Golden Years

Published in Barron’s.

After considering the many problems of retirement finance in a lower-return world, the article (“The New Retirement Strategy,” Jan. 5), gets to David Blanchett’s suggestion: “It might be better to simply work longer.”

Yup. The best way to finance retirement is not to retire, at least not too soon. Shorten the time to be financed. Lengthen the time when savings can be generated. The math is simple and inescapable.

The Fed is technically insolvent. Should anybody care?

Published in American Banker.

As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?

The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.

If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.

The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.

And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?

All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.

Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.

People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.

About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?

Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.

When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.

It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.

It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?

Higher interest rates and the looming end of the second real estate double bubble

Published in Housing Finance International Journal.

At this point, the most important thing about U.S. housing finance is that long-term interest rates are rising. The rate on 30-year fixed rate mortgages, the benchmark U.S. mortgage instrument, has since September 2017 gone from less than 4 percent to close to 5 percent. This is in line with the rise in 10-year U.S. Treasury note yields from something over 2 percent to more than 3 percent. The massive manipulation of long-term interest rates by the Federal Reserve is belatedly winding down, step by step. The house price inflation the Fed thereby promoted also must inevitably end.

The real (inflation-adjusted) interest rate on the 10-year Treasury note has gone from about 0.4 percent to just over 1 percent. These rate movements from extraordinarily low levels to somewhat higher levels are shown in Graph 1.

Read the rest here.

Testimony on The Bipartisan Housing Finance Reform Act of 2018

Published by the R Street Institute.

KEY POINTS

1. We should be heading for a reform which transforms the system into one which is 80% private and only 20% government.

2. The best place for mortgage credit risk to reside is with the lender who makes the loan in the first place, who should retain significant credit risk "skin in the game" for the life of the loan.

3. The best we can do to dampen price distortions is to move toward the goal of making the housing finance system 80% private.

4. Guarantee fees for the GSEs must be calculated to include the cost of capital that would be required for a regulated private financial institution to bear the same credit risk.

5. Congress should remove Fannie and Freddie's special government privileges and make them pay for their formerly free Treasury guarantee, turning them from GSEs into normal competitors, and creating a competitive, instead of duopolistic, mortgage securitization market.

6. The FHLBs should be authorized to form, own and manage a joint subsidiary dedicated to mortgage finance, including securitization and also advancing structures with lender skin in the game, on a national basis.

The bipartisan discussion draft advances the development of fundamental housing finance reform. As it proposes, we need to move toward a system with greater private capital at risk, more competition, and more robust risk distribution to achieve sustainable home finance for the American people.

Predicting is hard…

Published by the R Street Institute.

From Reuters, on June 27, 2017:

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe there will be another financial crisis for at least as long as she lives.

From CNBC, on Dec. 11, 2018:

There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.

The financial future is murky, but one of these predictions will be right.

The Bill Walton Show: Finance, Philosophy and more with Alex Pollock

Published by the Bill Walton Show.

People look to the government to prevent future financial crises and trust that politicians and economic experts can create policies to protect us and our 401(k) plans. We shouldn’t trust them. These experts are smart, mostly well-intentioned people but they can’t prevent the next crisis. No one can. Why is that? Why is a future crisis inevitable? I discuss these and many other questions with “Finance and Philosophy” author Alex Pollock.

India’s Central Bank Debates Remind Us the Fed Is Far From ‘Independent’

Published in Real Clear Markets.

Should central banks be “independent” from the elected parts of the government?  If so, should they be independent in all things, or just some things?  Or should they not be independent at all? These are classic questions.  Of course, central bankers themselves like the idea of independence, as do many economists, who believe they know better about economic and financial affairs than mere politicians.  Larry Summers, a leading economist, former Secretary of the Treasury and former contender for the office of Federal Reserve Chairman, recently wrote about President Trump’s criticism of Federal Reserve policy:

“No self-respecting central banker can be seen as yielding to pressure from a politician.”

Of course Professor Summers knows that there have been many instances over the decades of U.S. presidents and administrations exerting pressure on the Fed.  As Allan Meltzer wrote in his monumental A History of the Federal Reserve, “Missing from most explanations by economists is the political dimension.  By law the Federal Reserve was an independent agency.  In practice, it responded to political pressures.”

Interestingly, at the same time as President Trump’s criticisms, half a world away, the government of India’s Prime Minister Narendra Modi is putting much more pressure on India’s central bank, the Reserve Bank of India.

So India, a huge country with a big economy, a parliamentary democracy and a sophisticated central bank, has been having a highly interesting debate of the issue.  The Reserve Bank has maintained that its independence is a central principle, with its Deputy Governor Viral Acharya pronouncing that “Governments that do not respect the central bank’s independence will sooner or later…ignite economic fire and come to rue the day.”  Does this mean he thinks a central bank has no boss, no political accountability?

Under the original Federal Reserve Act of 1913, the executive branch was assumed to have an important voice in central bank affairs, since the Secretary of the Treasury was by law the Chairman of the Federal Reserve Board. This provision was removed in the Banking Act of 1935, which certainly pleased the new Fed Chairman, Marriner Eccles, when he assumed the role in that year.

In the Indian context, the Prime Minister’s government has a stronger hand than does a U.S. administration.  The central bank’s chartering act, the Reserve Bank of India Act of 1934, provides:

“The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

Although this power apparently has never been explicitly used, it could not be clearer: Have a discussion about the issues with the central bank, and then if you think it “necessary in the public interest,” tell the bank what to do and the bank has to do it.  While “the market and the banking system have been abuzz that the rift between the government and the RBI had reached a point of no return,” as India Today put it, the government has been forcefully and publicly reminding the Reserve Bank about this unambiguous provision of its chartering act.

Professor Summers, in the same essay as quoted above, added like a good two-handed economist, that on the other hand:

“There is a need for pragmatism regarding the independence of central banks.”  And: “It is foolish to suppose that a nation’s financial policies should be conducted independently of its elected officials.”

So the unelected central bankers should not be so independent, after all?  Arthur Burns, Chairman of the Fed in the inflationary 1970s, reportedly characterized such pragmatism, or political realism, in these memorable terms:  “We dare not exercise our independence for fear of losing it”!

What does the present Indian government consider necessary in the public interest?  First, it wants to get its hands on what it says are the “excess” retained earnings of the Reserve Bank, and more of the bank’s annual profit, in order to have the money to spend.

It may be of interest to compare the Federal Reserve’s situation in this respect.  The Congress has three times taken some of the retained earnings of the Federal Reserve Banks—half of their surplus in 1933 to fund the new Federal Deposit Insurance Corporation; $19 billion in 2015 to fund highways in a transportation act; and another $2.5 billion in 2018 to fill a gap in a budget deal.  Although it was “a raid on the capital base of the nation’s central bank,” as one critic said, it happened anyway.  As for profits, the Fed pays almost all of its annual profit, about 99%, right over to the U.S. Treasury.  The resulting consolidated Federal Reserve balance sheet has a trivial capital ratio of 0.9%.  Is that enough?  Who gets to say?

Prime Minister Modi’s idea of getting money to spend from the central bank’s reserves and profits is hardly a new idea.

Second, the Indian government wants the Reserve Bank to ease its regulatory constraints on banks which already have high ratios of bad loans, in order to promote more lending now, with as is often noted, an election coming up. That may be a bad idea, but who is the boss when it comes to financial regulation?  In the U.S., it is certainly the Congress, although the Fed and other regulators have significant discretion in interpretation.

After a marathon meeting of the Reserve Bank of India’s board on November 19, the bank agreed to reassess its policy on reserves and its rules for troubled banks. It does not seem too hard to guess what direction the “reassessment” will take.

While the immediate issues are about regulatory policy and helping out the government budget, the classic “independence” argument is that central banks should be independent in monetary policy, as their essential mandate. This aspect of independence has also been debated in India.  In contrast to its government’s preferences and to President Trump’s comments, recent Federal Reserve reform bills in the House of Representatives which would have subjected the Fed to significantly increased oversight, nevertheless always protected monetary policy independence.  Is that distinction a sacred principle or a sacred cow?  In U.S. history, the Truman administration, wanting the Fed to help finance the Korean War, certainly didn’t believe in it.  Will it be respected as the government of India continues to push the Reserve Bank?

It will be instructive to observe the continuing developments there, including the competing rationales and rhetoric.  As an example of the latter, “The independence of the central bank is still intact,” said one economist after the November board meeting—perhaps he proposes to redefine “independence.” “We don’t think that this issue has been fully solved yet,” said another.  For sure not–stay tuned.

Saving for Retirement

Published in Barron’s.

A house with no mortgage left on it is a classic retirement asset and a good way to save for one’s older years (“Remaking Retirement,” Cover Story, Nov. 19). A big issue not mentioned in your otherwise informative articles on 401(k) and other retirement savings accounts is how to utilize these accounts, now completely focused on stocks and bonds, to address the hardest financial problem of many young families. This is how to finance the down payment on their first house, which is also an excellent retirement asset.

In my view, Congress should amend the governing acts for retirement accounts to provide for a simple and penalty-free withdrawal from 401(k) and individual retirement accounts for the down payment on a first house, with the tax deferred on the income withdrawn (perhaps starting amortization at age 70½). We should give investing in a house of your own the same retirement-account tax treatment as investing in stocks and bonds.

Congress did have bills introduced in this direction in the 1990s—it would be a good bipartisan project to actually do it now.

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.