Juvenal’s Greatest Poser: ‘Who Will Guard the Federal Reserve?’

Published in The New York Sun.

The answer is the body in the government that is famously closest to the people.

“Who will guard these guardians?” That poser of Juvenal, satirist of Rome, is an immortal question — nowhere more pertinent, though, than in deciding who should oversee the Federal Reserve. In the Fed, we have supposed guardians of stable prices who have decided by themselves to create perpetual inflation.

Just to mark the point: Guardians of the currency have  decided by themselves to depreciate it forever. Guardians of financial stability have rendered themselves technically insolvent with negative capital now at more than $100 billion. Guardians who cannot make reliable economic forecasts are tirelessly claiming that they should be “independent.”

What total nonsense.  No part of our Constitutional government should be independent of the checks and balances that are part of the Founding scheme and must apply to all its parts. It is naturally the burning desire of every government bureaucracy to be independent of the elected representatives, but the idea that the Fed is “independent” is stated nowhere in the Federal Reserve Act.  

Displaying the contrary idea, the original Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board. A notable description from Fed history is that the Fed has “independence within the government” — something different from being independent. All — 100 percent — of the monetary powers granted in the Constitution to the government are granted to Congress.

It is well past due for Congress to start getting serious about oversight of the Fed within the government by promptly passing two pending bills:  “The Federal Reserve Transparency Act,” reintroduced by Senator Rand Paul, and the “Federal Reserve Loss Transparency Act,” reintroduced by Congressman French Hill. Enacting these mutually consistent bills would be a big step forward.  

The “Transparency Act,” which was previously passed by the House in 2014 with the overwhelming vote of 333 to 92, is commonly known as “Audit the Fed.”  It is about far more than a financial audit of the books, however, as important such audits are.  It is really about giving Congress the knowledge to carry out serious oversight.  As Senator Paul recently wrote, “transparency and oversight of every government institution is imperative.” 

The “Loss Transparency Act” would put Congress in a better position to understand the Fed’s own finances. It would do so by the obviously sensible requirement that the Fed’s balance sheet must apply Generally Accepted Accounting Principles. The bill would also, with admirable common sense, prohibit the Fed from paying the expenses of an unrelated agency while the Fed itself is losing $114 billion a year.

The profound questions of what kind of money is right for our country, including whether the Fed is empowered to create perpetual inflation rather than stable prices, are not decisions that may be made unilaterally by the Fed. And invite only more questions. If perpetual inflation, at what rate? If stable prices, how to ensure sound money? These are inherently political questions. It is hubristic of the Fed to imagine it has the authority to make such decisions. Let it bring formal recommendations to the Congress.

The Fed has an ever-recurring tendency to create inflations, asset price bubbles, systemic risk, and the ensuing painful corrections, because it combines great power with demonstrated, and inescapable, inability to foretell the financial future.  This combination makes it “the most dangerous financial institution in the world.” It needs serious oversight by and substantive interaction with elected representatives of the people who have made themselves expert in central banking questions.

So who should guard the Fed in the constitutional system of checks and balances?  The answer is Congress, with its unambiguous power over money questions clearly designated in the fifth clause of the Constitution’s Article I, Section 8. Congress needs to revise the laws to ensure effective oversight and to organize itself to be the required guardian of the people’s money and the central bank. 

In my opinion, this should include both the Senate and the House banking committees having a subcommittee devoted exclusively to oversight of the Fed, which is the central bank not only to the United States, but to the entire dollar-using world, and to its dominant credit, money and capital markets, and moreover has huge effects on the daily life of the American people by its debasement of the currency.

How to Recapitalize the Federal Reserve

Published in Law & Liberty with Paul H. Kupiec. Also published in RealClear Markets.

The Federal Reserve starts the new year with capital, properly accounted for, of negative $92 billion. How can that be? How can the world’s greatest central bank, the issuer of the world’s dominant reserve currency, be technically insolvent—and by such a huge number?

The answer is that the Fed has accumulated immense operating losses, which by January 3, 2024, totaled $135 billion. Since September 2022, the Fed has been paying out more in interest expense to finance its more than $7 trillion securities portfolio than it receives in interest income. The losses continue into 2024 at the rate of over $2 billion a week. When you subtract the Fed’s accumulated losses, which are real cash losses, from the Fed’s stated capital of $43 billion, you get the Fed’s true consolidated capital, that is: $43 billion in starting capital minus $135 billion in losses equals the current capital of negative $92 billion. This balance sheet math is straightforward and unassailable under generally accepted accounting principles (GAAP).

The Federal Reserve System includes 12 regional Federal Reserve Banks (FRBs), each one a separate corporation with its own shareholders, customers, and balance sheet. Considered on their own, with proper accounting, 8 of the 12 FRBs start 2024 with negative capital. This means their accumulated cash operating losses exceed 100% of their capital. Two others have lost more than 80% of their capital and will exhaust their capital in 2024. Only two FRBs have their capital intact. Their operating losses have been limited because these banks have an especially high proportion of their funding supplied by the paper currency (Federal Reserve Notes) they issue—currency does not pay interest and thus results in lower overall interest expense. Under commercial bank rules, 10 of the 12 FRBs would be classified as severely undercapitalized, as would the entire consolidated Federal Reserve System. As of January 3, 2024, the FRBs true capital numbers are:

Source: Federal Reserve H.4.1 January 4, 2024, and authors’ calculations.

At the current rate the Fed is losing money, its negative capital will exceed $100 billion by February 2024.

You will not find the Fed’s true capital position reported on the Fed’s official consolidated balance sheet or on the individual FRBs’ balance sheets. This is because the Fed—unbelievably—does not subtract its losses from its retained earnings. Instead, it pretends that its growing losses are an asset. “Ridiculous!” you may exclaim. The kindest way to describe this Fed accounting is that it is non-standard, but Congress has allowed the Federal Reserve to determine its own accounting rules. Since its accumulated operating losses have made the actual liabilities of the Fed larger than its assets, the Fed created a new “asset” because it doesn’t want to show that it has negative capital. We do not suggest you try this accounting sleight-of-hand if you are a private bank, a business, or filling out a home loan application.

The Fed claims that, even if it does have negative capital, it doesn’t matter because it can always print all the money it needs. However, there are, in fact, limits to its ability to print paper currency. But even if there were no limits, the Fed’s large negative capital, growing ever more negative each week, certainly makes the Fed look bad—incompetent even—and calls its credibility into question. While it is not widely understood, the deposits in FRBs are unsecured liabilities of each individual FRB. When an FRB has negative capital, the presumed risk-free status of its deposits hinges on a belief that the deposits are implicitly guaranteed by the US Treasury.

Maintaining market confidence in the Federal Reserve System and FRBs is critical. As the Fed’s losses continue to rapidly accumulate, it would be sensible for Congress to recapitalize the Fed and bring it back to positive capital with assets greater than, instead of less than, its liabilities, and restore it to technical solvency. This could be done with four steps, which would fit well with and expand Pollock’s proposals for Reforming the Federal Reserve:

• Suspend FRB dividends

• Exercise the Fed’s existing capital call on its stockholders

• Assess the stockholders to offset Fed losses, as provided in the Federal Reserve Act (FRA)

• Have the US Treasury buy stock in the Federal Reserve, consistent with the original FRA.

Suspend Dividends

When banks or any other corporations are suffering huge losses, especially if they have negative retained earnings, let alone negative total capital, a typical and sensible reaction is to stop paying dividends. Indeed, the Federal Reserve in its role as a bank regulator would insist on this for the banks and holding companies it regulates. The same logic should apply to the Fed itself. The central bank of Switzerland is an instructive example. Like the Fed, the Swiss National Bank is now facing losses but, unlike the Fed, it still has significant positive capital. Nonetheless, the Swiss National Bank has stopped paying dividends for the last two years. When the Fed is losing over $100 billion per year, there is scant justification for it to be paying $1.5 billion in dividends to its member bank shareholders annually.

However, to stop a technically insolvent Fed from paying dividends, Congress has to get involved and amend the Federal Reserve Act. The FRA currently provides that the Fed’s dividends are cumulative. This provision reflects the former belief that the Fed would always make profits. With today’s reality of massive losses, the Federal Reserve Act should be revised to make dividends noncumulative and to prohibit FRB dividend payments if such payments would result in negative retained earnings (“surplus” in Fed terminology) on a GAAP basis.

Exercise the Fed’s Existing Capital Call on its Stockholders

Section 2.3 of the Federal Reserve Act requires every bank that is a member of a Federal Reserve Bank to subscribe to shares of the FRB in an amount tied to the member bank’s own capital. The member-stockholders, however, are required to pay in and have paid in only half of the amount subscribed. The other half is subject to call by the Federal Reserve Board, and if called, must be paid in by the member bank.

The total paid-in capital of the Fed is $36 billion. An additional $36 billion in FRB capital could be raised if the Federal Reserve Board simply exercised its existing statutory call. This would reduce the Fed’s negative capital as of January 3, 2024, by 39%. If the Federal Reserve Board balks at exercising the capital call, Congress should instruct it to do so.

Under our recommended changes to Fed dividend policy, the newly paid-in shares would not receive dividends until FRBs return to positive GAAP retained earnings (“surplus”).

Assess the Stockholders to Offset Fed Losses, as Provided for in the Federal Reserve Act

In a very little-known but very important provision of the FRA, which goes back to its original 1913 enactment, Federal Reserve Bank shareholders are made liable in addition to their subscription to Fed stock, for another amount equal to that subscription, which they may be assessed to cover all obligations of their FRB; in other words, to offset negative capital. A member bank assessment would be a cash contribution to their FRB, not an investment in more stock. Says the FRA, “The shareholders of every Federal reserve bank shall be held individually responsible … to the extent of the amount of their subscriptions to such stock at the par value thereof in addition to the amount subscribed.” (Italics added.)

The total subscriptions to Fed stock are twice the outstanding paid-in capital of $36 billion, so the subscriptions total $72 billion, and the maximum possible assessment on the Fed member banks is thus $72 billion. Since two FRBs, Atlanta and St. Louis, still have their capital intact, the available assessment would be on the other ten FRBs. The maximum assessments would be these FRBs’ paid-in capital of $34 billion times 2, or $68 billion. By comparison, the Fed paid $177 billion in interest and dividends to its member banks in 2023.

The original Federal Reserve Act, as enacted in 1913, provided for the US Treasury to buy Federal Reserve Bank stock, if necessary.

With the maximum assessment on the members of these ten FRBs in addition to calling the unpaid half of the stock subscriptions for all the FRBs, the total raised would be $104 billion ($36 billion in new stock plus $68 billion in assessments). This amount would offset the Fed’s year-end capital deficit of $92 billion and would cover about six weeks of additional losses at the current rate of $2 billion a week.

Doubtless the Fed’s member banks would be exceedingly unhappy with these actions to shore up the capital of the Federal Reserve. But member banks, as the sole shareholders in the FRBs, have a clear statutory obligation to financially support FRBs that will soon have consolidated true negative capital in excess of $100 billion.

Judging by public financial statements disclosures, few—if any—Fed member banks have seriously considered the large statutory contingent liability that membership in the Fed brings. Taking into account FRBs’ financial condition and their shareholders’ clear legal obligations, it seems that FRB member banks should be disclosing this material contingent liability.

Have the US Treasury Buy Stock in the Federal Reserve, Consistent with the Original Federal Reserve Act

Suspending FRB dividends, calling the rest of the member banks’ stock subscriptions, and assessing FRB stockholders the maximum amount would make the Fed’s capital positive again until mid-February 2024. After that, continuing losses will put it back into negative territory and the Fed back into technical insolvency. Given the fact that the Fed is stuck with long-term fixed-rate investments yielding a mere 2%, and that $3.9 trillion of its investments have more than ten years left to maturity, the Fed’s very large cash losses will most likely continue for quite a while.

Another source of recapitalization is needed.

The original FRA as enacted in 1913 provided for the US Treasury to buy Federal Reserve Bank stock, if necessary. (It also provided for possible sale of FRB stock to the public, which did not happen and could not happen under today’s circumstances.) Section 2.10 of the FRA, which has never been amended, empowers an FRB to issue shares to the Treasury to raise needed capital:

Should the total subscriptions … to the stock of said Federal reserve banks, or any one or more of them, be, in the judgment of the organization committee [the Secretary of Treasury, the Secretary of Agriculture, the Comptroller of the Currency], insufficient to provide the capital required therefor, then and in that event the said organization committee shall allot to the United States such an amount of said stock as said committee shall determine. Said United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated, and shall be held by the Secretary of the Treasury, and be disposed of… as the Secretary of the Treasury shall determine.

In a 1941 opinion, the Federal Reserve Board argued: “As originally enacted, the Federal Reserve Act provided for a Reserve Bank Organization Committee … [and] was authorized to allot Federal Reserve Bank stock to the United States in the event that subscriptions to such stock … were inadequate. However, subscriptions by member banks were adequate. … Accordingly, [this section] is now of no practical effect.”

However, the Fed’s financial condition has dramatically changed since 1941. In 2024, the subscriptions to the capital of the FRBs are grossly inadequate—the FRBs cannot maintain positive capital. Allocation of Fed stock to the United States would now be of very significant practical effect.

In light of the Fed’s technical insolvency, ongoing huge losses, and massively negative capital, Congress could sensibly amend Section 2.10 to read as follows:

Should the total subscriptions to the stock of the Federal reserve banks and the further assessments of the shareholders be insufficient to maintain positive capital as measured by GAAP for any one or more of the Federal reserve banks, then the Board of Governors of the Federal Reserve shall allot to the United States such an amount of said stock as the Board shall determine will bring the capital as measured by GAAP of these Federal reserve banks to not less than $100 million and maintain the consolidated capital of the Federal Reserve System as measured by GAAP at not less than $1.2 billion. The United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated and shall be held by the Secretary of the Treasury. Said stock may be repurchased at par by a Federal reserve bank or banks at any time, provided that after the repurchase, the capital of each Federal reserve bank as measured by GAAP shall be not less than $100 million and that the consolidated capital of the Federal Reserve System as measured by GAAP shall be not less than $1.2 billion.

The stock purchased by the Treasury would be non-voting, since the FRA provides that “Stock not held by member banks shall not be entitled to voting power.”

If over the next 15 months the Fed loses the same $135 billion as it has in the last 15 months, the Treasury would own about $123 billion in par value of FRB stock by March 31, 2025, and the member banks would own $72 billion after the capital call. The Treasury would thus own about 62% of the consolidated Fed stock but could not vote its shares. Over the long-term future, the FRBs would repurchase the Treasury’s shares as their finances permit.

With these four steps, the recapitalization of the Federal Reserve would be complete. Our proposed consolidated capital of $1.2 billion compared to the Fed’s beginning of 2024 total assets of $7.7 trillion, would give the Fed a leverage capital ratio of 0.016%—small indeed, but always positive. In other words, this revised section of the Federal Reserve Act would mean that the Treasury would, as it does for Fannie Mae and Freddie Mac, ensure that over time, the most important central bank in the world would never again be technically insolvent, no matter how big its losses.

"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.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes.

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.

Hearkening to Hayek: How About a Free Competition Between Bitcoin, Paper Money, and Gold?

Published in the New York Sun:

That object of volatile speculation, the Bitcoin, is not a physical coin or any physical object at all. It is certainly not a gold coin and is not redeemable or backed by anything, let alone gold coins. Yet it is endlessly pictured in press illustrations as a gold coin with a “B” stamped on it.

Go ahead, kid me. These illustrations are a notable marketing success for Bitcoin, but why is there such an urge among publishers to show Bitcoins as gold coins? Not one of them would dream of illustrating United States dollars as gold coins — though our own government has tried the trick.

Gold coins are physical reality, while Bitcoins, being electronic accounting entries in a complex computer algorithm, never are. Gold coins with their durability, beauty, and scarcity will still be there even if all electric systems are knocked out and your computers don’t work at all.

The ubiquitous visual suggestion that Bitcoins are gold coins is, though, a misrepresentation. How could one more accurately suggest in an illustration the electronic accounting entry which Bitcoin is, given that one can’t actually draw a Bitcoin? Could one  show a drawing of a computer screen with Bitcoin prices on it?

For those who reasonably maintain that the unbacked Bitcoin is simply a form of gambling, a computer screen with an electronic roulette wheel on it might be used. Dollars are often depicted in publications as paper currency. Paper currency is physical reality which also will still be there if the electricity and the computers don’t work.

Then again, too, it’s only cheap paper which can be endlessly depreciated by its issuing central bank. Paper currency is normally convertible into bank deposits and vice versa. Yet if the bank fails, paper currency looks a lot better than deposits. It would be there, still at par, when the bank has folded, and one would not need to worry about what government bailouts may be in process.

Even so, in holding the paper currency, one would still be a target of the inflationist drive of the Federal Reserve and other central bankers. One would be holding a unit of money, in respect of the Fed has formally set a goal of depreciating at an average of two percent — forever. 

Historically, it would have been accurate to depict dollars as gold coins. Gold coins denominated in dollars freely circulated for parts of our history. Dollar paper currency was redeemable in and backed by gold. Bank deposits were withdrawable in gold coins. The Federal Reserve was required by law to hold gold collateral against its paper currency.

This gold standard world is hardly even imaginable by most people today. It ended in 1933 when the government made owning gold illegal for American citizens, with criminal penalties. This prohibition, which lasted more than 40 years, was remarkably oppressive. It enabled a vast expansion of government power.

The Nobel laureate Friedrich Hayek, in his 1974 essay “Choice in Currency,” argued that “With the exception… of the gold standard, practically all governments in history have used their exclusive power to issue money in order to defraud and plunder the people.” 

Therefore, Hayek asked, “why should we not let people choose freely what money they want to use?” Bitcoin enthusiasts love this idea, and propose Bitcoin as the alternative money to escape the monetary control of inflationist central banks.

Despite its remarkable record as an object of speculation, Bitcoin has a scant record as a currency in general use. What a contrast to the long history of gold-backed currency.

That a revived gold-backed currency would become a renewed alternative to pure paper currencies was Hayek’s actual hope. “It seems not unlikely that gold would ultimately reassert its place…if people were given complete freedom to decide,” he wrote. This would require paper and accounting money defined as a weight of gold and freely redeemable in gold coins.

Would such a money based on gold coins be chosen by the people over paper dollars and Bitcoins in a free competition? How instructive it would be, although directly against the self-interest of every deficit-monetizing government, to run this comparison.

A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

It’s time for universities to share the burden of student loan defaults

Published with Arthur Herman in The Hill.

While the nation is rightly worried about the proliferation of antisemitism on its college campuses, another higher education abuse also needs prompt attention.

On Dec. 6 – St. Nicholas Day – President Biden handed student loan defaulters another $5 billion gift in debt forgiveness. The administration’s eagerness to win the votes of student loan borrowers by shifting the cost of student debt from borrowers to taxpayers now adds up to $132 billion of student loans those borrowers will not have to pay — even though the Supreme Court ruled a related scheme unconstitutional last June.

But if borrowers don’t pay the debts they incurred and default on their debts, someone else has to pay. Right now, that someone else is American taxpayers. Now it’s time that the cost of nonpayment of student loans be shared by those who have benefitted the most directly from federal student loans: namely, the colleges and universities themselves.

By inducing their students to borrow from the government, higher education institutions collect vastly inflated tuition and fees, which they then spend without worrying about whether the loans will ever be repaid. This in turn incentivizes them to push the tuition and fees, and room and board, ever higher — by an average of 169 percent since 1980, according to a Georgetown University study.

In short, in the current system the colleges get and spend billions in borrowed money and put all the loan risk on somebody else — including those student borrowers who responsibly pay off their own debt and those who never borrowed in the first place, not to mention taxpayers, whether they attended a college or not.

This perverse pattern of incentives and rewards must stop. A more equitable model would insist that colleges have serious “skin in the game.” It would insist that they participate to some degree in the losses from defaulted and forgiven loans to their own students.

This idea has been thoughtfully discussed and proposed in Congress before, but now is the time to implement a model that realigns incentives and rewards in our national student loan system and distributes the burden of risk more equitably.

The first principle should be that the more affluent the college is, the higher its participation in the losses should be. The wealthiest colleges with massive endowments should be covering 100 percent of any losses on federal loans to their students, which they can easily afford. Others can cover a lower, but still significant, percentage, but every college that finances itself with federal student loans should assume some real cost when its students default on their loans. Four million student loans enter default each year, not counting the Biden scheme for student loan “forgiveness,” which creates even more losses.

Specifically, we propose the following “skin in the game” requirements for colleges on losses from federal student loans to their students, based on their endowment size:

Endowment Size     Cumulative Rank in Endowments   Coverage of Losses

Over $10 billion                           Top 0.6%                                          100%

$5 billion to $10 billion                Top 1.1%                                            80%

$3 billion to $5 billion                  Top 1.7%                                            60%     

$2 billion to $3 billion                  Top 2.6%                                            40%

All others                                         100%                                            20%

Any fair observer would have to conclude that this represents a rational and efficient matching of benefits and costs.

Moreover, we propose that the most affluent colleges that participate in federal student loans, such as Harvard, Yale and Stanford, should contribute to a “Trust to Offset Losses from Federal Student Loans” through an excise tax on their endowments — some of which are larger than the GDP of sovereign countries. 

This tax would apply to only about the top 1 percent or 2 percent of college endowments. The trust would then be used to offset some of the remaining losses the less affluent colleges cannot pay, thus sharing the wealth of the top 1 percent or 2 percent to help others in need.

For the excise tax to fund the Trust to Offset Losses, we propose:

Endowment Size           Cumulative Rank In Endowments          Tax Rate                     

Over $5 billion                             Top 1.1%                               1% per annum

$2.5 to $5 billion                          Top 2%                                   0.5% per annum

It seems only fair that the wealthiest colleges be asked to contribute to cover the student loan losses the Biden administration is sticking taxpayers with. After all, they benefited the most from the Great Tuition Bubble since the 1980s, just as subprime mortgage brokers benefited in the Great Housing Bubble in the early 2000s.

Since Biden’s St Nicholas Day gift to student borrowers simultaneously gave a large lump of coal to the taxpaying public, not to mention to those borrowers who made every sacrifice to meet their loan obligations, it’s high time to give the rest of us a Christmas present of a new model for government student loans. The proper model should be one that will keep on giving as colleges and universities take on the responsibility and accountability they have shirked until now.

How Can It Be That a ‘Thief in the Night’ Is Loosed by the Federal Reserve Under the Nose of a Passive Congress?

And what would it mean if Congress were active in the decisions?

Published in The New York Sun and also the Federalist Society.

The Federal Reserve is a problem for the constitutional order of our republic. How can it be that the central bank considers itself able to unilaterally impose permanent inflation on the country, without legislative debate or approval?

The shifting theories believed by central banks are among the most important of macro-economic factors. The chairman of the Federal Reserve Board between 1951 and 1970, William McChesney Martin, characterized inflation as “a thief in the night.” 

In remarkable contrast, the Fed under Ben Bernanke, chairman between 2006 and 2014, explicitly committed itself and the country to inflation forever at the rate of 2 percent a year, thus assuming that constant inflation should not only be taken for granted, but pursued. 

If the purchasing power of the currency continuously depreciates at the rate of two percent per year, as the Fed now promises, in the course of a single lifetime, average prices would quintuple. At three percent, as is sometimes suggested, prices in a lifetime would multiply by ten times. At four percent, they would multiply by 23 times.

Is this the kind of money the American people want? I don’t think so. Congress did acquiesce in the 1970s to the executive move to fiat money, untied to gold, as previously required by the Bretton Woods agreement, and later removed legislative ties of the dollar to gold. 

That’s the kind of money wanted by those who long to expand government power and finance it by an unlegislated inflation tax. The Congress didn’t, though, call for, enact, or approve a policy of pursuing inflation per se.  It wrote into the Federal Reserve Reform Act of 1977 a requirement that a principal goal of the Fed is “stable prices.”

The nature of money and the stability of its value is an essential political and social question. William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” On the other hand, we may proclaim, “You shall not drown mankind in a flood of paper money.” Who gets to choose between inflationist money and sound money?

Not the Fed by itself. Coining money, and regulating the value thereof,  are questions profoundly requiring the Congress. They are specifically enumerated in the Constitution as among the powers granted, in Article One, Section Eight, to Congress.

The press is full of references to “the Fed’s” two percent inflation target. But if there is to be such a target, it should be “the country’s” target, not “the Fed’s” target. The Fed’s proposal to constantly depreciate the people’s money should have been presented to the elected representatives of the people for approval or rejection. It wasn’t.

How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and depreciation of the currency at some rate of its own choosing? The only explanation I can think of is pure arrogance. 

Being the most powerful financial institution in the world and the purveyor of the dominant fiat currency might lead the Fed to an excessively high opinion of its own authority. At the same time, the Fed has crucial and dangerous inherent weaknesses.

It has demonstrated beyond question its inability to predict the financial and economic future. It can inflate disastrous asset price bubbles as well as consumer prices. It is unable to know what the results of its own actions will be.

This inability is notably shown by its own financial performance: a net loss of $111 billion since September 2022, as reported on October 19, tens of billions in net losses still to come, and a mark to market loss on its investments of more than $1 trillion.

Congress should, first and foremost, amend the Federal Reserve Act to make it clear that setting any “inflation target” requires review and approval by Congress, as a public choice between kinds of money. And make it clear that the Fed lacks  unilateral power to decide the nature of the money the Congress provides.

Congress should also cancel the two percent inflation target announced by the Fed, until the Congress has approved such an action or provided some other guidance — say, “stable prices” — a goal that is already stated in the Federal Reserve Act, but is being evaded.

Stable prices imply a long-run average inflation rate of approximately zero — in other words, a goal of sound money. All in all, we need to control the powerful and dangerous Federal Reserve by using the checks and balances of our constitutional republic.

Reforming the Federal Reserve

Published in Law & Liberty.

The Federal Reserve creates and manipulates the dominant fiat currency of the world. It produces the inflation of its supply and the continuous depreciation of its purchasing power. It manipulates dollar interest rates and the cost of debt, makes elastic the availability of credit (especially during financial crises), finances the government, and monetizes federal deficits in amounts limited only by the statutory debt ceiling. It is often imagined to be “managing the economy,” although, in fact, no one can successfully do that. It is a central bank not only to the United States, but to the entire dollar-using world. In short, the Fed is the most powerful financial institution there is or ever has been. That such a power is concentrated in a single, unelected institution is a problem for the constitutional order of the American republic.

Equally fundamental is that the Fed is always subject to deep uncertainty. It has clearly demonstrated its inability (like everyone else’s) to predict the economic or financial future, and it is inherently unable to know what the results of its own actions will be. Its remarkable power combined with its inescapable lack of knowledge of the future makes it the most dangerous financial institution in the world. This is true no matter how intelligent or brilliant its officers may be, however good their intentions, however many hundreds of economists they hire, or however complex the computer models they build. 

At the famous Jackson Hole central banking conference in August 2023, Fed Chairman Jay Powell, with admirable candor, pointed out some essential uncertainties in the current Federal Reserve debates. “We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty” about monetary policy, which is “further complicated by uncertainty about the duration of the lags” with which the policy operates and the “changing dynamics [that] may or may not persist.” He continued, “These uncertainties, both old and new, complicate our task.” They certainly do, and this is true of the Fed’s monetary issues at all times.

Powell used an apt metaphor in this respect: “We are navigating by the stars under cloudy skies.” The President of the European Central Bank, Christine Lagarde, used a different metaphor: “There is no pre-existing playbook for the situation we are facing.” But the former Governor of the Bank of England, Mervyn King, in his book, The End of Alchemy, drew a blunter conclusion from it all: “If the future is unknowable, then we simply do not know and it is pointless to pretend otherwise.”

All this should increase our skepticism about how much independent power central banks should have, and whether there is a meaningful path for reform.

Uncertainty and Big Losses 

A good example of the results of uncertainty is the Fed’s own dismal financial performance and growing technical insolvency. The Federal Reserve made net losses of $105 billion as of September 27, 2023 since September 2022. That shocking number is getting rapidly bigger. The Fed continues to lose money at the rate of about $9.5 billion a month or $114 billion a year and the losses may continue for a long time. The accumulated losses are already more than double the Fed’s total capital of $43 billion—indeed, the losses had shriveled its capital, when properly measured under Generally Accepted Accounting Principles (GAAP), to negative $50 billion when Chairman Powell was speaking at Jackson Hole. The Fed’s properly measured capital is likely headed for a negative $100 billion or worse by early 2024. The Fed finances this negative capital by borrowing, which increases the consolidated government debt and is a cost to taxpayers. 

The scale of the losses it is suffering doubtless came as a surprise to the Fed. This is apparent from the woefully inaccurate forecasts of continued “lower for longer” interest rates which it made while amassing trillions of investments in long term, fixed-rate Treasury and mortgage securities with very low yields—including, for example, the 1.25% Treasury bond not maturing until 2050—and funding them with floating rate liabilities. In doing so, the Fed created for its own balance sheet a $5 trillion interest rate risk position similar to that of a giant savings and loan. Such a position would inevitably produce huge losses if interest rates rose to anything like historically normal levels of 4% or 5%. They did, and the losses have followed.

It is impossible to believe that the leadership of the Federal Reserve planned and consciously intended to lose over $100 billion. (As you read this, ask yourself if you believe it.) Fed officials knew they had created a very large interest rate risk position, but as an old boss told me long ago, “Risk is the price you never thought you would have to pay.” The combination of the unknowable future with great financial power joined forces to put this massive cost on the taxpayers without a vote of the Congress.

An Independent Power?

Should the Fed have been able unilaterally to commit the country to perpetual inflation and perpetual depreciation of the dollar’s purchasing power at the rate of 2% per year? The correct answer is “no.”

The media is full of references to “the Fed’s” 2% inflation target—but it should be “the country’s” target. The Fed’s proposal about the nature of the people’s money should have been presented to the elected representatives of the people for approval. The U.S. Constitution provides among the powers of the Congress: “To coin Money [and] regulate the Value thereof.” Regulating the value of the national money and deciding whether it should be stable, or perpetually depreciating, and if so, at what rate, involve inherently political questions. 

Let us review the always-striking math of compound growth rates and apply it to inflation. Stable prices imply a long-run average inflation of approximately zero. At 1% inflation, average prices will more than double in a lifetime of 80 years. At 2% inflation, prices will quintuple. At 3%, they will go up by 10 times. At 4% inflation, prices in a lifetime will go up by 23 times. Which would the sovereign people through their representatives choose? William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” How about “You shall not drown mankind in a flood of fiat money”? This is not up to the Federal Reserve to decide on its own.

The Federal Reserve Act specifies “stable prices” as an institutional Fed goal. The concept of “stable prices” is not the same as “a stable rate of inflation,” which the Fed now calls “price stability,” a misleading rhetorical shift.

It is often claimed, especially by the Fed itself, that the Federal Reserve is, or at least ought to be, “independent.” Supporters of the Fed, especially academic economists, join this chorus. Earlier generations of Fed leaders were more realistic. They spoke of the Fed as “independent within the government”—that is, not really independent. In this context, we may recall that the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board.

“Independent” might mean independent of the U.S. Treasury, so that the Treasury cannot require the Fed to print up money to finance its deficits. However, the Fed has had significant experience as the willing servant of the Treasury. This was especially prominent during wars, such as when the Fed committed to buy however many long-term Treasury bonds it took to keep their yield down to 2.5% during World War II. Similarly, the Fed’s “quantitative easing” artificially lowered the cost of financing Treasury deficits for years. In financial crises, as it did in the Covid crisis, the Fed works hand in glove with the Treasury to finance bailouts.

Alternately, “independent” might mean independent of the Congress. In this sense, the Fed should not be independent. As a matter of fundamental government design, it should be in a system of effective checks and balances to which the Congress is essential. 

Since the original Federal Reserve Act in 1913, there have many amendments to the act, with notable Federal Reserve reform legislation in the 1930s and in 1977–78. After its unprecedented actions in the twenty-first century so far, I suggest that it is time again for serious reform of the Federal Reserve.

Reforming the Fed

With the foregoing problems in mind, I recommend eight specific reforms to promote responsibility to the elected representatives of the people in a system of Constitutional checks and balances, bring greater emphasis on genuine price stability, and align expectations with the realities of limited knowledge and pervasive uncertainty.

1. First and foremost, the Congress should amend the Federal Reserve Act to make it clear that the Fed does not have the authority unilaterally to decide on the nature of U.S. money, an essential public question. The revised act should provide that the maintaining or setting of any “inflation target” requires review and approval by Congress. This would make it consistent with the practice of other democratic countries, notably the father of the inflation targeting theory, New Zealand, where the inflation target has to be an agreement between the central bank and the parliamentary government. The original New Zealand target was zero to 2%. But no long-term target for depreciating the money the government provides and imposes on the people should be set without legislative approval.

A true public discussion of the “Money Question,” as they called it in the long debates that ultimately gave birth to the Federal Reserve, would be salutary.

In contrast to those historic debates, how in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? A new reform would straighten it out on that, establishing that the Fed is not a committee of independent economic philosopher-kings, but “independent within the government,” subject to the checks and balances reflecting a constitutional republic.

2. Consistent with the first reform, the Congress should cancel the 2% inflation target set unilaterally by the Fed until it has approved that or some other guidance. For better guidance, I recommend price stability, or a long-run average target inflation of approximately zero, cyclically varying in a range of perhaps -1% to +1%. This would be a modern form of “sound money.” A range is needed, because it is entirely unrealistic to think the inflation rate should be the same at all times, when every other economic factor is always changing. As an interim step, one could live with New Zealand’s original range of zero to 2%. 

3. From 1913 to 2008, the Fed’s investments in mortgages were exactly zero, reflecting the fundamental principle that the central bank should not use its monopoly money power to subsidize specific sectors or interests. The Fed’s buying mortgage securities was an emergency action in a housing finance crisis that has now been over for more than a decade. Its mortgage investments should go back to zero. The Fed made itself into the world’s biggest savings and loan; its mortgage portfolio totaled $2.5 trillion in August 2023. So the run-off will take a long time, but the Fed’s mortgage investments should finally go to zero and stay there, at least until the next mortgage finance crisis.

4. The fundamental structure of the Fed’s consolidated balance sheet, and the balance sheets of the 12 individual Federal Reserve Banks, should be reviewed by Congress, including their capitalization. An iron principle of accounting is that operating losses are subtracted from retained earnings and therefore from capital. Unbelievably, the Fed’s accounting does not follow this principle, but embarrassingly pretends that its operating cash losses are an intangible asset. This is in order to avoid reporting its true capital. Properly measured, using GAAP, at the end of August 2023, the Fed’s consolidated capital was negative $52 billion.

All Federal Reserve member banks have bought only one-half of the Fed stock to which they have subscribed, and the other half is callable at any time by the Federal Reserve Board. The Fed could raise $36 billion in new capital by issuing a call for the other half. It should do this, with due notice, to bolster the depleted or exhausted capital of the various Federal Reserve Banks.

In addition, the Fed is authorized by the Federal Reserve Act to assess the member bank shareholders up to 6% of the member’s own capital and surplus to offset Federal Reserve Bank losses. Since these losses otherwise become costs to the taxpayers, the Fed should discuss with Congress whether it should proceed to make such assessments.

5. The Fed should be required to use standard U.S. GAAP accounting in reporting its capital. It would not have to go as far as the Central Bank of Switzerland, which by law reports its earnings and capital on a mark-to-market basis, making its earnings and capital reflect the realities of market prices. The Fed’s mark-to-market loss as of June 2023 is over $1 trillion. Recognizing the Fed’s argument that these are “paper losses,” the Fed could continue to disclose them but not book them into capital. However, operating cash losses like the Fed is experiencing without question reduce capital and the Fed should be instructed to adopt GAAP in this respect. As Bishop Joseph Butler said, “Things and actions are what they are. … Why then should we desire to be deceived?”

 6. Dividends on Fed stock should be paid only out of Federal Reserve Bank profits. The Federal Reserve Banks pay attractive dividends, defined by the Federal Reserve Act, to their member bank shareholders: 6% dividends to small banks and the 10-year Treasury note rate, now over 4%, to larger banks. This is fine as long as the Fed is making money, but, as is little known, the act does not require profits to pay dividends and also makes the dividends cumulative, so they have to be paid, now or in the future. These statutory provisions obviously never contemplated that the Federal Reserve would someday be making gigantic losses. If Federal Reserve Banks have lost so much money that they have negative retained earnings, let alone negative total capital, they should not be paying dividends, and any dividends should not be cumulative. Otherwise, such dividends are being paid in effect by the taxpayers. 

7. Congress should revoke the Fed’s payment of the expenses of the Consumer Financial Protection Bureau. When the Fed is losing more than $100 billion a year, it is ridiculous for it to be paying over $700 million a year in the expenses of an unrelated entity for which it has no management responsibility. Far worse than ridiculous, it is against the Constitutional structure of the U.S. government, depriving Congress of its essential power of the purse. This issue may be decided by the Supreme Court in a current case involving whether the CFPB’s funding by the Fed violates the U.S. Constitution. It seems obvious to many of us that it does, and that whatever amount of money the Congress wants to spend on the Consumer Financial Protection Bureau, it ought to be appropriated in the normal way.

8. In general and throughout all considerations of the Federal Reserve, all parties, including the Congress and the Fed itself, should be realistic about the inherent inability of the Fed to reliably forecast the economic or financial future or to “manage the economy” or to know what the results of its own actions will be. In the memorable phrase of F. A. Hayek’s Nobel Prize Lecture, there should be no “pretense of knowledge” about central banking.

These proposed reforms reflect the lessons of the Federal Reserve’s eventful twenty-first-century career so far. As it heads for its 110th birthday, they would move the Fed, with its power and with its danger, toward operating more effectively in the context of our Constitutional republic.

The New Bank Bailout

Taxpayers are covering Federal Reserve losses, for which member banks are supposed to be liable.

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

Taxpayers are bailing out Federal Reserve member banks—institutions that own the stock of the Fed’s 12 district banks—and hardly anyone has noticed. For more than 100 years, our central-banking system has made a profit and reliably remitted funds to the U.S. Treasury. Those days are gone. Sharp rate hikes have made the interest the Fed pays on its deposits and borrowing much higher than the yield it receives on its trillions in long-term investments. Since September 2022, its expenses have greatly exceeded its interest earnings. It has accumulated nearly $93 billion in cash operating losses and made no such remittances.

The Fed is able to assess member banks for these losses, but it has instead borrowed to fund them, shifting the bill to taxpayers by raising the consolidated federal debt. That tab is growing larger by the week. Under generally accepted accounting principles, the Fed has $86 billion in negative retained earnings, bringing its total capital to around negative $50 billion.

Each of the Fed’s 12 district banks, except Atlanta, has suffered large operating losses. Accumulated operating losses in the New York, Chicago, Dallas and Richmond, Va., district banks have more than consumed their capital, making each deeply insolvent. A fifth district bank, Boston, is teetering on insolvency. At the current rate of loss, five others will face insolvency within a year and the taxpayers’ bill will grow by more than $9 billion a month until interest rates decline or the Fed imposes a capital call or assessments on its member banks.

The Federal Reserve Act requires that member banks subscribe to the shares issued by their district bank in a dollar value equal to 6% of a member institution’s “capital” and “surplus”—the definitions of which depend on the depository institution’s charter. Member banks must pay for half their subscribed shares, while the remaining half of the subscription is subject to call by the board.

The act empowers the Fed to compel member banks to contribute additional funds to cover their district reserve bank operating losses up to an amount equal to the value of their membership subscription. The provision reads: “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” (emphasis added).

In the century when district banks were reliably profitable, these provisions posed only a remote risk to Fed shareholders. The central bank didn’t need member banks to make any additional contributions. As district banks’ consolidated losses approach $100 billion, however, the risks to Fed stockholders have risen. If called on, member banks are legally responsible to make these payments. At a minimum, they should disclose this potential liability.

The risk is that the more than 1,400 Fed-shareholder banks could receive a call on their resources equal to as much as 9% of their capital and surplus—a call for a 3% additional equity investment and 6% cash payment to offset district bank losses. Member banks could be on the hook to contribute three times the capital they currently own in their district bank, or $108 billion in total for the central-bank system.

The Securities and Exchange Commission requires every registered firm to include in its annual 10K reports “an explanation of its off-balance sheet arrangements.” The provision applies to securities issued by banks and bank holding companies that are traded on national exchanges, but enforcement is delegated to the federal regulatory agencies that aren’t requiring Fed member banks and their holding companies to disclose the Fed’s contingent resource claim as a material risk or as a contingent liability.

Consider the Goldman Sachs Group, which includes at least two Fed member banks. The company’s 10K for 2022 includes page after page devoted to discussion of the group’s regulatory, market, competition, operational, sustainability and climate-change risks. Not included in that list is the risk of being compelled to recapitalize and share in the losses of its Fed district banks.

The larger of the two is a member of the New York Federal Reserve Bank, a district bank with accumulated losses of nearly $62 billion, or more than four times its $15 billion stated capital. A smaller Goldman Sachs Trust bank is a member of the Philadelphia Fed, a bank with $821 million in accumulated losses.

Goldman’s member banks had almost $44 billion in capital and surplus, according to our analysis of its June regulatory-call report data. Applying the 3% equity-investment and 6% cash-payment requirements, we calculate that Goldman would face a maximum contingent call of approximately $4 billion—a sum that would exceed the combined 2022 income of its two Fed member banks.

Those sums aren’t mere rounding errors, and they shouldn’t be placed on taxpayers’ tab. Federal bank regulators should require Fed member banks that are registered with the SEC and their holding companies to disclose their risks of being called on to prop up the finances of their Federal Reserve district banks.

The Fed Is Losing Tens of Billions: How Are Individual Federal Reserve Banks Doing?

Published in the Mises Institute with Daniel J. Semelsberger. Also published in RealClear Markets.

The Federal Reserve System as of the end of July 2023 has accumulated operating losses of $83 billion and, with proper, generally accepted accounting principles applied, its consolidated retained earnings are negative $76 billion, and its total capital negative $40 billion. But the System is made up of 12 individual Federal Reserve Banks (FRBs).1 Each is a separate corporation with its own shareholders, board of directors, management and financial statements. The commercial banks that are the shareholders of the Fed actually own shares in the particular FRB of which they are a member, and receive dividends from that FRB. As the System in total puts up shockingly bad numbers, the financial situations of the individual FRBs are seldom, if ever, mentioned. In this article we explore how the individual FRBs are doing.

All 12 FRBs have net accumulated operating losses, but the individual FRB losses range from huge in New York and really big in Richmond and Chicago to almost breakeven in Atlanta. Seven FRBs have accumulated losses of more than $1 billion. The accumulated losses of each FRB as of July 26, 2023 are shown in Table 1.

Table 1: Accumulated Operating Losses of Individual Federal Reserve Banks [2]

New York ($55.5 billion)

Richmond ($11.2 billion )

Chicago ( $6.6 billion )

San Francisco ( $2.6 billion )

Cleveland ( $2.5 billion )

Boston ( $1.6 billion )

Dallas ( $1.4 billion )

Philadelphia ($688 million)

Kansas City ($295 million )

Minneapolis ($151 million )

St. Louis ($109 million )

Atlanta ($ 13 million )

The FRBs are of very different sizes. The FRB of New York, for example, has total assets of about half of the entire Federal Reserve System. In other words, it is as big as the other 11 FRBs put together, by far first among equals. The smallest FRB, Minneapolis, has assets of less than 2% of New York. To adjust for the differences in size, Table 2 shows the accumulated losses as a percent of the total capital of each FRB, answering the question, “What percent of its capital has each FRB lost through July 2023?” There is wide variation among the FRBs. It can be seen that New York is also first, the booby prize, in this measure, while Chicago is a notable second, both having already lost more than three times their capital. Two additional FRBs have lost more than 100% of their capital, four others more than half their capital so far, and two nearly half. Two remain relatively untouched.

Table 2: Accumulated Losses as a Percent of Total Capital of Individual FRBs [3]

New York 373%

Chicago 327%

Dallas 159%

Richmond 133%

Boston 87%

Kansas City 64%

Cleveland 56%

Minneapolis 56%

San Francisco 48%

Philadelphia 46%

St. Louis 11%

Atlanta 1%

Thanks to statutory formulas written by a Congress unable to imagine that the Federal Reserve could ever lose money, let alone lose massive amounts of money, the FRBs maintained only small amounts of retained earnings, only about 16% of their total capital. From the percentages in Table 2 compared to 16%, it may be readily observed that the losses have consumed far more than the retained earnings in all but two FRBs. The GAAP accounting principle to be applied is that operating losses are a subtraction from retained earnings. Unbelievably, the Federal Reserve claims that its losses are instead an intangible asset. But keeping books of the Federal Reserve properly, 10 of the FRBs now have negative retained earnings, so nothing left to pay out in dividends.

On orthodox principles, then, 10 of the 12 FRBs would not be paying dividends to their shareholders. But they continue to do so. Should they?

Much more striking than negative retained earnings is negative total capital. As stated above, properly accounted for, the Federal Reserve in the aggregate has negative capital of $40 billion as of July 2023. This capital deficit is growing at the rate of about $ 2 billion a week, or over $100 billion a year. The Fed urgently wants you to believe that its negative capital does not matter. Whether it does or what negative capital means to the credibility of a central bank can be debated, but the big negative number is there. It is unevenly divided among the individual FRBs, however.

With proper accounting, as is also apparent from Table 2, four of the FRBs already have negative total capital. Their negative capital in dollars shown in Table 3.

Table 3: Federal Reserve Banks with Negative Capital as of July 2023 [4]

New York ($40.7 billion)

Chicago ($ 4.6 billion )

Richmond ($ 2.8 billion )

Dallas ($514 million )

In these cases, we may even more pointedly ask: With negative capital, why are these banks paying dividends?

In six other FRBs, their already shrunken capital keeps on being depleted by continuing losses. At the current rate, they will have negative capital within a year, and in 2024 will face the same fundamental question.

What explains the notable differences among the various FRBs in the extent of their losses and the damage to their capital? The answer is the large difference in the advantage the various FRBs enjoy by issuing paper currency or dollar bills, formally called “Federal Reserve Notes.” Every dollar bill is issued by and is a liability of a particular FRB, and the FRBs differ widely in the proportion of their balance sheet funded by paper currency.

The zero-interest cost funding provided by Federal Reserve Notes reduces the need for interest-bearing funding. All FRBs are invested in billions of long-term fixed-rate bonds and mortgage securities yielding approximately 2%, while they all pay over 5% for their deposits and borrowed funds—a surefire formula for losing money. But they pay 5% on smaller amounts if they have more zero-cost paper money funding their bank. In general, more paper currency financing reduces an FRB’s operating loss, and a smaller proportion of Federal Reserve Notes in its balance sheet increases its loss. The wide range of Federal Reserve Notes as a percent of various FRBs’ total liabilities, a key factor in Atlanta’s small accumulated losses and New York’s huge ones, is shown in Table 4.

Table 4: Federal Reserve Notes Outstanding as a Percent of Total Liabilities [5]

Atlanta 64%

St. Louis 60%

Minneapolis 58%

Dallas 51%

Kansas City 50%

Boston 45%

Philadelphia 44%

San Francisco 39%

Cleveland 38%

Chicago 26%

Richmond 23%

New York 17%

The Federal Reserve System was originally conceived not as a unitary central bank, but as 12 regional reserve banks. It has evolved a long way toward being a unitary organization since then, but there are still 12 different banks, with different balance sheets, different shareholders, different losses, and different depletion or exhaustion of their capital. Should it make a difference to a member bank shareholder which particular FRB it owns stock in? The authors of the Federal Reserve Act thought so. Do you?

______________

1. In order of their district numbers, which go from east to west, the 12 FRBs are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

2. Federal Reserve H.4.1 Release, July 27, 2023

3. Our calculations based on the July 27 H.4.1 Release.

4. Ibid.

5. Ibid.

Will the Fed take the medicine one of its presidents prescribes for other banks?

Published in The Hill.

The president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, like an old doctor for ailing banks, recently prescribed a stern regimen for those in weakened conditions from big mark-to-market losses on their long-term investments and loans. Speaking at a National Bureau of Economic Research panel this month, Kashkari pointedly asked: 

“What can a bank do that is already facing large mark-to-market losses?” 

An excellent and hard question, for the losses have already happened, economically speaking. Of course, these banks can passively hold on and hope that interest rates will go back down to their historic lows, and hope that depositors will stop demanding higher yields or departing elsewhere. 

Besides hoping, what can they do?

Doctor Kashkari unsympathetically reviewed the possible medicines, all bitter. These, he said, were three: 

1. Try to raise more equity. 

2. Sell the underwater assets. 

3. Cut dividends. 

Considering these options, Kashkari observed that raising equity may not be so easy or attractive, since investors may not be inclined to invest in funding losses. Divesting the underwater assets by definition means selling at a loss, so the unrealized losses become realized losses on the accounting books.  This perhaps would render the bank formally undercapitalized or worse and may frighten large depositors — will they run?

The third option of cutting dividends then appears as the most practical way to conserve some capital, but as Kashkari asked rhetorically, how many bank CEOs are likely to want to cut their dividends? So he proposed new stress tests with high-interest rates, which would lead to restricting the dividends by regulatory order.

Physician, Heal Thyself! 

Kashkari did not mention that the biggest bank in the country, the one he works for, is facing particularly large mark-to-market losses. The $8 trillion Federal Reserve has net mark-to-market loss of $911 billion as of its last report on March 31. This mark-to-market loss is a remarkable 21 times its total capital of $42 billion. Moreover, according to my calculations, the Fed appears to be heading for an operating loss of about $110 billion for the year 2023. 

So it is timely and appropriate to apply “Doctor” Kashkari’s three possible medicines to the Federal Reserve itself.  

1. The Fed is clearly in a position to raise more equity in the face of its losses if it chooses to. All the commercial bank members of the Federal Reserve are required to subscribe to stock in the Federal Reserve according to a formula based on their own capital, but they all have bought only half of their required subscriptions. The Fed has the right to call for the purchase of the other half at its discretion. It could issue that call right now, and double its paid-in capital. But will it?   

1. The Fed could obviously sell some of its underwater investments. But just as for other banks, that would turn unrealized losses into realized losses and make the Fed’s existing accounting losses even bigger. As the leading investor in mortgage-backed and long-term Treasury securities, large sales by the Fed could move market prices downward, increasing its mark-to-market losses on the remaining investments. Although it has produced projections of realizing losses by sales of underwater investments, the Fed, like the banks Kashkari discussed, chooses not to sell. 

1. How about dividends then? The Fed is paying rich dividends of 6 percent to small banks and the 10-year Treasury yield to large banks while it is running an estimated annual loss of about $110 billion, has a $911 billion mark to market loss, and properly accounted for per my calculations, has negative capital of $38 billion, which is getting more negative each week. It is borrowing money to pay its dividends. And what would a high interest rate stress test applied to the Fed’s massive interest rate risk show? Should the Fed take Kashkari’s dividend medicine and restrict or skip its dividends in light of its huge losses? Revising Kashkari’s rhetorical question, how many Federal Reserve presidents and governors want to do that, including the president of the Federal Reserve Bank of Minneapolis? 

As that president explained, when you already have large economic losses, none of the options are appetizing. 

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?