 

If interest rates continue to rise, as we expect they will, Fed market value losses will easily exceed $1 trillion. The irony, of course, is that the Fed was buying heavily to build its $8.8 trillion portfolio at top-of-the-market prices the Fed itself created with its extended near zero-interest rate monetary policy. In addition, the Fed is moving toward generating large operating losses, even if it never sells any of its underwater bonds and mortgage securities, because it must finance its long-term fixed rate assets with floating rate liabilities at ever-higher interest rates. The federal budget deficit will be bigger still, and possibly for a very long time because it will be short the billions of dollars of revenue the Treasury has been receiving from the Federal Reserve System’s remitted profits.

In the very same eventful quarter that Fed losses reached almost $1 trillion, President Biden issued an executive order (of dubious legality) that ordered the government to fully forgive, at taxpayer expense, hundreds of billions of dollars of defaulted student loans it had made, and to partially forgive over time billions more in unpaid student loan balances at taxpayer expense. Estimates of the cost to the taxpayer of writing off these loans run up to $1 trillion. 

Considered as a lending program, as it was enacted to be, the federal student loan program is nothing if not an utter and egregious failure. The loss is especially ironic since a decade ago it was claimed that student loans would be a big source of profits for the government and help to offset the cost of Obamacare subsidies.

According to a Congressional Budget Office report in March 2010, the federal government takeover of the student loan program would save $68 billion. These savings, it was claimed, would provide funding for an additional $39 billion of grants and make available the remainder to theoretically pay for Obamacare subsidies. A dozen years after the CBO produced this wildly overoptimistic estimate, the federal government student loan program is costing taxpayers $1 trillion, not generating $68 billion in additional revenues.

Considering the federal government’s propensity for producing unreliable forecasts, simultaneously authorizing trillions in new spending, and losing trillions of taxpayer dollars in off-budget government loans and investments, it certainly makes one doubt the acumen of the federal government as a financial manager.

The Fed’s Mark to Market Loss Approaches $1 trillion, while the write-off of student loans hits $420 billion

Published in the Federalist Society:

In May of this year, Paul Kupiec and I estimated that the Federal Reserve’s mark to market loss on its unprecedented portfolio of Treasury bonds and mortgage securities had grown to the staggering amount of $540 billion. Now we have the Fed’s official numbers for the end of June, which by then, it turns out, were much worse than that.

Down in the footnotes of the recently released financial statements of the combined Federal Reserve Banks for the second quarter of 2022, we find this startling disclosure: the mark to market loss on June 30 had increased to $720 billion. That’s a number to get your attention, even in these days of counting in billions, especially when compared to the Fed’s reported total capital on the same date of only $42 billion. The Fed’s mark to market or economic loss at the end of the second quarter was thus 17 times its total capital, making it deeply insolvent on a mark to market basis. (Woe to any bank supervised by the Fed which gets itself in the same situation! Oh yes, we know the Fed will earnestly insist that it is different, but that doesn’t change the fact of the market value losses.)

Since the reporting date at the end of June, interest rates have gone higher, the market value of the Fed’s massive investment portfolio has shrunk even more, and the mark to market loss has gotten even more huge. Using the price sensitivity the Fed’s portfolio displayed in the first six months of 2022, we estimate that the market value loss has during the third quarter increased by $275 billion, bringing it to about $995 billion.

The loss is $995 billion now, we guess, but if interest rates rise further toward more normal levels from their previously suppressed lows, the Fed’s mark to market loss will easily reach and exceed $1 trillion. The irony of course is that the Fed was buying heavily to build its $8.8 trillion portfolio at a market top created by its own actions. In addition, the Fed is moving toward generating operating losses, even if it never sells any of its underwater bonds and mortgage securities, because it must finance its long-term fixed rate assets with floating rate liabilities at ever-higher interest rates. These operating losses will mean the federal budget deficit will be bigger since it will lack the normal contributions from Fed profits, possibly for a long time.

In the very same eventful quarter, President Biden ordered (with dubious legality) the government not to even try to collect on hundreds of billions of dollars of defaulted student loans it had made and instead to write them off. The Congressional Budget Office estimates the cost to the budget of writing off these bad debts to be $420 billion. One must conclude that, considered as a lending program, as it was enacted to be, the federal student loan program is an utter and egregious failure. It has its own deep irony, since a decade ago the CBO claimed the program would be a big source of profits to the government.

Consider these two losses together—one in the Fed’s investing and one in making government student loans. It certainly makes one doubt the acumen of the federal government as a financial manager.

Federal Reserve Operating Losses and the Federal Budget Deficit

Published in AIER and RealClear Markets by Alex J. Pollock Paul H. Kupiec.

The Federal Reserve remits most of its operating profits to the US Treasury. Federal Reserve remittances are government revenues that directly reduce the federal budget deficit. But what is the budgetary impact of Federal Reserve System losses? The Federal Reserve System has not had an operating loss since 1915, so history provides no guidance as to how these losses will impact the official federal government deficit.

In 2023, the Fed will likely report tens of billions of dollars in operating losses as it raises interest rates to combat raging inflation. Will Fed losses increase the budget deficit as logic dictates they should, or will they be treated as an off-budget expenditure? Given the “transparency” of federal budgetary accounting standards, it is not surprising that a recent Congressional Budget Office (CBO) report suggests Federal Reserve operating losses will be excluded when tallying the official federal budget deficit.

The Federal Reserve earns interest on its portfolio of Treasury and federal government agency securities and receives revenues for the payments system services it provides.  Offsetting Fed revenues are the interest the Fed pays on bank reserve balances and reverse repurchase agreements, dividend payments to Fed member banks, contributions (if any) to the Fed surplus account, and the operating expenses of the Board of Governors, the 12 Federal Reserve district banks and their branches. Since 2012,  expenses also include the Consumer Financial Protection Bureau. Any remaining earnings are transferred to the US Treasury and counted as federal government receipts for federal budget purposes. 

The annual amount of Federal Reserve operating income remitted to the Treasury since 2001 is plotted in Figure 1. Also shown are estimates of the reductions in the reported federal deficits attributable to the remittances. (The Fed reports remittances on a calendar-year basis, while the federal deficit is calculated for a fiscal year ending September 30. The deficit reduction estimates in Figure 1 do not correct for this timing difference.)

Source: Various US Treasury monthly statements, Federal Reserve Annual Board Reports, and the authors’ calculations

In crisis years (2009-2011, 2020-2021) the federal budget deficit is bloated by congressionally appropriated stimulus outlays and reduced tax receipts. In these years, even very large Fed remittances offset only a fraction of the combined federal budget deficit. In years unburdened by massive federal stimulus expenditures, however, Fed remittances offset a substantial portion of the reported deficit.

By the FOMC’s own estimates, short-term policy interest rates will approach 3.5 percent by year-end 2022. As the Fed raises short term interest rates to fight inflation, its interest expense increases. The Fed’s interest expenses and operating expenditures, including about $630 million per year in off-budget funding it is required to provide to the Consumer Financial Protection Bureau, will soon exceed its revenues.

Our back-of-the envelope estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent, assuming the Fed has no realized losses from selling its SOMA securities. If short-term rates reach 4 percent, our estimates suggest that annualized operating losses could exceed $62 billion. As discussed below, these loss estimates are consistent with the Fed Board of Governors’ own public estimates. 

In 2011, the Federal Reserve announced its official position regarding realized losses on its investment portfolio and system operating losses:

[I]n the unlikely [sic] scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.

Among financial institutions, the Fed has the unique privilege of setting its own accounting standards, and the Fed has decided that, unlike for all its regulated banks, operating losses will not reduce the Federal Reserve’s reported capital and surplus. The Fed will maintain a positive reserve surplus account in the event it books operating losses by offsetting its operational losses, one-for-one, with an imaginary “deferred asset” account, no matter how large the loss. Unless Congress intervenes, the Fed will not remit any revenues to the US Treasury—even as it continues paying dividends to its member banks—as long as this deferred asset account has a positive balance. 

Instead of issuing a new marketable Treasury security, which would count towards the deficit, the Fed will cover its losses with a nonmarketable receivable called deferred assets recorded on the Fed’s balance sheet. The economic reality, of course, is that Fed losses increase the government’s deficit.

Federal Reserve Board estimates of the system’s potential cumulative operating losses are mirrored in estimates of its deferred asset balance pictured in Figure 2. The Federal Reserve Board’s own estimates suggest that its cumulative operating losses (in the estimated “90 percent interval” case) could approach $200 billion by 2026, Moreover, the Fed projects that it may not resume making any Treasury remittances until 2030 or later. Keep in mind that these projections assume the Fed can reduce inflation with fairly modest increases in short-term interest rates with the expected short-term rate path peaking at less than 4 percent in 2023, before slowly declining toward 2.5 percent in 2026. 

Figure 2: Federal Board of Governors Projection of Treasury Remittances and System Deferred Asset Account Balances 2023-2030

Source: FEDs Notes, 2022

While the Board of Governors fully anticipates operating losses beginning in 2023, the CBO did not get that memo. In its most recent forecast, the CBO projects that the Fed will continue making positive remittances to the Treasury every year between 2022 and 2032. While the CBO forecast anticipates a sharp decline in remittances in 2023 through 2025, it expects a recovery toward 2021 remittance levels thereafter, with the Fed reducing interest rates as inflation returns to targeted levels. 

While the CBO does not project any Fed operating losses, its explanation of budget accounting suggests any such losses would be excluded from budget deficit calculations: “Although it remits earnings to the Treasury (which are recorded as revenues in the federal budget), the Federal Reserve’s receipts and expenditures are not included directly in the federal budget…” Operating losses will be a Federal Reserve expenditure, so this CBO statement would appear to exclude Fed operating losses from the federal deficit calculation. It is strange not to count the Fed’s losses in the budget accounting, considering that the Fed’s profits are counted. Perhaps because the CBO does not anticipate Federal Reserve losses, it has failed to consider them explicitly in its description of deficit accounting. 

Simple accounting logic suggests that if the federal budget deficit is reduced when the Fed earns revenues in excess of expenses and remits these profits to the US Treasury, Fed losses should increase the reported federal budget deficit. This is especially true since Federal Reserve System losses now include the hundreds of millions of dollars of off-budget funding it is required to transfer to run the Consumer Financial Protection Bureau. If the current accounting rules remain unchallenged, the Congress could pass new legislation requiring the Federal Reserve to fund any number of activities off-budget without any impact on the reported federal budget deficit.

Volcker and the Great Inflation: Reflections for 2022

Published in Law & Liberty and also in RealClear Markets.

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

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

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

From Burns to Volcker

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

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

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

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

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

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

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

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

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

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

The Double Dip Recessions

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

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

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

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

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

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

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

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

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

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

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

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

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

Volcker’s Legacy

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

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

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

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

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

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

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

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

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

No Permanent Victories

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

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

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

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

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

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

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

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

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

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

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

The Fed’s Tough Year

Published in Law & Liberty and republished in RealClear Markets.

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

• It has failed with inflation forecasting and performance;

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

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

Forecasting Inflation

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

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

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

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

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

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

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

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

A Mark-to-Market Insolvent Fed

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What the Fed Can and Can’t Do Well

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

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

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

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

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

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

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

There are two things the Fed demonstrably does very well.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Biden’s Pension Bailout Is a Giveaway to Unions

Most plans were insolvent long before the pandemic.

Published in The Wall Street Journal.

By Howard B. Adler and Alex J. Pollock

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

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

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

Read the rest here.

Who owns the Fed’s massive losses?

Published in The Hill and RealClear Markets.

By Paul H. Kupiec and Alex J. Pollock

We estimate that at the end of May, the Federal Reserve had an unrecognized mark-to-market loss of about $540 billion on its $8.8 trillion portfolio of Treasury bonds and mortgage securities. This loss, which will only get larger as interest rates increase, is more than 13 times the Federal Reserve System’s consolidated capital of $41 billion.

Unlike regulated financial institutions, no matter how big the losses it may face, the Federal Reserve will not fail. It can continue to print money even if it is deeply insolvent. But, according to the Federal Reserve Act, Fed losses should impact its shareholders, who are the commercial bank members of the 12 district Federal Reserve banks.

Among Federal Reserve officials and many economists, it is fashionable to argue that any losses the Federal Reserve should suffer, no matter how large, will have no operational consequence. Now that the Fed has already experienced mark-to-market losses of epic proportions and will soon face large operating losses, something it has never seen in its 108-year history, we are about to see if this is true.

Member banks must purchase shares issued by their Federal Reserve district bank. Member banks only pay for half the par value of their required share purchases “while the remaining half of the subscription is subject to call by the Board.”

In addition to potential calls to buy more Federal Reserve bank stock, under the Federal Reserve Act member banks are also required to contribute funds to cover any district reserve bank’s annual operating losses in an amount not to exceed twice the par value of their district bank stock subscription. Note especially the use of the term “shall” and not “may” in the Federal Reserve Act:

“The  shareholders  of every  Federal  reserve  bank shall  be  held  individually responsible,  equally  and  ratably,  and  not  one  for  another,  for  all  contracts, debts,  and  engagements  of  such  bank  to  the  extent  of  the  amount subscriptions  to  such  stock  at  the  par  value  thereof  in  addition  to  the  amount subscribed.” (bold italics added).

Despite congressional revisions to the Federal Reserve Act over more than a century, the current Act still contains this exact passage.

By the Federal Open Market Committee’s own estimates, short-term policy rates will approach 3.5 percent by year-end 2022. Many think policy rates will go higher, maybe much higher, before the Fed successfully contains surging inflation. Our estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent. This estimate assumes the Fed has no realized losses from selling securities. If short-term rates reach 4 percent, we estimate an annualized operating loss of $62 billion, or a loss of 150 percent of the Fed’s total capital.

This unenviable financial situation — huge mark-to-market investment losses and looming negative operating income — is the predictable consequence of the balance sheet the Fed has created. The Fed is paying rising rates of interest on bank reserves and reverse repurchase transactions while its balance sheet is stuffed with low-yielding long-term fixed rate securities. In short, the Fed’s income dynamics resemble those of a typical 1980s savings and loan.

In 2011, the Federal Reserve announced its official position regarding realized losses on its investment portfolio and system operating losses:

“In the unlikely scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.”

Under this unique accounting policy, operating losses do not reduce the Federal Reserve’s reported capital and surplus. A positive reserve bank surplus account is ensured by increasing an imaginary “deferred asset” account district reserve banks will book to offset an operating loss, no matter how large the loss. Among other things, this accounting “innovation” ensures that the Fed can keep paying dividends on its stock. Similar creative “regulatory accounting” has not been utilized since the 1980s when it was used to prop up failing savings institutions.

The Fed’s stated intention is to monetize operating losses and back any newly created currency with an imaginary “deferred asset.” It is impossible to imagine that the authors of the Federal Reserve Act would have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks dividends and interest on their reserve balances, when the act itself makes member banks as stockholders liable for Federal Reserve district bank operating losses.

Clearly, if the Fed is required to comply with the language in the Federal Reserve Act and assess member banks for its operating losses it could impact monetary policy. The prospect of passing Fed operating losses on to member banks could create pressure to avoid losses by limiting the interest rate paid to member banks or discouraging asset sales needed to shrink the Fed’s bloated balance sheet. Moreover, if the Fed’s losses were passed on, some member banks may face potential capital issues themselves.  

Will the Fed ignore the law, monetize its losses, and create a new source of inflationary pressure? Or will it pass its losses on to its shareholders? Stay tuned.

The INDEX Act Is a Major Step Forward In Corporate Governance

Published in RealClear Markets. Also published in the Federalist Society.

An unsolved problem in American corporate governance is that a few big asset management firms have through their index funds grabbed dominating voting power in hundreds of corporations by voting shares which represent not a penny of their own money at risk. They have in effect said to the real investors whose own money is at risk, “I’ll just vote your shares.  I’ll vote them according to my agenda.  I don’t want to bother with what you think.”

This obviously opens the door for the exercise of hubris, as has perhaps notably been the case with BlackRock, but more importantly, it violates the essential principle that the principals, not the agents, should govern corporations. This principle is well-established and unquestioned when it comes to broker-dealers voting shares held in street name. The brokers can vote on significant matters only with instructions from the economic owners of the shares. Exactly the same clear logic and rule should apply to the managers of the passive funds which have grown so influential using other people’s money.

Now Senators Pat Toomey (R-PA), the Ranking Member of the Senate Banking Committee, and Dan Sullivan (R-Alaska), with eleven co-sponsors, have addressed the problem directly by introducing an excellent bill: The INDEX (Investor Democracy Is Expected) Act. This bill would apply the longstanding logic for broker-dealer voting to passive fund asset manager voting, which makes perfect sense. As Senator Toomey said in announcing the bill, “The INDEX Act returns voting power to the real shareholders…diminishing the consolidation of corporate voting power.” You couldn’t have a goal more basic than that.

This bill ought to be approved by overwhelming bipartisan majorities. To oppose it, any legislator would have to sign up to the following pledge: “I believe Wall Street titans should be able to vote other people’s shares without getting instructions from the real owners.” That does not sound like a political winner.

The asset management firms themselves seem to be feeling the force of the INDEX Act logic. BlackRock said it looks forward “to working with members of Congress and others on ways to help every investor—including individual investors—participate in proxy voting.” Vanguard said it “believes it is important to give investors more of a voice in how their proxies are voted.”

If enacted, as it should be, the INDEX Act will require these nice words to be put into action.