Time To Rein in a Runaway Federal Reserve That Took Congress for Granted

Published in the New York Sun and the Federalist Society.

Juvenal put it best when he asked, who will guard the guardians.

The ancient Roman poet, Juvenal, posed the incisive question that must be applied to all structures of power and authority, “Sed quis custodiet ipsos custodes?” Who will guard the guardians? Let us apply Juvenal’s question to the Federal Reserve.

The Federal Reserve endlessly repeats that it ought to be “independent.” If it is independent, though, who will guard our central bank? The Constitution grants that power — to “coin Money, and regulate the Value thereof, and of foreign coin” — to the Congress.

Every economist with whom I have ever discussed this question immediately replies, “You certainly don’t want a bunch of politicians managing monetary policy.” They all assume that elected politicians will always impose an inflationary bias which the expert central bank will resist.

Yet it was the Fed, without congressional approval, that unilaterally announced in 2012 that it was committing the nation to inflation and perpetual depreciation of its currency at the rate of 2 percent a year. That means average prices quintuple in a lifetime — an odd interpretation of the Fed’s statutory mandate of “stable prices.”

Would Congress have approved a commitment to 2 percent inflation forever? The Fed didn’t seek or wait for an approval from Congress. “The Congress let us put in an inflation target without being part of the process,” Mr. Bernanke, I was reminded by the Sun, boasted to a recent panel.

In internal Fed discussions when Alan Greenspan was chairman, he suggested that the right inflation target was “zero, properly measured” and that the setting of an inflation target should involve the Congress. The Bernanke Federal Reserve adopted neither suggestion.

Moreover, the Fed unilaterally increased its inflationary tilt in 2020 by announcing, again without the approval of Congress, that the 2 percent target meant on average over some unspecified time, so that it might run higher when the Fed desired.

In contrast, other countries — notably the first country with a formal inflation target, New Zealand — set that target of zero to 2 percent as an agreement between the parliamentary government and the central bank.

Why does the Fed need a guardian? Its formidable power combined with the inherent unknowability of the economic future makes it a most dangerous source of systemic risk, and it experiences the constant temptation to be the captive finance company of the Treasury.

A way to improve the substantive oversight of the Congress would be for the Senate Banking Committee and the House Financial Services Committee to each form a new subcommittee devoted solely to engaging the key issues of the Federal Reserve.

The central bank is important enough to the country and the world, and powerful enough for good or bad, to merit this accountability. How much the mandarins of the Fed would hate this idea is a good measure of how important it is.

Such subcommittees would not be impressed by the “pretense of knowledge,” in F.A. Hayek’s particularly perceptive and piercing phrase. Nowhere is this pretense so common as in the Federal Reserve and central banks in general.

These subcommittees would be studying and quizzing the Fed about its recently released first quarter financial statements. They would be probing its knowledge and skill, and examining its booking massive net losses. They would examine how the Fed has itself become technically insolvent.

These are the results of its truly remarkable $5 trillion mismatch of long term, fixed rate assets, including $2.6 trillion of mortgage securities, funded by floating rate liabilities. This has become an expensive mismatch indeed.

In the first quarter alone, the Fed suffered a net loss of $27.7 billion. That annualizes to a net loss for the year of about $110 billion — a number big enough to get anyone’s attention. When the Fed is making money, its profits go to reduce the federal deficit; when it loses money, the government’s deficit is increased.

Did the Fed discuss with the Congress how the interest rate risk it took was going to cost the government $110 billion this year? And how much in the coming years? What could be done? Should the Fed’s dividends to its shareholders be cut? Should its paying the expenses of the unrelated Consumer Financial Protection Bureau be scrapped?

The Federal Reserve has lost billions every month since October 2022, up to an aggregate net loss of $70 billion so far. This far exceeds its total capital of $42 billion, so the Fed’s actual capital is now negative $28 billion and constantly getting more negative. The Fed insists that its negative capital doesn’t matter, but would Congress agree? Might Congress prefer the greatest central bank in the world to have positive capital?

Finally, it is certainly time to reconsider the question of committing the nation to inflation forever at 2 percent, with the engagement and required approval of the Congress. The Money Question — in Latin or plain English — is far too important to be left to unguarded central bank guardians.

The debt ceiling debates are tainted by these common fallacies

Published in The Hill with Paul H. Kupiec.

After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

The media is full of stories and opinion pieces about the debt ceiling, many of them repeating administration officials’ and their surrogates’ claims that: It is unconstitutional for the U.S. to default on its debt, the U.S. has never defaulted on its debt and there are no other measures to prevent default, so the only solution to averting an imminent debt crisis is to raise the debt ceiling without reducing deficits. 

These claims are misleading, if not demonstrably false.

The 14th Amendment to the Constitution, ratified in 1868, included language that asserted the validity of war debt incurred by the Union while forbidding repayment of any debts incurred by the states of the Confederacy. The amendment states in part:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned” and “Neither the United States nor any state shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States.”

The Civil War context is clear.

In the midst of the 1995-1996 debt ceiling negotiations, President Bill Clinton said, if need be, he would use the 14th Amendment as justification for ignoring the debt ceiling “and force the courts to stop me.” In contrast, during the 2011 debt ceiling negotiations, the Treasury general counsel wrote that “the Constitution explicitly places the borrowing authority with Congress, not the President.” The latter is correct legal thought, the former mere political bravado. 

The 14th Amendment argument especially fails because it is obvious that the U.S. could easily pay all its debt by not making other expenditures, and moreover, because the United States has in fact defaulted on its debt multiple times since the amendment’s adoption, once explicitly upheld by the Supreme Court.

The U.S. government refused to redeem Treasury gold bonds for gold in 1933 as the bonds had unambiguously promised. In 1968, it refused to redeem its silver certificates for silver notwithstanding its explicit promise to pay “one silver dollar, payable to the bearer on demand.” In 1971, the U.S. government refused to redeem the dollar claims of foreign governments for gold, as promised in the Bretton Woods Agreement, approved by Congress in 1945. Reneging on its Bretton Woods commitments by the U.S. government in 1971 fundamentally changed the global monetary system, putting the whole world onto a pure fiat currency system — a significant default event by any measure.

The 1933 gold bond default is instructive since the government’s refusal to make the gold payments it had unquestionably promised was upheld by the Supreme Court in a 5-4 decision in 1935. The majority opinion found, “Contracts, however express, cannot fetter the constitutional authority of the Congress.” A concurring opinion wrote, “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion announced for the Court.”

Also, contrary to assertions by the secretary of the Treasury and the chairman of the Federal Reserve, there is a proven legal measure that could be used to materially postpone the day the U.S. Treasury runs out of cash without increasing the debt limit.

The Treasury owns 261.5 million ounces, or 8,000 tons, of gold that have a current market value of over $500 billion at the market price of just under $2,000 per ounce. However, for government accounting purposes, the value of the Treasury’s gold is set by the Par Value Modification Act of 1973, which “directed the Secretary of the Treasury … to establish a new par value of the dollar … of forty-two and two-ninths dollars per fine troy ounce of gold.“

Congress could allow the Treasury to raise cash and avoid a default by amending this law to value gold at or near its current market price. Such a revaluation would be consistent with the guidance in the Federal Accounting Standards Advisory Board’s Technical Bulletin 2011-1. This change would allow the Treasury to monetize more than $500 billion in new gold certificates with no additional Treasury debt issuance.

Updating the value of gold certificates to avoid default is not a hypothetical idea — it has been done before. In 1953, when the Eisenhower administration faced a debt ceiling standoff and needed more time to negotiate, it issued $500 million in new gold certificates to the Fed to raise cash and avoid a government default. The transaction worked as intended, as it would again.   

In contrast to what is often claimed in the current debt ceiling debate: The 14th Amendment does not allow an administration to ignore a congressional debt ceiling, the U.S. government has defaulted on its obligations multiple times and Congress and Treasury have a proven option they could use to produce large amounts of additional cash without raising the debt ceiling.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute. Alex J. Pollock is a senior fellow at the Mises Institute and co-author of “Surprised Again!—The Covid Crisis and the New Market Bubble” (2022). After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

Mandating Mortgage Taxes

Published in Law & Liberty.

The Federal Housing Finance Agency (FHFA) is the regulator of Fannie Mae and Freddie Mac. On top of that, it has controlled them as their Conservator since 2008, amazingly for nearly 15 years, since reform of Fannie and Freddie has proved politically impossible. As Conservator, FHFA can exercise the power of their boards of directors. It is therefore not only the regulator, but also the boss of both of these giant providers of mortgage finance. Fannie and Freddie together represent more than $7 trillion in mortgage credit and dominate the mortgage market. FHFA also regulates the $1.6 trillion Federal Home Loan Bank System. Thus, the FHFA has impressive centralized power over the huge US mortgage market, although most people have probably never heard of it.

Housing finance is always political, and a housing finance regulator is always sailing in strong political winds, in addition to the cyclical storms of housing finance crises. The American housing finance system has collapsed twice in the last 40 years, in the decades of the 1980s and the 2000s, with corresponding regulatory reorganizations. The FHFA is a second-generation successor to the unlamented Federal Home Loan Bank Board (FHLBB), the cheerleader-regulator of the savings and loan industry. It presided over the 1980s savings and loan industry collapse, a collapse which also caused the government’s Federal Savings and Loan Insurance Corporation to go broke. The FHLBB was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision (OTS) to regulate savings and loans and the Federal Housing Finance Board (FHLB) to regulate the Federal Home Loan Banks.

Beginning in the 1990s, the federal government made the disastrous mistake of promoting and increasing the amount of risky mortgage loans in the pursuit of increasing home ownership, notably requiring Fannie and Freddie to buy more and more such loans. The riskier loans were promoted as “innovative” mortgages by the Clinton administration. That push was a major contributor first to the housing bubble and then to the housing finance collapse of 2007–09. The homeownership percentage temporarily went up and then fell back to where it had been before. After the crisis, Congress abolished OTS. FHFB was also abolished, with its operations merged into the newly created FHFA. Less than two months after its creation in 2008, FHFA became the Conservator of Fannie and Freddie, which it remarkably remains to this day.

The housing politics and the enjoyment of its power seem to have gone to the FHFA’s head. Now, carrying out instructions from the White House, one imagines, or at a minimum with White House approval, it is trying once again to encourage riskier mortgage loans in Fannie and Freddie. Moreover, it proposes to act as if it were the Congress, trying by its own rule to mandate what are effectively taxes on mortgage borrowers with good credit, in order to provide subsidies to riskier borrowers with poor credit. The FHFA is thus de facto legislating to create in the nationwide mortgage market a welfare and income transfer operation through mortgage pricing. However misguided an idea this is, it could be done by the power of Congress, but the last time we checked, the FHFA wasn’t the Congress. Its project here is remarkable bureaucratic overreach.

In this case, the FHFA wants to politically manipulate Fannie and Freddie’s Loan-Level Price Adjustments (LLPAs). The LLPAs are meant to be credit risk-based adjustments, which reflect fundamental factors in the credit risk of a mortgage loan, to the price of getting Fannie or Freddie to bear the credit risk of the loan. They are an adjustment to the cost of the loan to the borrower, supposed to be based on objective measures of risk. As one mortgage guide says:

A loan-level price adjustment is a risk-based fee assessed to mortgage borrowers … [and] adjustments vary by borrower, based on loan traits such as loan-to-value (LTV), credit score, loan purpose, occupancy, and number of units in a home. Borrowers often pay LLPAs in the form of higher mortgage rates. … Similar to an auto insurance policy, a person loaded with risk will typically pay a higher premium.

Considering the key risks of smaller down payments (higher LTVs) and lower credit scores, there is no doubt that these factors statistically result over time in higher delinquencies, more defaults, and greater credit losses. Simply put, they are riskier loans. The AEI Housing Center has shown that default rates in times of stress differ dramatically based on these factors. For mortgage loans acquired by Fannie and Freddie in 2006–07, for example, the subsequent credit experience was “among borrowers with 20% down payments and credit scores between 720 and 769, the default rate was between 4.2% and 8.8%. Among borrowers with less than 4% down payments and credit scores between 620 and 639, the default rate was between 39.3% and 56.2%.”

Many commentators have pointed out that the FHFA project to manipulate the LLPAs for a political purpose is a distinctly bad idea. It is an “Upside Down Mortgage Policy … against every rational economic model, while encouraging housing market dysfunction and putting taxpayers at risk”; it signals to well-qualified borrowers, “Your credit score is excellent, so prepare to be penalized”; it is income redistribution by bureaucratic fiat; it will encourage the growth of riskier loans in Fannie and Freddie, just as the government disastrously did leading up to the great housing bust of 2007–09; it reduces the incentives to make significant down payments and for establishing a good credit rating—a notably dumb housing credit policy. This is the kind of thing Ed Pinto and I predicted in 2021 that a Biden administration FHFA would do, anticipating “the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.”

The rule is also ethically challenged. As Jeff Jacoby wrote in the Boston Globe, the policy is not only backwards credit logic: “First and foremost, it is egregiously unfair to creditworthy borrowers. … The new mortgage fees amount to a tax on responsible behavior.” In short, “You shouldn’t be punished for having done the right thing.” This seems incontrovertible.

The Congress long ago set up by law a very large, specialized government agency to enable subprime mortgage loans, the Federal Housing Administration (FHA). FHA mortgage loans outstanding total about $1.4 trillion. The FHA provides subsidized mortgage credit, allowing mortgage loans with down payments of as little as 3.5%. The FHA and its sister organization, Ginnie Mae, which guarantees securitized FHA loans, both operate with explicit government support and with direct risk to the taxpayers. The FHFA should not be trying to compete with the FHA for subprime mortgage financing.

The FHFA’s political initiative on loan-level adjustments is a bad idea on the merits, but there is an even more fundamental issue: the creation of a tax and mortgage subsidy program which increases risk to the taxpayers is a question for the Congress to decide—it is not the purview of the FHFA.

Very belatedly, FHFA announced it would issue a “Request for Input” from the public, which would include consideration of LLPAs. This announcement, however, did not alter FHFA’s egregious LLPA changes, which are being imposed long before the “input” will be received.

If the FHFA wanted to pursue its initiative in a constitutional way, it would withdraw its new rule and bring its proposal to Congress, requesting that a bill be introduced to authorize charging those with good credit more on their mortgage loans in order to subsidize those with riskier credit. I imagine that such a bill would not make much progress among the elected representatives of the People.

A Frightening Solution to the Debt Ceiling Crunch

Published in Law & Liberty by Alex J. Pollock and Paul H. Kupiec.

Could the debt ceiling crunch be avoided by the Federal Reserve forgiving treasury debt? Let's hope not.

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Alex J. Pollock is a Senior Fellow at the Mises Institute and was the principal deputy director of the office of financial research of the U.S. Treasury Department, 2019-21. He is author of Finance and Philosophy—Why We’re Always Surprised and co-author of Surprised Again!—The COVID Crisis and the New Market Bubble.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies systemic risk and the management and regulations of banks and financial markets. Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC) and director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Could the Treasury selectively default on the Fed’s debt?

Published in The Hill with Paul H. Kupiec.

A reporter from this publication recently asked how a debt ceiling standoff might impact the banking system. One obvious answer is that if the Treasury ran out of cash and defaulted on the payments owed on its debt securities, the banking system would suffer since it collectively owns, per our calculations, about $1.3 trillion in Treasury securities that have always been treated as “risk-free.”

U.S. Treasury securities do not have cross-default clauses, so the Treasury could choose to default on only a specific set of selected securities sparing banks and others. This gives rise to a provocative question:

Could the U.S. Treasury save cash by selectively defaulting just on securities owned by the Federal Reserve System? How would this impact the Fed? How much cash would be freed up to pay other Treasury bills?

The Federal Reserve owns about $5.3 trillion in U.S. Treasury securities. The Fed’s 2022 audited financial statements show that $721 billion of these securities mature between April 1 and Dec. 31 and that the Fed received almost $116 billion in interest payments from the Treasury last year, or about $9.6 billion a month. Between now and Dec. 31, the Fed is scheduled to receive about $800 billion in interest and maturing principal payments from the Treasury, cash Treasury could use to pay its other bills if it stopped paying the Fed.

How would the Fed cope with a selective Treasury default? The same way it is managing what we’ve calculated is an ongoing $8.6 billion in operating losses per month — by borrowing the additional money it needs to operate and thus creating more debt for the consolidated government and ultimately a taxpayer liability.

If the Treasury suspended all payments due on its securities held by the Federal Reserve System, presumably by agreement with the Federal Reserve, the Fed would be short the cash it previously received. It would increase its borrowing to fund its operations, but the impact on the Fed’s reported operating loss would depend on the details of the suspension agreement and the accounting treatment adopted by the Fed.

Once Congress lifts the debt ceiling, we presume that the Treasury would pay the Fed its balances in arrears. Would the Treasury also pay accrued interest on the suspended amounts it owes the Fed? If so, at what rate?

The suspension of interest payments would clearly reduce the Fed’s cash interest received but it would not immediately increase the reported Federal Reserve operating losses. The Fed would likely account for suspended interest payments as non-cash interest income earned and create a new asset category, “interest income receivable from Treasury,” on its balance sheet.

The non-payment of interest would increase, dollar-for-dollar, the amount the Fed needs to borrow to pay its bills. Going forward, the Fed would have to continue borrowing to fund suspended Treasury balances. If these balances accrued interest at the Fed’s borrowing cost, there would be no future impact on the Fed’s reported operating income. If the Treasury agreed to a lower interest accrual rate or no interest accrual, the Fed’s reported operating losses would increase.

If the suspended maturing principal payments are merely delayed until Congress increases the debt ceiling, the Fed would likely record these as deferred balances due from the U.S. Treasury and would not create a reserve for a credit loss. The suspension would disrupt the Fed’s quantitative tightening plans as its Treasury security balances would not run off as planned.

With the suspension of interest payments on the Fed’s portfolio of U.S. Treasury securities, the Fed would increase its borrowing to cover not only its ongoing operating losses, now about $8.6 billion per month, but also the additional cash shortfall created by the suspension, about $9.6 billion a month, for a total new borrowing of $18.2 billion a month.

The Fed would fund its cash shortfall by (1) printing paper Federal Reserve Notes or (2) borrowing reserves from banks and other financial institutions through its reverse repurchase program. Because the Fed’s ability to fund its losses by printing paper currency is limited by the public’s demand for Federal Reserve Notes, the Fed will have to borrow most of the funds paying an interest rate of 4.90 percent on borrowed reserve balances and 4.80 percent on the balances borrowed using reverse repurchase agreements.

Loans to the Federal Reserve System, whether from reserve balances or repurchase agreements, are backed by Treasury securities owned by the Fed, or by the full faith credit of the U.S. federal government, since the Fed is the fiscal agent of the U.S. Treasury. However, unlike securities issued by the Treasury, when the Federal Reserve borrows, its loans are not counted in the federal government debt that is limited by the statutory debt ceiling. Indeed, Federal Reserve system cash operating losses are not counted as expenditures in federal budget calculations. Because of these budgetary loopholes, Fed operating losses are excluded from any federal budget deficit cap and its borrowings circumvent the statutory federal debt ceiling.

Could the U.S. Treasury take the extraordinary step of selectively halting interest and principal payments on the Treasury securities owned by the Federal Reserve System? We do not recommend such an action but see nothing in law or current Federal Reserve accounting and operating practices that would preclude it should the Treasury need to take emergency measures to avoid a wider federal government default.

If extraordinary measures are needed, a better alternative is free up funds by updating the Congressionally legislated price of the Treasury’s 8,000 tons of gold to ensure prompt payments on all the Treasury’s debt and maintain the credit performance of the United States government.

The Fed’s Capital Goes Negative

Published in NY Sun.

The Fed’s Capital Goes Negative

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion — just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level.  The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.  

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen — about how a billion here and a billion there starts to add up to real money —  we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.  

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative?  I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.  

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie. 

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages.  The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.  

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”  

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses.  Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent.  Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent. 

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury.  So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.  

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans.  Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.  

All banks together have tangible capital of about $1.8 trillion.  So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

For the First Time, the Fed Is Losing Money

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

Thanks to interest-rate risk exposure, the central bank will soon have negative equity capital.

Like all central banks, the Federal Reserve was designed to make money for the government from its monopoly on issuing currency. The Fed did generate profits, which it sent to the Treasury, every year from 1916 on—until last fall. In a development previously unheard of, the Federal Reserve has suffered operating losses of about $42 billion since September 2022.

That month, the massive interest-rate risk created by the Fed’s asset-liability maturity mismatch began generating cash-operating losses, and the losses now average $7 billion a month. This is because the Fed’s trillions of dollars of long-term investments yield 2% but cost 4.6% to finance. The Fed will soon have negative equity capital, and as operating losses continue to mount, its equity-capital deficit will grow.

In a July 15, 2022, note, the Fed’s Board of Governors discussed the possibility that the system could incur substantial operating losses as it increased interest rates to fight inflation. The Fed tried to play down the importance of the issue, arguing that its “mandate is neither to make profits nor to avoid losses”—a deflection that is disappointingly transparent to anyone familiar with central banking.

The Fed traditionally avoided policies that would expose it to significant losses. In the early years, member banks could borrow from reserve banks only by posting specific collateral. The Federal Reserve Act required loans to be backed by qualifying short-term self-liquidating bills—what today we call commercial paper. Over time, loan collateral requirements evolved, but as they did, the Fed introduced policies to protect it from losses when lending to member banks.

When Congress or the executive branch tapped the Fed for emergency loans to avert a wider financial crisis, it sought government guarantees to protect itself from default losses. Franklin D. Roosevelt’s administration asked the Fed to stand ready to provide loans to banks that were allowed to reopen after the 1933 national bank holiday. Instead of lending directly to these banks, the Fed proposed that it lend to the Reconstruction Finance Corp., which could then lend the proceeds to the newly reopened banks—because the RFC had an explicit federal-government guarantee that would protect the Federal Reserve system from potential losses should a newly reopened bank fail.

Similarly, the Fed’s special lending programs in response to the 2008 and 2020 financial crises were undertaken only after the Treasury allocated funds to absorb losses the Fed might incur from emergency loans. The latest Fed special lending facility, announced on March 12, also protects the Fed from lending losses. The first $25 billion of losses incurred by this new emergency program (which lends banks the par value of their underwater mortgage-backed securities and Treasurys) will be covered by the Treasury.

Avoiding credit losses is a requirement Congress added to the Federal Reserve Act in 2010. Section 1101 of the Dodd-Frank Act requires the Federal Reserve Board to establish “policies and procedures . . . designed to ensure that any emergency lending program or facility . . . protect taxpayers from losses.” Federal reserve banks are also mandated to assign “a lendable value to all collateral for a loan executed by a Federal reserve bank . . . in determining whether the loan is secured satisfactorily.”

While the Federal Reserve Act requires the Fed to avoid taking credit related losses that could have an impact on taxpayers, it makes no mention of losses from interest-rate risk exposures. The act’s authors never imagined such losses. Monetary policy was all but assured to generate Fed profits prior to 2008. That changed once the Fed started paying banks interest on their reserve balances and making large open market purchases of long-maturity Treasurys and mortgage-backed securities.

Fed losses from its interest-rate-risk exposures—unrecognized taxpayer losses—are now being realized in ways Congress never intended and at magnitudes neither the Congress nor the Fed ever expected.

Mr. Kupiec is a senior fellow at the American Enterprise Institute. Mr. Pollock is a senior fellow at the Mises Institute and a co-author of “Surprised Again! The Covid Crisis and the New Market Bubble.”

The Silicon Valley Bailout

Published in Law & Liberty.

In spite of the financial market losses and crashes of 2022, government agencies kept assuring us that the banking system was in good shape. Until it wasn’t. Then they were citing “systemic risk” as the reason for a bailout. Surprised again!

The Silicon Valley Bank (SVB) failed on March 10 with great fanfare, as befitted the second largest bank failure in U.S. history. It failed, it turns out, with the balance sheet mistake of borrowing very short and investing very long, a mistake so elementary as to display remarkable financial incompetence.

SVB’s failure was preceded by the collapse of Silvergate Bank, and followed by the failure of Signature Bank (the third largest bank failure), by lines of customers making withdrawals from First Republic Bank, and pressure on banks known to have large unrealized losses on their investments. As always happens in a banking crisis, the government intervened. In this case, it guaranteed the uninsured deposits at the failed banks—and presumably all banks—and created a special Federal Reserve loan facility backed by the U.S. Treasury that will lend on an under-collateralized basis to banks which have large market value losses on their bonds and mortgage-backed securities.

After SVB failed, wealthy depositors, including venture capitalists and cryptocurrency barons, presumably sophisticated financial actors, whose money was caught in the failure, immediately began begging the government for a bailout. (It is reasonable to assume that those among the begging parties who are large Silicon Valley Democratic contributors could get their calls to Washington answered.)

The SVB situation reminds us that deposits are in fact unsecured loans to the bank by another name. As everybody knows, for up to $250,000 per depositor per bank, they are guaranteed by the government. For any amount beyond that, as a lender, you are at risk, or supposed to be. If the banks fails, you become an unsecured creditor of the insolvent estate. Every big depositor in SVB knew this perfectly well. They nonetheless chose to make unsecured loans of huge amounts, in one case of $3.3 billion to one poorly managed bank. Thinking of them correctly as lenders, should sophisticated lenders who make bad loans suffer losses accordingly? Of course.

The perpetual wisdom of managing a bank was expressed by Walter Bagehot, the great financial thinker and partner in a successful private bank himself, 150 years ago. It has been re-learned to their sorrow by the banks, both failed and threatened, in recent days. Wrote Bagehot in 1873:

 A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for…. Adventure is the life of commerce, but caution… is the life of banking.

Bagehot added that what is required is “a wise apprehensiveness, and this every trained banker is taught by the habits of his trade, and the atmosphere of his life.” But the management of SVB and other failures, perhaps too caught up in a speculative environment and too focused on public relations, did not develop sufficient apprehensiveness.

Bagehot’s insight reflects the inherent logic of bank runs. Once a bank has lost its credibility and a widespread withdrawal of deposits and other credit has begun, the holder of a non-government guaranteed deposit (an unsecured loan to the bank, as we have said) is faced with a compelling logic. To hold on and keep the deposit in the now-risky bank has zero upside. The best you can ever get is your money back. But it has a huge downside: you may suffer a big loss on funds that you supposed had minimal risk, you may have even the money you do eventually get back tied up in a receivership, you will have made yourself a first class sucker, and if you are a professional short-term money manager, you may well lose your job. In sum: zero upside, huge downside. So you take the money now. Everyone else is making the same totally rational calculation, and good-bye bank.

All the desperate statements from the bank’s management, as long as they last in their jobs, that really everything is OK, will only convince you that things must be really bad—and every plea from the government to stay calm and have confidence will confirm that your fear is justified. As Bagehot also said, “Every banker knows that if he has to prove he is worthy of credit… in fact his credit is gone.” This is now being demonstrated once again.

Every bailout means taking some people’s money and giving it to others.

“Yellen dismisses bailout” began the page one headline of the Financial Times for March 13, the Monday after the Friday closure of SVB. But by the time that issue of the paper landed in my driveway, a huge bailout had been announced.

The FT article related that “Treasury Secretary Janet Yellen…dismissed calls from some of those with money caught up in SVB to launch a full-scale bailout.” “But,” it continued, “US authorities were facing mounting calls from investors, entrepreneurs and some lawmakers to step in more forcefully to ensure all depositors were made whole.”

Of course, that “all” only meant that big depositors were to made whole, since those with claims up to the quite respectable amount of $250,000 were guaranteed already. The $250,000 obviously covered all the widows and orphans and anybody of modest means. These are the people who proponents of government deposit guarantees always argue are unsophisticated and cannot understand how a bank works, so need to be unconditionally protected. But they already were. So the actual issue was bailing out very sophisticated venture capitalists, cryptocurrency promoters, and various billionaires, all of whom were quite capable of understanding the nature and risks of banking in the SVB fashion.

Should such sophisticated lenders to banks be bailed out from their own financial mistakes?

One partner of a Silicon Valley venture capital firm wrote in this context, “I’m sure many will look upon [SVB’s] demise…and chuckle gleefully about how the technology industry just got a spanking. So be it. We are not seeking special treatment or handouts.”

But they were seeking very special treatment and a very big handout: the government giving them in immediate cash 100% of their uninsured claims on a failed bank receivership. And they got the handout. Whether one was surprised or not by this is perhaps a measure on one’s cynicism.

It is easy for cynics to imagine the calls from the wealthy uninsured depositors and their agents with the U.S. Treasury, the Federal Reserve and the White House. Naturally, internet posts were soon talking of political favors to Silicon Valley Democratic contributors.

As my colleague, Benjamin Zycher, considered the matter:

Now that the bailout of the SVB depositors at 100 percent rather than the nominal $250,000 limit has been announced, it is difficult to discern whether the primary motivation is avoidance of future bank runs… or an old-fashioned effort to reward the wealthy friends of the Democratic Party in Silicon Valley.

As Ben suggests, it is probably both.

Every bailout means taking some people’s money and giving it to others. President Biden has claimed that this bailout does not involve taxpayer money. To the contrary, it makes the U.S. Treasury, in other words the taxpayers, first in line to take losses on the under-collateralized loans the Federal Reserve will make to banks under the bailout plan. Every such bailout tends to encourage risk taking and a lack of wise apprehensiveness in the next cycle.

Meanwhile, losses to the Federal Deposit Insurance Corporation from the bailout of the SVB’s wealthy depositors will be assessed on all other banks. That still means taking money from other people to give to the big SVB depositors. So a small, sound, careful bank in, say, small town Wisconsin, will have money taken from it to give to the California venture capitalists, crypto barons, and billionaires, to cover their losses from the incompetence of the Silicon Valley Bank. That is the idea. How do you like it?

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.”