Congressional hearing on the future of money & crypto: “These innovations should be fostered not smothered”

Published in Crowdfund Insider.

As previously reported, the list of witnesses included the following individuals;

Dr. Rodney J. Garratt, Maxwell C. and Mary Pellish Chair, Professor of Economics, University of California Santa BarbaraDr. Norbert J. Michel, Director, Center for Data Analysis, The Heritage FoundationDr. Eswar S. Prasad, Senior Fellow, The Brookings InstitutionMr. Alex J. Pollock, Distinguished Senior Fellow, R Street Institute[…]

Pollock quoted Hayek in his remarks. Sympathizing with the famous economist;

“Why should we not let people choose freely what money they want to use? … I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful. … I hope it will not be too long before complete freedom to deal in any money one likes will be regarded as the essential mark of a free country.”

While adding he did not expect a “revolution in the international monetary system,” Dr. Prasad stated;

“While reserve currencies might not be challenged as stores of value, digital versions of extant reserve currencies and improved cross-border transaction channels could intensify competition among reserve currencies themselves.”

[…]

Pollock, on the other hand, called having a CBDC one the the worst ideas of the times.

Representative Barr asked if crypto could supplant US dollars as a reserve currency? And what type of implications this may have.

Michel said it is not going to happen. The US dollar has a competitive advantage of wealth storage added Pollock.

US Congressman stands against cryptos

Published by Live Coin Watch.

However, there are also many who are opposing the idea, pointing out potential risks, and not wanting to change the traditional methods. The concept reached the Wednesday’s hearing, and R Street Institute’s senior fellow, Alex Pollock, stood against it, saying that it is the worst financial idea that has been conceived lately.

US Congress hearing: Central bank digital currency ‘one of the worst financial ideas’

From Cointelegraph:

Alex Pollock, senior fellow at the R Street Institute, argued that “to have a central bank digital currency is one of the worst financial ideas of recent times, but still it’s quite conceivable…” Pollock said that central bank digital currencies would only increase the size, role, and power of the bank, adding that the Federal Reserve adopting a CBDC would result in it become the “overwhelming credit allocator of the U.S. economic and financial system.” He continued:

“I think we can we can safely predict that its credit allocation would unavoidably be highly politicized and the taxpayers would be on the hook for its credit losses. The risk would be directly in the central bank.”

Pollock explained that if fiat money becomes digitized, its nature will not be changed, and will still be issued by a central bank. While Pollock can envision some type of private digital currency backed by assets, he concluded that it will not be “private fiat currency” like Bitcoin. In Pollock’s view, cryptocurrencies are essentially the same as scrip.

“We should prohibit U.S. persons from buying or mining cryptocurrencies,” says Rep. Brad Sherman

Published in Hacked.com.

Unfortunately, Rep. Sherman’s utterances were not the only anti-cryptocurrency statements at the hearing. Specifically, Alex Pollock, a fellow from the Pro-Free Market think R Street Institute, stated his view that, “a central bank virtual currency is one of the worst ideas in recent times.”

A central bank digital currency is one of the worst financial ideas ever – US Congress hearing

Published in Smartereum.

Another member of the committee from R. Street Institute, Alex Pollock, argued that having a digital currency owned and regulated by the Central Bank is the worst financial idea in the recent times. According to Pollock, the digital currencies by the central bank would do nothing but increase the role and power of the central bank. It would also make the Central Bank an overwhelming credit allocator in the United States economy.

In Pollock’s words:

“Its safe to predict that the credit allocation of the central bank will undoubtedly become politicized. Taxpayers will be on hook for credit losses. The Central Bank will bear the risk directly.”

According to Pollock, if fiat money is digitized, the nature of the currency will not change and the Central Bank will still be responsible for issuing it. He said that cryptocurrencies are more or less the same as scrip.

Digital Money: More competition? Even more central bank monopoly?

Published by the R Street Institute.

Mr. Chairman, Ranking Member Moore and Members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. As part of my many years of work in banking and on financial policy issues, I have studied the history and various concepts of money, including the development of central banks and banking systems, and authored many articles, presentations and testimony on related subjects. Before joining R Street, I was a resident fellow at the American Enterprise Institute 2004-2015, and president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

Central Bank Monopoly or Privately Issued Money?

As we think about the future of money, which grows ever more digital in its transactions and records, it helps to consider the varieties of money displayed by the past. Today, we are accustomed to the Federal Reserve and other central banks having a monopoly on the issuance of each national money. A senior officer of the Bank of England has summed up the prevailing view:

The distinctive feature of a central bank derives from its role as the monopoly supplier of outside money, [that is] notes and coin and commercial bank reserve deposits. These constitute the ultimate settlement asset for an economy and mean that the central bank has a unique ability to create or destroy liquidity.

But do you have to have a central bank as the monopoly supplier of money? Historically, clearly not. For one thing, there have not always been central banks. The Bank of Canada, for example, dates only from 1934 and there was obviously money in Canada before that, as there was in the United States before the Federal Reserve was chartered in 1913 and subsequently developed its currency-issuing monopoly. Even with the Fed, there were other forms of U.S. currency existing until the 1960s—namely, silver certificates and United States notes. National banks issued their own currency until the 1930s, as authorized under the National Bank Act of 1863-64.

One of the intriguing questions posed by bitcoin and other “cryptocurrencies” (hereafter “bitcoin” for short) is whether today there can be a successful privately issued currency that is widely accepted and constantly used in settlement of purchases and sales, and thus actually serves as money. This would be a money which is not issued by the government or its central bank, and is not backed by the force and power of compulsion of the federal government.

There have been numerous historical examples of private currencies, but to my knowledge there has never been a private fiat currency. They all were claims on some kind of assets, which bitcoin and its siblings are explicitly not.

Consider a classic form of money: gold and silver coins. As the interesting book Money and the Nation State tells us, “Nothing about operating a mint requires the state rather than private enterprise to perform that function. … Private mints operated in the United States until they were prohibited during the Civil War.” Such coins, unlike all currency today, were intrinsically valuable, whether minted privately or by governments.

A common form of private money in the American 19th century were the circulating notes of state-chartered banks. So you might have carried in your wallet a $5 bill issued by something like the Third State Bank of Skunk Creek or hundreds of others. I had an acquaintance who had a huge collection of such banknotes—he gave me a copy of a $3 bill issued by the Wisconsin Marine and Fire Insurance Co., a predecessor of one of my former employers, now a tiny part of today’s JPMorgan Chase. All such notes were backed by the loans, investments and capital of the issuing bank—they were not fiat money, as bitcoin wishes it might become.

The “free banking” theory maintains that a monetary system is better when composed of competing currency issued by private banks, instead of a monopoly currency of the central bank. This is far from the dominant view, however.

Most money used in transactions today is in the form of deposits, already a kind of digital money, operated for the most part and settled electronically, in this country denominated in U.S. dollars. Deposits are also backed by the assets and capital of the issuing bank, as well as the guaranty of the federal government, which if its deposit insurance fund fails, can tax some people to make good the deposits of others. Deposits are thus a mix of private and government money.

Troubled financial times have given rise to experiments with currency. “In America’s first depression, 1819-1821,” we learn from economist Murray Rothbard, “four Western states (Tennessee, Kentucky, Illinois and Missouri) established [their own] state-owned banks, issuing fiat paper.” Unfortunately, this did not end well, as “the new paper depreciated rapidly.” In contrast, the strategy of the Federal Reserve today is to have its paper depreciate slowly and steadily.

During the Great Depression of the 1930s, many municipalities, including the financially desperate City of Detroit, issued their own currency, or “scrip,” to make payrolls. They were out of U.S. dollars and could not borrow any more. The scrip could be used to pay property and other local taxes, which gave it some currency. It often traded at discounts to regular dollars, but still could be used to buy things locally. Says one history of this emergency experiment:

Some sort of scrip was issued by several hundred municipalities, business associations, companies, banking organizations, barter and self-help cooperatives. … Cash-strapped counties and cities across the country paid their employees with scrip issued against prospective tax receipts and good for current taxes and other public fees. In the early 1930s, 25 states revised their laws to authorize the issue of scrip.

These were interesting, but temporary expedients. They do not provide much support for the monetary hopes of bitcoin enthusiasts.

Turning to theory as opposed to history, the great economist, Friedrich Hayek, in his essay, “Choice in Currency,” provided a theory congenial to the libertarian strain of bitcoin backers. Said Hayek:

Why should we not let people choose freely what money they want to use? … I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful. … I hope it will not be too long before complete freedom to deal in any money one likes will be regarded as the essential mark of a free country.

I sympathize with these ideas, but I think that Hayek’s hope, expressed in 1975, will continue to be disappointed.

Heading Toward an Even Greater Monopoly?

Will the new and ubiquitous computing power of our time reverse the historical trend toward central bank monopoly of money and create more competition in currency? Bitcoin theorists imagine that it will, but it is easier to imagine digital currency moving us in exactly the opposite direction: toward even greater monopolization of money by the central bank.

Many central banks are interested in the idea of having their own digital currency. That means letting the general public, not only banks, have deposit accounts directly with the central bank, in addition to carrying around its paper currency. The appeal of this idea to central banks is natural: it would vastly increase their size, power and role in the economy.

In a digital age, it would clearly be possible for a central bank, in our case the Federal Reserve, to have tens of millions of accounts directly with individuals, businesses, associations, municipal governments and anybody else, which would be all-electronic. In terms of pure financial technique, there is nothing standing in the way. But would this be a good idea? Should Congress ever consider it?

In a recent article, “The Bank of Our Dreams,” Matthew Klein suggests that it would be a wonderful idea. “It is time for the largest U.S. bank to open its doors to the public,” he says. Citing the proposal of three law school professors, “A Public Option for Bank Accounts (Or Central Banking for All),” he summarizes:

Their ‘public option for bank accounts’ would offer every American household and business a checking account [though presumably there would be no paper checks] at the Fed.’ This would ‘create a frictionless system, like email.’

The Federal Reserve would be in direct competition with all private banks in such a scheme. It would certainly be a highly advantaged government competitor. It could offer “risk-free” accounts and pay a higher interest rate, if it liked, cross-subsidizing this business with the profits from its currency-issuing monopoly. It would be regulating its competitors while shot through with conflicts of interest. It would put the evolution of central banks a hundred years into reverse.

There are in the American banking system about $12 trillion in domestic deposits. Could the Federal Reserve grab half of them? Why not? That would be $6 trillion, which would expand its balance sheet to $10 trillion. A pretty interesting and unattractive vision of enhanced monopoly.

Says Klein:  “Offering Federal Reserve accounts to the general public would also reduce the taxpayer subsidy for bank risk-taking.” Actually, it would do the opposite: vastly increase taxpayer risk by putting the risk into the Federal Reserve itself.

For the Federal Reserve would have to do something with mountain of deposits—namely make loans and make investments. It would automatically become the overwhelming credit allocator of the financial system. Its credit allocation would unavoidably be highly politicized. It would become merely a government commercial bank, with the taxpayers on the hook for its credit losses. The world’s experience with such politicized lenders makes a sad history.

In short, to have a central bank create digital currency is a terrible idea—one of the worst financial ideas of recent times.

The Future of Money

There is no doubt that the digitalization of financial transactions, records, access to information and communication will continue to increase, and that the electronic networks underlying the activity continue to grow more intense and omnipresent. But the fundamental nature of money, it seems to me, will not change. It will either be:

• The monopoly issuance of a fiat currency by the central bank as part of the government, backed by the power of the government. That the whole world operates on such currencies is a remarkable—and dangerous—invention of the 20th century.

• Or if private currencies do again develop, they will, as in the past, have to be based on a credible claim to reliable assets. With Hayek, we could hope (without much hope) that this might bring competition for government fiat money.

It is clear that having a fiat currency is far too precious and profitable for governments for them ever to go back to a government currency backed and convertible into actual assets, whether gold coins or otherwise.

Government fiat currencies will operate in increasingly digitalized forms. Still, paper money will retain its advantages of secure privacy, immediate settlement without intermediaries and the ability to function when the electricity is shut down. Recently, I was amazed to find that my younger son, an up-and-coming banking officer, was walking around with the total of $1 in his wallet, but of course with a well-used debit card. As this generational difference indicates, doubtless our ideas of money will grow ever more dependent on having the electricity on at all times and everywhere.

Attempts at private fiat currencies, with no claim to any underlying assets, in my view have a very low probability of ever achieving widespread acceptance and functioning as money.

An increase of the monopoly power of central banks, of which we already have too much, should be avoided.

Thank you again for the chance to share these views.

Il Parlamento USA discute sul futuro delle crypto

Published in The Cryptonomist.

All’audizione parteciperanno il dr. Rodney J. Garratt, Maxwell C. e Mary Pellish Chairdell’Università della California a Santa Barbara, il Dr. Norbert J. Michel, Direttore del Centro per l’analisi dei dati della Heritage Foundation, il Dr. Eswar S. Prasad, Senior Fellow presso il Brookings Institution, e Alex J. Pollock, Distinguished Senior Fellow presso R Street Institute.

Is inflation “quite good” or “a thief in the night”?

Published by the R Street Institute.

“Consumer Price Inflation Hits Six-Year High,” is the headline of a July 12 economic report.  The Bureau of Labor Statistics has just reported that as of June, the Consumer Price Index was up 2.9% over a year ago, its biggest increase since 2012. Without food and energy prices, which the Federal Reserve likes to exclude, consumer prices were up 2.3% over the twelve months.  Earlier this week, financial commentator Wolf Richter helpfully reminded us of the obvious: “Consumer price inflation whittles down the purchasing power of labor.”

How should we think about that?  Let us contrast the views of high officers of the Federal Reserve at different times.

William McChesney Martin was the all-time longest serving Chairman of the Federal Reserve Board, from 1951 to 1970, spanning five different U.S. presidents.  A Federal Reserve building in Washington is named after him.

Charles Evans is the current President of the Federal Reserve Bank of Chicago.  He has held this position for more than a decade, since 2007.

Dr. Evans recently told the Wall Street Journal that he thinks the current inflation “looks quite good,” adding, “I’d like to see inflation expectations a little bit higher.”

Such language would presumably have surprised Chairman Martin, who memorably described inflation as “a thief in the night.”  A scholar of the Fed as an institution, Peter Conti-Brown, interprets Martin’s vision of the central bank accordingly: “The keeper of the currency is the one that one that has to enforce the commitment not to steal money through inflation.”

So does inflation “look quite good” or is it “a thief in the night”?

Fashions in central bank ideas change over time: Which view do you prefer?

Humphrey-Hawkins originalist

Published in Grant’s Interest Rate Observer.

Supreme Court nominee Brett Kavanaugh isn’t the only news-making student of original American texts. Alex J. Pollock, distinguished senior fellow at the R Street Institute in Washington, D.C., is fresh from a deep reading of the 1978 Humphrey- Hawkins Act. What it says may surprise you.

It may surprise Jerome H. Powell, who is expected to deliver his semiannual Humphrey-Hawkins testimony (on the 40th anniversary of that oft invoked legislation) on July 17. If past is prologue, the new Fed chairman will advert to the central bank’s so-called dual mandate, i.e., the promotion of “price stability,” which the Fed defines as a 2% rate of inflation, and “full employment,” which the Fed is pleased to leave undefined.

Pollock—and we—have long wondered how stable prices could be if they’re always rising. Congress is not, in fact, the source of a law to command a quintupling in the price level over the course of an 82-year lifespan, which is the clear arithmetic implication of a 2% per annum inflation target. The brain boxes at the Eccles Building and their counterparts at central banks as far away as New Zealand dreamt it up all by themselves.

Never mind by what process of reasoning the Fed settled on 2%. Pollock rather asks, What does the law say?

The Federal Reserve Reform Act of 1977, for one, does not say “price stability,” as Pollock notes: “It does in particular not say ‘a stable rate of inflation.’ It says ‘stable prices.’ Does the term ‘stable prices’ mean perpetual inflation? What did Congress mean by ‘stable prices’ when it put that term into law?”

Who is the boss when it comes to Federal Reserve and Congress?

Published in The Hill.

In January 2008, Federal Reserve Chairman Ben Bernanke made this memorable announcement: “The Federal Reserve is not currently forecasting a recession.” This was a poor forecast indeed, since as we now know, a very deep and painful recession had already started by the time of this prediction that there would not be one.

But this is only one of many such errors. If you have the unrealistic belief that the Fed should somehow manage the economy, banking system, stock market, financial stability, interest rates, employment, inflation and risks, you run into a granite wall of a knowledge problem. The Fed does not know and cannot know enough to do all this.

The simple fact is that the economic and financial future of this great nation is not only unknown, but unknowable, for the Fed as it is for everybody else. It is not that our central bank is any worse than anybody else at knowing the future, including what the results of its own actions will be, but the Fed is just not any better than anybody else.

Yet, the Fed keeps insisting and has enshrined as part of its own confession of faith that it ought to be “independent” as an immensely powerful fiefdom answerable only to its own theories. Should the Fed be independent of Congress? Given the inherent human will to power, naturally those leading the central bank would like to be.

This desire to act as independent economic philosopher kings could be justified by a claim to superior knowledge. But the Fed demonstrably does not have such superior knowledge. Still, we cannot avoid observing that there is a strange and quite common faith in the Fed. For example, it is endlessly repeated in the media that an inflation rate of 2 percent a year must be good because that is the Fed target, apparently without wondering whether this target is a good idea or not.

Of course, some people have more skeptically considered the 2 percent question. Olivier Blanchard, formerly the chief economist of the International Monetary Fund, has stated, “There is no sound economic research that shows 2 percent to be the economically optimal inflation rate.” He was arguing for higher inflation. On the other hand, Alan Greenspan, when asked what the right inflation target was, said “zero” and added “if measured correctly,” a wonderfully famous hedge.

A remarkable thing about the current idea of a Fed inflation target is that it is a target in perpetuity at 2 percent a year forever. To commit for 2 percent a year forever means that in an expected lifetime of 82 years, average prices will quintuple. With a straight face, the Fed informs us that this is “price stability.” Should Congress have anything to say about whether it wants inflation of 2 percent a year forever?

The Fed often states that “price stability” is part of its statutory “dual mandate.” The reference is to the Federal Reserve Reform Act of 1977. But this law does not say “price stability.” It says “stable prices.” It does in particular not say a “stable rate of inflation.” It says “stable prices.” Does the term “stable prices” mean perpetual inflation? What did Congress mean by “stable prices” when it put that term into law?

We learn from the minutes of the Federal Open Market Committee that in 1996, when the Fed was discussing whether it should have an inflation target, one member of the committee dared to ask what Congress meant by the statutory language. This question was quickly passed over and not pursued. But it was a good question, was it not?

In fact, we have a good indication of what Congress meant by “stable prices.” The very next year, in the Humphrey Hawkins Act of 1978, Congress provided the “goal of achieving by 1988 a rate of inflation of zero.” Obviously, this was not achieved and somehow, we never hear the Fed discussing this goal as expressed in statute.

Bernanke advised Janet Yellen, his successor as head of the central bank, to remember that “Congress is our boss.” But does the Fed and those who work there really believe that Congress should be the boss? That these mere politicians, elected by the American people, should be in charge of the powerful economic and financial experts of the Fed?

William Proxmire, a former senator from Wisconsin, once put the case for Congress pretty bluntly in a hearing. He stated, “You recognize, I take it, that the Federal Reserve Board is a creature of Congress?” and “Congress can create it, abolish it, and so forth?” While that is certainly true, but short of abolishing it, what steps can be taken for greater accountability and more effective legislative governance of the Fed?

It seems the best model might be to think of Congress as the board of directors and Federal Reserve officers as the management of government operations in money. With this model in mind, the relationship of the Fed and Congress should evolve into a grown up and real discussion of issues, alternatives, strategies and risks. That would be quite a contrast to the media event that Fed testimony now represents.

Such discussions might even include the Fed asking Congress what it means by “stable prices” as a goal. Of course, the Fed could lay out all its arguments for 2 percent inflation and its thoughts on alternatives for legislative consideration. Can you imagine that? Perhaps you cannot, but as the long history of the Fed demonstrates, many things that were previously unimaginable nevertheless came to pass.

North America update: A bubble and a boom both nearing their ends?

Published by the R Street Institute.

North America certainly presents an interesting housing-finance picture, with big house-price inflation in both Canada and the United States.

Canada’s house price inflation is bigger. Indeed, Canadian house prices surely qualify as a bubble. They have ascended to levels far higher than those at the very top of the U.S. bubble. The increases have been remarkable, and the many years of their run, with hardly a pause, has kept surprising observers (like me) who thought it would have to end before now. Canadian government officials have been worried about it for some time and have tried to slow it down by tightening mortgage credit standards and putting special taxes on foreign house buyers in Toronto and Vancouver. Meanwhile, in the United States, house prices since 2012 – for about six years, have again been booming, fueled by the cheap mortgage credit manufactured by the Federal Reserve. Average U.S. house prices are now over their bubble peak of 2006. However, they are nowhere near the records set in Canada.

Graph 1 shows the paths of average Canadian versus U.S. house prices in the 21st century, with the price indexes set to the year 2000 = 100.

Read the rest here.

Fixing capitalism

Published in Barron’s.

In “A Radical Proposal for Improving Capitalism” (Other Voices, June 16), Eric A. Posner and E. Glen Weyl repeat the venerable observation of Adolph Berle and Gardiner Means (in The Modern Corporation and Private Property, published in 1932) that in corporations, “ownership was separated from control,” where the shareholders are seen as principals and the management as hired agents. But this is old news.

The fundamental structure of corporations has changed little since 1932, but the structure of capital markets has changed a lot. In addition to the concentration of voting power that Posner and Weyl reasonably worry about, a more fundamental problem is that we now have an additional, dominating layer of agents: the investment managers. The result is a further separation: that of ownership from voting. The hired employees of the investment-management firms control the votes, and claim to be stockholders, but in fact they are merely agents with other people’s money.

What do those other people, the real owners, have to say in contrast to whatever their hired agents may think? Those may not be at all the same. If you don’t like agents being in control in the one case of separation, why would you like them being in control in the other?

Have financial follies changed since Walter Bagehot’s day?

Published by the R Street Institute.

Among everything you might read in the realm of finance, there is nothing more enjoyable than reading Jim Grant, with his sparkling mixture of ideas, research and wit—except perhaps reading the great Walter Bagehot himself, with his wonderful Victorian rhetoric. Now we have Jim Grant writing on Walter Bagehot—a terrific combination. I have had the pleasure of reading several chapters from this new book in process.

Of course, Jim finds striking quotations from Bagehot, sometimes from surprising sources. For example, in a letter to his fiancée, Eliza Wilson, written during the financial panic of 1857, Jim has found what Bagehot observed about the “nature of financial faith.”

All banking rests on credit and credit is rather a superstition. At any rate it is adopted not from distinct evidence but from habit, usage and local custom.

That is why it is true that, as Bagehot later wrote in Lombard Street, “(e)very banker knows that if he has to prove he is worthy of credit … in fact his credit is gone.”

When the 1857 panic was over, Bagehot wrote Eliza from London:

The last few times I have been here everybody was on their knees asking for money, now you have to go on your knees to ask people to take it.

“Few better observations of the cycles of bankerly feast and famine have ever been written,” says Jim, continuing: “Historians of economic thought may make of it what they will that the passages formed part of Bagehot’s love letters” to Eliza!

I’m not sure what to make of that, either.

Credit expansion replaced panic, and proceeding to the 1860s, Jim relates, “Financiers reconsidered the field of opportunity. They found it to be bigger and more alluring than before,” just as their successors did in the 1970s, 1980s, 1990s, 2000s and 2010s. Continuing Jim’s text:

The British government borrowed at 3% with the assurance of absolute safety. The Turkish government, with no such assurance, willingly paid 12% to 15%; the Egyptian government, 8% to 9%; the government of the Confederate States of America [this is in the 1860s, remember] 7% along with an option on the price of cotton.

This international credit expansion, like others, led ultimately to defaults and losses. Need we add that today we are once again experiencing stresses in emerging market debts?

The mention of the bonds of the Confederate States of America should remind us of Pollock’s Law of War Finance, which is: Do not lend to the side that is going to lose. By 1865, it was clear that the holders of Confederate bonds were out of luck. The next year, 1866, brought the infamous collapse of the previously prestigious and unquestioned financial firm of Overend, Gurney & Co. in London. As Overend was going down, we learn from Jim’s text:

Their only recourse was to the Bank of England. Would the Old Lady Bank extend a helping hand? The Bank dispatched a three-man team to inspect the supplicant’s books. The verdict was negative—[Overend] was insolvent—and the Bank declined to assist. The heretofore unimaginable occurred. Overend, Gurney closed its doors. The ensuing panic exhausted the descriptive powers of the financial press.

The formerly famous insolvent bank as supplicant to the central bank; this may sound too familiar.

“In the aftermath of the failure of Overend, Gurney,” Jim writes, “investors in foreign bonds arrived in force … In the dull, post-panic British economy, savers strained to earn more than the 3 ¼% available on British government bonds. Risky borrowers, arm-in-arm with their opportunistic bankers, stepped forward to fill the void.” But “Bagehot anticipated the consequences of the coming overseas bond bubble.”

In the 1870s, Jim continues:

Egypt, then a semi-autonomous province of the Turkish, or Ottoman, Empire, was one such seeker of funds. In the case of Egypt, not even the Egyptian government had the [financial] figures.

We may instructively note, much more recently, that neither did, nor does, the government of Puerto Rico, the largest municipal insolvency in history, have its financial figures straight. Nor did the biggest municipal insolvency of its time, the government of New York City, a generation ago and a century after Bagehot was writing on Egypt. But in none of these cases did it stop the investors from sending in their money on faith.

So Bagehot acutely described the financial adventures, mistakes, and foibles of his day, which were a lot like those of our day. Jim draws a further key conclusion about his subject’s character:

Bagehot stood up for the ideal of personal responsibility in financial dealings.

May we all.

We are certainly looking forward to reading the whole of Jim’s new book on Bagehot’s life, ideas, controversies and times.

We won’t know the final lessons of QE until it’s over

Published in Real Clear Markets.

A justly famous line of John Maynard Keynes is:  “Soon or late, it is ideas…which are dangerous for good or evil.”

The first lesson from ten years of Quantitative Easing (QE) is that the ideas of those who run fiat currency central banks, as these ideas change over time and go in and out of central bank fashion, are extremely important for good or evil, on a very large scale.

Contrasting the ideas of QE to earlier governing ideas of the Federal Reserve is instructive.  In the 1950s under Chairman William McChesney Martin, the Fed adopted the “bills only” policy.  That meant the only investment assets from the Fed’s open-market operations were short-term Treasury bills.  The theory was that the Fed’s open market interventions should not operate directly on long-term interest rates and should never try to allocate credit among economic sectors.

This was clearly the opposite of the theory of QE.  It was not a policy directed at financial crisis, as QE originally was.  But the last crisis has now been over for a long time, and QE still amounts to $4.2 trillion on the balance sheet of the Fed.

How many Treasury bills does the Fed own today?  The answer is zero.

So over 50 years, the Fed has gone from believing in all Treasury bills to no Treasury bills.

Another lesson of QE:  Do not look for the ideas of central bankers to be eternal verities—they aren’t.  The times call forth the ideas, for better or for worse.

The Credit Crunch of 1966 was created by the Fed’s regulatory ceilings for interest rates—the Fed used to believe in those, too.  In that year, mortgage lending funds dried up, the savings and loan industry (then politically powerful, believe it or not) was unhappy, and many in Congress wanted the Fed to buy the bonds of Fannie Mae and the Federal Home Loan Banks in order to support housing and housing finance.

Chairman Martin did not agree.  Correctly pointing out that this would be credit allocation by the Fed, he found it a bad idea “to divert open market operations from general economic objectives to the support of specific markets for credit.”  This would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

In my judgment, Martin was right about this, but Congress loves nothing better than to subsidize and overleverage real estate.  Here was the consequent threatening message to the Fed sent by a future Banking Committee chairman, Senator Proxmire, in a 1968 hearing:

“You recognize, I take it, that the Federal Reserve Board is a creature of Congress?

The Congress can create it, abolish it, and so forth?

What would Congress have to do to indicate that it wishes the Board to change its policy and give      greater support to the housing market?”

If Proxmire were still alive, he would presumably be a fan of QE forever.

The new Fed Chairman, Arthur Burns, who arrived in 1970, decided that the Fed should “demonstrate a more cooperative attitude.”  So by the 1980s, the Fed’s bond portfolio came to include the debt of Fannie Mae, the Federal Home Loan Banks, the Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks for Cooperatives, the United States Postal Service, Ginnie Mae, the General Services Administration, the Farmers Home Administration, the Export-Import Bank, and even the Washington Metropolitan Area Transit Authority.  In other words, the Fed was helping fund the Washington DC Metro system!  That was along with funding Fannie Mae when it was insolvent on a mark-to-market basis, as well as the Farm Credit System when it was broke.

Still, at their peak, all these totaled about $9 billion—or about 0.2% of the current size of QE.

Let’s review where the Fed’s QE-dominated balance sheet is now.  As of May 30, 2018, it includes:

Treasury bills:                                                     zero

Longer term Treasury securities:               $2.4 trillion

Long-term mortgage-backed securities:   $1.8 trillion.

These MBS are funded with floating-rate deposits, which makes the Fed in effect the biggest savings and loan in the world.  Even if we needed the world’s biggest S&L in the crisis—do we now?

Total assets:                                                   $4.3 trillion

Total capital:                                                   $39 billion

This means the Fed is leveraged 110 to 1.

As we know, the immense QE portfolios are very slowly running off—not being sold.   Among the reasons for not selling is that the Fed does not want to face the very large losses in its super-leveraged balance sheet that it would probably realize when selling any meaningful part of its huge, unhedged QE position.

Another lesson: It is easier for a central bank to get into a QE portfolio than to get out.

Thus, the exit strategy is constrained to being very gradual, accompanied by the Fed’s intense hope that the ultimate adjustment in inflated house prices, and inflated stock and bond prices, will also be gradual.  This is especially true for house prices, which affect 64% of American households.

Here is a further QE lesson, this one fundamental:  In principle, a fiat currency central bank can make unlimited investments in anything, financed by monetization.

The Federal Reserve is the champion investor in mortgages.  The European Central Bank has invested in corporate bonds, government agencies, regional and local government debt, asset-backed securities, and covered bonds (which include mortgages). The Bank of Japan has bought asset-backed securities and equities, in addition to vast amounts of government debt.  The Swiss central bank has a huge portfolio of foreign currency bonds, a big position in U.S. equities, and also makes loans to domestic mortgage companies.

The Swiss central bank, by the way, is required by law to mark its investment securities to market, a discipline the Fed sedulously avoids.

All of these versions of QE involve credit allocation.  In the case of the Fed, its two favored allocations are housing and long-term financing of the government deficit.

The only limits to what a fiat currency central bank can finance and subsidize are: the law, politics, and the ideas of central bankers.  There are no intrinsic financial constraints.

Whether there will be new legal and political constraints in the future depends, I believe, on how the end of the QE experiments ultimately turn out.  In other words, will the correction of the QE-induced asset price inflations be a soft landing or a hard landing?  If the latter, you can easily imagine a legislature wanting to enact future constraints.

Ten years into QE, what should the Fed be doing now?  The distinguished expert on central banking, Charles Goodhart, recently wrote that it is “generally agreed” that “Where the QE involved directional elements, to support credit flows through critical but weak markets, e.g. the mortgage market in the USA, such assets should be entirely run off, and the assets left in the central bank’s balance sheet should be entirely in the form of government debt.”

With all due respect to Senator Proxmire, this seems correct to me.

But, as Goodhart continues, it does not answer a further question QE makes us ask: What is the optimal size of central bank balance sheets in normal times?  They have become so large—how much smaller should they get?

Other related questions include:  Will the central banks’ credit allocations become viewed in retrospect as misallocations?  And how should we understand the respective roles of the Treasury and the central bank?   Are they essentially one thing masquerading as two, as QE tends to suggest?

I conclude with a final lesson:  We won’t know what the final lessons are until after the exit from QE has been completed.  It ain’t over till it’s over.

Fed continues negative real interest rates

Published by the R Street Institute.

The Federal Reserve yesterday raised its target fed funds rate to a range of between 1.75 percent and 2 percent; let’s just call it 2 percent. That feels a lot higher than the nearly 0 percent it was from the end of 2008 to 2015, but it is still very low and still less than the current rate of inflation. The Consumer Price Index rose over the last 12 months by 2.8 percent, so to do the simple arithmetic:

New Federal Reserve target interest rate: 2%

Less: Inflation rate: 2.8%

Equals: Real short-term interest rate: (0.8%)

In short, nine years after the end of the last recession, nine years into the bull stock market and six years after house prices bottomed and began a new ascent, the Fed is still forcing negative real short-term interest rates on the economy, the financial system and savers.

No wonder that it continues to preside over a massive asset price inflation.

Gold: An especially bad prediction

Published by the R Street Institute.

The history of finance and economics is full of utterly wrong predictions. This should, but doesn’t, teach us intellectual humility when it comes to pontificating about the future. Here is a memorable one, worthy of special mention in the all-time worst financial predictions list:

When the U.S. government stops wasting our resources by trying to maintain the price of gold, its price will sink…to $6 an ounce rather than the current $35 an ounce.

–Henry Ruess, chairman of the Joint Economic Committee of the U.S. Congress, 1967*

In the 1960s, pace Chairman Ruess, the U.S. government was not trying to hold up the price of gold, but to hold up the price of its dollar; that is, to hold down the price of gold. In this effort, it admitted complete defeat in 1971 by reneging on its Bretton-Woods commitments.

The price of gold today is $1,291 an ounce. It is equally true to say that the price of the dollar is 1/1,291 of an ounce of gold, as compared to the official price in Ruess’ day of 1/35 of an ounce.

__________________

*Thanks to investor-philosopher David Kotok of Cumberland Advisors for this instructive quotation.

The great waves of industrial innovation

Published in Law & Liberty.

How did the world of lord and serf, horse and carriage, superstition and disease, turn into the world of boss and worker, steam and steel, science and medicine?

Jonathan Steinberg asks us to ponder this in his lecture series “European History and European Lives: 1715 to 1914.” We can add to his question, among countless other things previously unimaginable, “and the world of jets and space probes, computers and Google searches, antibiotics and automatic washing machines, and sustained long-term economic growth per capita?” Relative to all previous human life, this new world, the one we live in, is truly astonishing. As Steinberg asks us to wonder, “How and why did what we call the modern world come about?”

The answer at the most fundamental level is through the creation and harnessing of scientific knowledge. Far and away the most important event in all of history was the invention of science based on mathematics by the geniuses of the seventeenth century. This is symbolized above all by Isaac Newton, whose masterwork, Philosophiae Naturalis Principia Mathematica, we may freely render into English as “Understanding Nature on Mathematical Principles.” The invention of mathematicized science was the sine qua non of the modern world. Other important modernizing developments in government, law and philosophy are handmaidens to it.

As Alexander Pope versified the impact:

Nature and Nature’s laws lay hid in night:

God said, Let Newton be! And all was light.

Of course, the translation to the modern world was not quite that direct. The new and multiplying scientific knowledge had to be transferred into technical inventions, those into economically useful innovations, those expanded into business ventures by entrepreneurial enterprise, and with the development of management processes for large-scale organizations, those spread around the world in great waves of industrial innovation.

We may picture these great waves over the last two and a half centuries like this:

Waves of Innovation

The result of these sweeping creations by the advantaged heirs of the Newtonian age is the amazing improvement in the quality of life of ordinary people like you and me. As measured by real GDP per capita, average Americans are about eight times better off than their ancestors of 100 years ago. (They in turn were far better off than their predecessors of the 18th century, when the modern world began to emerge.)

In 1897, average industrial wages per week have been estimated at $8.88. That was for a work week of about 60 hours (say six ten-hour days—and housewives had to work 70 hours a week to keep home life going). The industrial wages translate to 15 cents an hour. Correcting for inflation takes a factor of about 25, so 15 cents then is equivalent to $3.75 today. Current U.S. average hourly manufacturing wages are $21.49, adding benefits gives total hourly pay of over $30. In other words, real industrial hourly pay has multiplied about eight times. While this was happening, over the course of a century a lifetime’s average working time per day fell in half, while average leisure time tripled, according to estimates by Robert Fogel.

Along the way, of course, there were economic cycles, wars, recessions, depressions, revolutions, turmoil, crises, banking panics, muddling through and making mistakes. But the great waves of industrial innovation continued, and so did the improving standard of living on the trend.

Joseph Schumpeter memorably summarized the point of economic growth as not consisting in “providing more silk stockings for queens, but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort.” The Federal Reserve Bank of Dallas demonstrated how more goods for less effort indeed happened—showing how prices measured in hours and minutes of work at average pay dropped dramatically during the twentieth century. Their study, “Time Well Spent—The Declining Real Cost of Living in America,” is full of interesting details—here are a few notable examples. The time required to earn the price of milk fell 82%; of a market basket of food, 83%; of home electricity, 99%; of a dishwashing machine, 94%; of a new car, 71%; and of coast-to-coast airfare, 96%. Of course, no amount of work in the early twentieth century could have bought you an iPhone, a penicillin shot, a microwave oven, a ride on a jet across the Atlantic Ocean, or a myriad of other innovations.

These advances in the economic well-being of ordinary people are consistent with a famous prediction made by John Maynard Keynes in 1930.  In the midst of the great global depression, which might have led to despair about the future, Keynes instead prognosticated that the people of 2030, of 100 years from then, would be on average four to eight times better off due to innovation and economic growth. As 2030 approaches, we can see that his forecast will be triumphantly fulfilled near the top of its range.

How much can the standard of living continue to improve? In 1900, according to Stanley Lebergott, the proportion of Americans who had flush toilets was only 15%. Only 24% had running water, 1% had central heating, 3% had electricity, and 1% owned an automobile. The people of that time could not imagine ordinary life as it is now. Correspondingly, it is exceptionally difficult for us to imagine how hard, risky and toilsome the average life was then.

And if we try to imagine the ordinary life of 100 years into the future, can we think that people will once again be eight times better off than we are? Can the great waves of innovation continue? Julian Simon maintained that since human minds and knowledge constitute “the ultimate resource,” they can. “The past two hundred years brought a great deal of new knowledge relative to all the centuries before that time,” he wrote, “the past one hundred years or even fifty years brought forth more than the preceding one hundred years,” and we can confidently expect the future to continue to “bring forth knowledge that will greatly enhance human life.”

June brings to mind weddings, homeownership and their paradoxical relationship

Published by the R Street Institute.

June, we learn from the National Association of Realtors, is “National Homeownership Month.” Since June is also a traditional month for weddings, it is a good time to address an important and logical, but little understood and virtually never-discussed connection: that between homeownership and marriage.

Homeownership is much higher for married than for not-married households. This makes intuitive sense. But the difference in homeownership rates is pretty remarkable: for the United States as a whole, more than 78 percent of married households own their home, nearly double the 43 percent for those not married. Thus, the overall homeownership rate of 63.5 percent is composed of two very different parts by marital status. This difference holds for all major demographic groups. The married versus not-married dynamic, in turn, gives rise to an intriguing homeownership paradox that we explore below.

We examine homeownership in this context over 30 years, from 1987 to 2017. This makes the homeownership effects of the housing bubble-and-bust into a temporary anomaly in the course of the three decades. That U.S. homeownership was artificially pumped up and then fell back to its trend now looks like a blip in the midst of the longer-term pattern. The artificial homeownership inflation was, of course, heavily promoted by the U.S. government, notably by the Clinton administration’s unwise “National Homeownership Strategy.” This strategy may be summarized as: pump up homeownership by making bad mortgage loans. Naturally, they didn’t say it that way—what they said was by making “innovative” mortgage loans. But it turned out the same.

Looking at the longer term, in 1987, the U.S. homeownership rate was 64 percent. Thirty years later, in 2017, it was 63.5 percent, according to the U.S. Census Bureau’s Current Population Survey.

But the homeownership rate for married households went up significantly over the same period: from 76.2 percent to 78.4 percent. And the homeownership rate for not-married households also went up a lot, indeed by a lot more than the married rate did: from 35.3 percent to 43 percent.

The sum of married plus not-married households are all the households there are. Their homeownership rates both went up from 1987 to 2017. So how is it possible that the overall homeownership rate went down?  That is the paradox. It is summarized in Table 1.

The explanation of the paradox is that the mix of married versus not-married households in the U.S. population changed a lot over these years. The proportion of married households, with their much higher homeownership, fell dramatically from 70.2 percent to 57.8 percent of U.S. households. The proportion of not-married households, with their much lower homeownership rate, correspondingly increased. This is shown in Table 2.

Adjusting out the effect of this shift in household mix, U.S. homeownership rates fundamentally rose over these three decades, as many of us would have hoped.

In sum, to understand trends in homeownership, we must include, as is seldom done, its interaction with marriage.

Letter to Editor Barron’s: Listen up, Uncle Sam

Published in Barron’s.

Governments “should take particular care to prevent real estate bubbles,” writes Michael Heise (“Global Debt Is Heading Toward Dangerous Levels, Again,” Other Voices, May 19).

He’s right, of course. But the U.S. government does the opposite. As it has for decades, it promotes real estate debt and inflates real estate prices through government credit, subsidies, guarantees, and regulation—not to mention the massive monetization of mortgages by the Federal Reserve. When will they ever learn? The best bet is never.

Governments could take bitcoin out of circulation

Published in the Financial Times.

Nima Tabatabai asks about bitcoin, “can financial regulators control this emerging digital monetary asset?” ( Letters, May 18). The answer is they can. If a government sets its mind on it, it can tax, punish and regulate any monetary asset out of circulation. In the 1860s, Congress put a 10 percent tax on state bank notes to prevent their competing with the new U.S. national bank notes. State banks survived by expanding deposits, but state bank notes as a currency were gone. In the 1930s, the U.S. government, formerly on the gold standard itself, made it illegal for its citizens to own gold or denominate payments in it. Violating the prohibition was made a crime punishable by a fine of $10,000 or 10 years in prison. In the 1960s, the U.S. government simply refused to honor its explicit promise to redeem paper silver certificates with the silver dollars which were certified as “payable to the bearer on demand.” Thus U.S. dollar bills convertible to silver ceased to exist as a currency.

What might governments do to bitcoin or its holders or users? That depends on how threatened by it they feel.