Tags
Financial Systemic Issues: Booms and Busts - Central Banking and Money - Corporate Governance - Cryptocurrencies - Government and Bureaucracy - Inflation - Long-term Economics - Risk and Uncertainty - Retirement Finance
Financial Markets: Banking - Banking Politics - Housing Finance - Municipal Finance - Sovereign Debt - Student Loans
Categories
Blogs - Books - Op-eds - Letters to the editor - Policy papers and research - Testimony to Congress - Podcasts - Event videos - Media quotes - Poetry
Video: The New Monetary Regime: An Expert Panel Discusses Government Debt and Inflation
Hosted by Law & Liberty.
For decades, the U.S. Government has been charging a credit card with no limit, running up previously unimaginable trillions of dollars on the balance sheet at the Federal Reserve, leaving future generations as the guarantor—and the bill may be coming due sooner rather than later. What will be the effects of this Fed/Treasury alliance on our economy and our society?
Law & Liberty and the Real Clear Foundation hosted a distinguished panel of experts who discussed the growing crisis of inflation and debt in our government.
The discussion was moderated by Alex J. Pollock of the R Street Institute, and the panelists included Law & Liberty Senior Writer David P. Goldman of the Claremont Institute, Veronique de Rugy of the Mercatus Center, and Christopher DeMuth of the Hudson Institute.
Another Bad Idea: Fannie and Freddie as Utilities
Published by the American Enterprise Institute with Patrick Lawler and Edward J. Pinto.
In the more than twelve years since their 2008 failure, nobody has been able to figure out how to end Fannie Mae and Freddie Mac being wards of the state, as their continued existence is wholly dependent on the generosity of the taxpayer by way of the U.S. Treasury’s credit. Many proposals, legislative and otherwise, for restructuring or replacing these behemoths have come and gone. Now, arguments are increasingly being made to retread these government sponsored enterprises (GSEs) as privately owned, public utilities. While this idea has its promoters, we believe it is fundamentally a bad idea. How the Government Mortgage Complex does love to propose rent-seeking solutions that operate with the largest possible government guarantee.
In March 2020, the Center for Responsible Lending published a paper by Eric Stein and Bob Ryan urging that a utility approach to regulation of the GSEs be implemented post-conservatorship, which they asserted was essentially how they were being regulated in conservatorship. In December, 2020 the National Association of Realtors in a paper by Richard Cooperstein, Ken Fears, and Susan Wachter, reiterated and updated their earlier position that made the public utility model the centerpiece of their “enduring vision of housing finance reform.” They recommend that the GSEs should be prevented from excessive competition for market share in good times and from hiking fees in bad times to an extent that would undermine their public missions. In January 2021, the former CEO of Freddie Mac, Don Layton, now at the Harvard Joint Center for Housing Studies, continued to argue for utility style regulation of GSE guarantee fees, the amount they change lenders for assuming mortgage credit risk.
Also in January 2021, the Treasury Department released a blueprint for GSE reform that called for continued regulatory oversight of GSE pricing post-conservatorship in a way that would simultaneously protect the safety and soundness of the GSEs while seeking to channel the benefits of federal support to homebuyers and renters rather than shareholders and managers. The blueprint builds on its earlier housing reform plan that appeared to endorse giving greatly enhanced regulatory authorities, such as a utility regulator might have, to the Federal Housing Finance Agency (FHFA) with regard to permissible activities and products. And in February 2021, the Brookings institution published a paper by Michael Calhoun (president of the Center for Responsible Lending) and Lewis Ranieri calling for utility oversight focusing on increased transfers to affordable housing and racial equity programs. These proposals build on previous ideas going back more than 20 years, but are now achieving greater visibility and wider mention.
These encomiums ignore the all too foreseeable consequences of a public utility structure, especially when applied to these national financial giants that have little in common with a local water company. The combination of political clout and a greatly expanded cookie jar of fees and cross subsidies would repeat, and in some respects worsen, the ills of the GSE structure that failed so spectacularly in 2008. Their insolvencies were critical precipitating events of the financial chaos in the fall of that year. In the early post-crisis years, there was general agreement that reliance on these giant institutions as the foundation of that market had revealed manifold problems that required a major change in approach. Fannie and Freddie:
Were intended for public purposes, but controlled by private investors; they earned outsized returns for their owners during most of their existence, but in 2008 needed massive taxpayer bailouts exceeding all their previous profits;
Used the advantages of their special status to expand their franchises into new activities, crowd out competitors, and dominate less favored firms;
Concentrated mortgage risks in two entities with extraordinary leverage;
In response to congressional low-income affordable housing mandates, used a portion of the subsidy provided by the taxpayer’s implicit guarantee to increase debt, and subsidize the cost of that debt, rather than making homes more affordable and building wealth for low-income buyers.
Failed to durably raise homeownership rates, but did contribute to significantly bigger houses for the all classes of homebuyers; and
Wielded powerful economic and political clout to bully customers, suppliers, regulators, executive branch agencies, and Congress for their own benefit.
Please click here to view the PDF
Government policies reshape the banking industry: Changes, consequences, and policy issues
Hosted by the American Enterprise Institute.
On April 12, AEI’s Paul H. Kupiec hosted a panel discussion on recent changes in the banking industry and their consequences for the wider economy. He reviewed how the industry has consolidated, is lending less to the private sector, and is relying more on federal guarantees.
Richard E. Sylla of New York University summarized the history of the banking industry. Aside from a 50-year period of stability, US banking has trended toward a system characterized by a few large banks with extensive branch systems, branch systems that are now in decline themselves.
Charles Calomiris of Columbia University summarized more recent trends in the banking industry as a “three-legged stool”: extreme consolidation, extreme dependency on government support, and reliance on real estate lending. Alex J. Pollock of the R Street Institute added that the greater “banking credit system” is increasingly influenced by the Federal Reserve and government-sponsored enterprises.
Bert Ely of Ely & Company enumerated the industry risks. Depository institutions are intermediating deposits into government debt. Low interest rates have also squeezed bank margins and reduced the cushion to absorb losses that may arise from the pandemic.
— John Kearns
Event Description
The federal government response to the 2008 financial crisis, including new laws, prudential regulations, and Federal Reserve monetary policies, has left a lasting impact on the banking industry. Not only has the number of independent depository institutions almost halved since 2000, but the industry has also become much more concentrated in a few large “systemically important” institutions. Moreover, the characteristics of the largest banks have changed dramatically according to incentives established by heightened prudential regulatory requirements and the Federal Reserve’s long-lived zero interest rate environment.
Join AEI as a panel of banking experts discusses postcrisis changes in the banking industry and their consequences for the wider economy.
Event Materials
Paul H. Kupiec: “20 years of banking history in 67 charts and tables”
Richard Sylla: “From exceptional to normal: Changes in the structure of US banking since 1920”
Alex J. Pollock, Hashim Hamandi, and Ruth Leung: “Banking credit system, 1970–2020”
Charles W. Calomiris: “Introduction: Assessing banking regulation during the Obama era”
Agenda
10:00 AM
Introduction and opening remarks:
Paul H. Kupiec, Resident Scholar, AEI
10:15 AM
Panel discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Bert Ely, Principal, Ely & Company
Alex J. Pollock, Distinguished Senior Fellow, R Street Institute
Richard E. Sylla, Professor Emeritus of Economics, New York University
Moderator:
Paul H. Kupiec, Resident Scholar, AEI
11:30 AM
Q&A
12:00 PM
Adjournment
Inflation Risk
Published in Barron’s.
To the Editor:
Regarding “Why—and How—Investors Should Gird for Inflation Risk” (The Economy, March 26), what the Federal Reserve says always reflects politics and its attempts to manipulate expectations. But being prepared for the risk of higher inflation, as Lisa Beilfuss suggests, is perfectly aligned with what the Fed is doing, namely printing money. As for the Fed’s forecasts, they are as unreliable as anybody else’s guesses about the future.
The Many Faces of Government Default
Published in Law & Liberty.
Although government debt is a favored investment class all over the world, it has a colorful history of over 200 defaults in the last two centuries, which continue right up to the present time.
This record reflects a perpetual political temptation, memorably described by the sardonic observer of sovereign defaults, Max Winkler in 1933. Of “the politicians in the borrowing countries,” he wrote, “from Abyssinia to Zanzibar”—which we may update to Argentina to Zambia, both governments having defaulted again in 2020—“Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures . . . and exchange favors by the misuse of the public treasury. In order to enjoy the present, they cheerfully mortgage the future.” Of course, we can’t read this without thinking of the Biden $1.9 trillion project to spend, borrow, and print.
Often enough, historically speaking, booming government debt has resulted in “national bankruptcy and default” around the world. Winkler chronicled the long list of government defaults up to the 1930s. He predicted that future investors would again be “gazing sadly” on unpaid government promises to pay. He was so right. Since then, the list of sovereign defaults has grown much longer.
A Short Quiz: Here are six sets of years. What do they represent?
1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014, 2020
1828, 1898, 1902, 1914, 1931, 1937, 1961, 1964, 1983, 1986, 1990
1826, 1843, 1860, 1894, 1932, 2012
1876, 1915, 1931, 1940, 1959, 1965, 1978, 1982
1826, 1848, 1860, 1865, 1892, 1898, 1982, 1990, 1995, 1998, 2004, 2017
1862, 1933, 1968, 1971
All these are years of defaults by a sample of governments. They are, respectively, the governments of:
Argentina
Brazil
Greece
Turkey
Venezuela
The United States.
In the case of the United States, the defaults consisted of the refusal to redeem demand notes 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; and the refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.
With the onset of the Civil War in 1861, the war effort proved vastly more costly than previously imagined. To pay expenses, Congress authorized a circulating currency in the form of “demand notes,” which were redeemable in precious metal coins on the bearer’s demand and promised so on their face. Secretary of the Treasury Salmon Chase declared that “being at all times convertible into coin at the option of the holder . . . they must always be equivalent to gold.” But soon after, by the beginning of 1862, the U.S. government was no longer able to honor such redemptions, so stopped doing so. To support the use of the notes anyway, Congress declared them to be legal tender which had to be accepted in payment of debts. About issuing pure paper money, President Lincoln quoted the Bible: “Silver and gold have I none.”
In 1933, outstanding U.S. Treasury bonds included “gold bonds,” which unambiguously promised that the investor could choose to be paid in gold coin. However, President Roosevelt and Congress decided that paying as promised was “against public policy” and refused. Bondholders sued and got to the Supreme Court, which held 5-4 that the government can exercise its sovereign power in this fashion. Shortly before, when running for office in 1932, Roosevelt had said, “no responsible government would have sold to the country securities payable in gold if it knew that the promise—yes, the covenant—embodied in these securities was . . . dubious.” A recent history of this failure to pay as agreed concludes it was an “excusable default.”
In the 1960s, the U.S. still had coins made out of real silver and dollar bills which were “silver certificates.” These dollars promised on their face that they could be redeemed from the U.S. Treasury for one silver dollar on demand. But when inflation and the increasing value of silver induced people to ask for redemptions as promised, the government decided to stop honoring them. If today you have a silver certificate still bearing the government’s unambiguous promise, this promise will not be kept—no silver dollar for you. The silver in that unpaid silver dollar is currently worth about $20 in paper money.
An underlying idea in the 1944 Bretton Woods international monetary agreement was that “the United States dollar and gold are synonymous,” but in 1971 the U.S. reneged on its Bretton Woods agreement to redeem dollars held by foreign governments for gold. This historic default moved the world to the pure fiat money regime which continues today, although it has experienced numerous financial and currency crises, as well as endemic inflation. Since 1971, the U.S. government has stopped promising to redeem its money for anything else, and the U.S. Treasury has stopped promising to pay its debt with anything except the government’s own fiat currency. This prevents explicit defaults in nominal terms, but does not prevent creating high inflation and depreciation of both the currency and the government debt, which are implicit defaults.
Winkler related a pointed 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 debts 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, reminted them, “Stamping at two drachmae each one-drachma coin.” Brilliant! With these, he paid off his nominal debt, becoming, Winkler said, “the Father of Currency Devaluation” and thereby expropriating real wealth from his subjects.
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. In all cases, like Dionysius, the U.S. government broke a promise, depreciated its currency, and reduced its obligations at the expense of its creditors. Default can have many faces.
So convenient it is to be a sovereign when you can’t pay as promised.
Financial Triangle
Published in Barron’s.
Henry Kaufman, as quoted by Randall W. Forsyth in “Where Wall Street’s ‘Dr. Doom’ Sees Danger Now” (Up & Down Wall Street, March 12), is so right that we have a “dangerous dependency on the Fed” and that “the central bank and the Treasury are ‘joined at the hip.’ ” Of course, a core mandate of every central bank is to finance, as needed, the government of which it is a part, although you won’t find this in the Federal Reserve’s public-relations materials. The close link of the Fed and the Treasury goes back to the Fed’s 1913 chartering act, which originally made the secretary of the Treasury automatically the chairman of the Federal Reserve Board.
But now, the joining at the hip is even tighter than Kaufman suggests, because it includes the mortgage market, too. With its $2.1 trillion and growing mortgage portfolio, the Fed owns about 20% of all residential mortgages. It buys mortgage securities with the guarantee of Fannie Mae and Freddie Mac; but with virtually no capital of their own, the value of Fannie and Freddie’s guarantees is completely dependent on the Treasury. Moreover, the Treasury is their principal owner.
Thus, the real joining at the hip is not only the Fed and the Treasury, but also the Fed and the Treasury and Fannie/Freddie—a gigantic government financial triangle.
The Oversight Board Keeps Working On Puerto Rico’s Record Insolvency
Published in Real Clear Markets.
The government of Puerto Rico continues to hold the all-time record for a municipal insolvency, having gone broke with over $120 billion in total debt, six times as much as the second-place holder, the City of Detroit.
Faced with this huge, complex, and highly politicized financial mess, and with normal Chapter 9 municipal bankruptcy legally not available, the Congress wisely enacted a special law to govern the reorganization of Puerto Rico’s debts. “PROMESA,” or the Puerto Rico Oversight, Management, and Economic Stability Act, provided for a formal process supervised by the federal courts, in effect a bankruptcy proceeding. It also created an Oversight Board (formally, the Financial Oversight and Management Board for Puerto Rico) to coordinate, propose and develop debt settlements and financial reform. These two legislative actions were correct and essential. However, the Oversight Board was given less power than had been given to other such organizations. The relevant models are notably the financial control boards of Washington DC and New York City and the Emergency Manager of Detroit, all successfully called in to address historic municipal insolvencies and deep financial management problems.
It was clear from the outset that the work of the Puerto Rico Oversight Board was bound to be highly contentious, full of complicated negotiations, long debates about who should suffer how much loss, political and personal attacks on the Board and its members, and heated, politicized rhetoric. And so it proved to be. Since the members of the Oversight Board are uncompensated, carrying out this demanding responsibility requires of them a lot of public spirit.
An inevitable complaint about all such organizations, and for the Puerto Rico Oversight Board once again, is that they are undemocratic. Well, of course they are, of necessity, for a time. The democratically elected politicians who borrowed beyond their government’s means, spent the money, broke their promises, and steered the financial ship of state on the rocks should not remain in financial control. After the required period of straightening out the mess and re-launching a financial ship that will float, normal democracy returns.
It is now almost five years since PROMESA became law in June, 2016. It has been, as it was clear it would be, a difficult slog, but substantial progress has been made. On February 23, the Oversight Board announced a tentative agreement to settle Puerto Rico’s general obligation bonds, in principle the highest ranking unsecured debt, for on average 73 cents on the dollar. This is interestingly close to the 74 cents on the dollar which Detroit’s general obligation bonds paid in its bankruptcy settlement. If unpaid interest on these bonds is taken into account, this settlement results in an average of 63 cents on the dollar. In addition, the bondholders would get a “contingent value” claim, dependent on Puerto Rico’s future economic success—this can be considered equivalent to bondholders getting equity in a corporate reorganization–very logical.
The Oversight Board has just filed (March 8) its formal plan of adjustment. It is thought that an overall debt reorganization plan might be approved by the end of this year and that the government of Puerto Rico could emerge from its bankrupt state. Let us hope this happens. If it does, or whenever it ultimately does, Puerto Rico will owe a debt of gratitude to the Oversight Board.
We can draw two key lessons. First, the Oversight Board was a really good and a necessary idea. Second, it should have been made stronger, on the model of previous successes. In particular, and for all future such occasions, the legislation should have provided for an Office of the Chief Financial Officer independent of the debtor government, as was the case with the Washington DC reform. This was highly controversial, but effective. Any such board needs the numbers on a thorough and precise basis. Puerto Rico still is unable to get its audited annual reports done on time.
A very large and unresolved element of the insolvency of the Puerto Rican government remains subject to a debate which is important to the entire municipal bond market. This is whether the final debt adjustments should include some reduction in the almost completely unfunded government pension plans. Puerto Rico has government pension plans with about $50 billion in debt and a mere $1 billion or so in assets.
There is a natural conflict between bondholders and unfunded pension claims in all municipal finance, since not funding pensions is a back door deficit financing scheme. General obligation bonds are theoretically the highest ranking unsecured credit claims, and senior to unfunded pensions. But the reality is different. De facto, reflecting powerful political forces, pensions are the senior claim. Pensions did take a haircut in the Detroit bankruptcy, but a significantly smaller one than did the most senior bonds. In other municipal bankruptcies, unfunded pensions have come through intact.
What should happen in Puerto Rico? The Oversight Board has recommended modest reductions in larger pensions, reflecting the utter insolvency of the pension plans. Puerto Rican politicians have opposed any adjustment at all. Bondholders of Illinois: take note of this debate.
I suggest a final lesson: the triple-tax exemption of interest on Puerto Rican bonds importantly contributed to its ability to run up excess and unpayable debts. Maybe there was a rationale for this exemption a hundred years ago. Now Puerto Rico’s bonds should be put on the same tax basis as all other municipal bonds.
The Coming Bailout of State Pension Plans
Published in The Wall Street Journal.
In “Prelude to a State Pension Bailout” (op-ed, March 1), Andrew C. Biggs is doubtless right that the coming bailout of hopelessly insolvent multiemployer pension plans will lead to further bailouts of other broke pension plans. These will be justified with the argument that the pensions were “promised”—but by whom? They weren’t promised by the taxpayers, only by the defaulting plans and a government insurance program that is itself insolvent. How very clever it was to set up the Pension Benefit Guaranty Corporation and promise it would never call on the taxpayers: This very same illusion created Fannie Mae and Freddie Mac and their subsequent bailout. The multiemployer pension plans are deeply in need of structural reform, and so are many public-employee pension plans, and so is the PBGC. If indeed, as Mr. Biggs argues, the political urge to bail them out is irresistible, the opportunity for reform thereby created should not be missed. The unquestionable governing principle must be that bailouts require reform: No reform, no bailout.
Inflation Comes for the Profligate
Published in Law & Liberty.
Printing money to finance wars with resulting inflation is the most time-honored monetary policy. It can also be used for other crises thought of as analogies to wars, like to finance the massive expense of bridging the Covid 19-triggered bust of 2020.
In these situations, the central bank necessarily becomes the Treasury’s partner and servant, stuffing its balance sheet with government debt and correspondingly inflating the supply of money. This captures an essential mandate of every central bank, though it is not one you will find in the Federal Reserve’s public relations materials, namely lending money to the government of which it is a part.
Now, as the economic recovery from the Covid bust strengthens, soaring government debt is still being heavily monetized in the Federal Reserve’s balance sheet, which has now expanded to a previously unimagined $7.6 trillion, in a classic Treasury-Fed cooperation. The printing (literal and metaphorical) continues and the new administration wants to expand it even more. Isn’t accelerating inflation on the way?
The distinguished former Secretary of the Treasury, economist Larry Summers, recently suggested that it may be. “There is a chance,” he wrote, that government actions “on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.” I believe this is correct.
If we agree that there is such “a chance,” how big a chance is it? With political delicacy, Summers’ essay does not address this question. Instead, he carefully points out the “enormous uncertainties” involved. While the fog of uncertainty always obscures the economic future, it looks to me like the answer is that the chance is substantial. It would not be at all surprising to see inflation move significantly higher.
“There is the risk,” Summers writes, “of inflation expectations rising sharply.” Well, inflation expectations are already rising among bond investors and analysts, giving rise to such commentaries as these:
“According to the Bank of America’s January fund manager survey, some 92% of respondents expect rising inflation.” (Almost Daily Grant’s Newsletter, February 10, 2021)
“Bonds Send Message that Inflation is Coming” (Barron’s, February 5, 2021)
“For those of us not inclined to believe in free lunches, the funding of large deficits with printed money is another source of inflation and financial stability concerns” (Barron’s, February 12, 2021)
“A new worry now is whether the tremendous spending plans…can really be done without prompting a historic inflation.” (Don Shackelford, Proceedings newsletter)
“With growth in unit labor costs surging and a range of survey indicators also pointing to rising price pressures, we think inflation will be much stronger over the rest of this year.” (Andrew Hunter in Capital Economics)
“Inflation Worries Drive Platinum Up” (Wall Street Journal)
“The rat the Treasury market is smelling is consumer price inflation.” (Wolf Street, February 13, 2021).
Reflecting these concerns, the yield on the 10-year Treasury note, while still low, has risen meaningfully of late, to about 1.4 percent from 0.7 percent six months ago. This move has imposed serious losses on anybody who bought long-term Treasuries last summer and held them. The price of the iShares Treasury Bond ETF, for example, is down about 18 percent since the beginning of August.
In contrast to the views just quoted, Summers observes “administration officials’ dismissal of even the possibility of inflation.” Who is right, the investors or the politicians? Whose assessments of inflation risk do you believe? Politicians may be expected to deny an economic result that would get in the way of their intense desire to spend newly printed money.
As has frequently been discussed, a notable inflation has already been running for some time—the inflation in asset prices. Monetary expansion, needing to go somewhere, has gone into the prices of equities, bonds, houses, gold, and Bitcoin. The “Everything Bubble” stoked by the Federal Reserve and the other principal central banks has taken asset prices to historically extreme, and in the case of Bitcoin, amazing, valuations. Financial history presents an essential recurring question: How much can the price of an asset change? It also provides the answer: More than you think.
U.S. house prices have been and are inflating rapidly. They are substantially over their Housing Bubble peak of 2006. According to December’s Case-Shiller index, they are rising at an annualized rate of 10 percent, and AEI’s December Home Price Appreciation Index shows a year-over-year increase of 11 percent. This is abetted by the Fed’s monetization of long-term mortgages, of which it owns, including unamortized premiums, a striking $2.3 trillion—a sum 2.6 times its total assets in 2007—and which it continues to buy in size. This huge monetization of mortgages by the institution they created would greatly surprise the founders of the Federal Reserve, could they see it, and displease them. Instead of taking away the punch bowl as the party warms up, the Fed is now pouring monetary vodka into the housing finance punch. Reflecting on this inversion of the famous metaphor, Ed Pinto of the American Enterprise Institute has reasonably asked if they couldn’t at least stop buying mortgages. But it appears this will not happen anytime soon.
Of course, as a base line, we have endemic inflation of goods and services prices. The Federal Reserve has moreover formally committed itself to perpetual inflation. The Covid bust notwithstanding, the Consumer Price Index increased 1.4 percent year-over-year in January, 2021, and over the two months of December-January at an annualized rate of 3.1 percent. We are told frequently by the Fed about its “2% target” and hear it endlessly repeated by a sycophantic chorus of journalists. Since the Constitution unambiguously gives the power of regulating the value of money to the Congress, I believe the Federal Reserve acted unconstitutionally in announcing on its own, and carrying out without the approval of the Congress, a commitment to perpetual depreciation of the purchasing power of the U.S. currency.
Last year it formally added a new willingness to let inflation go higher than 2 percent for a while. How much higher and for how long nobody knows, including the Fed itself, but this willingness is consistent with a greater chance of accelerating inflation.
How much inflation is a sustained 2 percent? At that rate, average prices quintuple in a lifetime. The global movement among central banks, including the Fed, to trying for 2 percent inflation is a notable example of the changing intellectual fashions of central bankers. When serving as Federal Reserve Chairman, Alan Greenspan suggested the right inflation target was zero, correctly measured, and an inflation rate of zero was the long-term goal of the Humphrey-Hawkins Act of 1978. The distinguished economist, Arthur Burns wrote in 1957 that “our economy is faced with a threat of gradual or creeping inflation over the coming years.” He was right about that, except that gradual unexpectedly became galloping in the 1970s (ironically, when he was Fed Chairman).
“It is highly important that we try to…stop the upward drift of the price level,” Burns argued. Over time, “even a price trend that rises no more than 1 percent a year will cut the purchasing power of the dollar”—so much the more would 2 percent, he added. How ideas have changed. . Since the 1970s, we never are told about “creeping inflation” anymore. While Burns in the 1950s attacked 1 or 2 percent inflation, our current monetary mandarins strive for 2 percent forever and more than 2 percent for now. This increases the risk, consistent with Summers’ observations, that they will get more than they are bargaining for.
Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.
At 3 percent inflation, prices would multiply by 11 times in the course of a lifetime. We are always a little surprised at the result over time of relatively small changes in a compound growth rate like the average rate of inflation.
One of the key Keynesian arguments for inflation was that wages are sticky downwards, so that if real wages economically need to fall, you can make then go down by inflation instead. Over the decade prior to the Covid crisis, average U.S. hourly earnings for all employees were rising first at about 2 percent and later 3 or 3.5% percent a year. So a 2 or 3 percent inflation would sharply cut or wipe out real wage gains, at the same time as it imposes negative real returns on savers. Other items you will never see in the Federal Reserve’s public relations materials are its potent abilities to reduce real wages and punish savers.
“Throughout history, there’s absolutely no currency in the world that has maintained its value,” international fund manager Mark Mobius pronounced. The U.S. dollar certainly has not, losing 96 percent of its purchasing power since the creation of the Federal Reserve and losing 98 percent of its value in terms of gold since 1971. (That was when the U.S reneged on its Bretton Woods commitments and led the world into a pure fiat currency regime.) Increasing inflation going forward from here would be consistent with history.
Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.
With the opinion farthest from mine, we have the cheerleaders for monetizing a lot more debt and practicing “What, me worry?”—these are the proponents of “MMT” or Modern Monetary Theory. Of course, it should be written “M”MT, or “Modern” Monetary Theory, since solving your problems by printing up money and forcing the people to accept the depreciating currency is a very old financial idea. The City of Venice used it in 1630, for example, to spend with inflationary result during an attack of bubonic plague. Alternately, we could consider calling it “WMT” or “ZMT” for Weimar Monetary Theory or Zimbabwe Monetary Theory. Even better would be “JLMT” for John Law Monetary Theory.
John Law was the creative, persuasive theorist of risk and paper money, “secretary to the King of France and controller general of His Majesty’s finances,” who presided over first the inflation and then the panicked collapse of the Mississippi Bubble of 1720. A main theme, then as now, was how to produce paper assets to cover the government’s debts, but his history also provides a precedent for our house price discussion: “Thanks to Law’s money-printing, land and houses were expensive.”
Like the close ties of John Law to the French monarchy, the question of debt monetization and its inflationary risks is closely tied to the question of what kind of government we want. Should the federal government’s power be limited or expansive and dominant? What the proponents of “M”MT really long for is a vastly expanded and more powerful government, with themselves in charge. If debt can be indefinitely expanded by bloating the central bank, then you don’t have to tax much in order to spend forever. Thus one of the most important limits on the power of Leviathan to dominate the society can be removed. We see that much more is involved than a monetary theory.
Are those desiring to wield the expanded power willing to cause much higher inflation to get it? This is the political meaning of the monetary question.
What Drove Five Decades of Big Changes in Banking?
Published by the Office of the Comptroller of the Currency.
A new post authored by Alex J. Pollock, Hashim Hamandi, and Ruth Leung (2021) on the Office of Financial Research (OFR) website helps answer that question, and it focuses specifically on the changes in U.S. banking that occurred from 1970 to 2020. The analysis includes chartered state and national banks, other depository institutions, and some specialized banking intermediaries, such as the 12 Federal Reserve Banks, and what the authors label the government mortgage complex, which consists of Fannie Mae, Freddie Mac, and Ginnie Mae. It also considers subgroups of banks—in particular, the ten largest commercial banking enterprises.
…
Much of this is well known. What is less understood is how the expansion in the generosity of deposit insurance has fueled real estate lending by deposit-financed intermediaries. A typical U.S. bank today has about three-quarters of its lending devoted to real estate loans of some kind. As observed by Pollock (2019), “We still use the term ‘commercial banks,’ but a more accurate title for their current business would be ‘real estate banks.’” This is a far cry from the prohibition on real estate lending for national banks prior to 1913. How does increased deposit insurance generosity affect banks’ mortgage lending?
…
Alex J. Pollock (2019), “Bigger, Fewer, Riskier: The Evolution of U.S. Banking since 1950,” The American Interest , February 25.
Alex J. Pollock. Hashim Hamandi, Ruth Leung (2021). “Fifty-Year Changes in the Banking Credit System, 1970-2020.” Post, Office of Financial Research.
Banking Credit System, 1970-2020
Published by the Office of Financial Research, U.S. Department of Treasury.
BY Alex J. Pollock, Hashim Hamandi, Ruth Leung, OFR*
This essay puts the depository institutions industry into broad historical perspective, looking at the fifty year changes from 1970 to 2020.
For this analysis, we aggregate the Banking Credit System, defined as the government-chartered depositories and their principal chartered support entities. We define the relevant components as:
The largest ten bank holding companies (BHCs)
All other insured depository institutions
The Government Mortgage Complex (Fannie Mae + Freddie Mac + Ginnie Mae)
The Federal Reserve Banks.
As the following five tables demonstrate, the changes in this system and its components over this period with respect to asset size, relative size, share, size relative to nominal GDP, and long-term growth rates are dramatic.
As shown in Tables 1 and 2, there has been dramatic expansion in the scale of the institutions involved. Table 1 measures this in nominal dollars. Table 2 adjusts these numbers for inflation, using constant 2020 dollars. The increase in size in both nominal and real terms is remarkable.
Over the same period, the number of insured depositories has dropped dramatically: from over 19,800 in 1970 to about 5,000 in 2020—a reduction of 75% since one co-author (Alex Pollock) was a bank management trainee.
Meanwhile, the huge residential mortgage sector has become dominated by the Government Mortgage Complex, which was in 1970 relatively small, almost a rounding error, but has grown very big indeed. In nominal terms, it is now almost 260 times as big as it was in 1970, compared to the depository institutions asset growth of 28 times.
Table 1.
(1)Our goal is to understand the banking sector. If we expanded to non-bank companies, the size and growth would be even larger. Some of these companies’ activity is reflected in the Government Mortgage Complex, where they have a dominant share of mortgage servicing, and also in auto loans, credit cards and other consumer lending.
(2)1971
Of course, a lot of the growth when expressed in nominal dollars represents the endemic inflation of the post-1970 monetary regime. Table 2 shows the system’s still remarkable growth after adjusting for inflation.
Table 2.
(1)Values for 1970 are expressed in constant 2020 dollars using CPI values for June 2020 and December 1970.
Equally remarkable is the shift in the composition of the system, as shown in Table 3.
The ten largest BHCs in 1970 together equaled only 16% of the Banking Credit System, equal to about one-quarter of the aggregate size of all the other insured depositories. By 2020, the top ten have become 34% of the total system and have 1.3 times the assets of all the rest of the banks put together. Alternately stated, over these decades the consolidation of the historically highly fragmented American banking business has proceeded very far.
The big winners of share of the system over 50 years are the largest ten banks, the Government Mortgage Complex, and the Fed. The big losers of share are all the other depository institutions.
Table 3.
(1)Totals may not sum exactly due to rounding.
As shown in Table 4, the Banking Credit System over 50 years grew enormously relative to the economy as a whole—from 89% to 182% of GDP.
Table 4.
(1)Totals may not sum exactly due to rounding.
The assets of the biggest ten banks grew much faster than the other banks, increasing from 14% to 62% of GDP. All the other banks put together, now numbering about 5,000, fell from 63% to 47% of GDP.
The Government Mortgage Complex hugely inflated from 3% of GDP to 40%, by far the biggest change.
Table 5 shows the 50-year compound average rates of growth, both nominal and real, for the Banking Credit System, and GDP growth rates as a baseline comparison.
Table 5.
The Banking Credit System as a whole grew substantially faster than GDP over 50 years.
The Federal Reserve, now by far the biggest bank of all, grew much faster than GDP.
The Government Mortgage Complex grew fastest of all by far, at 11.8% per year in nominal terms, almost double the 6.1% for nominal GDP.
In Sum
Over the last 50 years, the Banking Credit System grew vastly bigger relative to the economy, much more consolidated, and much more dependent on both the government mortgage complex and the government’s central bank, greatly increasing its dependence on explicit and implicit government guarantees. This history exemplifies the maxim of Charles Calomiris and Stephen Haber (1) that every banking system is a deal between the bankers and the politicians.
(1)Fragile by Design (2014)
*Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury. All the data used in this paper are from public sources, including the Board of Governors of the Federal Reserve System, Congressional Budget Office, Federal Deposit Insurance Corp., Department of Housing and Urban Development, Office of Federal Housing Enterprise Oversight and U.S. Bureau of Labor Statistics.
Congress Must Take Control of Money Back From the Fed
Published in Real Clear Markets.
The question of Money is always political. What is the definition of “money,” what is its nature, how is it created, and how are debts settled—these are questions that have been much debated over time, sometimes very hotly. Recall, for example, William Jennings Bryan’s famous, burning rhetoric of 1896:
“You shall not press down upon the brow of labor this crown of thorns—you shall not crucify mankind upon a cross of gold”!
He was addressing the definition of money.
What the U.S. Constitution says about the definition of money is succinct. Article I, Section 8 gives Congress the express power:
“To coin money [and] to regulate the value thereof.”
As writers on the subject have pointed out innumerable times, to “coin” is obviously not the same as to “print.”
How then does it come about that the American government issues irredeemable, fiat, paper money, and this is the only kind of money we have today?
The Constitution expressly prohibits the states from issuing such paper money, but is silent about the national government on this point.
Considering original intent through the Constitutional debates, the founding fathers were nearly unanimous in their strong opposition to paper money, as the Notes of the Debates in the Federal Convention make completely clear. In general, they shared the view later expressed by James Madison about:
“The rage for paper money…or any other improper or wicked project.”
Although this was the dominant opinion of the members of the convention, and although they debated an express prohibition of national paper money, they decided not to include it. Of course, neither was there an authorization.
In the discussion, George Mason explained:
“Though he had a mortal hatred to paper money, yet…he could not foresee all the emergencies” of the future and was “unwilling to tie the hands of the legislature.”
Paper money in this view is a matter only for emergencies.
The Constitutional result was the express power “to coin” and silence on “to print.” Should one conclude that there is an implied power for the government to print pure paper money? Further, is there an implied power to make it a legal tender in payment of debts, even if those debts had been previously contracted for and explicitly required payment in gold coin?
A lot of supreme judicial ink would later be devoted to debating and ultimately deciding this question.
In the Constitutional Convention debates, Gouverneur Morris:
“Recited the history of paper emissions and the perseverance of the legislative assemblies in repeating them, with all the distressing effects.”
He further predicted:
“If a war was now to break out, this ruinous expedient would again be resorted to.”
This prediction was proved right when the Civil War did break out, and the Lincoln administration soon turned to paper money to pay the costs of the Union Army.
In 1861, faced with the staggering expenses of the war, Congress authorized the issuance of paper money, or “greenbacks,” as they were called. In 1862, it made them a legal tender. Predictably, the greenbacks went to a large discount against gold—their value fluctuated with the military fortunes of the ultimately victorious Union.
As another war measure, national bank notes were created by the National Currency Acts of 1863 and 1864, which we now know as the National Bank Act. The main point was to use the new national banks to monetize the Treasury’s debt. Governments always like the power to monetize their deficits.
After the Civil War, the expedient of paper money as legal tender resulted in a series of Supreme Court cases in which:
First, making paper money a legal tender for debts previously contracted in gold was found unconstitutional in a 4-3 decision.
Then, soon afterwards, the Court reversed itself 5-4, after the addition of two new justices, finding that it was constitutional, after all. The new majority stressed the sovereign right of a government to do what was necessary to preserve itself.
About the legal tender cases it has been said:
“Measured by the intensity of the public debate at the time, it was one of the leading constitutional controversies in American history.”
Yet they are now largely forgotten.
In one of the series of legal tender decisions, one later overruled, the Court wrote:
“Express contracts to pay in coined dollars can only be satisfied by the payment of coined dollars…not by tender of United States notes.”
That this decision did not stand was handy for the United States government later—in 1933, when it defaulted on its express promise to pay Treasury gold bonds in gold. Instead it paid in paper money.
This action the Supreme Court upheld in 1935 by 5-4, although no one doubted the clarity of the promise to pay that was broken. Among the majority’s arguments were the sovereign right of the government to default if it wanted to and the sovereign right of the national government to regulate money.
Coming to today: We have a pure fiat money system of the paper Federal Reserve notes in your wallet and bookkeeping entries on the books of the Fed.
This paper currency, the Federal Reserve on its own has committed to depreciate by 2% per year forever, in spite of the fact that the Federal Reserve Act instructs it to pursue “stable prices.”
By promising perpetual 2% inflation, the Fed keeps promising to make average prices quintuple in a normal lifetime. (That is simply the math of compound interest.)
The Fed made this momentous, inherently political, decision on its own, without the approval of the Congress. It did not ask Congress for legislative approval and no hearings on this debatable proposal about the nature of money were held.
Where, under the Constitution, did the Fed get this right to proceed without Congress? That the Fed presumed to do this on its own authority was a highly questionable action of the administrative state.
I believe one could correctly argue that this was an unconstitutional violation of Article I, Section 8. Unfortunately, we have no lawsuit about it, so we can only observe it.
One scholar of the legal tender cases concluded:
“There remains the intriguing question of the Constitutional basis for today’s legal tender paper… today’s fiat money.”
Indeed there does. But the political basis rules and life goes on.
In Memoriam: George Kaufman, PhD
Published in Loyola University Chicago.
At a retirement dinner held following the conference, banking leader Alex J. Pollock gave a speech about Kaufman and his contributions to the field entitled “57 Years of Banking Changes and Ideas.” He ended his remarks: “Let us raise our glasses to George Kaufman and 57 years of achievement, acute insights, scholarly contributions, policy guidance and professional leadership, all accompanied by a lively wit. To George!” Read Pollock’s entire speech→
Are Remote Workers More Productive? We Finally Have the Answer
Published in FOND.
Productivity is typically measured by an individual’s output vs. input over a period of time. One example of this is gross domestic product (GDP) per worker, which measures output by person over the course of a year. However, the ways in which we measure productivity today are much more complex.
Comment Letter To OCC, Board of Governors of the Federal Reserve System, and FDIC
Published by the R Street Institute.
Via e-mail to:
Office of the Comptroller of the Currency
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Re.: Comments on the Proposed Joint Rule on “Regulatory Capital Treatment for Investments in Certain Unsecured Debt Instruments of Global Systemically Important U.S. Bank Holding Companies, Certain Intermediate Holding Companies, and Global Systemically Important Foreign Banking Organizations”
OCC: Docket ID OCC-2018-0019; RIN 1557-AE38
Board: Docket No. R-1655; RIN 7100-AF43
FDIC: RIN 3064-AE79
Dear Sirs and Mesdames:
Thank you for the opportunity to comment on this proposed joint rule.
In my view, the logic of the proposal is impeccable. Because it is, it should be applied to another, parallel situation, as discussed below. The proposal’s objective, “to reduce interconnectedness and contagion risk among banks by discouraging banking organizations from investing in the regulatory capital of another financial institution,” makes sense, but might be improved by adding, “or if such investments are made, to ensure that they are adequately capitalized.”
I believe another rule with exactly the same logic and exactly the same objective is required to address a key vulnerability of the U.S. banking system. That is to apply the logic of the proposed rule to any investments made by U.S. banks in the equity securities of Fannie Mae and Freddie Mac, two of the very largest and most systemically risky of American financial institutions. As you know, hundreds of American banks took steep losses on their investments in the preferred stock of Fannie and Freddie when those institutions collapsed, and such investments caused a number of banks to fail. That banks were able to make these investments on a highly leveraged basis was, in my judgment, a serious regulatory, as well as management, mistake. On top of this, U.S. regulations allowed banks to own Fannie and Freddie securities without limit.
Banks were thus encouraged by regulation to invest in the equity of Fannie and Freddie on a hyper-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned about $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a mere 1.6%, since changed to a still inadequate 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (With due respect, your broker’s margin desk wouldn’t letyou do that.)
In short, the banking system was used to double leverage Fannie and Freddie, just as the investments in TLAC debt addressed by the proposal would otherwise double-leverage big banks. To analogously correct the systemic risk, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so that it really would be equity from a consolidated system point of view.
I respectfully recommend, true to the principle and the logic of the proposed joint rule, that any investments by a bank in the preferred or common stock of Fannie and Freddie should be deducted from its Tier 1 regulatory capital. I believe this should apply to banks of all sizes.
These are my personal views. It would be a pleasure to provide any further information or comments which might be helpful.
Thank you for your consideration.
Respectfully,
Alex J. Pollock
Financial Goblins
Published by the R Street Institute.
Just in time for Halloween last week, three financial goblins appeared in the Financial Times in the same October 31 issue:
-China Minsheng Investment Group, “the country’s largest private investment company,” with “crushing debt problems,” reportedly is cutting senior and mid-tier salaries by 53% “in a bold decision to save itself.”
-WeWork, the struggling former financial darling, drew a forecast from hedge fund manager Bill Ackman that it has “a high probability of being a zero for the equity as well as for the debt.”
-“South Korea’s biggest hedge fund, Lime Asset Management” is “swamped by investors’ demands to get their money back,” is “forced to sell hard-to-trade assets…at fire-sale prices,” and has “suspended withdrawals.”
The next day, the Wall Street Journal added:
“Depositors swarmed a rural bank here…rushing to pull money out.”
Perhaps these four goblins represent various leaks springing in the global “Everything Bubble” the central banks have inflated?
Will the Federal Reserve have a monopoly in digital currencies?
Published in The Hill.
Cryptocurrencies started out with a libertarian desire to give people an alternative to national money, thereby escaping government power to depreciate their fiat currencies through inflation. Many governments, including the United States, have gone so far as to promise perpetual inflation, a key function of which is to help governments depreciate their own debt. Governments can also completely destroy the value of their currency through hyperinflation, as has happened throughout history.
To create a meaningful alternative to this government money monopoly was a noble intent, consistent with the classic proposal by Friederich Hayek in “Choice in Currency.” He asked, “Why should we not let people choose freely what money they want to use?” He argued, “Practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.” Cryptocurrency enthusiasts agreed. They were, however, too optimistic about how forcefully governments could react, first by imposing regulation and then by realizing that governments themselves could issue digital currency to the public.
The great irony here is that the idea of a digital alternative to national money can morph into an idea to expand and solidify the government money monopoly. According to a survey by the Committee on Payments and Market Infrastructure of the Bank for International Settlements, more than 60 central banks, representing 80 percent of the world population, are researching central bank digital currencies. More than half of them have moved on to actual experiments or more “hands on” activities.
The broadest form of government digital currency would be the central bank offering deposit accounts to the public at large, so individuals, businesses, corporations, nonprofit organizations, and municipal entities could have deposit accounts at the Federal Reserve instead of with a private bank. Then their financial transactions in the digital currency with each other would be settled directly by the accounting entries on the electronic books of the Federal Reserve. Efficient and risk reducing!
Such a centralization has happened before. Paper currency became monopolized by the Federal Reserve in the form of government notes in the early 20th century. Until then, private banks issued their own paper currency. I have a copy of a $3 bill issued in the 1840s by a previous banking employer. Needless to say, no such currency is used today.
Could money in the form of deposits, such as money in the form of paper currency, be monopolized by the central bank, given current technology? In principle that could be the case. Direct deposits at the Federal Reserve would be close to being default and liquidity risk free. No need to worry about whether your bank might fail, whether it might become illiquid or insolvent, or whether your deposit was over the insurance limit. You would have no need to withdraw cash if you were worried about banks in a crisis because you would be holding a direct Federal Reserve obligation. That would no doubt appeal to many holders of money and, in our electronic world, it is quite easy to imagine such a central bank digital currency.
Do we like the idea, however, that deposits would be concentrated in the government instead of spread among 5,000 private banks? How much of the deposit market the central bank could take over depends on whether it would pay interest on the deposits. If it paid zero interest, its market share would be much less. But the Federal Reserve can and does pay interest on deposits. There are $14 trillion in total deposits in the banking system. Suppose 50 percent of them moved to digital deposits with the Federal Reserve compared to the 100 percent market share the Federal Reserve has in paper currency. That would be a towering $7 trillion. The government money monopoly would become bigger and more powerful.
What would the Federal Reserve do with its new $7 trillion? It would have to invest it. It would become an even bigger allocator of credit. It might allocate a lot more credit to the government itself and its favored housing sector. Or it might get into corporate credit, displacing private investors and becoming a state commercial bank. The history of such banks has been generally pathetic because their credit decisions inevitably become politicized. The Federal Reserve could also more readily impose negative interest rates directly on the people, thereby expropriating their savings.
On top of all that, the government would also have financial Big Data extraordinaire. It would know almost everything about our financial lives. Digital currency would then have traveled from libertarian choice to Big Brother. If not strictly limited and controlled, central bank digital currency could turn out to be one of the worst financial ideas of the 21st century.
Should the Fed Be Run by Economists?
Published in Law & Liberty.
Tomorrow, November 2, marks two years since the nomination of Jerome Powell to be Chairman of the Federal Reserve. Leaving aside President Trump’s subsequent expressions of regret at his choice, the nomination represented an important institutional change for the Fed: the first Chairman in 30 years lacking a Ph.D. in economics.
The anniversary of Powell’s appointment offers us an opportunity to reflect: Was this a good thing, or should the Fed always be an “econocracy,” run by economists? Does other expertise matter?
In a 1977 conference at the American Enterprise Institute, Irving Kristol observed: “Most professors of economics genuinely believe they know how to run the economy and would very much like to have the chance to prove it.”
It does seem that inside every macroeconomist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king—or at least an assistant deputy philosopher king.
On the other hand, the will to power is hardly limited to economists. What kind of education and experience, we may wonder, helps us best moderate our natural ambitions, apply wisdom to our actions, and control, in Friedrich Hayek’s terms, the “fatal conceit” of “the pretense of knowledge”?
On the 100th anniversary of the creation of the Federal Reserve, I made a dozen predictions about the Fed’s next 100 years.[1] Among them was this:
An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of Chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro-economics is or can be a science.
I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.
This prediction was fulfilled much more quickly than I thought with the appointment of Chairman Powell, and I think it is a good thing for the Fed to move away from econocracy. Whatever the illusions in the past may have been, we not only no longer believe, but we all ought to know by now that macroeconomics is not a science. Moreover, in my view, it cannot ever be one. Therefore, it is healthy to move the chairmanship of the Fed around among various professional domains.
Chairman Powell was trained as a lawyer and has significant Wall Street experience in investment banking and private equity investing. This is a completely appropriate background, as it seems to me.
Speaking of lawyers, the first Chairman of the Federal Reserve Board was William G. McAdoo, who was at that time the Secretary of the Treasury. Under the original Federal Reserve Act, the Treasury Secretary was automatically the chairman. McAdoo was a lawyer and a businessman, who among other things built two tunnels under the Hudson River between Manhattan and New Jersey. As Treasury Secretary during the cataclysm of the First World War, he set out to and succeeded in helping New York displace London as the world financial center.
But the real power inside the Fed in its early days was Benjamin Strong, the president (they called it “Governor” at the time) of the Federal Reserve Bank of New York from 1914 to 1928. Strong was definitely one of Kristol’s “men of experience.” He went to work in banking right out of public high school—no college, let alone a graduate degree for him. He nonetheless became president of Bankers Trust Company and then took charge of the New York Fed.
If you were President of the United States, whom would you want to pick as chairman of the central bank to the dollar-based world? Here, by principal vocation, are the ones who did get picked in chronological order: Lawyer, banker, lawyer, banker, investment banker, banker, banker, corporate executive, financier, Ph.D. economist (we have reached Arthur Burns), corporate executive, economist without Ph.D. (that is, Paul Volcker), Ph.D. economist, Ph.D. economist, Ph.D. economist, financier (bringing us up to the present).
We may further consider that there are two major Federal Reserve buildings in Washington, DC. The first is the main Fed headquarters. This familiar, impressive temple to the importance of money is the Eccles Building, named for Marriner Eccles, who was chairman of the Fed from 1934 to 1948, and after that stayed on the Federal Reserve Board without being chairman until 1951. About Eccles, we read:
Although he neither attended college nor received any formal training in economics, Marriner S. Eccles became the intellectual force who led the Fed through financial crises during the Depression and World War II.
Eccles was a Salt Lake City banker who controlled two dozen banks, in addition to a number of other companies, and set up one of the first multiple bank holding companies. It is fair to say that this powerful Fed chairman bore little resemblance to an economics Ph.D.
The second main Federal Reserve building in Washington is the Martin Building. It is named for William McChesney Martin, who was chairman of the Fed from 1951 to 1970, which included serving under five U.S. presidents, and represents the record tenure in the job.
Martin’s highest academic degree was a B.A. in English from Yale, where he also studied Classics. Perhaps this prepared him to be, as Peter Conti-Brown has written, the Fed’s greatest creator of language. His most famous metaphor, of course, was “the punchbowl,” which the Fed must take away “just when the party was really warming up.”
Martin did take classes in economics in college, in which “he was astonished,” we are told, that the academic economists believed that his father, who was the president of the St. Louis Federal Reserve Bank, and other Fed bankers were “hopelessly out of date because of their misguided warnings about excessive speculation in the stock market” of the 1920s. Of course, his father and friends turned out to be right.
Among other things, Martin served as the president of the New York Stock Exchange. He did take some graduate classes in economics, too, but through his long tenure at the Fed, he remained highly skeptical of economic models and forecasts.
History does make clear that while having professional education in economics can be a relevant qualification for leading the Federal Reserve, it certainly isn’t the only one or a necessary one.
A very instructive book on whom you might want as Federal Reserve chairman is Donald Kettle’s Leadership at the Fed. Its final chapter, “The Chairman as Political Leader,” draws these insightful conclusions:
The Fed’s policymaking is inevitably political, and no institutional (or even constitutional) fix can change that. History demonstrated the folly of thinking that monetary management can be reduced to a process of technical adjustment, for any monetary policy has political implications and creates political conflicts. The very attempt to shield such inherently political decisions behind “technical” standards and legal “independence” is itself a political strategy.… In framing monetary policy, the chairman operates as a political leader. He seeks to craft a policy for which he can build political support (and deflect attack)… [while enmeshed in] the intricate and complex balance of political forces in the Fed’s constituencies.
These points seem to me correct and to reflect reality. They must make us think of Alan Greenspan, Chairman of the Fed from 1986 to 2006, who earned an economics Ph.D., but was not an academic, and repeatedly demonstrated his skills as a master politician and political leader. This took him all the way to being “The Maestro”—though even he could not sustain that exalted but unrealistic perception.
In sum, are we better off for having had at the Fed an econocracy of Ph.D.s for most of the last three decades? Forty years ago, Kristol mused: “I am not so sure the world has improved much since we began being governed by economic theories rather than by men of experience using some common sense.” As with other counter-factual speculations, we can never know what would otherwise have been.
Turning to the future, it is safe to predict that the Federal Reserve staff will continue to be full of economics Ph.D.s, whose advice and analysis any Fed chairman will want to consider.
But at the top of the Fed, will Chairman Powell be the start of a new phase, which returns to a model of financial experience and practical knowledge—like Eccles, Martin, McAdoo, and Strong? In my view, this would be a good addition to the Fed leadership mix over time. We should certainly not exclude economics Ph.D.s from the office, but they should most definitely not have an exclusive claim on this hugely powerful, globally impactful, systemically important job. The Fed should not be an econocracy.
Eliminating Fannie & Freddie’s Competitive Advantages by Administrative Action
Published in Real Clear Markets.
Among the strategic goals for reform of Fannie Mae and Freddie Mac specified by Treasury Secretary Steven Mnuchin in Congressional testimony on October 22 was: “Legislation could achieve lasting structural reform that…eliminates the GSEs’ competitive advantages over private-sector entities.” A good idea, except legislation won’t happen.
As the Secretary suggests, replacing the current government-dominated, duopolistic secondary housing finance sector with a truly competitive one is an excellent goal. But fortunately, it does not take legislation. It can be achieved with purely administrative actions—three of them, to be exact. These administrative actions are:
1. Set Fannie and Freddie’s capital requirements equal to those of private financial institutions for the same risks.
2. Have Fannie and Freddie pay the same fee to the government for its credit support that other Too Big To Fail financial institutions have to pay.
3. Set Fannie and Freddie’s g-fees at the level that includes the cost of capital required for private financial institutions to take the same risk.
The Same Capital Requirement
The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator, has full authority to set their capital requirements. FHFA simply has to set them in a systemically rational way: namely, so that the same risk requires the same capital across the system: the same for Fannie and Freddie as for private financial institutions.
Running at hyper-leverage was a principal cause of Fannie and Freddie’s failure and bailout. It naturally induced market actors to perform capital arbitrage and send credit exposure to where the capital was least—that is, into Fannie and Freddie—thereby sticking the taxpayers with the risk.
The capital for mortgage credit risk is still the least at Fannie and Freddie and the risk is still sent every day to the taxpayers by way of them. Even with the revised agreement between the FHFA and the Treasury announced on September 30, Fannie and Freddie will be able to in time increase their capital only to $45 billion combined. This is exceptionally small compared to their risk of $5.5 trillion: it would represent a capital ratio of less than 1%, still hyper-leverage.
Something like a 4% capital requirement would be more like the equilibrium standard required to eliminate the capital arbitrage, which would imply a total capital for the two government-backed entities of about $220 billion. I do not insist on the exact numbers, only that the FHFA should implement the right principle: same risk, same capital.
The Same Fee for Government Support
Fannie and Freddie are Too Big To Fail (TBTF). No one doubts or can doubt this. Their business and indeed their existence utterly rely on the certainty of government support. This means their creditors have immense moral hazard: they don’t have to worry about the credit risk of the trillions of Fannie and Freddie fixed income securities they hold. History has proved that the creditors are right to rely on government support—when Fannie and Freddie were deeply insolvent, the bailout assured that the creditors nonetheless received every penny of interest and principal on time.
What is this government support worth? A huge amount. There is widespread agreement that Fannie and Freddie should pay an explicit fee for it, but how much? The right answer is to remove their unfair competitive advantage by having them pay at the same rate as any other Too Big To Fail institution with the same leverage and the same risk to the government.
In other words, have the FDIC determine what the deposit insurance rate for a TBTF bank with Fannie and Freddie’s leverage and risk would be, and require them to pay that to the Treasury. Then they would be on the same competitive basis as private financial institutions.
Setting the right fee in exchange for the ongoing government support is within the power of the FHFA as Conservator and the Treasury, by the two of them amending their Fannie and Freddie Senior Preferred Stock Purchase Agreements accordingly.
The Same Guaranty-Fee Logic
The key action here, which the FHFA is already not only empowered but directed by Congress to take, is already in law—to be specific, in the Temporary Tax Cut Continuation Act of 2011. This statute requires the setting of Fannie and Freddie’s g-fees to include not only the risk of credit losses, but also “the cost of capital allocated to similar assets by other fully private regulated financial institutions.” The FHFA Director is instructed to make this calculation and increase the g-fees accordingly. The FHFA has egregiously not carried out this unambiguous instruction. It should do so now, thereby removing the third distorting competitive advantage which historically allowed Fannie and Freddie to drive out private capital.
Each of these administrative actions by itself would create a serious advance toward the stated goal. To take all three of them would settle the matter: game, set, match. No legislation needed.
Given Enough Time
Published in Barron’s.
Randall W. Forsyth distorts Murphy’s celebrated law with a truncated version of it, writing “whatever can go wrong, will” (“Sometimes Things Can Go Right—and a Lot Did for the Stock Market Last Week,” Up & Down Wall Street, Oct. 11).
Although a common misquotation, this is an incomplete version. The full, correct, and much subtler statement of Murphy’s Law is, “Whatever can go wrong, will go wrong, given enough time.” It is with enough time that structural flaws in a system will necessarily emerge, and that financial vulnerabilities will burst from potential dangers to an actual bust. As properly stated, Murphy’s Law will doubtless prevail once again in finance, as in other domains.