At AEI, a Monetary Panel Expressed Pessimism About Inflation

Published in Real Clear Markets.

“While their conjectures are as speculative as any vulnerability identified in an official financial stability report, unlike official financial stability reports, they have the freedom to identify government policies and regulatory shortcomings as vulnerabilities,” Kupiec said.

The first panelist to speak was Alex Pollock, distinguished senior fellow at R Street Institute, a free market think tank in Washington, DC. Pollock mentioned several possible causes of the next financial crisis, including errors in judgment by the world’s central banks, a housing-market collapse, a future pandemic, or war. He cautioned that a crisis could be caused by a factor that “nobody sees coming,” which would inevitably hamper state response.

“If the next crisis is again triggered by what we don’t see, the government reaction will again be flying by the seat of their pants, making it up as they go along,” Pollock said.

Read the rest here.

Two house price inflations, two central banks

Published in Housing Finance International.

In 2021, North America is the home of runaway house price inflation. In both the U.S. and Canada, house prices are far over their Bubble peaks of the first decade of the 2000s and they continue to rise rapidly. In both countries, they are increasing at double-digit annual rates: over 15% in the U.S., according to the AEI Housing Center’s current estimate, and 11.9% in Canada, according to Teranet. They are journalistically described by terms like “surging,” “soaring,” and “red-hot.”

The Case-Shiller national index of U.S. house prices is at about 243, compared to its 2006 Bubble peak of 184. That puts it 32% higher than at the top of the Bubble. “Record-high home prices are happening across nearly all markets, big and small,” says the National Association of Realtors.

In Canada, the comparison is even more striking. The Teranet Canadian composite house price index is at about 261, almost double its 2008 peak of 133.

Anecdotes match the numbers. “Brokers describe the current market as frenzied,” the Wall Street Journal reported. “Many homes receive multiple offers within days.” One Texas broker “said she has never seen a market like this before. In some cases, buyers are offering $100,000 above asking prices. …It’s just crazy, there’s no other word to describe it.”

One Canadian commentator wrote recently, “A sellers’ market prevails…I was surprised to learn that bidding wars…were now common in my hometown, Windsor, Ontario, for sales of even relatively modest houses.” Windsor is a modest industrial city, across the river from Detroit, Michigan.

This house price inflation of both countries, far outrunning the growth of wages, is obviously not sustainable, but it has already gone on longer and to higher prices than many thought possible, including me. As one of my economist friends said recently, “It can’t go on, but it does.”

Very appropriately, in my view, the Bank of Canada in February discussed “excess exuberance” in Canada’s housing market. In April, it added that this market shows “signs of extrapolative expectations and speculative behavior” – strong language for a central bank to use. The term “excess exuberance” is obviously a variation on the “irrational exuberance” made famous by then-Federal Reserve Chairman Alan Greenspan in 1996, warning about the dot.com stock bubble of the day. That bubble pushed prices up for three more years after Greenspan’s warning, but did ultimately implode. How long will the Canadian and U.S. house price inflations continue, and how will they end?

The Federal Reserve is far less direct than the pointed comments of the Bank of Canada, but it also discusses house prices, albeit with much blander language (or “Fedspeak,” as we say in the U.S.). In its updated Financial Stability Report of May 2021, the Fed observes about asset prices in general, “Prices of risky assets have risen further” and “Looking ahead, asset prices may be vulnerable to significant declines.” True, and it applies among other things to house prices. A number of my financial friends were particularly amused that this report never mentions the Fed’s own continuing role in stoking the inflation of asset prices and the systemic risk they represent.

Specifically on housing, the Fed says, “House price growth continued to increase, and valuations appear high.” Further, “Low levels of interest rates have likely supported robust housing demand.” Yes, except that we need to change that “likely” to “without question.” Implied in this statement, although not made explicit, is how vulnerable house prices, which depend on financing with high leverage, are to interest rates rising from their current historic lows of 3% or so.

What might a more normal interest rate be for the typical U.S. 30-year, fixed rate, freely prepayable mortgage? We can guess that if inflation were at 2%, and the 10-year Treasury yield at inflation plus 1.5%, and the mortgage rate at 1.5% over the 10-year Treasury, that suggests a mortgage rate in the 5% range. An increase in U.S. mortgage interest rates to this level would doubtless entail major house price reductions. (Of course, general inflation going forward may be higher, perhaps a lot higher, than 2%.)

The single most remarkable factor in the U.S. housing finance system at this point is that the central bank has become a massive investor in long-term mortgages. This started as a radical, emergency action in 2008 and ballooned again as an emergency action in 2020, but continues to expand – for how long? As of May 26, 2021, the Fed owned over $2.2 trillion in mortgages at face value, or over 20% of the whole national market. It also reported $349 billion of total unamortized premiums on its books. Assuming half of that is for mortgages, the Fed’s total investment in mortgages is $2.4 trillion. It is by far the biggest savings and loan in the world and getting constantly bigger.

In instructive contrast, the Bank of Canada stopped buying mortgages last year, in October 2020. But the Fed keeps buying, continuing to increase its mortgage portfolio at the rate of $40 billion a month, or $480 billion a year. The central bank thus continues to stimulate and subsidize a market already experiencing a buying frenzy and runaway price inflation – a fascinating, and some would say, astonishing, dynamic in unorthodox housing finance and central banking. The Federal Reserve, like the Bank of Canada, should stop buying mortgages.

Pity FOMC Members Trying to Divine a Future They Can’t Know

Published in Real Clear Markets.

Pity the poor members of the Federal Open Market Committee! These Federal Reserve Board Governors and Federal Reserve Bank Presidents all know in their hearts, for sure, each one, that they do not and cannot know the financial and economic future—that they do not and cannot know, among other things, how bad the current hot inflation is going to get, or how long it will last.

Yet they are forced to make forecasts and statements published all over the world about things they cannot know.  Their statements move markets and influence behavior, so they have to guess and worry about not only about what will happen, but about what others will do based on what they say.  They cannot know for sure what the results of their own actions will be, or what actions others will take, no matter how sincerely they try to make their best guesses.  And of course, they have to worry about what the politicians will say or demand.

How seriously should we take the Fed’s forecasts?  Last December, they projected inflation for 2021 at 1.8%.  Half way through the year, this looks to have been wildly wrong.  The rapid inflation of 2021, with the Consumer Price Index increasing year to date at well over 6% annualized, clearly surprised them. I am speaking of the inflation as experienced only in 2021, with no comparison to the crisis time of 2020 or “base effect.”  You might say this was a blind side hit on the FOMC quarterbacks.

On June 16, FOMC members upped their guess for this year’s inflation to 3.4%–an 89% increase in their expected inflation rate, best thought of as the rate of depreciation in the dollar’s purchasing power, of your wages and of your savings.  This revised expectation came with an essential hedge: “Inflation could turn out to be higher and more persistent than we expect”– a sensible and true statement by Fed Chairman Powell.

Powell also made this sound observation: “We have to be humble about our ability to understand the data.”  Just like the rest of us!  But the rest of us are not assigned a part in the public drama of the FMOC.  “All the world’s a stage,” but the FMOC is an especially challenging stage.  The Fed is no better at economic and financial forecasting than anybody else, but the show must go on.

The FMOC continues to characterize the current high inflation as mostly “transitory.”  Well, paraphrasing J.M. Keynes, we may observe that in the long run, everything is transitory.  In the process of transitioning, a lot can happen.  FMOC members are now hoping and making estimates for inflation to fall back to around 2% by the end of 2022—a long forecasting way away.  There is a self-referential problem here: what inflation does depends on what the FOMC does. So the poor FOMC members must forecast their own behavior under future, unknown circumstances.

In particular, future inflation depends on whether the Fed keeps up its historic, giant monetization of government debt and mortgages, and on how big it bloats its own balance sheet, already over $8 trillion as of this week.  At its June meeting, the FMOC gave instructions to keep up the big buying, including buying more mortgages at the rate of $480 billion a year.

Consider that the housing market is in the midst of a runaway price inflation.  By March, using the Case-Shiller Index, house prices were up by 13% year over year.  The most current data indicates, according to the AEI Housing Center, house price inflation now running at over 15%.  Yet the Fed continues to stimulate and subsidize a market which is already red hot.  One is hard pressed to imagine any remotely plausible excuse for that.

We have to wonder what the poor FOMC members must feel in their own hearts about this issue.  Do they really believe in some rationale?  Is it a case of “We easily believe that which we wish to believe,” as Julius Caesar said?  Or in their private hearts, are the FOMC members only voting “yes” for monetizing more billions of mortgages with serious mental reservations and doubts?  I have to believe the latter is the case, but suppose we won’t know until their memoirs are published.

Meanwhile, the members of the FOMC are like the airmen in the old World War II song, “Comin’ in on a wing and a prayer!”  They have no alternative to that, so we must all wish them good luck.

A Public Letter of Concern about the Federal Reserve

Published in National Review.

This is not a partisan issue. Our objections would be equally strong if the Fed involved itself in industrial policy or national security. All Americans benefit from a central bank devoted to effective monetary and regulatory policy. The Fed should refocus on its core missions.

…

Alex J. Pollock — Former Principal Deputy Director, Office of Financial Research

United States Department of the Treasury; Distinguished Senior Fellow, R Street Institute

Read the rest here.

Inflation pain allegedly caused by Biden’s spending demands transparency, Republican says

Published in Fox Business.

But Alex Pollock, a distinguished senior fellow for finance, insurance and trade at the libertarian R Street Institute, told FOX Business that despite the other factors, he “certainly” thinks the president’s policies are playing a large role in the current inflation.

Pollock said the biggest contributor is massive government spending that’s financed by monetizing the debt. And the inflation, Pollock emphasized, is reducing Americans’ “real wages” and cutting the value of their savings.

Read the rest here.

Video: Is inflation back?

Hosted by the American Enterprise Institute.

The recent increase in US inflation numbers has shocked the stock market and begun a debate about whether an inflationary period is starting. This surge comes while the Joe Biden administration engages in the country’s largest peacetime fiscal stimulus, monetary policy remains highly accommodative, and demand has been pent-up due to social distancing and COVID-19 restrictions.

Join AEI and a distinguished panel of economists for an event evaluating whether there is an immediate inflationary risk to the US economy, the longer-run inflation outlook in light of anticipated demographic changes in China and elsewhere, and what the implications might be for future monetary and fiscal policy.

Letter to the editor: Fed’s Inflation Genie May Deliver More Than Wanted

Published in The Wall Street Journal.

For the first four months of this year, the seasonally-adjusted consumer-price index is rising at an annualized rate of 6.2%. Without the seasonal adjustments, it is rising at 7.8%.

“The consumer-price index rose at a remarkable 4.2%,” says your editorial, “Powell Gets His Inflation Wish” (May 13). Remarkable, yes, but our current inflation problem is far worse than that 4.2%, which is bad enough. The real issue is what is happening in 2021. We need to realize that for the first four months of this year, the seasonally-adjusted consumer-price index is rising at an annual rate of 6.2%. Without the seasonal adjustments, it is rising at 7.8%. Meanwhile, house prices are inflating at 12%.

We are paying the inevitable price for the Federal Reserve’s monetization of government debt and mortgages. As for whether this is “transitory,” we may paraphrase J.M. Keynes: In the long run, everything is transitory. But now it is high time for the Fed to begin reducing its debt purchases, and to stop buying mortgages.

Letters to the Editor of Barron’s: Fed Distortion

Published in Barron’s.

Randall W. Forsyth’s column, “The Fed Might Start to Act Sooner to Head Off Housing Boom and Bust. What Could Happen,” (Up & Down Wall Street, May 21), is excellent, but he is too diplomatic when it comes to the Federal Reserve continuing to buy mortgages. Specifically, I’d rewrite two sentences.

1) “There seems little justification to stoke housing demand” should be, “There is no justification to stoke housing demand;” and 2) “The Fed might be exacerbating those problems” should be, “The Fed is exacerbating those problems.”

With the Fed’s postcrisis mortgage portfolio at $2.3 trillion (plus a lot of unamortized premium) and heading up, its distorting effects as the world’s biggest savings and loan are clear.

The New Monetary Regime – Debt and The Inflation Crisis: A Special Panel Presented by The Liberty Fund and The RealClear Foundation

Hosted by Real Clear Politics.

The roundtable is 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.

A New Inflationary Era

Published in Law & Liberty.

In this provocative but calmly argued book, The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan predict a new era of widespread and lasting inflation. Goodhart, who has been a respected expert in financial, monetary, and central banking issues for decades, and Pradhan, a macroeconomist who studies global financial markets, express as their “highest conviction view” that “the world will increasingly shift from a deflationary bias to one in which there is a major inflationary bias.”

This conviction reflects their “main thesis” that “demographic and globalization factors were largely responsible for the deflationary pressures of the last three decades, but that such forces are now reversing, so the world’s main economies will, once again, face inflationary pressures over the next three or so, decades.”

The demographic factors include the end of the “positive supply shock” to the global supply of labor provided by China over the previous decades. That is because “China’s working age population has been shrinking, a reflection of its rapidly aging population,” and “the surplus rural labor supply no longer provides a net economic benefit through [internal] migration.” Thus, “China will no longer be a global disinflationary force” and it “no longer stands in the way of global inflation.”

A second key factor is that birth rates around the world continue to decline and longevity to increase, furthering the aging of society and increasing dependency ratios. In this context, the authors point out that the average fertility rate in advanced economies has fallen to well below replacement. This includes the U.S. For the foreseeable future, there will be an ever-lower ratio of active workers to the dependent elderly, with the huge expense of support and health care for the elderly stressing government budgets. They add this striking thought: “Our societies today are still relatively young compared to what is to come.”

These are longer-term, not short-term movements. The implication is that we may envision a slow, great cycling over decades of inflationary and disinflationary or deflationary periods. The 2020s swing to inflation would mark a great cycle reversal, with perhaps a book like The Death of Inflation of 1996 symbolizing the previous reversal.

In a different estimate of the duration of the coming inflationary era, Goodhart and Pradhan make it somewhat shorter: “The coronavirus pandemic… will mark the dividing line between the deflationary forces of the last 30-40 years, and the resurgent inflation of the next two decades.” But whether it’s two or three decades, the authors expect two or three decades, not two or three years, of significantly higher inflation.

The effects of such an inflation would be, they write, “pervasive across finance, health care, pension systems and both monetary and fiscal policies,” and they surely would be. For example, they suggest, “It will no longer be possible to protect the real value of pensions from the ravages of inflation.” Nominal interest rates will be higher, but “Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate,” so “negative real interest rates… will happen.” Here they should have written, “will continue,” since we already have negative real interest rates, the yield on the 10-year U.S. Treasury note now falling short of the year-over-year inflation rate.

Further, “The excessive debt amongst non-financial corporates and governments will get inflated away.” In other words, governments will implicitly default on their bloated debt through inflation, a classic strategy. Of the three alternatives the book cites for reducing excess debt, “inflation, renegotiation and default,” inflation is the easiest for a government with debt in its own currency.

As the authors say, “neither financial markets nor policymakers are prepared” for such an inflationary future world.

In a final chapter written in 2020, Goodhart and Pradhan conclude that the government deficits and debt created in response to the coronavirus pandemic have reinforced and accelerated the coming inflationary era. Government-mandated quarantines and lock-downs were “a self-imposed [negative] supply shock of immense magnitude.” To finance it, “the authorities quite rightly opened the floodgates of direct fiscal expenditures,” in turn financed by escalating debt and monetization.

“But,” they logically ask, “what then will happen as the lock-down gets lifted and recovery ensues”—as is now well under way—“following a period of massive fiscal and monetary expansion?” To this question, “The answer, as in the aftermaths of many wars, will be a surge in inflation.”

Directionally, I think this is a very good forecast. We are already seeing it play out in the first months of 2021.

How much inflation might there be? They suggest the inflation numbers will be high: “quite likely more than 5%, or even on the order of 10% in 2021.”

Is 5% inflation possible? Well, the U.S. Consumer Price Index rose from December 2020 to April 2021 at the annualized rate of 6.2% when seasonally adjusted, and 7.8% when not seasonally adjusted. Signs of increasing inflation are widespread.

It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

How about that 10%? Could we really go to a 10% inflation? It has happened before. The U.S. has been at 10% inflation or more in 1917-20, 1947, 1974, and 1979-81. Most of these followed inflationary financing of wars, but the fiscal deficits and money printing of late are as great as during a war.

The authors proceed to the question of “What will the response of the authorities then be?” and offer this prediction—made in 2020: “First and foremost, they will claim that this a temporary and one-for-all blip.” We already know that this prediction was correct.

Overall, is this theory of a new inflationary era plausible? It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

Speaking of the central bankers, Goodhart and Pradhan observe something important: “In recent decades Central Banks have been the best friends of Ministers of Finance [and Secretaries of the Treasury], lowering interest rates to ease fiscal pressures and to stabilize debt service ratios.” But what will happen “when inflationary pressures resume, as we expect”? Will the relationship become more tense or even hostile? To put it another way, might the disputes of 1951 between the U.S. Treasury and the Federal Reserve be re-played and the celebrated “Accord” between them come out in the opposite way: with the central banks more subservient? “Inevitably,” the authors rightly say, “central banks have to be politically agile.”

The book interestingly comments on an implied cycle in the standing of macroeconomics and macroeconomists. How credible are their pronouncements and forecasts? “From the Korean War until about 1973 was a transient golden age for macroeconomics.” The 1960s featured the misplaced confidence of macroeconomists that they could “fine tune the economy,” and control inflation and employment using the “Phillips Curve” they believed in. Sic transit gloria: “It all then went horribly wrong in the 1970s,” when they got runaway inflation and high unemployment combined. And “the second golden period for macroeconomics (1992-2008) [also] went horribly wrong.” That time the announcements of the “Great Moderation,” which central bankers gave themselves credit for, turned into a Great Bubble and collapse. The golden macroeconomic ideas of one era may seem follies to the next.

If the new inflationary era predicted by Goodhart and Pradhan becomes reality, the follies of the present will seem blatant. Should we adopt their “highest conviction” that this inflationary era is on the way? In my view, the economic and financial future is always wrapped in fog, but their argument is well worth pondering and entering into our considerations of the biggest economic risks ahead.

Financial pain in the behemoth assets

Published in The Australian:

“Are banks too big to fail? Of course they are, as much as ever and probably even more so,” says Alex Pollock, who was deputy director of financial research at the US Treasury until February.

...

The US Federal Reserve banks have become the biggest player in the commercial banking system. “They are now huge home lenders; their $US2.2 trillion of mortgage loans is bigger on an inflation-adjusted basis than the entire savings and loans industry before its collapse in the 1980s,” Pollock says.

Governments and regulators quite like a big, concentrated financial system, which explains why little real reform was achieved in the wake of the financial crisis. What did happen was a huge increase in complexity that benefits large incumbents and regulators themselves. Regulators can “manage the system” more easily and treasurers can enjoy lower interest rates. And activist central banks can ensure governments enjoy much lower borrowing costs than otherwise.

“Banking everywhere has been, is and will be a deal between bankers and politicians,” Pollock says.

Inflation Is Here

Published by Barron’s.

Randall W. Forsyth (“Flood of Liquidity Is Sweetening Retirement for Stock Owners and Home Sellers,” Up & Down Wall Street, April 30) points out the rapid first-quarter growth in gross domestic product, final sales, and personal income, but oddly fails to mention that the consumer price index increased from December to March at an annualized rate of 6.8%. Inflation isn’t coming; it’s here.

It is intensely here in house prices, as he says, up in double digits (about 12%). Forsyth writes forthrightly: “The Fed keeps inflating that bubble by buying $40 billion of agency mortgage-backed securities…every month.” Yup. But why is the Federal Reserve still buying? Why is the Fed still monetizing mortgages when house prices are in runaway inflation? The answer is simple: It needs to stop.

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?

1. 1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014, 2020

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. They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

6. 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.