Hume’s Timely Political Advice from 1741

Published by the R Street Institute.

I am neither surprised nor upset by the divisive partisanship of current times. Emotional partisanship is nothing new in the world. But we certainly must condemn the bad manners it now engenders.

David Hume, the great philosopher, economist and historian, reflected calmly on partisan passions in 1741, in his Essays Moral and Political. Here are some relevant excerpts (with ellipses deleted):

“There are enow of zealots on both sides who kindle up the passions of their partisans, and under pretense of public good, pursue the interests and ends of their particular faction.

“Those who either attack or defend a minister in such a government as ours, where the utmost liberty is allowed, always carry matters to an extreme, and exaggerate his merit or demerit. His enemies are sure to charge him with the greatest enormities, both in domestic and foreign management, and there is no meanness or crime, of which in their account, he is not capable. On the other hand, the partizans of the minister make his panegyric run as high as the accusations.

“When this accusation and panegyric are received by the partizans of each party, no wonder they beget an extraordinary ferment on both sides, and fill the nation with violent animosities.”

Hume included this excellent and timely advice for us, reading it 277 years later:

“For my part, I shall always be more fond of promoting moderation than zeal. Let us therefore try, if it be possible to draw a lesson of moderation with regard to the parties into which our country is at present divided.”

Good manners should control our behavior, whatever our feelings may be inside, and moderation frees the mind to think. Like Hume, let us be fond of promoting it.

Alex Pollock: What is the most dangerous institution in the world?

From McAlvany Weekly Commentary:

Perpetual Inflation vs. Sound Money

Published in Law & Liberty.

Among the most important financial forces in the world are fashions in central bankers’ ideas. The dominant central bank fashion in recent years is the notion that they should create perpetual inflation at the rate of 2% per year—not 2% sometimes, but 2% always. If this indeed should happen, in a lifetime of 80 years, consumer prices on average will nearly quintuple. Current central banks’ rhetoric insists on calling this “price stability,” a striking instance of newspeak. They have converted the journalists, who earnestly report whether inflation is meeting the central bank “target,” simply taking it on faith that this target must be a good idea.

The central banking commitment to 2% inflation forever has become internationally widespread, including of course the Federal Reserve, which is the dollar-issuing central bank to the world, not only to the United States. The Fed adopted this debatable doctrine on its own and simply announced it in 2012, without the approval of the Congress, although Congress has the Constitutional duty to regulate the value of money.

Brendan Brown, London-based senior economist for Mitsubishi UFJ Bank and iconoclastic monetary thinker, attacks the 2% inflation fashion head on, as the title of his new book expresses: The Case Against 2 Per Cent Inflation. He argues instead for a regime of sound money (for his definition of what this means, see below).

This complex book first reviews the 2% inflation doctrine’s place in the history of shifting central banking ideas:

Since the fall of the full international gold standard in 1914, the fiat money ‘system’ has wandered through four successive stages…. The first three all ended in dismal failures…. The fourth [2% inflation] is headed in the same direction.

Following the destruction of the gold standard by the First World War and the related wild inflations, the stages have been, according to Brown:

• The gold exchange standard of the 1920s, meant to restore stability but ending with “the bust of the global credit bubble” of the late 1920s.

• 1930s disorders leading to the stabilization efforts of the Bretton Woods agreement of 1944. This system collapsed in 1971.

• Pure fiat currencies with floating exchange rates among them. This period featured the Great Inflation of the 1970s, but also monetarist doctrines, most notably in Germany and also temporarily in the U.S. It ended “most spectacularly” with “the bubble and bust in Japan” in 1989.

• Then “out of the monetarist retreat,” says Brown, “was born…a new stabilization experiment—the targeting of perpetual inflation at 2% p.a.,” the current theory. Since the Fed first formally adopted this idea in 2012 we have had a spectacular global asset price inflation—will it end with a bang or a whimper?

Surveying this history must prompt us to ask: is there is any eternal central banking truth?

The book quotes the changing central banking ideas over time as described by Stanley Fischer, formerly Vice Chairman of the Fed and Governor of the Bank of Israel:

Emphasis on a single rule as the basis for monetary policy implies that the truth has been found, despite the record over time of major shifts in monetary policy—from the gold standard, to the Bretton Woods fixed but changeable exchange rate rule, to Keynesian approaches, to monetary targeting, to the modern frameworks of inflation targeting….

This led Fischer reasonably to suggest that these matters need appropriate awareness of the “human frailty” and the “considerable uncertainties” involved.

Should we put our faith in the most recent central banking fashion of 2% inflation forever? Or will it also end up, as Brown thinks, in “the dustbin of monetary history” with the others?

The book addresses four key questions about the 2% theory:

1. Where did it come from?

2. What is its rationale?

3. Is the rationale convincing?

4. How does it contrast with sound money?

Where Did the 2% Doctrine Come From?

The answer, as the book explains, is that it came from New Zealand; specifically, an act of its Parliament: the Reserve Bank of New Zealand Act of 1989. The whole point of the original project was to get inflation downfrom its unacceptably high level, then about 5%. In its origin, it had nothing to do with making inflation go up. Very important in this context was that the original goal was not 2% inflation, but a range of zero to 2%, as agreed to between New Zealand’s Minister of Finance the Governor of the Reserve Bank. In subsequent international central banking evolution, the “zero” part seems to have been forgotten.

Similarly, the Humphrey Hawkins Act of 1978 in the United States held out the idea that by 1988 the inflation rate could be reduced to zero. We never hear this statutory provision discussed by the Federal Reserve.

Thus, New Zealand’s creation of what has become the international 2% doctrine began with an act of its legislature, followed by an agreement with the government, not an announcement of the central bank by itself. This is a striking contrast with American developments. Does the Fed have the authority to decide this essential question on its own, without the approval of Congress? I don’t think so, and neither did Alan Greenspan.

At the end of the 1980s, the book relates, then Fed Chairman Greenspan “had no inclination to adopt a formal 2% inflation target—seeing this as potentially irritating relations with Congress (here he feared that some members might question why inflation rather than price stability).” This was before the Federal Reserve rhetoric had redefined “price stability” to mean perpetual inflation.

Further, in a key 1996 discussion of whether there should be a specific inflation target, Greenspan argued that “The question is really whether we as an institution can make the unilateral decision to do that. I think this is a very fundamental question for this society. We can go up to the Hill and testify… but we as unelected officials do not have the right to make that decision.” A very sound point. But in 2012, the Federal Reserve on its own made a formal commitment to perpetual inflation at 2%, anyway.

What Is the Rationale for the 2% Doctrine?

One important argument is from the point of view of central bank power. With 2% inflation, it is easier for central banks to run negative real interest rates when needed, while still keeping nominal interest rates over zero. The argument is focused on how to avoid hitting the “zero lower bound” for nominal interest rates. We all know by now that nominal interest rates can in fact go below zero, but presumably not too far below. With 2% inflation, you just have to get nominal rates below 2% to make them negative in real terms. In the meantime, we are assured that 2% inflation is “low.”

This argument assumes that central banks should be in the business of setting of interest rates by discretion, the very thing that sound money advocates doubt or deny that central banks can successfully do. Do central bankers themselves share this doubt? They should.

A deeper economic argument for inflation (though not necessarily perpetual inflation) is that it allows real wages to fall while nominal wages do not, and thus enables required adjustment in real prices to take place, even though wages are “sticky.” This was the key argument that Janet Yellen made to the Fed’s Open Market Committee in the opening 2% target debate in 1996, and it will be recognized as a classic Keynesian idea. It does depend, however, as then-Governor Yellen herself said at the time, on people believing in nominal dollars rather than inflation-adjusted ones—in other words, in “money illusion,” though she did not use that term.

Making sure inflation is 2% runs another important theme, we will make sure that we will never have price deflation, assumed to be always bad. But is moderate deflation always and necessarily bad? Brown doesn’t think so, as explained below. Constant inflation with low or negative real rates also makes sure that debt is favored, strengthening its tendency to induce financial bubbles.

A clear and firm repetitive communication of the 2% target, it is further argued, will manage market and popular expectations of future inflation or deflation, “anchoring” them at about 2%. “I don’t see anything magical about targeting 2% inflation,” former Fed Chairman Ben Bernanke said later, “my advocacy…was based much more on the transparency and communication advantages.” Of course, central bankers can neither bind their successors, nor know that 2% is the perfect number now, let alone forever.

An additional argument is that standard government measures overstate the rate of inflation, so you have to make your inflation target high enough to offset this mistake.

Is the Rationale Convincing?

In a word, according to Brown: No. I agree. Celebrated central banker Paul Volcker has recently added his distinguished No to this discussion, as noted below.

Underlying Brown’s rejection of all perpetual inflation targets, including 2%, is his fundamental insight about the natural course of average prices in a free market, entrepreneurial economy. The natural course, he says, is not forever upwards, nor always stable. “In a well-functioning capitalist economy, sound money goes along with prices on average for goods and services which fluctuate upwards and downwards over considerable periods, with some tendency to revert to a mean over the long run.” [italics added] A natural rhythm of prices makes them sometimes go down, notably in periods of “spurts in productivity growth, resource abundance, or perhaps a change in product and labor market structure.” This kind of deflation is not a disaster to be fought at all costs by central banks because it shows that productivity is making real incomes rise. Combined with alternating periods of rising prices, in this currently non-existing scenario, prices on average tend to go sideways in the long term.

Instead, modern central banks keep attempting to manipulate prices to a different and “better” outcome—to rise constantly at the same 2% rate forever. But, Brown asks rhetorically (and convincingly to me), “Why should we believe these super claims about central bank wisdom and insight when the record suggests otherwise?” Why indeed?

Further, “Attempts of central banks to drive up prices when the natural rhythm is downwards end up with likely virulent asset price inflation (and eventual bust),” Brown argues. With modern central bank policies, asset price booms and busts are certainly what we experienced, followed by another remarkable asset price inflation.

“You will not find in the advocacy literature for monetarism or for the 2% inflation standard,” the book observes, “any mention of asset price inflation.” I recently read two presentations made at the Brookings Institution discussing whether the 2% doctrine should be changed. Neither mentioned asset price inflation. Certainly, no monetary theory or policy makes sense which does not address the issue of asset price inflation.

Concerning other defenses of 2% inflation forever, we may ponder: How much of central bank actions should be based on trying to fool the people with money illusion? And if your position is that you don’t believe the government’s inflation statistics, wouldn’t it be a superior approach to state, as Greenspan reasonably suggested, that the right inflation goal is “zero, if inflation is properly measured”?

Finally in this context, we note that Paul Volcker, in his new book, Keeping At It: The Quest for Sound Money and Good Government, provides these thoughts about the 2% theory: “I know of no theoretical justification,” and “All these arguments [for it] seem to me to have little empirical support.”

How Does 2% Forever Contrast with a Sound Money Regime?

Brown’s fundamental recommendation is for “a journey away from the 2% inflation standard to a sound money alternative.” What does he mean by “sound money”? Not, as we have seen, that price levels should be always the same, instead of price levels rising forever at 2% per year. His definition of sound money is rather this:

The guiding features of sound money are market determination of short- and long-term interest rates free of any official manipulation; the quality of money and consumer satisfaction with it are the lead objectives of the money suppliers; persistent moves of money prices of goods and services in one direction should not be expected; over the long run, there should be some tendency for prices to revert to the mean, but in no precise or assured manner; money must not be a tool of the sovereign usable towards funding expenditures without legislating tax rises or floating loans on the free market at non-manipulated rates; [or of] bailing out cronies including the banks.

This is a radically market-based doctrine. It retains no role for the central bank serving as the national price fixing committee to manipulate interest rates or prices generally. Although an amazing number of people naively accept the idea that central banks can successfully fix prices, Brown shows why we should reject that pretense. The book also rejects central bank policies of financial repression “levying inflation tax on the small and the weak” to finance the government’s deficits. It certainly does not flatter the ambitions of central bankers to “manage the economy” or the desire of governments for monetization of their debts and collection of inflation taxes. In short, it is not a doctrine to appeal to political elites.

How then shall you get some country to try it? Ay, there’s the rub. Perhaps some small country or countries might play the New Zealand of a new sound money monetary doctrine? Brown speculates about this possibility, but it does not seem too hopeful. Still, as has been wisely observed, “Many things which had once been unimaginable nevertheless came to pass.” Is it possible that the fashion in central bankers’ ideas will turn to sound money after the next crisis?

In sum, Brown has written an interesting history, thorough analysis, and penetrating criticism of the 2% inflation forever doctrine, and provided provocative food for thought about what in contrast a sound money regime would be like.

A Most Enjoyable History of a Most Remarkable Bank

Published in Real Clear Markets.

This is a colorful book, full of great stories and forceful (if not always admirable) personalities, who deserve to be remembered.  It gives us repeated lessons of how banking is a business always intertwined with the government, demonstrated in the long history of Citibank, a very important, very big, often quite creative, and sometimes very troubled bank.  It reminds us of the theory of Charles Calomiris that every banking system should be thought of as a deal between the bankers and the politicians.

According to then-Treasury Secretary Henry Paulson’s instructive memoir of our most recent financial crisis, on November 19, 2008:

“Just one week after I had delivered a speech meant to reassure the markets, I headed to the Oval Office to tell the president that yet another major U.S. financial institution, Citigroup, was teetering on the brink of failure.

‘I thought the programs we put in place had stabilized the banks,’ he said, visibly shocked.

‘I did, too, Mr. President.’”

This exchange led to the instructions from the President which appear on page 1 of Borrowed Time:

“Don’t let Citi fail.”

At this point, as the book tells us, “The Office of the Comptroller of the Currency and Citigroup guessed that Citibank would be unable to pay obligations or meet expected deposit outflows over the ensuing week.  Citigroup’s own internal analysis projected that ‘the firm will be insolvent by Wednesday, November 26.’”

“As ever,” the authors add, “the latest crisis in the banking sector caught many regulators by surprise.”

Now, if Citibank had failed and defaulted on its obligations, what would have happened?  Nobody wanted to find out.  Then-New York Federal Reserve President Tim Geithner forecast that it would be a “catastrophe,” the book relates, and quotes the then-head of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair: “We were all fearful.”

In their place would you, ladies and gentlemen, have been fearful, too?

Yes, you would have been.

Would you have decided on a bailout of Citibank, as they did?

Yes, you would have.

The FDIC had a special and very pointed reason to be fearful: a failure of Citibank would have busted the FDIC, too—this government insurance fund would itself have needed a taxpayer bailout.  As we learn from the book:

“The FDIC staff did a seat-of-the-pants calculation and estimated the agency’s potential exposure to Citibank to be in the range of $60 billion to $120 billion.  Even at the low end of that estimated range, losses would ‘exhaust the $34 billion or so in the [Deposit Insurance Fund].’”

So the FDIC would have been broke—just like the Federal Savings and Loan Insurance Corporation was twenty years before.  In short, the bailout of Citibank was an indirect bailout of the FDIC.  This insightful lesson is not made explicit in the book, but is a clear conclusion to draw from its account.

Going back in history to 147 years before these events of 2008, we find the situation interestingly reversed.  In 1861, at the beginning of the Civil War, City Bank—at that point spelled with a sensible “y” and not the marketing “i” of much later times—was helping save the government, as the U.S. Treasury scrambled to raise money for the army.

We learn from the book that Moses Taylor, then the head of City Bank, “played a leading role in gathering private and municipal funds to equip and sustain Union troops and also in managing the issuance of federal debt to pay for the war.”

In the summer of 1861, “Secretary of the Treasury Salmon Chase visited a group of New York bankers and told them he needed $50 million ‘at once.’  The bankers huddled, and the Tylor, speaking for the group, announced, ‘Mr. Secretary, we have decided to subscribe for fifty millions of the United States government’s securities that you offer, and to place the amount at your disposal immediately.’”

We can imagine how relieved and happy that must have made the Treasury Secretary.

As the Civil War dragged on and became vastly more expensive, one of the ways to finance it was the creation of the national banking system to monetize the government debt.  City Bank then became a national bank, as it still is.

However, the limitations of the national bank charter made it hard to be in the securities business.  How City Bank got around this in the boom of the 1920s makes interesting reading, including how it actively financed the stock market bubble of the decade.

Then came, of course, the collapse and the disaster of the 1930s, and that brought government investment in the preferred stock of City Bank by the Reconstruction Finance Corporation.  “The debate is over whether City really needed Washington’s money,” the book tells us, “or was persuaded to participate in a broader program intended to show that the government was shoring up the nation’s banking system.”  It continues, “Just as in 2008”—note how financial ideas as well as events repeat themselves—“federal officials in the 1930s wanted healthy banks to accept government investment so that the weak banks that really needed it would not be stigmatized.”  But which category was City Bank in?

The authors conclude that “it seems likely that City really did need the money.”

Citibank was and is a very international bank.  This has its advantages, but also its problems.  In the 1930s, City was in trouble from its international loans to, as the book relates, Chile, Cuba, Hungary, Greece and most importantly, Germany.

Germany had boomed in the 1920s and was the second largest economy in the world.  It had financed its boom with heavy international borrowing, especially from the United States.  By the 1930s, it was obvious that this had not been a good idea from the lenders’ point of view.

In the natural course of events, the costly 1930s experience became “ancient history,” and in the 1970s, Citi (now spelled with an “i”) was the vanguard of a great charge into international lending, in which a lot of other banks followed.

The leader and chief proponent of the charge was Walter Wriston, Citi’s CEO and the most innovative and best known banker of his day.  Says the book:

“Wriston’s most remarkable achievement at Citibank was persuading Washington that lending money to governments in developing countries was nearly risk-free.”

But the government was already cheering for these loans.  “There had for years been a tendency among many government officials to look with favor on loans to less-developed countries [LDCs].”

About these loans, Wriston notoriously said, “They’re the best loans I have.  Sovereign nations don’t do bankrupt.”

No, they don’t.  But they do default on their loans—and quite often, historically speaking.  And default many foreign governments did, starting in 1982.

At that point, the Chairman of the Federal Reserve was the famous Paul Volcker.  As the book discusses, his solution to the possibility the U.S. banking system had become insolvent was to mandate that the LDC loans not be called the bad loans they were, that no loan losses would be booked against them, and that the banks would indeed have to make new loans to keep the Ponzi scheme going.  In other words, the solution was to cook the books.

With this big gamble, as it turned out, things did keep going.  When LDC loans were finally charged off in the late 1980s, there was a new boom on: financing commercial real estate.  This boom in turn collapsed in the early 1990s.  We might say there is a theme and variations involved.

In 1981, just before the Wriston-led charge into LDC debt went over the cliff, the biggest ten banks in the United States, in order, were:

Bank of America (the one in San Francisco, long since sold)

Citibank

Chase Manhattan

Manufacturers Hanover

Morgan Guaranty

Chemical Bank

Bankers Trust

Continental Illinois

First National Bank of Chicago

Security Pacific

Consider this:  of the ten, only two still exist as independent companies.  Eight of the ten are gone.  To people not in the financial trade, or even to younger ones in it, these once-important names are probably unknown.  As a song written by one of my old banking friends goes:

“You were a big bank, Blink and now you’re gone!”

But Citibank, the subject of the eventful history related by Borrowed Time, is not gone—it is still here.

Which is the only other survivor of the former top ten?  Maybe you would like to guess?*

In short, if you have a taste for the adventures and evolving ideas, the ups and downs, the growth and reverses, and the innovations and blunders of banking over the years, you will enjoy this history of a most remarkable institution.

*The answer is Chemical Bank, although it has changed its name to JPMorgan.

Consider default rates when assessing claims of disparate impact

Published in American Banker with Edward J. Pinto.

Consider default rates when assessing claims of disparate impact

One of us earlier this year proposed a statistical relationship essential to understanding the issue of disparate impact.

This is the relationship between each demographic group’s (1) ratio of credit approvals-credit declines, and (2) its default ratio. In the popularized data, we are always told of the inputs — approval and decline rates, but we are never told of the outcomes — default rates. With only half of the data, you can’t know what it means.

So one fundamental change would greatly enhance objectivity and clarity, while greatly reducing the uncertainty involved. We need to add to the analysis of Home Mortgage Disclosure Act mortgage origination data the actual default rates on mortgages, organized by the same demographic categories used in HMDA reporting.

Default data by HMDA category has not been readily available from typical mortgage servicing records. But now, thanks to the AEI Center on Housing Markets and Finance, we have a large sample of mortgage loans covering five years of experience to test the relationships, showing that the relevant data matching is indeed practicable and useful.

Applying the same credit standards to everybody in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing and is what the law requires. What, however, if a lender applies exactly the same credit standards to all credit applicants, but this results in different groups having different credit approval-credit decline ratios? For example, suppose minority borrowers have lower approval rates than white borrowers, or in general, that any Group A has lower approval and higher decline rates than some Group B. Does that necessarily mean there was discrimination? No, it doesn’t. That is only half the relevant data. You cannot draw conclusions until you know what the matching loan default rates are.

In other words, we must take the default rates on the mortgages for each group and compare them to the approval-decline ratios. We also need to adjust the default rates for differences in ex-ante credit risk factors and make sure, of course, that the results are statistically significant.

If the risk-adjusted default rates for Group A are the same as for Group B, the approval-decline ratios were appropriate and fair, since they resulted in the same default outcome. Controlling and predicting defaults is the whole point of credit underwriting. If the defaults rates are equal, there is no disparate impact problem.

If the risk-adjusted default rates for Group A are higher than for Group B, then A has effectively been given easier credit than B, in spite of A’s lower approval and higher decline rates. Indeed, the origination process may have inadvertently operated in Group A’s favor. If its default rates are higher, there is no disparate impact problem for Group A.

Only if Group A’s risk-adjusted default rates are lower than Group B’s would there be evidence that A is experiencing an effectively higher credit standard, which suggests a problem.

Nobel laureate in economics Gary Becker stated the point succinctly two decades ago: “The theory of discrimination contains the paradox that the rate of default on loans approved for blacks and Hispanics by discriminatory banks should be lower, not higher, than those on mortgage loans to whites.”

If the default rates are the same or higher, in short, there is no problem — the issue arises only if they are lower.

What do the data say?

The AEI Center on Housing Markets and Finance compiled the records for and analyzed the performance of originations of FHA loans for the five years 2013 to 2017. This sample represents more than 2.7 million mortgage loans. It divides the borrowing population into two categories of white and minority (defined as black or Hispanic). The AEI Mortgage Risk Index of ex-ante credit risk is used to risk-adjust the default rates.

The empirical results are that credit approval rates for minorities were lower, but their default rates were significantly higher, as were their risk-adjusted default rates.

In 2017, for example, the FHA approval rates for minorities were about 69.6%, compared to 77.1% for whites, but 90 day or more default rates were 2.7% for minorities, compared to 1.6% for whites; risk-adjusted default rates were 2.5% compared to 1.6%, respectively. In 2013, the first year of the data, approval rates were 65.2% for minorities and 73.9% for whites, but default rates were 12.4% for minorities compared to 9.2% for whites, and risk-adjusted default rates were 11.5% compared to 9.2%, respectively.

This same pattern is true in all the intermediate years. The data is summarized in the charts below.

Thus there is no indication of a disparate impact issue in the aggregate because the relevant default rates for minorities are in all cases higher, showing no bias in the credit decisions. There would only be an issue if their default rates were lower.

We conclude that this mode of analysis shows the way to address the disparate impact question on an objective basis. The encouragement to use this analysis should be written into the disparate impact regulations of the Department of Housing and Urban Development, and it should be required as part of any government report on the issue.

Finance and Philosophy: Why We’re Always Surprised

Published by Paul Dry Books. Order here.

“Pollock tells us all we need to know about money and banking, risk and uncertainty, debt and temptation, and science and economics. He delights as he instructs.”―James Grant, founder and editor, Grant’s Interest Rate Observer

Finance and Philosophy provides a concise and witty account of how bankers and financial regulators think, of the alleged causes of the cycles of booms and busts, of the implicit and often un-thought-out assumptions shaping retirement finance, fiat money, corporate governance. Pollock deftly shows how poorly bankers have measured the risk their banks have been exposed to. With candor and clarity, he uncovers the persistent and unavoidable uncertainty inherent in the business of banking. We learn that a banker’s confidence in his ability to measure banking risk accurately is the lure which has repeatedly led to bank failures. Pollock has a modest and compelling suggestion: Acknowledge the unavoidability of ignorance with respect to financial risk, and, in the light of this ignorance of the future, act moderately.

“Why can’t human beings take the lessons of boom and bust, bubbles and crashes that are clearly described in history books―and learn from experience? That’s where Mr. Pollock’s wry humor and philosophic bent help understand the hubris that makes every generation believe that not only can it predict the markets, but control them . . . [Finance and Philosophy] should be required reading in economics classes, or before opening an investment account―and by every member of Congress.”―The Washington Times

“At the height of the 2008 financial panic, Queen Elizabeth plaintively asked why nobody saw it coming. In the winning pages of Finance and Philosophy, Her Majesty can find the answer. With a lightness of touch that belies the complexity of his subject, Alex Pollock shows why the financial future is now, why it has been and always must be a closed book. A successful banker and gifted writer, Pollock tells us all we need to know about money and banking, risk and uncertainty, debt and temptation, and science and economics. He delights as he instructs.”―James Grant, founder and editor, Grant’s Interest Rate Observer

“Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.”―Real Clear Markets

“An intellectually penetrating and thought-provoking book.”―Central Banking

“Alex Pollock shows how financial jargon obscures simple realities, how very smart people are prone to spectacular financial mistakes, and how government efforts to make finance smarter and more stable have made it much worse on both scores. Drawing on Pollock’s highly successful career in banking and scholarship, Finance and Philosophy is a fount of sharp insight and high wisdom.”―Chris DeMuth, President, American Enterprise Institute, 1986–2008

“As in all of Alex Pollock’s writings, Finance and Philosophy combines the author’s subtle but caustic wit with brilliant insights grounded in his long experience analyzing America’s financial fads and foibles. No one does a better job of pointing out the philosophical and historical fallacies underlying the portentous pronouncements by our leading economic and fiscal ‘experts’ on everything from the future of interest rates and the national debt to the tech bubble of the 1990s and the 2007–09 financial meltdown. This book needs to be read by every present and future Secretary of the Treasury and chairman of the Federal Reserve.”―Arthur Herman, author of 1917: Lenin, Wilson, and the Birth of the New World Disorder

2 percent inflation is just a central bank fad

Published in the Financial Times.

Your interview with Shinzo Abe (“Japanese PM targets big reforms to cement legacy,” Oct. 8) may indicate some momentum in a fundamental shift in ideas — a shift away from the in-retrospect foolish “golden age” theory of retirement, which was invented in the 1950s. This led to the notion that, starting in their 60s, people should be paid while spending a couple of decades or more in idleness and entertaining themselves, rather than remaining productive. Mr Abe instead wants “a society where people never retire and pursue lifelong careers.” If not lifelong, perhaps, at least significantly longer.

Your article proceeds to assert dogmatically that this “will count for little if deflation is not banished” because “the Bank of Japan’s 2 percent inflation objective is still far off.” This treats the necessity of 2 percent inflation as a fact instead of a pretty dubious theory. In reality, perpetual inflation at 2 percent is merely the latest fashion in central banking ideas. It follows many other central bank fashions, which have succeeded each other over a century, going back to the gold standard. Like the “golden age” theory of retirement, I believe the “2 percent inflation forever” theory will be found wanting and replaced.

Government Debt: A Quiz

Published by the R Street Institute.

Government debt is a favored investment class all over the world, but it has a colorful history full of financial adventures. Often enough, historically speaking, it has resulted in investors gazing sadly on unpaid sovereign promises to pay, to paraphrase Max Winkler’s “Foreign Bonds: An Autopsy,” his chronicle of the long list of government defaults up to his day in the 1930s. The list has grown much longer since.

Here are six sets of years.  What do they represent?

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

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

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

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

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

6. 1862, 1933, 1968, 1971

All these are years of defaults by a sample of governments. For the first five of them, see Carmen Reinhart’s “This Time Is Different Chartbook: Country Histories.” They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

And No. 6 is the United States.

In the case of the United States, the defaults were: The refusal to redeem greenbacks for gold or silver, as promised, in 1862. The refusal to redeem gold bonds for gold, as promised, in 1933. The refusal to redeem silver certificates for silver, as promised, in 1968. The refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.

The U.S. government has since stopped promising to redeem money for anything else, making it a pure fiat currency, and stopped promising to redeem its bonds for anything except its own currency.  This prevents future defaults, but not future depreciation of both the currency and government debt.

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

Observe that Dionysius’s stratagem was in essence the same as that of the United States in its defaults of 1862, 1933, 1968 and 1971.

So advantageous it is to be a sovereign when you are making promises.

Knowledge, Risk, and the Surprised Banker: A Conversation with Alex Pollock

Published in Law and Liberty’s LibertyLawTalk podcast.

Longtime Law and Liberty contributor Alex Pollock joins this edition of LibertyLawTalk to discuss his new book Finance and Philosophy.

Better late than never

Published by the R Street Institute.

September brought endless discussions of the 10th anniversary of the bankruptcy of Lehman Brothers and the failures of Fannie Mae and Freddie Mac. Tomorrow, Oct. 3, brings the 10th anniversary of congressional authorization of the Troubled Asset Relief Program (TARP) bailouts created by the Emergency Economic Stability Act.

After all this time, we still await reform of American housing finance – the giant sector that produced the bubble, its deflation, the panic and the bust.

During the panic in fall 2008, in the fog of crisis, “We had no choice but to fly by the seat of our pants, making it up as we went along,” Treasury Secretary Henry Paulson has written of the time. That is no longer the problem.

In retrospect, it is clear that the panic was the climax of a decadelong buildup of leverage and risk, much of which had been promoted by the U.S. government. This long escalation of risk was thought at the time to be the “Great Moderation,” although it was in fact the “Great Leveraging.”

The U.S. government promoted and still promotes housing debt. The “National Home Ownership Strategy” of the Clinton administration—which praised “innovative,” which is to say poor-credit-quality, mortgage loans—is notorious, but both political parties were responsible. The government today continues to promote excess housing debt and leverage though Fannie and Freddie. It has never corrected its debt-promotion strategies.

A profound question is why the regulators of the 2000s failed to foresee the crisis. It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is the mismatch between prevailing ideas and the emergent, surprising reality when the risks turn out to be much greater and more costly than previously imagined.

There is a related problem: regulators are employees of the government and feel reluctant to address risky activities the government is intent to promote.

At this point, a decade later, reform of the big housing finance picture is still elusive. But there is one positive, concrete step which could be taken now without any further congressional action. The Financial Stability Oversight Council (FSOC), created in 2010, was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions (SIFIs) for increased oversight of their systemic risk. In general, I believe this was a bad idea, but it exists, and it might be used to good effect in one critical case to help control the overexpansion of government-promoted housing finance debt.

FSOC has failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important and systemically risky. This failure to act may reflect a political judgment, but it is intellectually vacuous.

Fannie and Freddie should be forthwith designated as the SIFIs they so unquestionably are. Better eight years late than never.

The adventures of investing in Fannie Mae and Freddie Mac stock, or how to lose 99% in a government deal

Published in Housing Finance International.

Fannie Mae and Freddie Mac are the most important housing-finance institutions in the United States—and therefore, in the world—with combined assets of a remarkable $5.4 trillion, which include nearly half of all the $10.6 trillion in outstanding U.S. residential mortgages. They are without question “systemically important”: any default on their obligations would rock both the domestic U.S. and the global financial markets. The largest investor in their mortgage-backed securities is the U.S. central bank, which holds about $1.7 trillion of them.

Fannie and Freddie have a hybrid legal form: they are basically government agencies, “implicitly guaranteed” by the U.S. Treasury, as it was often said, but in reality fully guaranteed. At the same time, they also have private shareholders and publicly traded stocks. The shareholders expected to profit greatly by trading on the credit of the United States and the numerous other special advantages that Fannie and Freddie had been granted by politicians and regulators.

How did the shareholders do? For a long time, their optimistic expectations were more than justified. Then they lost close to everything. After that, Fannie and Freddie’s stocks became purely speculative vehicles, which made, first, big profits and then big losses. This essay chronicles the adventures of investing in the stock of these companies sponsored by, guaranteed by and later entirely controlled by the U.S. government.

Fannie’s all-time high stock price was $86.75 per-share in December 2000. Ten years before, the price had been $8.91, so the aggregate gain in price over the 1990s was 874 percent. This means Fannie’s stock price went up on average 25 percent per-year for a decade. Not bad! Fannie created a powerful, ruthless and feared lobbying organization to protect its no-fee government guaranty and its other competitive privileges. Its political clout and its arrogance became legendary.

“Pride goeth before destruction and a haughty spirit before a fall,” says the Book of Proverbs. This was certainly true of Fannie with matching consequences for its private shareholders. From its peak, after Fannie’s massive losses put it into government conservatorship, its stock price dropped to a low of 20 cents per share in November 2011. That was a loss for the shareholders of 99.8 percent. Now, at the end of July 2018, Fannie’s stock price is somewhat higher, at $1.51. This still represents a loss of 98.3 percent from its peak.

Who would have thought that could happen? Probably nobody. But a fundamental characteristic of prices in a financial bust is that they can go down a lot more than you thought possible.

The shareholders of Freddie Mac experienced a similar elation and then collapse. Freddie’s all-time stock price high was $73.70 in 2004. Ten years earlier it had been $12.63, so the shareholders in this government deal had enjoyed a 484 percent aggregate gain over the decade, or on average over 19 percent per year. Then came the losses, the conservatorship, and the shriveling of its stock price to the trough of the same 20 cents per share in 2011. That meant a 99.7 percent loss from the peak. From the peak to now, the loss is 97.9 percent.

Reviewing the losses for the equity investors in these former political and stock-market darlings, one can only exclaim, “Mirabile dictu!” They form a memorable lesson.

The history of this adventure in investing to trade on the government’s guaranty is shown in Graph 1, which displays three decades of stock prices for Fannie and Freddie, from 1990 to July 2018.

At their stock price bottom of 20 cents per share, Fannie and Freddie were completely controlled by the government, but the two stocks continued to exist and trade. They became and remain a pure speculation on political events and the outcomes of various lawsuits that investors brought against the government. The lawsuits have been unsuccessful and the politicians, although they have debated the matter mightily, have not been able to agree on any legislative restructuring. As the Washington saying goes, “When all is said and done, more is said than done.” In this case, vast volumes have been said, but nothing has been done.

Fannie and Freddie continue to live on the government’s guaranty. They could not exist for one minute without it. Under the conservatorship agreement, the U.S. Treasury takes essentially all their profits, so their capital continues to round to zero. As long as this situation lasts, there can never be any cash for the shareholders, so the price of the shares is a pure gamble on the situation changing by some political outcome. This speculative essence has made Fannie and Freddie’s shares over the last seven years extremely volatile.

Had you had the courage to buy at 20 cents, you might have multiplied your investment up to 29 or 27 times, as the intervening highs have been $5.82 for Fannie and $5.52 for Freddie. But had you been tempted by the optimism of those highs while investing based on the possible actions of the government, you could once again have had huge losses – of over 70 percent.

Table 1 shows your returns had you bought Fannie or Freddie stock at the lows, or had you bought at various subsequent dates, including at the post-2011 highs, and in each case held the shares to July 2018.

As the table makes clear, such purchases during the speculative phase generated very large profits at first, and very large losses afterward, measured on the assumption that you held the shares until now. Of course, the results of interim purchases and sales could have varied a lot in both directions.

The end of this eventful history of Fannie and Freddie’s stockholders has not yet been written. Whatever future chapters may add, the story has demonstrated that, however attractive the deal is at first, the government can be a dangerous business partner over time.

Federal Reserve brings the real Fed Funds Rate up to about zero

Published by the R Street Institute.

As everybody knew it would, the Federal Reserve Board announced today it is bringing its target federal funds rate up to a range of 2 percent to 2.25 percent—in shorter form, to about 2.25 percent. That is still a very low rate, especially translated, as is economically required, to a real interest rate—that is, one adjusted for inflation. The new Federal Reserve target rate, in real terms, is more or less zero.

To adjust for inflation, you have to choose a measure of inflation. The Consumer Price Index over the 12 months through August 2018 rose 2.7 percent. Thus, using the CPI, the new inflation-adjusted Fed Funds target is 2.25 percent minus 2.7 percent, or a real rate of -0.45 percent.

Suppose as an inflation measure you like the Personal Consumption Expenditures Index (PCE) instead. Over the 12 months ended in July 2018, it went up 2.3 percent, so 2.25 percent is still a slightly negative real interest rate.

But the Fed likes to use the “core” PCE, which excludes food and energy prices. This is especially good for people don’t have to buy things to eat or gas for their car. Core PCE rose 2 percent for the same period. That would result in a slightly positive real interest rate of 2.25 percent, minus 2 percent, or 0.25 percent.

Averaging these three estimates together gives a real fed funds target rate of negative 0.08 percent—close enough to zero for monetary policy work, given its vast uncertainties.

Zero is a remarkably low real fed funds rate nine years after the end of the last recession, nine years after the end of the 2007-2009 financial crisis, in a time of strong economic growth and, more to the point, in the midst of a remarkable asset price inflation in houses, commercial real estate and securities.

Nobody, including the Federal Reserve, knows what real interest rates should be, but there is little doubt that a free market, without central bank manipulation, would by now have set them higher.

When and how will the current asset price inflation end?  Nobody, including the Fed, knows that either.

Ten Years After the 2008 Crisis: The Downside of the 30-year Fixed-Rate Mortgage

Published by the R Street Institute.

Here’s a lesson on the 10th anniversary of the 2008 financial crisis that almost nobody seems to have noticed:  the serious downside of the standard U.S. 30-year fixed rate mortgage, as displayed during the collapse of the housing bubble.

To hear politicians, promoters of government mortgage guarantees, proponents of Fannie Mae and Freddie Mac, and typical American housing-finance commentators at all times loudly singing the praises of the 30-year fixed-rate mortgage, you would think it has no downside at all. But of course, like everything else, it does.

Glenn Hubbard, former chairman of the Council of Economic Advisers, wrote recently of the crisis: “Millions of homeowners who were current on their mortgage payments were unable to refinance to lower rates because they were underwater” — in other words, the price of their house had fallen below what they owed on the mortgage. But that is only half of the explanation; the other half is that these homeowners could not get a lower interest rate because they had a fixed-rate mortgage. Therefore, they were stuck with what had become a burdensome interest rate relative to the market.

In contrast, the interest rate on floating-rate mortgages automatically goes down, even if the falling price of the house has put the loan underwater. This automatically reduces the mortgage payments due, reduces the financial pressure on the borrowers, and improves their cash position. Mortgage borrowers in many countries benefited from this reality during the financial crisis, but not the unlucky Americans who had a 30-year fixed-rate mortgage combined with a sinking house price.

Floating-rate mortgages naturally do become more expensive if interest rates rise, but are less expensive when interest rates fall — as they did dramatically during the crisis. Conversely, our 30-year fixed-rate mortgages are fine if house prices inflate upward forever, but in a housing deflation with falling interest rates, they are terrible for the borrowers. As the housing bubble shriveled, they turned out not to be a “free lunch” of a continuous option to refinance, but a very expensive lunch for, as professor Hubbard says, “millions of homeowners.” The more highly leveraged the mortgages were, the more expensive it was.

There is no doubt that the prevalence of the 30-year fixed-rate mortgage made the American housing finance crisis worse. Few people understand this.

It’s time for the Fed to be made accountable for its actions

Published in The Hill.

The U.S. Constitution assigns responsibility for the nature of money to the Congress. As Article I, Section 8 famously says, “Congress shall have Power…To coin Money [and] regulate the Value thereof.”

How can this be consistent with the idea that the Federal Reserve should be “independent,” as it is so often proclaimed, especially by the Fed itself? The answer is that it is not consistent.

Last week, the House Financial Services Committee approved the Federal Reserve Reform Act of 2018, H.R. 6741, which was sponsored by Rep. Andy Barr (R-Ky.), the chairman of the Subcommittee on Monetary Policy and Trade. The full committee passed the bill 30-21, with the vote along party lines.

This is an important effort to move toward the proper constitutional ordering of authority over money and regulating the value thereof, which we now call “monetary policy,” whatever the future of the bill may be.

Who should be in charge of money and its value? The Fed all by itself or the Fed as accountable to Congress? Almost all of the very many economists I know think that the Fed, a very large employer of economists, should be independent.

But that cannot be the right answer in a government whose essential character requires robust checks and balances.

I believe proponents of Fed independence tend to view it as a committee of economic philosopher-kings. But this fits neither its existence as part of a democratic government, nor the inherent uncertainties and limitations of its knowledge of the economic present, let alone the future.

Section 2 of the bill, Monetary Policy Transparency and Accountability, requires the Fed to discuss with Congress what the Fed is trying to do, in some specificity and in plain English, as distinct from “Fedspeak.”

The Fed would be required to discuss what its monetary strategy for each coming year is, how it plans to use the various instruments at its disposal, what monetary policy rules it has adopted and how these might change.

After the fact, it must discuss how the monetary strategy did change, if it did. This seems a pretty reasonable discussion for the Fed to have with the elected representatives of the people, who have the constitutional responsibility for the value of money.

Section 11 C (b) contains a nice definition of what money should mean in the pure fiat currency system we now have:

A generally acceptable medium of exchange that supports the productive employment of economic resources by reliably serving as both a unit of account and store of value.

This is what the bill instructs the Fed to produce. It is in notable contrast to the endemic inflation the Fed has presided over for the last several decades, which has resulted in a dollar today being worth what a dime was in 1950.

In the bill as originally proposed, a Section 12 would have changed the Fed’s so-called “dual mandate” of “maximum employment [and] stable prices” to simply “stable prices.” This vividly contrasts with the current Fed’s formal commitment to perpetual inflation. This provision did not make it into the committee’s approval, but is such an important idea that it deserves discussion.

The “dual mandate” was enacted in the 1970s, when people believed in the Phillips Curve theory that you would increase employment by running up inflation.

If it were up to me, on the next opportunity, I would write this new mandate somewhat differently, along these lines: “All Federal Reserve strategies are to be consistent with stable prices on average over the long run.”

This is because in an innovative, free-market economy with sound money, prices will rise sometimes and sometimes fall, but have a basically flat trend over the long run. It must not be forgotten that the Fed’s original 1913 mandate, “to furnish an elastic currency” to finance crises, is still there.

Section 3 (a) of the bill, “Returning to a Monetary Policy Balance Sheet,” would require the Fed’s investment portfolio to be essentially held in Treasury securities (with a few exceptions for gold certificates, foreign central bank obligations or the International Monetary Fund).

The real point is to take the Fed out of being a massive investor in real estate mortgage securities, thus out of being a promoter of house price inflation and out of effectively being a giant savings and loan vehicle. The Fed would have to give all non-qualifying investments to the U.S. Treasury in exchange for Treasury securities.

This is not as strict as the “Bills Only” policy adopted by the Fed under Chairman William McChesney Martin in the 1950s, but reflects similar ideas. Martin’s policy required that all Fed investments be in short-term Treasury bills.

To show how much things can change, the Fed for the last several years owned zero Treasury bills, and today, bills represent about 2 percent of its assets.

The Federal Reserve has grown over time to be an institution that combines immense power with a yearning for “independence.” Rep. Barr is right that, faced with this behemoth, the Congress should be improving its oversight and exercising its duty to define money and regulate its value.

Efforts to close the ‘doom loop’ are destined to fail

Published in the Financial Times.

Thomas Huertas (“Bank holdings of sovereign debt need scrutiny,” September 7) makes very reasonable proposals of how to control the “doom loop” of government debt making the banking system more risky, while the banks make the government’s finances more risky. But the sensible reforms he recommends won’t happen and can’t happen. This is for a simple and powerful reason: the financial regulators who would have to take the actions are employees of the government which wants to expand its debt. A top priority of all governments is to be able to increase their debt as needed. The regulators will not act against this fundamental interest of their employer.

An egregious example of this problem in the U.S. context is that as the bubble inflated the banking regulators did, and still do, allow the banks to hold unlimited amounts of the debt of Fannie Mae and Freddie Mac, the government-backed mortgage firms, long since failed and in conservatorship. Moreover, the regulators allowed (and indeed promoted, through low risk-based capital requirements) banks to own and finance with deposits the preferred equity of Fannie and Freddie. These were distinctly bad ideas. But what were the poor regulators to do? Their employer, the US government, wanted to expand housing debt and leverage through Fannie and Freddie, and they went along.

What will cryptocurrency be like in 10 years?

Published in ReadWrite.

The second issue the subcommittee raised was that of government-created cryptocurrencies. Alex J. Pollock of the R Street Institute said that: “In short, to have a central bank digital currency is a terrible idea — one of the worst financial ideas of recent times.” Pollock argued that “[The Federal Reserve] 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.”

Two books that will enrich your understanding of banking and bank crises

Published in Real Clear Markets.

Over the summer, I had the pleasure of reading the prerelease versions of two books about banking and financial crises: Finance and Philosophy: Why We’re Always Surprised, by Alex J. Pollock, (Paul Dry Books, October 16, 2018), and Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi, by James Freeman and Vern McKinley (Harper Business, 2018). Pollock’s book is being released in October, and Freeman and McKinley’s book is already available. If the history of banking and financial crises interests you, I think you will find both books to be rich in content and enjoyable to read. I know I did.

In Finance and Philosophy Alex Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, applies his formidable intellect and a lifetime of banking experience to explain in a simple and entertaining way why we continue to have banking crises and why post-crisis regulatory reforms are doomed to fail.

Banking systems will be prone to crises so long as investors confuse risk and uncertainty writes Pollock. Risk can be modeled, assessed and managed, but not so uncertainty.

[…]

Pollock recounts numerous historical examples where the accuracy of heuristic models evaporated once investors and regulators adopted models to guide their actions. For example, in the recent financial crisis, institutions relied on models to parse the risk in subprime mortgage-backed securities. To describe the impact of uncertainty, Pollock quotes Tony Saunders “[t]he rocket scientists built a missile which landed on themselves.”

In Pollock’s view, over confidence in heuristic models is especially problematic when models are sanctioned by bank regulators or the Federal Reserve. For example, time and again, investors have been crushed when uncertainty reveals that investments like government bonds—presumed to be “riskless” in regulatory models— aren’t. Or markets presumed to be deep and dependably liquid—like commercial paper—cease to function.

The confusion between risk and uncertainty is not limited to private bankers and investors—in Pollock’s view, it is endemic among the modern central bankers entrusted with managing the economy. Unable to anticipate economic uncertainty, their economic models often misinterpret the economic tea leaves and lead central bankers (Pollock’s would-be “philosopher kings”) to adopt policies that magnify financial instability as they did in the great inflation of the 1970s and the great moderation (a.k.a. the housing bubble) more recently.

Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.

Is the Senate banking bill a big win for Wall Street? Yes and no

Published in Politifact.

Phone interview with Alex Pollock, senior fellow with the R Street Institute, March 15, 2018

Subcommittee examines ways to reform the Federal Reserve

Published by the House Financial Services Subcommittee on Monetary Policy and Trade.

“The proposals under consideration today are all parts of a timely and fundamental review of America’s central bank. As Congressman Huizenga has rightly said, ‘With the Federal Reserve having more power and responsibility than ever before, it is imperative the Fed…become more transparent and accountable.’… The Federal Reserve without question needs to be accountable to the Congress, be subject to appropriate check and balances, and be understood in the context of inherent financial and economic uncertainty. It would benefit from rebalancing of centralized vs. federal elements in its internal structures.” — Alex J. Pollock, Distinguished Senior Fellow, R Street Institute

Remarks at AEI’s ‘Conference on the 10th anniversary of the financial crisis’

Published by the R Street Institute.

Thanks, Peter. It’s a pleasure to be in a panel with such distinguished colleagues.

I’d like to begin by pointing out that, in addition to being the instructive 10th anniversary we have been discussing, today is also a notable 11th anniversary: On Sept. 14, 2007, Northern Rock bank, a major British mortgage lender, could no longer fund itself in wholesale markets, and an emergency lender-of-last-resort facility from the Bank of England was announced. That day, long lines of depositors began to form outside branches of Northern Rock, its website collapsed and its phone lines were jammed.

The first bank run in England since the days of Queen Victoria was underway. So was the first bailout of the 2007-2009 financial crisis. The crisis reached its peak panic just one year later, as Lehman Brothers went down.

Let’s review a few of the events as the ultimate panic approached.

In June 2008, Larry Lindsay wrote an article for AEI entitled, “It’s Only Going to Get Worse.” He was so right.

In July, Congress passed the law authorizing the Treasury to put money into Fannie and Freddie. Secretary Paulson said he wouldn’t need to. “Nervous calls” from officials of foreign countries to the U.S. Treasury were urging that their large investments in the securities of the tottering Fannie Mae and Freddie Mac be protected by the U.S. government.

On Sept. 7, Fannie and Freddie were put into conservatorship along with their Treasury bailout. Fannie’s common stock had closed at $7 a share Friday, Sept. 5. On Monday, Sept. 8, it was 73 cents.

A week later, Friday, Sept. 12, Lehman’s common stock closed at $3.65 a share. By Monday, Sept. 15, it was 21 cents.

On Sept. 16, losses on Lehman commercial paper forced the Reserve Primary money market fund to “break the buck”; also the Federal Reserve loaned AIG $85 billion.

On Sept. 20, the Bush administration submitted TARP legislation to Congress.

The times were frightening, to be sure and obscured by the “fog of crisis.” As Secretary Paulson later wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.”

Imagine you are a Treasury secretary, finance minister or head of a central bank. You are in the fog of crisis, but you can see that you and your colleagues are standing on the edge of a cliff, staring down into the abyss of potential debt deflation. Will you choose to risk the eternal obloquy of being the one who did nothing?  Of course not. You will intervene and keep intervening with whatever bailouts seem necessary. Your only objective will be to survive the crisis. That’s what you would do, if you were in office, and so would everybody else, just as is always done.

Only, of course, in 2008, they didn’t bail out Lehman. Would you have done so, under the circumstances of the time?

But more fundamentally, the panic was the climax of more than a decade of a long buildup of leverage and risk, and much of this, as has been rightly said, was promoted by the U.S. government. How had the long increase in risk seemed at the time?

Well, the central bankers believed they had created the “Great Moderation,” which turned out to be the “Great Leveraging.” Tim Geithner, then-president of the Federal Reserve Bank of New York, thought in 2006 that “[f]inancial institutions are able to measure and manage risk more effectively,” a belief common at the time.

But: “The reality is that we didn’t understand the economy as well as we thought we did,” as Fed Vice Chairman Don Kohn candidly reflected. “Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis.”

That is reasonably close to a mea culpa, although he sweeps in a lot of other people in his confession. Does the Fed understand the economy any better today than it did in the 2000s?  Is it ever, as Peter Fisher has asked, “candid about the uncertainty” it always faces?

The government promoted housing debt. Most notoriously, the “National Home Ownership Strategy” of the Clinton administration pushed for “innovative” – that is, poor credit quality – mortgage loans. It goes without saying that the government promoted excess housing debt and leverage though Fannie and Freddie, as it continues to do today. These debt-promotion strategies never have been rejected by the U.S. government.

The crisis ended in the spring of 2009, after the Fed had the very good sense to replace mark-to-market tests with “stress tests.” That was an ingenious way out of a problem. Whether by cause or coincidence, the stock market started back up on its long bull run. The S&P Bank Index, which had been at 281 on Sept. 12, 2008, bottomed at 77 on March 5, 2009, after a loss of more than 70 percent. It has since then gotten up over 500.

In the boom, it seems like the boom will last forever. In the bust, it seems like the bust will last forever. Of course, neither is the case, but it feels that way.

By midyear 2009, it was clear we had survived the crisis. Now, it was time for the inevitable political reaction to it, as happens in every financial cycle. Now was the hour for the politicians, including those who had pushed the policies that made things worse, to show how they could fix the problems.

Imagine you are a politician. What would you do in the wake of a huge crisis and bust?

First of all, you certainly have to Do Something!  You can’t just stand there, any more than the central bankers and regulators could during the panic.

Some of us, including Peter Wallison, Ed Pinto, Chairman Jeb Hensarling and me, thought it was a great opportunity to restructure U.S. housing finance into a primarily private, market system, with private capital bearing the risk of its actions.

In 2010, I proposed, in a piece called “After the Bubble,” a list of reform actions which included these:

-Create a private secondary market for prime, middle-class mortgages;

-Design a transition to having no government-sponsored enterprises;

-Stop using the banking system to double-leverage the GSEs, should they survive;

-Facilitate credit-risk retention by mortgage originators;

-Develop countercyclical loan-to-value discipline;

-Create bigger loss reserves in good times;

-Use a one-page key mortgage information form focused on whether the borrower can afford the loan;

-Address the banking system’s overconcentration in real estate risk; and

-Rediscover savings as an explicit goal of housing finance.

It still seems like a good list to me, but needless to say, this wasn’t the direction taken.

A different path was chosen, one always available to the legislature: to expand regulations and the regulatory bureaucracy, with orders that they are not to allow such problems again. This was in spite of the fact that “[n]o regulator had the foresight to predict the financial crisis,” as Andrew Haldane of the Bank of England said, adding, “although some have since exhibited supernatural powers of hindsight.”

But the most interesting question is why did regulators fail to foresee the crisis?  It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is one of knowledge of the future, not of effort. The problem is the inherent uncertainty, the ineluctable lack of knowledge of the future—the mismatch between prevailing ideas and the emergent, surprising reality.

There is another problem: regulators are employees of the government and cannot be expected to stop activities the government is intent on promoting, or act against the interests of their employers. As Bill Poole so convincingly wrote in his paper for this conference:

“An obvious first observation is that the affordable housing policy and mortgage goals given to the GSEs were policies of the Congress, President Clinton and President Bush.” He asks rhetorically, “Should the Fed somehow have undercut the stated policies of the president and the Congress?” The same question applies to all the other regulators.

In spite of these problems, the politicians did what they usually do in the wake of the bust: expand the regulatory bureaucracies and give them more power, renewing Woodrow Wilson’s faith in “expert” bureaucracy. The resulting many thousands of pages of new rules protect the politicians who had to Do Something from the charge of not doing anything or of not doing enough. There is no doubt that the thousands of man-years that went into negotiating and writing the new rules were spent by intelligent, informed, well-intentioned people intent on making the financial system into a mechanism with less chance of failure, although we all know the chance of failure never becomes zero. This is a fine goal, but suffers because financial markets are not a mechanism. (Of course, the bureaucratic excesses of Dodd-Frank were enabled by the temporarily overwhelming congressional majorities of the Democratic Party, which only lasted until they were lost in 2010.)

In the wake of the crisis, the power of the Federal Reserve was also greatly expanded, its role in feeding the bubble and its complete failure to anticipate the collapse notwithstanding. This is the latest of numerous examples in history of Shull’s Paradox, which is that the Fed always gets more powerful, no matter what blunders it makes.

Another action always available to politicians is to set up a committee and give them a big, great-sounding assignment. In this case, the committee was FSOC (the Financial Stability Oversight Council) and its assignment was to figure out, address and avoid systemic risk. There is no evidence that FSOC has the ability to do this, but creating it was a perfectly sensible action from the politicians’ point of view. No one can accuse them of ignoring systemic risk!

FSOC was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions, or SIFIs. FSOC has designated a few firms, then de-designated most of them, but it has utterly failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important. This may be politically prudent on its part, but is intellectually vacuous. I believe Fannie and Freddie should be designated as the SIFIs they so obviously are immediately. Better late than never.

The Fannie and Freddie problem displays the more general fatal flaw in FSOC. It cannot control or even point out the systemic risk created by the government itself. Its members cannot criticize their employer.

The last point I will mention here is a key one: the post-crisis political reaction insisted that there had to be more equity capital in the financial system. This was a good idea, agreed upon by almost everybody. But note that the banks’ capital was able to get so small in the first place, only because the government was correctly believed to be guaranteeing the depositors. Fannie and Freddie’s capital was able to get even smaller because of the correct belief that the government was guaranteeing their creditors.

In the wake of the bust, the Federal Reserve set out to create a “wealth effect” by pushing back up the prices of houses and the prices of financial assets, in order in theory to stimulate economic growth. As we all know too well, it pursued this by massive purchases of long-term Treasury bonds (while reducing its portfolio of short-term Treasury bills to zero) and of very long-term mortgage-backed securities, increasing the Fed’s own balance sheet, as is well-known, up to $4.5 trillion. The Fed also kept real short-term interest rates negative for the better part of seven years.

Whatever the arguments for doing these things as short-term measures, the Fed has kept them as long-term, unquestionably distortionary programs, even now reducing its balance sheet only slightly and getting real short-term interest rates up to approximately zero. The result has been a massive asset price inflation in real estate, financial assets and other assets.

The Fed got its renewed house price boom, all right. Nominal house prices are now well over their bubble peak.

The Fed also instituted the payment of interest on excess reserves held with it by banks. This allowed it to suppress the credit expansion that would have occurred in classic banking theory, and to itself allocate credit instead. To what did it allocate credit?  To housing and to the government deficit.

Where and how will the Fed-induced remarkable asset price inflation end?  I don’t know. The Fed doesn’t know. The financial regulators don’t know. That is hidden in the uncertainty of the economic future. It may be the Fed’s hoped-for soft landing, but then, it might not be.

Finally, here is a reminder of some essential things not done by the politicians or the regulators or the central bank in the wake of the crisis, among others:

• They did not create a primarily private secondary market for prime mortgages.

• They did not design a transition to having no GSEs.

• They did not develop countercyclical LTV discipline.

• They did not address the overconcentration of the banking system in real estate risk.

• They did not rediscover savings as an explicit goal of housing finance.

They did get equity ratios increased, which was good.

They did preside over an efflorescence of bureaucracy and a giant asset price inflation.

What next?  This is a period of uncertainty, just like every other period.