Seven Possible Causes of the Next Financial Crisis

Published in Law & Liberty.

The great financial historian, Charles Kindleberger, pointed out in the 1970s that over several centuries, history showed there was a financial crisis about once every ten years. His observation still holds. In every decade since his classic Manias, Panics and Crashes of 1978, such crises have indeed continued to erupt in their turn, in the 1980s, 1990s, 2000s, 2010s, and again in 2020. What could cause the next crisis in this long, recurring series? I suggest seven possibilities:

1. What Nobody Sees Coming

A notable headline from 2017 was “Yellen: I Don’t See a Financial Crisis Coming in Our Lifetimes.” The then-head of the Federal Reserve was right that she didn’t see it coming; nonetheless, well within her and our lifetimes, a new financial crisis arrived in 2020, from unexpected causes.

It has been well said that “The riskiest stuff is what you don’t see coming.” Especially risky is what you don’t think is possible, but happens anyway.

About the Global Financial Crisis of 2007-09, a former Vice Chairman of the Federal Reserve candidly observed: “Not only didn’t we see it coming,” but in the midst of it, “had trouble understanding what was happening.” Similarly, “Central banks and regulators failed to see the bust coming, just as they failed to anticipate its potential magnitude,” as another top central banking expert wrote.

The next financial crisis could be the same—we may take another blindside hit for a big financial sack.

In his memoir of the 2007-09 crisis, former Secretary of the Treasury Henry Paulson wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.” If the next financial crisis is again triggered by what we don’t see coming, the government reactions will once again be flying by the seat of their pants, making it up as they go along.

2. A Purely Malicious Macro-Hack of the Financial System

We keep learning about how vulnerable to hacking, especially by state-sponsored hackers, even the most “secure” systems are. Here I am not considering a hack to make money or collect blackmail, or a hack for spying, but a purely malicious hack with the sole goal of creating destruction and panic, to cripple the United States by bringing down our amazingly complex and totally computer-dependent financial information systems.

Imagine macro-hackers attacking with the same destructive motivation as the 9/11 terrorists. Suppose when they strike, trading and payments systems can’t clear, there are no market prices, no one can find out the balances in their accounts or the value of their risk positions, and no one knows who is broke or solvent. That is my second next crisis scenario.

3. All the Central Banks Get It Wrong Together

We know that the major central banks operate as a tight international club. Their decisions are subject to vast uncertainty, and as a result, they display significant cognitive and behavioral herding.

I read somewhere the colorful line, “Central banks have become slaves of the bubbles they blow.” Whether or not we think that, there is no question that the principal central banks have all together managed to create a gigantic global asset price inflation.

Suppose they have also managed to set off a disastrous, runaway general price inflation. Then ultimately interest rates must rise, and asset prices fall. This will be in a setting of stretched asset prices and high debt. As asset prices fall, speculative leverage will be punished. “Every great crisis reveals the excessive speculations of many houses which no one before suspected,” as Walter Bagehot said. The Everything Bubble of our time would then implode and the crisis would be upon us. Huge government bailouts would ensue.

We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

4. A Housing Collapse Again

A particularly notable asset price inflation is, once again, that in the price of houses, which are the biggest investment most households have and are the mortgage collateral for the biggest loan market in the world. House prices are now rising in the U.S. at the unsustainable rate of more than 18% a year, but this is also global problem. Many countries, about 20 by one reckoning, face extreme house price inflation. Said one financial commentator, “This is now a global property bubble of epic proportions, never before seen by man or beast, and it has entrapped more central banks than just the Fed.”

House prices depend on high leverage and are, as is well known, very interest rate sensitive. What would an actual market-determined mortgage rate look like, instead of the Federal Reserve-manipulated 3% mortgage rate the U.S. has now? A reasonable estimate would begin with a 3% general inflation, and therefore a 4.5% 10-year Treasury note. The long-term mortgage rate would be 1.5% over that, or 6%. That would more or less double the monthly payment for the same-sized mortgage, house prices would fall steeply, and our world record house price bubble implode. Faced with that possibility, so far the Federal Reserve’s choice has been to keep pumping up the bubble.

Overpriced, leveraged real estate is a frequent culprit in financial crises. Maybe once again.

5. An Electricity System Failure

Imagine a failure, similar to our financial system macro-hack scenario, resulting from an attack maliciously carried out to bring down the national electricity system, or from a huge solar flare, bigger than the one that took down the electric system of Quebec in 1989.

Physically speaking, the financial system, including of course all forms of electronic payments, is an electronic system, utterly dependent upon the supply of electricity. Should that fail, it would certainly be good to have some paper currency in your wallet, or actual gold coins. Bank accounts and cryptocurrencies will not be working so well.

6. The Next Pandemic

It feels like we have survived the Covid pandemic and the crisis is passing. Even with the ongoing problem of the Delta variant, we are certainly more relaxed than at the peak of the intense fear and the lockdowns of 2020. Instead of financial markets being in free fall as they were, they are booming.

But what about the next pandemic? We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

How soon could a new pandemic happen? We don’t know.

Might that new pandemic be much more deadly than Covid? Consider Professor Adam Tooze: “One thing 2020 forces us to come to terms with is that this wasn’t a black swan [an unknown possibility]. This kind of pandemic was widely and insistently and repeatedly predicted.” What wasn’t predicted was the political response and the financial panic. “In fact,” Tooze continues, “what people had predicted was worse than the coronavirus.”

If the prediction of an even worse and more deadly new pandemic becomes right, perhaps sooner than we might think, that might trigger our next financial crisis.

7. A Major War

By far the most important financial events of all are big wars.

A sobering talk I heard a few years ago described China as “Germany in 1913.”

This of course brings our mind to 1914. The incredible destruction then unleashed included a financial panic, and the war created huge, intractable financial problems which lasted up to the numerous sovereign defaults of the 1930s.

What if a big war happened again in the 21st century? If you think that is not possible, recall the once-famous book, Norman Angel’s The Great Illusion, which argued that a 20th-century war among European powers would be so economically costly that it would not happen. In the event, it was unimaginably costly, but nonetheless happened.

One distinguished scholar, Graham Allison of Harvard, has written: “A disastrous war between the United States and China in the decades ahead is not just possible, but much more likely than most of us are willing to allow.” A particular point of tension is the Chinese claim to sovereignty over Taiwan.  Might a Chinese decision to end Taiwan’s freedom by force be the equivalent of the German invasion of Belgium in 1914?

Would anyone be crazy enough to start a war between China and the United States? We all certainly hope not, but we should remember that such a war did already occur: most of the Korean War consisted of battles between the Chinese and American armies. In his history of the Korean War, David Halberstam wrote, “The Chinese viewed Korea as a great success,” and that Mao “had shrewdly understood the domestic benefits of having his county at war with the Americans.”

If it happened again it would be a terrific crisis, needless to say, with perhaps a global financial panic thrown in.

Overall, we can say there is plenty of risk and uncertainty to provide the possibility of the next financial crisis.

Based on remarks at an American Enterprise Institute teleconference, “What might cause the next financial crisis?” on June 29, 2021.

The Next Housing Bust

Published in Law & Liberty.

The Supreme Court has determined that the Federal Housing Finance Agency (FHFA)—the regulator and conservator of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—was unconstitutionally structured because its director could only be removed from office for cause. The Court held in its June 23, 2021 decision that the constitutional issue could be resolved by striking the “for cause” language—leaving the FHFA in place, but headed by a director who could be removed from office at any time by the President.

Immediately upon the Court’s decision, the White House fired the FHFA director, Mark Calabria, and replaced him with a temporary appointment. Calabria had been following a policy of increasing the capital of the GSEs in preparation for privatizing them and reducing their risk to the taxpayers; his temporary replacement forthwith reversed course. Said Sandra Thompson, Calabria’s acting replacement, “It is FHFA’s duty through our regulated entities to ensure that all Americans have equal access to safe, decent, and affordable housing.”

This means a sharp change in marching orders for Fannie and Freddie—from a future as privatized companies to a future of being used to accumulate the risk of the government’s housing policies and increase the risk to taxpayers. 

This sets up the conditions for the next housing bust. We have seen this movie twice before and know the ending.

The first time began in 1968 when HUD developed a “10-year housing program to eliminate all substandard housing.” Since there were then, like now, very large budget deficits, this program was implemented off-budget. The answer was the 1968 Housing and Urban Development Act, which had FHA insuring the 10-year plans’ subsidized single- and multifamily loans and Fannie funding them. Fannie was up to then a government agency with its debt on-budget. The 1968 Act converted it to an off-budget GSE. Now it was in a position to fund the largest expansion of newly built and rehabilitated subsidized housing in the nation’s history with up to 40-year fixed-rate loans. There have been only two years where privately owned single- and multifamily housing completions exceeded 2 million: 1972 (2.00 million) and 1973 (2.10 million)—when the population was 210 million and the number of households was 67 million, 36% and 48% respectively and smaller than today. As a reference, in 2006, at the peak of the Housing Bubble, there were 1.98 million completions.

In just a few years, HUD’s program turned into a disaster for cities and their residents, as described in the book Cities Destroyed for Cash: The FHA Scandal at HUD written in 1973.  Detroit, Chicago, Cleveland, and many other cities never fully recovered from the effects of HUD’s scheme. By the early 1980s, Fannie’s investment in these loans had suffered huge interest rate risk losses that left it effectively insolvent. It was only able to continue in business given its GSE status and backing by the Treasury.   

The second time began in 1992. Over the following years, the government forced Fannie and Freddie to reduce their credit standards so as to acquire trillions in risky loans under the rubric of affordable housing. The first of many trillion-dollar commitments was announced by Jim Johnson, Fannie’s very politically connected CEO, in March 1994. He vowed to “transform the housing finance system.” He did, but not in the way he intended. In 1994, HUD followed with its National Homeownership Strategy, about which President Clinton claimed: “Our home ownership strategy will not cost the taxpayers one extra cent.” A poor prediction indeed!

This government policy was pursued until 2008 through HUD’s authority to impose what were called “Affordable Housing Goals” on the GSEs. To meet ever more aggressive HUD goals, Fannie and Freddie had to continually reduce their mortgage credit standards, especially with respect to loan-to value and debt-to-income ratios. Instead of HUD’s strategy promoting homeownership, it resulted in some 10 million foreclosures and once again devastated our cities.

The full extent of the catastrophic credit risk expansion that took place has now been documented in a detailed analysis that researchers at FHFA and AEI released in May 2021. This is the first “comprehensive account of the changes in mortgage risk that produced the worst foreclosure wave since the Great Depression.” By analyzing over 200 million mortgage originations from 1990 onward, they showed “that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis well before the actual event.” Average leverage and average DTI (the debt-payment to income ratio) on both home purchase and refinance loans increased significantly over the decade. Since Fannie and Freddie accounted for about 50% of the total mortgage market over the period 1994-2007, their complicity in the ensuing disaster is clear. The bubble’s inevitable collapse brought down many banks and other financial institutions, creating the 2008 financial crisis. In 2008 Fannie and Freddie were bailed out by the taxpayers and put into conservatorship, where they remain today, 13 years later.

The Democratic Congress elected in the wake of the crisis adopted the Dodd-Frank Act of 2010. It reflected the Democrats’ view that insufficient regulation caused the crisis. But the most important culprits—Fannie and Freddie—were left untouched, insolvent, and still functioning. Because it has become entirely clear that the US government is effectively the 100 percent guarantor of the GSEs, with the taxpayers fully on the hook, the financial markets provide unlimited funds for their operations. Thus the GSEs are allowed to operate profitably in their government conservatorship by using the U.S. Treasury’s global credit card. Today their off-budget, taxpayer-backed debt totals nearly $6 trillion, with the Federal Reserve funding more than $2 trillion of their mortgage-backed securities. 

As the saying goes, those who cannot remember the past are condemned to repeat it, and the U.S. has a history of catastrophic housing blunders to remember, also including the spectacular failure and bailout at taxpayer expense of the savings and loan industry in 1989. Three dramatic failures in four decades—not an enviable track record. 

Any president, thanks to the Supreme Court decision, now has direct control over most of the mortgage finance system. This includes Fannie and Freddie through FHFA; and the FHA and Ginnie Mae through HUD.

Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

While the Supreme Court’s decision about the governance of FHFA is correct on its merits, the main problem is that we have a nationalized and socialized housing finance system. The American Jobs Plan proposes spending $318 billion to construct, restore, and modernize more than two million affordable homes. It is almost certain that the government will use its new control over the GSEs to once again make them the central elements of its plan with another weakening of credit standards. Thus we face the prospect of combining some of the worst features of HUD’s 1968 subsidized housing debacle with the GSEs’ disastrous foray into high-risk lending. Given this, can another mortgage debt crisis be far behind? 

However, the government does not have to follow the fatally flawed policies of the Johnson, Clinton, and Bush administrations. If instead the following four principles were implemented, the United States would have a robust, successful housing finance system it needs and its citizens deserve.

I. The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should function principally as a private market, not a government-dominated one.

The foreclosures and financial losses associated with the 1968 Housing Act, the savings and loan (S&L) debacle of the 1980s, and the actions of Fannie, Freddie, and HUD did not come about in spite of government support for housing finance but because of that government backing. Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

Although many schemes for government guarantees of housing finance in various forms have been circulating in Washington ever since the GSEs entered receivership, they are fundamentally the same as the policies that caused failures in the past. The flaw in all these ideas is the notion that the government can successfully guarantee increasing risk and will establish an accurate risk-based price for its guarantees. Many examples show that this is politically beyond the capacity of government.

First, the government’s guarantee eliminates an essential element of financial discipline—it removes credit risk from the investors. Second, the seemingly free-lunch nature of the off-budget guarantees creates the lure of the “affordable housing cookie jar”—cross-subsidies, “free money,” FHA and the GSEs competing for high-risk borrowers, and the perennial weakening of underwriting standards—all of which are backed by a government guarantee. So the outcome will be the same: underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.

II. Ensuring mortgage credit quality, and fostering the accumulation of adequate capital behind housing risk, can create a robust housing investment market without a government guarantee.

This principle is based on the fact that high-quality mortgages are good investments and have a long history of low losses. Instead of expanding government guarantees to reassure investors in MBS, we should simply ensure that the mortgages originated and distributed are predominantly of good quality. The characteristics of a good mortgage do not have to be invented; they are well known from many decades of experience. These are loan characteristics that, taken together, are highly predictive of loan performance. They include the borrower’s credit score, the debt-payment to income ratio (DTI), the combined loan-to-value ratio (CLTV), loan type (fixed or adjustable mortgage rate), loan term, loan purpose, whether the borrower’s income is fully documented, and whether the mortgage has a feature that modifies the amortization of loan principal. We know that mortgage lending must limit risk layering. We know how to apply a summary measure of default risk. The Stressed Mortgage Default Rate (MDR) is a simple, straightforward way to do this.

Regulation of credit quality could help prevent the deterioration in underwriting standards, although in previous cycles regulation promoted lower credit standards. The natural human tendency to believe that good times will continue—and that “this time is different”—will continue to create price booms in housing. Housing bubbles spawn risky lending; investors see high yields and few defaults, while other market participants come to believe that housing prices will continue to rise. Future bubbles and the losses suffered when they deflate can be minimized by focusing regulation on the maintenance of credit quality.

Stressed MDRs have demonstrated their efficacy. Calculated solely on the basis of loan characteristics present at origination, Stressed MDRs are highly predictive of default rates both in a non-stress delinquency environment (R-squared is 96%) and in a stress delinquency environment (R-squared is 99.9%) for all types of mortgage loans. By using MDR to risk rate loans at origination and regulate loan risk, we can control the accumulation of future losses which result from deteriorating underwriting standards.

III. All programs for assisting low-income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.

The third principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must explicitly balance the interest in low-income lending against the risks to the borrowers and to the taxpayers. In the past, implicit “affordable housing” subsidies through weak credit standards turned out to escalate the risks for both borrowers and taxpayers. The quality and budgetary trade-offs of riskier lending should be clear and on-budget.

The boom-bust cycle that low-income homebuyers have been subjected to for decades under the guise of making homes more affordable by escalating risk with weak lending standards should be broken. This result could be accomplished with the 20-Year Wealth Building Home Loan combined with an interest rate buy down provided by the federal government to an income-targeted group of first-time buyers. This would materially reduce defaults in low-income neighborhoods and sustainably foster generational wealth building. 

If the federal government wants to subsidize low and moderate income homebuyers effectively, it should use this and other on-budget, transparent and sustainable ways to do it. Fannie and Freddie have no role here, as the only way they can participate is through reducing their credit standards with the real cost hidden in the form of expanding risk.

IV. Fannie Mae and Freddie Mac should be truly privatized, with their hidden subsidies and government-sponsored privileges eliminated over time.

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so the private sector takes on more of the secondary market as the GSEs withdraw. The progressive withdrawal of GSE distortions from the housing finance market should lead to the sunset of the GSE charters at the end of the transition. This should include successive reductions in the GSEs’ conforming loan limits by 20 percent of the previous year’s limits each year, according to a published schedule, so the private sector can plan for the investment of the necessary capital and create the necessary operational capacity. The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance (MI) companies, and private securitization. Congress should make sure that it facilitates opportunities for additional financing alternatives.

We know that none of this will happen in the near term, and the opposite of these principles will probably be followed by the current administration. Nonetheless, the principles define the housing finance direction that a future, market-oriented Congress and administration should take. In the meantime, all mortgage actors should try to protect themselves against the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.

The Rise (and Fall) of the Modern Bank of England

Published in Law & Liberty.

The notion of “an essentially contestable concept” means an issue which by its very nature can never be definitively settled, no matter how much brilliance is expended on it, and about which no logic or evidence can ever force disputing parties to agree. Thus, they are, in the words of Stuart Hampshire, “permanently and essentially subject to revision and question.” In short, the debate never ends. How many such essentially contestable propositions have we seen! Macroeconomics, like politics and philosophy, is full of them.

In macroeconomics, one essentially contestable issue is what the ideal nature and functions of a central bank should be. Given the immense financial and political importance of central banks in a world that runs entirely on the fiat currencies they create and inflate, these are critical questions. But no answer, though it may be in fashion for a time, turns out to be permanent. Crises occur, theories run up against surprising reality, the debates resume, and central bank evolution has no end, no ideal final state.

Harold James’ Making a Modern Central Bank is a very instructive book in this respect. It relates in great and often exhausting detail the lengthy debates concerning the functions and organization of that iconic central bank, the Bank of England, in the midst of the financial events of the years 1979-2003, with a brief but essential update at the end on what has happened since then. “The Bank of England seemed to be engaged in a constant quest to determine what its real function might be,” James observes. The quest involved lots of brilliant minds and colorful personalities, and they remind us that it is easier to be brilliant than right when dealing with the economic and financial future.

In the longer historical background of these debates, and important to their psychology, is that “the Bank,” as the book usually refers to it, had had a great run as the dominant central bank in the world under the gold standard. It had impressive traditions going back to its founding in 1694. Then, in the wake of the financial destruction (as well as all the other destruction) of the First World War, the role of the world’s leading central bank was taken over by the Federal Reserve representing the newly dominant U.S. dollar.

Still, the Bank of England “punches internationally above its weight,” James writes, “not because of the strength of the British economy, but because [quoting Paul Krugman] of its ‘intellectual adventurousness.’” This intellectual flair is well displayed in the book. Moreover, in its institutional history, the Bank calls on long experience in the grand sweep of economic and financial evolution. In 1979, it was approaching its 300th anniversary, while the Fed was less than 70 years old.

At that point, the Bank of England was facing severe stress. “The 1970s were years of crisis everywhere, but especially in the U.K.” There was “in particular the collapse of the fixed exchange rate world of Bretton Woods,” which was the final disappearance of the gold standard over which the Bank had once presided. There were the two oil price shocks, generating “substantial instability.” The global Great Inflation was roaring. The British pound sterling kept getting weaker

According to James, “The policy discussions of the U.K. in 1976 were dramatic and humiliating. They turned into an indictment of a Britain that had failed. Because of the foreign exchange crisis, the Governor of the Bank of England and the Chancellor of the Exchequer could not make their scheduled journeys to the IMF [International Monetary Fund] Annual Meetings.” The prime humiliation was that Britain, once a vast imperial and financial power, had been forced to ask the IMF for a loan which imposed heavy cuts in the government budget. “’Goodbye Great Britain” said a 1975 Wall Street Journal headline.

Of course, there were different ideas about what to do: “There was a struggle between differing parts of the British economic establishment, a clash [between] Treasury and Bank.” The discussions, debates, and political dialectic between the Treasury and the Bank are a central theme of the entire book. Can a central bank be truly independent, or is it instead just a subsidiary and a servant of the Treasury, or is it something in between—perhaps “independent within the government,” as the Federal Reserve used to incoherently but diplomatically say? For James, “The relationship between Treasury and Bank remained permanently haunted by potential or actual controversy.”

Always in the background in the Bank of England case, James points out, is this provision of the Bank of England Act of 1946:

The Treasury may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest.

That’s pretty clear. There is certainly nothing in the Federal Reserve Act about giving directions in that fashion, although the U.S. Treasury Department and the White House always do want to give directions to the Fed and sometimes succeed. As Donald Kettl observed in Leadership at the Fed, “The Fed’s power continues to rest on its political support,” and James shows how true this is of the Bank of England.

The Bank of England Act of 1998 is more nuanced, but does not change who the senior partner is:

The objectives of the Bank of England shall be—(a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government.

It is the Treasury (Her Majesty’s Government) that gets to determine what “price stability”—that is, the inflation target— will be, not the Bank. The Bank thus has “operational” independence, but not target independence. In contrast, the Federal Reserve has had the remarkable hubris to assert it can set an inflation target (define “price stability”) by itself. In most other countries it is given by or negotiated with the government.

Throughout these challenging events, the roles of the Bank of England as promoter of systemic financial stability, provider of financing to combat the panics and financial instability, coordinator and regulator of the banking firms, and creator of moral hazard by bailouts, are prominent—all in addition to its key monetary, inflation-controlling role.

As the book proceeds, the Bank moves from 1970s humiliation to what appears to be a successful “modern central bank” by 2003, although that afterwards turns out to be ephemeral. Along the way were many crises, all interestingly related for those with a taste for financial history.

There was another foreign exchange crisis, involving more humiliation. On “Black Wednesday”—September 16, 1992—the pound sank in spite of very costly “and ultimately futile” support by the Bank of England, breaking the European Exchange Rate Mechanism of fixed parities and famously making giant profits for George Soros and other speculators. “The experiment in European cooperation had ended in failure,” bringing “a progressive distancing of the U.K. from Europe,” and was “an earlier version of Brexit,” James suggests.

There were multiple credit and banking crises and bailouts. These included a deep real estate bust, when house prices fell from 1989 to 1993 and many banks fell along with them. A larger one, National Home Loans, had “two-fifths of its loan book over two months in arrears.” There was the scandalous collapse of BCCI, the Bank of Credit and Commerce International, “popularly dubbed the Bank of Crooks and Cocaine International.” In 1991, “it looked as if there might be a panic and a run on the Midland Bank,” one of the largest banks. The Bank of England considered Midland “indeed too big to fail.”

The famous firm of Barings, “London’s oldest merchant bank,” collapsed in 1995 from the notorious losses of a rogue trader in Asia. Barings had also failed in 1890 from Argentine entanglements, when it was rescued by the Bank of England; this time it got sold to a Dutch bank for one pound. The 1995 Barings crisis involved a particularly British problem: “the worry that the Queen had very nearly lost some of her funds.”

Throughout these challenging events, the roles of the Bank of England as promoter of systemic financial stability, provider of financing to combat the panics and financial instability, coordinator and regulator of the banking firms, and creator of moral hazard by bailouts, are prominent—all in addition to its key monetary, inflation-controlling role. How many functions should the Bank of England have? This kept being debated.

“In the 1990s, the Bank began to specify essential or core purposes, in particular initially three: currency or price stability, financial stability, and the promotion of the U.K. financial service sector,” James points out. However, the Bank still had “fourteen high-level strategic objectives, twenty-seven area strategic aims, forty-nine business objectives and fifty-five management objectives.”

And then came the big redesign. Complex, intensely political, intellectually provocative negotiations among strong personalities in the government and the Bank, related in enjoyable journalistic detail, led to the 1998 Bank of England Act. This act sharply focused the Bank on the core function of maintaining price stability, which as defined turned out to be an inflation target. The Bank would get to choose the methods to achieve this, though it would be given the target. The act also took financial supervision away from the Bank and moved it all to a new, consolidated regulator, the Financial Services Authority (FSA).

The result was an “independent,” “modern” central bank in line with the international central banking theories and fashion of the new 21st century. As James explains: “A modern central bank has a much narrower and more limited set of tasks or functions than the often historic institution from which it developed. The objective is the provision of monetary stability, nothing more and nothing less.” For the Bank of England, “By the early 2000s . . . that task looked like it had been achieved with stunning success.”

It takes the book 450 scholarly pages to reach this outcome. The remaining 11 pages relate how it didn’t work. The “modern” central bank turned out to be far from the end of central banking history or the end of the related debates:

“The monetary and financial governance . . . which appeared to have been functioning so smoothly and satisfactorily, was severely tested after 2007-2008.”

“The crisis . . . required central banks to multi-task feverishly.”

“A new wave of institutional upheaval set in.”

“The 2012 Financial Services Act abolished the FSA.”

“By 2017 . . . Something that looked rather more like the old Bank . . . was being recreated.”

“The old theme of the Bank as provider or guarantor of financial stability came back.”

And so in central banking, the great evolution and cycling of ideas and of fashions continues. The essentially contestable concepts keep being contested.

The Price of Inflation, Now and in the Future

Published in The Wall Street Journal.

Your excellent editorial “Biden Has an Inflation Problem” (Aug. 12) points out that average real wages have fallen for seven months in a row. In other words, the Biden inflation has reduced the real wages of workers in every month that he has been in office. This confirms yet again that high inflation is a way of cutting wages by sneaky central-bank means.

This inflation has come as a surprise to the Federal Reserve, as it busily monetizes government debt, but it is no surprise at all. It reflects the most fundamental principle in economics: Nothing is free. You pay for monetizing government debt by taking money from the wage earners and robbing the savers.

Alex J. Pollock

R Street Institute

Fifty Years Without Gold

Published in Law & Liberty.

Fifty years ago, on Sunday evening, August 15, 1971, after crisis meetings with close advisers at Camp David, President Richard Nixon announced an historic decision in his “Address to the Nation Outlining a New Economic Policy.” It was by then clear that the United States might not have enough gold to meet its international commitment to redeem dollars. It was experiencing “the start of a run on the dollar.” Paul Volcker, then with the Treasury Department, reported to the President on gold losses. “Dollar dumping accelerated. France sent a battleship to take home French gold from the New York Fed’s vaults.” The French not unreasonably believed that the special status of the dollar gave it an “exorbitant privilege,” making it “monumentally over-privileged.” Already in the 1960s, French President Charles de Gaulle had ordered the Bank of France to increase the amount of payments in gold from the United States.

Said Nixon to the nation, “The speculators have been waging an all-out war on the American dollar,” and that to “protect the dollar from the attacks of the international money speculators” would take “bold action.” “Accordingly,” he announced, “I have directed [Treasury] Secretary Connolly to suspend temporarily the convertibility of the dollar into gold.” The suspension of course turned out to be permanent. Today everybody considers it normal and almost nobody even imagines the slightest possibility of reversing it.

Nixon had thereby put the economic and financial world into a new era. By his decision to “close the gold window” and have the American government renege on its Bretton Woods commitment to redeem dollars for gold for foreign governments, he fundamentally changed the international monetary system. In this new system, still the system of today, the whole world always runs on pure fiat currencies, none of which is redeemable in gold or anything else, except more paper currency or more accounting entries. Instead of having fixed exchange rates, or “parities,” with respect to each other, the exchange rates among currencies can constantly change according to the international market and the interventions and manipulations of central banks. The central banks are free to print as much of their own money as they and the government of which they are a part like.

This was a very big change and highly controversial at the time. The Bretton Woods agreement was a jewel of the post-World War II economic order, negotiated in 1944 and overwhelmingly voted in by the Congress and signed into law by President Truman in 1945. Its central idea was that all currencies were linked by fixed exchange rates to the dollar and the dollar was permanently linked to gold. Now that was over. Sic transit gloria.

Economist Benn Steil nicely summed up the global transition:  “The Bretton Woods monetary system was finished. Though the bond between money and gold had been fraying for nearly sixty years, it had throughout most of the world and two and a half millennia of history been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was, in essence, the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good.” It was sailing, we might say, from a Newtonian into an Einsteinian monetary world, from a fixed frame of reference into many frames of reference moving with respect to each other. Nobody knew how it would turn out.

Fifty years later, we are completely used to this post-Bretton Woods monetary world. We take a pure fiat money system entirely for granted as the normal state of things. In this sense, in this country and around the world, we are all Nixonians now.

How very different our prevailing monetary system is from the ideas of Bretton Woods. The principal U.S. designer of the Bretton Woods system, Harry Dexter White insisted, strange to our ears, that “the United States dollar and gold are synonymous.” Moreover, he opined that “there is no likelihood that . . . the United States will, at any time, be faced with the difficulty of buying and selling gold at a fixed price.”

This was a truly bad forecast. It may have been arguable in 1944, but by the 1960s, let alone 1971, it was obviously false. (White’s misjudgment here was exceeded by his bad judgment in being, in addition to an officer of the U.S. Treasury, a spy for the Soviet Union.)

A better forecast was made by Nixon’s Treasury Secretary, John Connally. Meeting with the President two weeks before the August 15, 1971 announcement, he said, “We may never go back to it [convertibility]. I suspect we never will.”  He’s been right so far for fifty years.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard. . . . But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.”

Running low on gold and facing the inability to meet its Bretton Woods obligations, the American government had to do something. Instead of cutting off gold redemption, it could have devalued the dollar in terms of gold. A decade before, British Prime Minister Harold Macmillan had suggested to President John Kennedy that the already-apparent problems could be addressed if the dollar were devalued to $70 per ounce of gold, from the official $35. Whether you have enough gold or not depends on the price. But announcing a formal devaluation was politically very unattractive and no one could really know what the right number was going forward. Today, after fifty years of inflation, it takes about $1,800 to buy an ounce of gold, which is a 98% devaluation of the dollar relative to the old $35 an ounce.

How shall we judge the momentous Nixon decision? Was it good to break the fetters of the “barbarous relic” of gold and voyage into uncharted seas of central bank discretion? Most economists say definitely yes. At the time, the public response to Nixon’s speech was very positive. The stock market went up strongly.

But wasn’t it dangerous to remove the discipline Bretton Woods provided against wanton money creation and inflationary credit expansion? The end of Bretton Woods was followed by the international Great Inflation of the 1970s, and later by our times in which central banks, including the Federal Reserve, with a clear conscience, commit themselves to perpetual inflation instead of stable prices, and promise to depreciate the value of the currency they issue. They speak of “price stability,” but mean by that a stable rate of everlasting inflation. As we observe the renewed unstable and very high rate of inflation of 2021, we may reasonably ask whether discretionary central banks can ever know what they are really doing. Personally, I doubt it.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard….But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.” Central banks, including the Federal Reserve, are indeed subject to political pressure and depend on political support. Politicians, Hayek added, are governed by the “modified Keynesian maxim that in the long run we are all out of office.” If Hayek is watching today from economic Valhalla as the Federal Reserve buys hundreds of billions of dollars of mortgages, and thus stokes the housing market’s runaway price inflation, he will be murmuring, “As I said.”

The distinguished economist and scholar of financial crises, Robert Aliber, pointedly observed that the Nixonian system of pure fiat money and floating exchange rates has been marked by a recurring series of financial crises around the world. Such crises erupted in the 1970s, 1980s, 1990s, 2000s, and 2010s. The fiat currency system was born to solve the 1971 crisis, but it certainly cannot be given a gold medal for financial stability since then. Aliber wrote to me recently: “I used to think that the failure to ‘save Lehman’ was the biggest mistake that the U.S. Treasury ever made, now I realize 1971 was the bigger mistake.”

Professor Guido Hülsmann, speaking in 2021, described the results of the end of Bretton Woods in these colorful terms: “All central banks were suddenly free to print and lend as many dollars and pounds and francs and marks as they wished. . . . Nixon’s decision led to an explosion of debt public and private; to an unprecedented boom of real estate and financial markets;…to a mind-boggling redistribution of incomes and wealth in favor of governments and the financial sector;…and to a pathetic dependence of the so-called financial industry on every whim of the central banks.”

As always in economics, you cannot run the history twice. What would have happened had there been a different decision in 1971, and whether it would have been better or worse than it has been under the Nixonian system, is a matter for pure speculation. Another speculation, good for our humility, is to wonder what we ourselves would usefully have said or done, had we been at Camp David among the counselors of the President, or even been the President, in that crucial August of fifty years ago.

The Bretton Woods system had developed by then a severe, and as it turned out, fatal problem. Our Nixonian system is seriously imperfect. But given the deep, fundamental uncertainty of the economic and financial future at all times; the inescapable limitations of human minds, even the best of them; and the inevitable politics that shape government behavior, including central bank behavior, we are not likely ever to achieve an ideal international monetary system. We are well-advised not to entertain either foolish hopes or foolish faith in central banks.

In any case, there is no denying that August 15, 1971 was a fateful date.

Podcast: A Webinar on Central Bank Digital Currencies

Hosted by the Federalist Society.

With expressions ranging from enthusiasm to serious interest, central banks from China to Europe have been actively exploring the potential for Central Bank Digital Currencies (CBDCs).  On June 28, Federal Reserve Board Vice Chairman for Supervision Randal Quarles offered comments that, far from equivocal, expressed great doubt about the feasibility and desirability for the Federal Reserve sponsoring such a currency.

On July 29 at 2 PM ET the Federalist Society hosted webinar of CBDC experts to comment on Vice Chairman Quarles’ remarks.  What were the key points he made, what did he not say, what is the significance of his comments, what issues remain?  Most important of all, what are the prospects for CBDCs, abroad as well as in the U.S.?

Controversies focus on CBDC implications for privacy, greater personal financial inclusion, government control of credit, innovation, government assumption of banking activities, broadening the tax base, and more.

Featuring:

• Bert Ely, principal of Ely & Co. Inc., long-time expert, consultant, and commentator on financial services institutions and developments, including conditions in the banking industry and the FDIC, monetary policy, the payments system, and the growing federalization of credit risk.

• Chris Giancarlo, former Chairman of the Commodity Futures Trading Commission, and currently senior counsel at Willkie Farr & Gallagher. On June 9, 2021, he testified on CBDC before the Senate Banking Committee’s Economic Policy Subcommittee.

• Peter C. Earle, economist and writer with the American Institute for Economic Research, with 20+ years as a trader and analyst at a number of securities firms and hedge funds, his research focuses on financial markets, cryptocurrencies, monetary policy-related issues, the economics of games, and problems in economic measurement.

• Moderator: Alex J. Pollock, Distinguished Senior Fellow, R. Street Institute; former Principal Deputy Director, Office of Financial Research, U.S. Department of Treasury; author of Finance and Philosophy–Why We’re Always Surprised

Listen here.

‘Biden Inflation’ made simple: Borrow from the Fed, take away from the rest of us

Published in The Hill and MSN.

“What is the difference between banking and politics?” a pointed old witticism goes. “Banking is borrowing money from the public and lending it to your friends. Politics is taking money from the public and giving it to your friends.”

The current American government has a new twist on this, however: Politics is borrowing money from the Federal Reserve and giving it to your friends. Clever, eh? The Fed can print up all the money it wants and the government can borrow it and pass it out. Except that, eventually, you find out that this depreciates the nation’s currency and brings high inflation.

So now we have the ‘Biden Inflation’, which I calculated as running at an annualized rate of more than 7 percent from the end of 2020 through June.

Let us state the obvious facts which everybody knows about a 7 percent rate of inflation. It means that if you are a worker who got a pay raise of 3 percent, the government has made your actual pay go down by 4 percent — that is, plus 3 percent minus 7 percent = minus 4 percent.  If you got a raise of 2 percent, the government cut your real pay by 5 percent.

If you are a saver earning, thanks to the Federal Reserve’s policies, the average interest rate on savings accounts of 0.1 percent, then with a 7 percent rate of inflation, the government has taken away 6.9 percent of your savings account.

If you are a pensioner on a fixed pension or annuity, the government has cut your pension by 7 percent.

In a sound money regime, in order to spend a lot, the politicians have to tax a lot. They then have to worry about whether workers, savers and pensioners will vote for those who escalated their taxes.

With the borrowing from the Federal Reserve ploy, the politicians avoid the pain of having to vote for increased taxes but they still savor the pleasure of voting for their favorite spending. Nonetheless, all the money for the politicians to give their friends has, in fact, been taken from the workers, the savers and the pensioners. It has just been taken in a tricky way by using the Fed.

In a previous generation, when the Federal Reserve was led by William McChesney Martin, for example, the public discourse was clear about this. Martin, who was Fed chairman from 1951 to 1970, called inflation “a thief in the night.” He also said, “We can never recapture the purchasing power of the dollar that has been lost.”  This was long before the Fed newspeak of today, which pretends that inflation at 2 percent forever is “price stability.”

But not even today’s Fed can languidly face a 7 percent rate of inflation. So while still planning to create perpetual inflation, it keeps repeating, and hoping against hope, that the very high inflation is “transitory.”

However transitory the current high inflation may be, the money of the workers, the savers and the pensioners has still been taken and won’t be given back. If the rate of inflation falls, their money will still be being taken, just at a lower rate. If inflation speeds up further, as it may, their money will be taken faster.

Why a Fed Digital Dollar is a Bad Idea

Published in Real Clear Markets with co-author Howard Adler.

On July 19, the top-level President’s Working Group on Financial Markets met to address “the need to act quickly to ensure there is an appropriate U.S. regulatory framework in place” for stablecoins,  a form of cryptocurrency backed by assets, often denominated in dollars. The meeting cited “the risks to end-users, the financial system and national security.”  This is a pretty clear message from a group composed of the Secretary of the Treasury, the Chairs of the Federal Reserve, SEC, CFTC, and FDIC and the Comptroller of the Currency.

Another element of federal policy on this issue was telegraphed by Fed Chair Jerome Powell when he recently discussed the Federal Reserve’s research on issuing its own digital dollar stablecoin.  “You wouldn’t need stablecoins, you wouldn’t need cryptocurrencies if you had a digital U.S. currency– I think that’s one of the stronger arguments in its favor,” he said.  The impetus towards such central bank digital currencies (CBDCs) in many other countries, coupled with the thought that this might weaken the dollar’s global role, added to regulatory concerns about private stablecoins, appear to be pushing the Fed towards the issuance of its own CBDC.  The motivation is understandable, but we still think it would be a bad idea.

There are now a number of private stablecoins circulating that are backed in some fashion by U.S. dollar-denominated assets, such as Tether and USD coin.  Facebook has announced its intention to launch its own U.S. dollar-backed stablecoin, the “diem,” later this year.  If used by a meaningful proportion of Facebook’s several billion subscribers, this could enormously increase the stablecoin universe.  Government officials, unsurprisingly, are focusing on the lack of any regime for their regulation and the need for one.

At the same time, central banks worldwide are considering their own CBDCs.  As of April 2021, more than 60 countries were in some stage of exploring an official digital currency, including many highly developed countries. But it is China’s digital yuan, now being tested in a dozen Chinese cities, that causes the most concern.

China seems to have two goals in establishing a CBDC. The first is more control over its citizens. If the digital yuan became ubiquitous, the Chinese government would have instant knowledge and control over its citizens’ money, potentially allowing it, for example, to confiscate the funds of political dissidents or block their payments and receipts.

The second goal is to challenge the dominance of the U.S. dollar in international transactions. The dollar is the currency used in 88 percent of foreign exchange transactions, while the renminbi was used in only four percent, according to the Bank for International Settlements. Who, located outside of China, would choose to give the Chinese Communist Party control over their money? The answer is those potentially subject to U.S. sanctions. As the issuer of dollars that the world’s banks need to transact business, the United States government has long demanded and received access from banks to information related to international transactions, which it has used to impose sanctions on hostile states and those it considers terrorists and criminals. Some countries (perhaps Iran, Cuba and Venezuela) may choose to use the digital yuan to avoid U.S. sanctions, as may countries participating in China’s Belt and Road program whose large debts to China may provide the Chinese with leverage over their choices.

If the digital yuan and other CBDCs are widely implemented, as seems almost inevitable, proponents of the Fed digital dollar may argue that there would be erosion in the dominance of the U.S. dollar in international trade and less demand for U.S. dollar-denominated assets including U.S. Treasury securities, pushing interest rates on Treasuries up, making it more costly for the United States to fund its historic deficits. The Federal Reserve might also believe it is in the public interest to issue its own stablecoin because it would be safer and less prone to fraud than private cryptocurrencies.  In order to preserve the dollar’s dominance and to constrain the use of private cryptocurrencies, it appears likely that the Federal Reserve will decide this fall, when it is scheduled to report on its consideration of a digital dollar, to move forward with its own CBDC.  Is this desirable?

Regulation of private stablecoins is on the way in any case, regardless of whether the Fed issues a stablecoin.  More importantly, a digital dollar would further centralize and provide vastly more authority to the already powerful Federal Reserve.  The negative impact of a Fed CBDC, both on citizens’ privacy rights and by shifting the power to allocate credit from the private sector to the government, would be enormous.

A Fed CBDC would make it hard for private citizens to avoid financial snooping by the government in every aspect of their financial lives. Moreover, suppose, as one would expect, that that the Fed’s CBDC siphoned large deposit volumes from private banks. The Fed would have to invest in financial assets to match these deposit liabilities, which would centralize credit allocation in the Federal Reserve, politicizing credit decisions and turning the Fed into a government lending bank. The global record of government banks with politicized lending has been dismal. A digital dollar could therefore undo more than a century of central bank evolution, which has usefully divided the issuer of money from private credit decisions. In the process, a digital dollar would subject private banks to vastly unequal and inevitably losing competition with the government’s central bank.  Finally, a CBDC would make it easier for the central bank to expropriate the people’s savings through negative interest rates.  For these reasons, a CBDC may fit an authoritarian country like China, but not the United States.

The delicious irony in the CBDC saga is that cryptocurrency was created because people were afraid of government control and wished to insulate their financial lives from monetary manipulation by central banks. With CBDCs, their ideas would be used to increase exactly the type of government interference and control that the crypto-creators sought to escape.

Event: What might cause the next financial crisis?

Hosted by the American Enterprise Institute.

Panelists:
Rebel A. Cole, Lynn Eminent Scholar Chaired Professor of Finance, Florida Atlantic University
Gerald P. Dwyer, BB&T Scholar, Clemson University
Edward Kane, Professor, Boston College
Alex J. Pollock, Distinguished Senior Fellow, R Street Institute
Ehud I. Ronn, Professor, University of Texas at Austin
Richard Christopher Whalen, Chairman, Whalen Global Advisors LLC

Moderator:
Paul H. Kupiec, Resident Scholar, AEI

More than 60 countries and multinational organizations produce financial stability reports. All are political documents that rarely identify actual financial crises in advance, especially if risks arise from government-regulated institutions or are linked to government policies that promote financial excesses such as lax lending standards, over-stimulative monetary policy, or unsustainable exchange rates.

Financial activities believed to be fail-safe frequently are not. Successfully identifying the activities that result in disastrous losses before they materialize requires imagination, intuition, and luck. Statistical models rarely predict economic turning points.

Join AEI as six financial-sector experts use data, statistics, and their keen intuition and in-depth knowledge of our financial system to propose risks that could trigger the next financial crisis.

Expect Lower Credit Standards, More Risk From Biden Housing Authority

Published in The Wall Street Journal.

Fannie and Freddie will take orders from a ‘housing czar’ with an agenda for politicized lending.

Your editorial “A Conservative Court Awakening” (June 26) rightly says a new Biden administration Federal Housing Finance Agency (FHFA) director will “ease underwriting standards again to boost home-ownership.” But let us restate this more clearly: This director will reduce credit standards and increase risk once again to promote temporary home-ownership through low-credit-quality loans. This will revivify the notorious “originate and sell” model for such loans, so the lenders can stick the taxpayers with the credit risk. Systemic financial risk will rise.

When a regulator becomes a cheerleader, it is always bad news. Even more so in this case because the FHFA director will remain the conservator of Fannie Mae and Freddie Mac, with more power over its charges than a normal regulator. What a chance was missed by the Trump administration Treasury to designate Fannie and Freddie as the “systemically important financial institutions” they are. Then they would be subject to additional risk oversight by the Federal Reserve, instead of simply taking orders from a “housing czar” with an agenda for politicized lending.

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.