Risk, Uncertainty and Profit 100 Years Later

Published in Law & Liberty. Also appears in AIER.

The year 2021 marks the 100th anniversary of Frank Knight’s great book, Risk, Uncertainty and Profit (RU&P), which established uncertainty as a fundamental idea in economics and finance, and as a key to understanding enterprise, entrepreneurship, cycles of booms and busts, and economic growth. Viewed from the present, it also explains why faith in economic management by central banks will be disappointed, and why any idea that economies or financial markets are governed by “mechanisms” is deluded. Its ideas open the way to seeing that economies and financial markets are a different kind of reality than are machines, and thus why the econometric equations that seem so plausible in some times, at other times fail.

Knight lived from 1885 to 1972; RU&P was published in 1921 when he was 35. Although he subsequently had a long and distinguished career at the University of Chicago, where he influenced numerous future economists including Milton Friedman, RU&P is far and away his magnum opus, a book that “ended up changing the course of economic theory” and established Knight “in the pantheon of economic thinkers.” It might also be called “the most cited economics book you have never read.” Indeed, it is long, complex, and often difficult, but contains brilliant insights which do not go out of date. We may enjoy the irony that it arose from a contest by the publishers in 1917 in which its original text won second, not first, prize.

RU&P is most and justifiably famous for its critical distinction between Uncertainty and Risk, with the term “Knightian Uncertainty” immortalizing the author, at least among those of us who have thought about it. Although in common language, then and now, “It’s uncertain” or “It’s risky” might be taken to mean more or less the same thing, in Knight’s clarified concepts, they are not only not the same, but are utterly different, with vast consequences.

Knight set out to address, as he wrote in RU&P, “a confusion of ideas which goes down deep into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein.” So “the answer is to be found in a thorough examination and criticism of the concept of uncertainty, and its bearings upon economic processes.”

“But,” Knight continued, “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated”—until RU&P in 1921, of course. They are “two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different.”

Specifically, risk means “a quantity susceptible of measurement,” but uncertainty is “unmeasurable,” and “a measurable uncertainty is so far different from an unmeasurable one that it is not in effect an uncertainty at all.” It is only a risk.

Another way of saying this is that for a measurable risk, you can know the odds of outcomes, although you don’t know exactly what will happen in any given case. With uncertainty, you do not even know the odds, and more importantly, you cannot know the odds.

When facing risk, since you can know the odds, you can know in a large number of repeated events what the distribution of the outcomes will be. You can know the mean of the distribution of outcomes, its variation, and the probability of extreme outcomes. With fair pair of dice, you know that rolling snake eyes (one spot on each die) has a reliable probability of 1/36. We know that the extreme outcome of rolling snake eyes three times in a row has a probability of about 0.00002—roughly the same probability of flipping a fair coin and getting tails 16 times in a row. Of course, even that remote probability is not zero.

With risk, by knowing the odds in this fashion, and knowing how much money is being risked, you can rationally write insurance for bearing the risk when it is spread over a large number of participants. It may take specialized skill and a lot of data, but you can always in principle calculate a fair price for insuring the risk over time, and the ones taking the risk can accordingly buy insurance from you at a fair price, solving their risk problem.

Faced with uncertainty, however, you cannot rationally write the insurance, and the uncertainty bearers cannot buy sound insurance from you, because nobody knows or can know the odds. Therefore, they do not and cannot know the fair price for bearing the uncertainty.

In short, an essential result of Knight’s logic is that risk is in principle insurable, but uncertainty is not.

Of course, you might convince yourself that the uncertainty is really risk and then estimate the odds from the past and make calculations, including complicated and sophisticated calculations, manipulating your guesses about the odds. There is often a strong temptation to do this. It helps a lot in selling securities, for example, or in making subprime loans. You can build models using the estimated odds, creating complicated series of linked probabilities for surviving various stress tests and for calculating the required prices.

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it.

Your analysts will certainly solve the mathematical equations in the models properly; however, under uncertainty, the question is not doing the math correctly, but the relationship of the math to the unknown and unknowable future reality. In the uncertainty case, your models will one day fail, because in fact you cannot know the odds, no matter how many models you run. The same is true of a central bank, say the Federal Reserve, running a complex model of the whole economy and employing scores of economists. Under uncertainty, it may, for example, in spite of all its sophisticated efforts, forecast low inflation when what really is about to happen is very high inflation—just as in 2021.

There is no one to ensure against the mistake of thinking Uncertainty is Risk.

Let us come to the P in RU&P: Profit. Every time Knight writes “profit,” as in the following quotations, and also as used in the following discussion, it does not mean accounting profit, as we are accustomed to seeing in a profit and loss statement, but “economic profit.” Economic profit is profit in excess of the economy’s cost of capital. When economic profit is zero, then the firm’s revenues equal its costs, including the cost of capital and the cost of Risk, so the firm has earned exactly its cost of capital.

In a theoretical world of perfect competition, prices, including the price for insuring Risk, would adjust so that revenues always would equal cost. That means in a competitive world in which the future risks are insurable, there should be no profit. We obviously observe large profits in many cases, especially those earned by successful entrepreneurs. Knight concludes that in a competitive economy, Uncertainty, but not Risk, can give rise to Profit.

It is “vital to contrast profit with payment for risk-taking,” he wrote. “The ‘risk’ which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis,” and “the only ‘risk’ which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured.” Thus, “profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated…a probability calculation in regard to them is impossible and meaningless.” Loss also arises from the same brute fact, of course. We are again reminded that human activity is a different kind of reality than that of predictable physical systems.

Economic progress, or a rising standard of living for ordinary people, depends on creating and bearing Uncertainty, but this obviously also makes possible many mistakes. These include, we may add, the group mistakes which result in financial cycles. We don’t get the progress without the uncertainty or without mistakes. “The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress.” The paradox of economic progress is that there is no progress without Uncertainty, and no Uncertainty without mistakes.

To have Uncertainty, there must be change, for “in an absolutely unchanging world the future would be accurately foreknown.” But change per se does not create an unknowable future and Uncertainty. Change which follows a known law would be insurable; so “if the law of change is known…no profits can arise.” Profits in a competitive system can arise “only in so far as the changes and their consequences are unpredictable.”

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it. He takes the “ultimate responsibility” of bearing uncertainty in business.

Knight clearly enjoyed summing up “the main facts in the psychology of the case” of the entrepreneurs, when the uncertainties “do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance.” The entrepreneurs may have “an irrational confidence in their own good fortune, and that is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves.” They are “the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.” This suggests that a kind of irrational faith is required for progress.

A former student of philosophy, Knight always was a very philosophical economist. On the last page of RU&P comes this true perspective on it all: “The fundamental fact about society as a going concern is that it is made of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. . . . Life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out.” We need to be reminded of this as we in our turn strive to increase the great funds of inheritance for those who will carry on into the ever-uncertain future.

For it is as true now and going forward as when RU&P was published one hundred years ago that, as Knight wrote, “Uncertainty is one of the fundamental facts of life.”

Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion

Published by the Mises Institute,

With inflation running at over 6 percent and interest rates on savings near zero, the Federal Reserve is delivering a negative 6 percent real (inflation-adjusted) return on trillions of dollars in savings. This is effectively expropriating American savers’ nest eggs at the rate of 6 percent a year. It is not only a problem in 2021, however, but an ongoing monetary policy problem of long standing. The Fed has been delivering negative real returns on savings for more than a decade. It should be discussing with the legislature what it thinks about this outcome and its impacts on savers.

The effects of central bank monetary actions pervade society and transfer wealth among various groups of people—a political action. Monetary policies can cause consumer price inflations, like we now have, and asset price inflations, like those we have in equities, bonds, houses, and cryptocurrencies. They can feed bubbles, which turn into busts. They can by negative real yields push savers into equities, junk bonds, houses, and cryptocurrencies, temporarily inflating prices further while substantially increasing risk. They can take money away from conservative savers to subsidize leveraged speculators, thus encouraging speculation. They can transfer wealth from the people to the government by the inflation tax. They can punish thrift, prudence, and self-reliance.

Savings are essential to long-term economic progress and to personal and family financial well-being and responsibility. However, the Federal Reserve’s policies, and those of the government in general, have subsidized and emphasized the expansion of debt, and unfortunately appear to have forgotten savings. The original theorists of the savings and loan movement, to their credit, were clear that first you had “savings,” to make possible the “loans.” Our current unbalanced policy could be described, instead of “savings and loans,” as “loans and loans.”

As one immediate step, Congress should require the Federal Reserve to provide a formal savers impact analysis as a regular part of its Humphrey-Hawkins reports on monetary policy and targets. This savers impact analysis should quantify, discuss, and project for the future the effects of the Fed’s policies on savings and savers, so that these effects can be explicitly and fairly considered along with the other relevant factors. The critical questions include: What impact is Fed monetary policy having on savers? Who is affected? How will the Fed’s plans for monetary policy affect savings and savers going forward?

Consumer price inflation year over year as of October 2021 is running, as we are painfully aware, at 6.2 percent. For the ten months of 2021 year-to-date, the pace is even worse than that—an annualized inflation rate of 7.5 percent.

Facing that inflation, what yields are savers of all kinds, but notably including retired people and savers of modest means, getting on their savings? Basically nothing. According to the Federal Deposit Insurance Corporation’s October 18, 2021, national interest rate report, the national average interest rate on savings account was a trivial 0.06 percent. On money market deposit accounts, it was 0.08 percent; on three-month certificates of deposit, 0.06 percent; on six-month CDs, 0.09 percent; on six-month Treasury bills, 0.05 percent; and if you committed your money out to five years, a majestic CD rate of 0.27 percent. 

I estimate, as shown in the table below, that monetary policy since 2008 has cost American savers about $4 trillion. The table assumes savers can invest in six-month Treasury bills, then subtracts from their average interest rate the matching inflation rate, giving the real interest rate to the savers. This is on average quite negative for these years. I calculate the amount of savings effectively expropriated by negative real rates. Then I compare the actual real interest rates to an estimate of the normal real interest rate for each year, based on the fifty-year average of real rates from 1958 to 2007. This gives us the gap the Federal Reserve has created between the actual real rates over the years since 2008 and what would have been historically normal rates. This gap is multiplied by household savings, which shows us by arithmetic the total gap in dollars.

To repeat the answer: a $4 trillion hit to savers.

The Federal Reserve through a regular savers impact analysis should be having substantive discussions with Congress about how its monetary policy is affecting savings, what the resulting real returns to savers are, who the resulting winners and losers are, what the alternatives are, and how its plans will impact savers going forward.

After thirteen years with on average negative real returns to conservative savings, it is time to require the Federal Reserve to address its impact on savers.

Biden Pick for Bank Regulator Proposed Fed Take Over Banking, Manipulate Stock Prices

Published in the Epoch Times:

“If you have all of the deposits in the government bank, then all of the loans, or at least a very high percentage of the loans, are going to be there as well,” said Alex Pollock, former head of the Federal Home Loan Bank of Chicago and financial research executive at the Treasury who is currently a senior fellow at the classical liberal Mises Institute.

Controlling credit means the Fed—and de facto the federal government—would have a say in most major individual economic decisions, such as what factory or office tower gets built, who gets to build or buy a home, and even who gets to go to college or buy a car.
“If you’re politically correct, well, then you can get a loan; if you’re not, you can’t,” Pollock told The Epoch Times about the implications.

...

“She wants government to control the allocation of capital in the economy, which is a recipe for politicizing everything,” said David Burton, financial regulation expert at the conservative Heritage Foundation.

Pollock concurred: “It would become purely political.”

...

It isn’t clear what such price signals would be worth when the investors would be limited to options predetermined by the NIA, Pollock noted.

In fact, it isn’t clear how the Fed would determine what is or isn’t productive in a system in which credit flows are largely determined by the government. The ordinarily robust private credit to serve as a frame of reference would be largely absent and so the Fed would have to fall back on its own judgment.

“Nobody, especially a government bureaucracy, can know enough to do this,” Pollock commented in an email. “It is a totally naïve and, in fact, silly idea.”

At times, Omarova contrasted “productive” investment with speculative investment, which she called “misallocation of capital.”

But speculation “can be destabilizing or stabilizing,” Pollock said. Suppressing it by government mandate doesn’t necessarily heal the monetary woes. In fact, the current practice of the Fed buying up securities seen as safe, like government bonds and mortgage-backed securities, depresses yields on such instruments and pushes investors toward riskier assets, he said.

....

Pollock estimated that such an all-powerful Fed “would go on inflating the money supply by lending to the government itself (monetizing government debt) and to politically favored entities of all sorts.”

...

According to Pollock and several other economists, there are a number of problems with this view.

Let Me Vote Those Shares for You

Published in the Federalist Society.

BlackRock’s idea to give institutional clients more control over how shares of stock are voted could be a good step. Some, such as Alex Pollock, say that it is still a ladder with the first rung above the head of most investors.

The fundamental idea of owning stock in a corporation is that shareholders acquire, along with their investment, ownership rights in the company, including the right to vote on company questions commensurate with their investment. These questions can include composition of the board of directors, compensation for company executives, company auditors, and company investment and disclosure policies, among others.

As Alex Pollock notes in an October 13 letter to the editor of the Financial Times, BlackRock acknowledges, “The money we manage is not our own, it belongs to our clients.” Hence, BlackRock’s new policy idea.

. . .

BlackRock hopes to relieve some of that pressure by passing it on to investment funds that place their clients’ money with BlackRock. As Alex Pollock explains in his Financial Times letter, however, “BlackRock is handing zero voting power to the real owners of the shares which it manages as agent.” It is making it easier for others—the fund managers of your investments—to vote your shares, but they do not own your shares. You do, and the BlackRock proposal does not reach to you to learn what you think.

Your broker-dealer cannot vote your shares. In many cases, though, the managers of funds through which you own stock can. They can use your investments to vote as if they were their investments. That can give them a lot of financial and, increasingly, political clout. With your money, they can pursue their agenda, not yours.

Alex Pollock recommends in his letter that “All investment agents, both broker-dealers and asset managers alike, should have the same requirements: no voting of shares by the agents without instructions from the principals.” “From the principals” means from you, the shareholder. That is the requirement for broker-dealers. Why should it not apply to the fund managers who, without your money, would have nothing but their own?

More on the Vision of Biden’s Pick to Regulate the Nation’s Banks

Published by the Cato Institute:

Now, Alex Pollock, the former deputy director of the U.S. Treasury’s Office of Financial Research, has taken a careful look at some of Omarova’s other writings. Some of the work will seem quite familiar, but most of it exposes ideas that are even more fundamentally opposed to a free enterprise system and the American system of government.

Letter: Principals must have the final say in how funds use their votes

Published in the Financial Times.

Michael Mackenzie and Attracta Mooney write that BlackRock is to hand clients a greater say in proxy voting (Report, October 8). It’s a good idea in general, but in fact BlackRock is handing zero voting power to the real owners of the shares which it manages as agent.

Indeed, BlackRock represents a giant and profound principal-agent conflict. It should not be voting any shares at all without instructions from the real owners, whose money is really at risk. As BlackRock itself has stated: “The money we manage is not our own, it belongs to our clients.” For sure. But the other asset managers to whom BlackRock wants to give votes are also not the ones whose money is at risk — they are mere agents, like BlackRock itself.

The real owners whose own money is at risk are the owners of the mutual fund and exchange-traded fund shares and the beneficiaries of pension funds, not their hired agents.

Large proportions of these principals certainly do not want their shares voted according to the political preferences of BlackRock’s management — or more cynically, they do not want the possibility of having their shares voted to advance the political strategies of that management.

The voting instructions of the principals for all shares should be solicited exactly as broker-dealers must solicit instructions from the real owners of the shares that the brokers hold in street name. Without such instructions, the shares should not be voted. Surely the systems for this process are well within the capability of our wondrous computer age.

Biden's radical Treasury nominee in her own words

Published in The Hill.

In an incomprehensible act, President Biden has nominated as comptroller of the currency Saule Omarova — a law school professor who thinks that banks should have their deposit business taken away and transferred to the government, the Federal Reserve should be the monopoly provider of retail and commercial deposits, the Fed should perform national credit allocation, the Federal Reserve Bank of New York should intervene in investment markets whenever it thinks prices are too high or too low (shorting or buying a wide range of investments accordingly), the government should sit on boards of directors of private banks with special powers and disproportionate voting power, new federal bureaucracies should be set up to regulate financial regulators and carry out national investment policy and in general, it seems, has never thought of a vast government bureaucracy or a statist power that she doesn’t like.

What follows is a collection of such particularly unwise proposals in Professor Omarova’s own words, which might be appropriately called “Omarova’s Little Book.” 

“On the liability side” of the banking system, Professor Omarova “envisions the ultimate ‘end-state’ whereby central bank accounts fully replace — rather than compete with — private bank accounts,” according to her 2020 paper, “The People’s Ledger: How to Democratize Money and Finance the Economy.”

“On the asset side,” she “lays out a proposal for restructuring the Fed’s investment portfolio and redirecting its credit-allocation power…leaving the asset side free to serve as the tool of the economy-wide credit allocation.”

In short, “the key is…eliminating private banks’ deposit-taking function and giving the Fed new asset-side tools of shaping economy-wide credit flows,” the proposed regulator of national banks writes.

At this point, it is already unnecessary to proceed any further, but we will.

In the paper, “The ‘Too Big To Fail’ Problem,” Omarova suggests “an expansion of the Federal Reserve’s so-called ‘open market operations’…to encompass trading in a wide range of financial assets. … If, for example,  a particular asset class — such as mortgage-backed securities or technology stocks — rises in market value at rates suggestive of a bubble trend, the FRBNY trading desk would short these securities.” 

“The FRBNY trading desk would go long on particular asset classes when they appear to be artificially undervalued.” 

Also, a “National Investment Authority” would be “charged with developing and implementing a comprehensive strategy of national economic development.” 

In “The Climate Case for a National Investment Authority,“ she said "The NIA will act directly within markets as a lender, guarantor, market-maker, venture capital investor and asset manager. … It will use these modalities of finance in a far more assertive and creative manner.”

These ideas will perhaps strike you, as they do me, as exceptionally naïve.

Meanwhile, in “Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation,” Omarova proposes creating a “Public Interest Council,” which “would have a special status … outside of the legislative and executive branches." The Council "would comprise…primarily academic experts [!]" and "it would have broad statutory authority to collect any information it deems necessary from any government agency or private market participant and to conduct targeted investigations.”

On top of that, in “Bank, Governance and Systemic Stability: The ‘Golden Share’ Approach,” she recommends a “new golden share mechanism” which would give “the government special, exclusive and nontransferable corporate-governance rights in privately owned enterprises.”

“As a holder of the golden share, the government could have disproportionate voting power with respect to the election of the company’s directors and various strategic decisions,” reads the paper.

“This ability to affect directly a private firm’s substantive business decisions — without holding a controlling economic equity stake — is a particularly promising feature of the golden share,” Omarova thinks. Do you?

While considering this quite remarkable nomination, any member of the Senate Banking Committee who personally supports these proposals of Omarova should boldly hold up their hand and then speak in their defense. It seems hard to believe there would be many hands.

No More Debt Ceiling Increases: Let the Federal Government Default

Published in Real Clear Markets:

In the meantime, the Democratic Party and the media will predictably continue to scream, “The United States has never defaulted on its debt!” As ‘The Hill’ recently pointed out, this isn’t true, but nonetheless we’ll be told that if Congress doesn’t raise the debt ceiling the world will end.

The US has never defaulted on its debt — except the four times it did

Published in The Hill.

Every time the U.S. government’s debt gets close to the debt ceiling, and people start worrying about a possible default, the Treasury Department, under either party, says the same thing: “The U.S. government has never defaulted on its debt!” Every time, this claim is false.

Now Treasury Secretary Yellen has joined the unfailing chorus, writing that “The U.S. has always paid its bills on time” and “The U.S. has never defaulted. Not once,” and telling the Senate Banking Committee that if Congress does not raise the debt ceiling, “America would default for the first time in history.”  

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This is all simply wrong. If the United States government did default now, it would be the fifth time, not the first. There have been four explicit defaults on its debt before. These were:

1. The default on the U.S. government’s demand notes in early 1862, caused by the Treasury’s financial difficulties trying to pay for the Civil War. In response, the U. S. government took to printing pure paper money, or “greenbacks,” which during the war fell to significant discounts against gold, depending particularly on the military fortunes of the Union armies.

2. The overt default by the U.S. government on its gold bonds in 1933. The United States had in clear and entirely unambiguous terms promised the bondholders to redeem these bonds in gold coin. Then it refused to do so, offering depreciated paper currency instead. The case went ultimately to the Supreme Court, which on a 5-4 vote, upheld the sovereign power of the government to default if it chose to. “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States,” wrote Justice Harlan Stone, a member of the majority, “the government, through exercise of its sovereign power…has rendered itself immune from liability,” demonstrating the classic risk of lending to a sovereign. In “American Default,” his highly interesting political history of this event, Sebastian Edwards concludes that it was an “excusable default,” but clearly a default.

3. Then the U.S. government defaulted in 1968 by refusing to honor its explicit promise to redeem its silver certificate paper dollars for silver dollars. The silver certificates stated and still state on their face in language no one could misunderstand, “This certifies that there has been deposited in the Treasury of the United States of America one silver dollar, payable to the bearer on demand.” It would be hard to have a clearer promise than that. But when an embarrassingly large number of bearers of these certificates demanded the promised silver dollars, the U.S. government simply decided not to pay. For those who believed the certification which was and is printed on the face of the silver certificates: Tough luck.

4. The fourth default was the 1971 breaking of the U.S. government’s commitment to redeem dollars held by foreign governments for gold under the Bretton Woods Agreement. Since that commitment was the lynchpin of the entire Bretton Woods system, reneging on it was the end of the system. President Nixon announced this act as temporary: “I have directed [Treasury] Secretary Connally to suspend temporarily the convertibility of the dollar into gold.” The suspension of course became permanent, allowing the unlimited printing of dollars by the Federal Reserve today. Connally notoriously told his upset international counterparts, “The dollar is our currency but it’s your problem.”

To paraphrase Daniel Patrick Moynihan, you are entitled to your own opinion about the debt ceiling, but not to your own facts about the history of U.S. government defaults.

Fireside Chat: Alex Pollock and Fifty Years Without Gold

Hosted by the Federalist Society.

Fifty years ago, on August 15, 1971, President Richard Nixon put the economic and financial world into a new era. Through his decision to "close the gold window," he fundamentally changed the international monetary system into the system of today, where the whole world runs on pure fiat currencies. "The dollar was the last ship moored to gold, with all the other currencies on board, and the U.S. cut the anchor and sailed off." Nobody knew how it would turn out. Fifty years later, we are completely used to this post-Bretton Woods monetary world with endemic inflation and floating exchange rates, and take it for granted. Nobody thinks it is even possible to go back to the old world: We are all Nixonians now. How shall we judge the momentous Nixon decision in its context and since? A fundamental question with pluses and minuses remains. Is the international monetary system now permanently open to more money printing and more monetization of government debt, making faith in central banks misplaced, and expectation of an ideal monetary policy foolish?

Featuring:

• Alex J. Pollock, Distinguished Senior Fellow, R. Street Institute, Author of Fifty Years Without Gold

• Moderator: Hon. Wayne A. Abernathy, Chairman, Federalist Society Financial Services & E-Commerce Practice Group

Event Transcript

[Music]

Dean Reuter:  Welcome to Teleforum, a podcast of The Federalist Society's practice groups. I’m Dean Reuter, Vice President, General Counsel, and Director of Practice Groups at The Federalist Society. For exclusive access to live recordings of practice group Teleforum calls, become a Federalist Society member today at fedsoc.org.

Evelyn Hildebrand:  Welcome to The Federalist Society's virtual event. This afternoon, September 16, we are holding a fireside chat with Mr. Alex Pollock to discuss his recent article published last month and entitled, "Fifty Years Without Gold."

      My name is Evelyn Hildebrand, and I'm an Associate Director of Practice Groups at The Federalist Society. As always, please note that all expressions of opinion are those of the experts on today's call.

      Today we are fortunate to have with us Mr. Alex Pollock and Mr. Wayne Abernathy. I will introduce Wayne, who will be moderating this afternoon's discussion. Wayne is a former U.S. Treasury Assistant Secretary for Financial Institutions, and he's also the chair of The Federalist Society's Financial Services and E-Commerce Practice Group Executive Committee. We're very pleased that he's agreed to moderate this afternoon. He will introduce Mr. Pollock.

      After our speaker gives opening remarks, we will turn to audience questions. If you have a question, please enter it into the Q&A feature at the bottom of your screen. You can enter questions at any time during the program, but we will handle those towards the end of this afternoon. And again, if you have a question, please enter it at the bottom of your screen in the Q&A tab.

      With that, thank you for being with us today. Wayne, the floor is yours.

Hon. Wayne A. Abernathy:  Thank you very much, Evelyn. And very much appreciate all of those who are joining with us, and most especially, I would say, opportunity -- and a pleasure. Whenever you have the chance to sit and have a chat with Alex Pollock, you’ll always learn something and you'll enjoy it. So I think you'll enjoy this conversation today.

      Alex Pollock is a Distinguished Senior Fellow at the R. Street Institute in Washington D.C. He was the principal deputy director of the Office of Financial Research at the U.S. Treasury from 2019 into 2021. I'd also point out that the depth of experience that Alex has is very much hands-on. He was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 through 2004 -- a very eventful period of time in the transition and the evolution of the policies of the Federal Home Loan Bank system, and a lot of opportunities to learn, with hands-on -- working with the financial system.

      He is the author of the book, Finance and Philosophy: Why We're Always Surprised -- much as we were in 2020. I had the privilege, shortly after that book was published, of having an interview like this with Alex on The Federalist Society's tab where we talked about the book and were able to discuss some of the really very important, but also very interesting, points there. And so that's -- if you want, you can go onto The Federalist Society page and probably go and look up Alex Pollock, type in that book, and you might even find that conversation that we had. It was wonderful.

      He is also the author of numerous articles in a variety of different publications and frequent testimony before Congress. Today, we will be discussing some very important issues. I also want to mention -- I thought this was interesting. I was not aware of this, Alex. Alex serves as a director of the Great Books Foundation, where he was chairman of the board from 2006 to 2014.

      Now, as the introduction to what Mr. Pollock is going to talk to us about -- in the class of important anniversaries nearly missed, the most recent August was the 50th anniversary of the day in 1971 when the financial and monetary world changed by the unilateral action of the president of the United States and the U.S. Treasury. Alex Pollock is here today to help us remember, and also to understand why we need to remember, that important event, as well as to understand why it continues to affect the lives of all of us today.

      Alex will offer a few remarks to set the table, then he and I will engage in a bit of a conversation, after which we will turn to the questions that you have submitted to us. Evelyn has explained, you can submit those at any point by just going down to the Q&A tab. The chat tab is, frankly, for you to communicate with other listeners. But if you want to give us a question, use the Q&A tab, if you would do that. We will draw from that Q&A tab and bring those questions to the fore and share them with all of you. And most importantly, Alex will share his answers. And that's the opportunity we'll have. And now let me turn to Mr. Alex Pollock.

Alex J. Pollock:  Thank you, Wayne, very much. As always, it's a real pleasure to have a discussion with you and to be here with The Federalist Society thinking about this 50th anniversary of a truly fundamental and definitive event in the monetary system of the whole world. The system President Nixon created in 1971 is our system of today, and tomorrow, as well, and for as many tomorrows as we can now foresee. And the issues it entails are -- and did entail, starting in 1971 -- are very much still with us in the debates we're having now.

      The title of this essay, "Fifty Years Without Gold" was not what I called the essay for, as you know, the editors get to pick the title of publications. The "Without Gold" title stresses what we don't have. But what I wanted to really stress about the anniversary of August 15, 1971 was what we do have, and still have, and that is to say, a worldwide pure fiat currency -- that is to say, pure paper and accounting entry money system -- everywhere in the world, with floating exchange rates among fiat currencies, hugely powerful central banks, which operate as part of their respective governments. Along with this has come, and continues, endemic inflation, and indeed, central banks, which promise to give us inflation forever -- that is, they promise to depreciate their fiat currencies without limit.

      Now, this is a remarkable contrast. And it all comes from that eventful Sunday announcement in 1971. It's a remarkable contrast to the idea of what was previously called "honest money," which classic central bankers thought they were responsible to maintain. "Honest money" meant money with a stable value, not a constantly depreciating value. But now, we all take for granted as normalcy the system that comes from 1971—a pure-fiat-money, pure-paper-currency system with endemic inflation. That just seems like normal to all of us, whereas before 1971, this world would have been considered extremely abnormal. But nobody now thinks it's possible to go back to that old Bretton Woods system, or before it, a gold-standard-of-one-kind-or-another system. And it probably isn't possible to go back.

      So this brings me to the title of what I called the essay originally -- and the title I like better -- which is, "We Are All Nixonians Now." Yes, when it comes to the world's monetary system, at least, we are all Nixonians now. Now, this is, you will recognize, a play on Nixon's own statement that we are all Keynesians now, as he said. But whereas, in fact, we're not all Keynesians, in fact, we are all Nixonians everywhere in the world, practically everybody who -- at least who thinks about the issue on this topic.

      Now, what does it mean that we're all, everywhere in the world, Nixonians now? Well, part of what we might think about is it's interesting to consider the price -- or what is really more appropriately thought of as the exchange rate -- of gold and the dollar. You will remember that at the time of Bretton Woods, the United States had promised to redeem in gold any outstanding dollar liabilities in the hands of foreign governments. Long before that, they had taken away the ability of US citizens to redeem dollars for gold. But they still promised it for foreign governments at $35 an ounce. So for $35 in dollars, you got one ounce in gold, or alternately stated, for a dollar, you got 1/35 of an ounce of gold.

      Now, of course, it's now about $1,800 an ounce, or alternately stated, about 1/1800 of an ounce of gold for a dollar. And you will see, if you do the math, this represents a 98 percent -- 98 percent -- devaluation of the dollar with respect to gold since Nixon's speech on that Sunday evening in 1971.

      Now, how ironic, in retrospect, is the claim of the principal US negotiator at the Bretton Woods conference, Harry Dexter White, that, as he put it, "The United States dollar and gold are synonymous"? That statement from 1944 sums up nicely the vast gulf between the intellectual world of Bretton Woods and the Nixonian world and the Nixonian beliefs of today. But more important than the role of gold in this discussion -- just as I mentioned in talking about the titles of what one might call this essay -- is the monetary role of central banks as part of their governments, now everywhere in the world.

      As the invitation to this webinar asks, is the international monetary system now permanently open to more money printing and more monetization of government debt, making faith in central banks misplaced and an expectation of an ideal monetary policy foolish? Now, the answers to this series of questions are, yes, yes, yes, and yes. Yes, the international monetary system is now permanently open to more money printing. Yes, the international monetary system is now vastly more open to the monetization of government debt, as we're experiencing these days. We might note it's also open to the monetization of real estate mortgages by the federal reserve big time -- for a couple of trillion dollars -- and to other assets, such as equity securities by the Central Bank of Switzerland, for example.

      And yes, faith in central banks, should you happen to suffer from it, is misplaced. And yes, the expectation of an ideal monetary system is foolish. Such a thing does not exist. There is no ideal. There are only trade-offs. As usual in economics and in politics, everything has a cost and nothing is free. So we should note, for example, while Nixon's decision and announcement of 1971 avoided the default by the United States when people were demanding gold and they would run out of gold, well -- but they could avoid that default only by defaulting on their commitment to redeem dollars at all.

      The next big cost of the decision was the so-called great inflation of the 1970s which was immensely destructive and maybe is a little hard to remember for many people now. But the runaway inflation was the dominant financial reality of the time. Following the inflation of the 1970s came a series of financial crises. First, a disastrous series of crises in the 1980s, and then another series of crises in the 1990s, and then in the 2000s and then in the 2010s, and then, of course, in 2020. So the monetary system of pure fiat currencies and floating exchange rates, which had strong and serious financial theoretical support and practical reasons to do it, has gotten us into -- we might have had them anyway, who knows -- but we have had a whole series of credit and foreign exchange and financial crises—about one a decade.

      Now, what would have happened if President Nixon had made a different decision 50 years ago? First, of course, we have to remember that Nixon and his advisors, as you may remember, went for several days to Camp David to debate all this and work this out. And they knew at the time -- and we should remember that nobody knew what would happen after this announcement. They decided what they were going to do, but then nobody really knew how it would turn out. But they did know that they had to do something. It looked like there was a building run on gold, and of course, like any fractional reserve system, the United States had many multiples of dollar liabilities outstanding greater than the amount of gold they had as people started to demand their gold back. And France is a particular example.

      In retrospect, it's a great decision they made to take the gold instead of the rapidly depreciating dollar. Other countries at the time did not demand gold, particularly the ones that were most dependent on United States military protection and were big dollar holders— namely Germany -- West Germany, at the time -- and Japan, were loyal holders. And they took the losses when we reneged on Bretton Woods. But certainly, others were demanding gold. And France, notably, was demanding gold. And they could see the gold running down. So they had to do something.

      Secretary of the Treasury Connally, at the time, said, "We're sending out our gold by the bushel full," or words to that effect. We've got to do something and we've got to do it now. So that's what they decided to do. So they had to do something, but they didn't have to just cut off the redemption in gold. They could have devalued the dollar in terms of gold. And they knew that. That had various problems with it. One, it's very politically unpopular to announce you're devaluing your currency. Now, note, what they did resulted in devaluation, but it wasn't formally a devaluation.

      And the uncertainty is also hard. If you devalue, you have to devalue to some other number, but what is it? $70 an ounce? The Prime Minister of England suggested a decade before, to President Kennedy, "You're at $35 an ounce, just go to 70." Well, that would be a 100 percent rise in the gold price or fall in the dollar. Would it be -- one of my academic friends suggested to me recently, they should have gone to $100 an ounce in '71, and that would have been better. But nobody knows. You can't even know in retrospect, let alone for them at the time, what the right number was.

      Now, two of the participants at Camp David before the 1971 announcement -- namely, the chairman of the Federal Reserve, Arthur Burns, and a future famous chairman of the Federal Reserve, Paul Volcker -- both favored trying to keep Bretton Woods going, effectively devaluing, working it out with the other countries. But that was not the decision. The decision was to stop redemption of gold. However, even then, in his speech, President Nixon -- and I remind you this was a Sunday evening at prime time and on TV. They cut off other popular programming to bring you this announcement announcing the suspension of gold convertibility, along with other things -- and by the way, blaming it all on the international money speculators.

      But what Nixon said, specifically, was, "I've ordered Secretary Connally, temporarily, to cease redemption of gold." Temporarily. Well, of course, it turned out to be permanent, and maybe will always be permanent. But at the time, they thought maybe it would be temporary and they'd work something else out. So you have all this uncertainty. They had to do something. They could have done other things, but this is what they did choose at the time. And it's a choice that we still have today. So what did happen was, for the first time ever in history, in peacetime, there was a worldwide fiat currency system. Note that it was common in wars to debase your currency and print up however much money you needed to pay the soldiers and to buy the ammunition and the tanks. But in peacetime, this is the first time ever.

      And so here we are now, with this system. Now, and going forward, we’re all Nixonians. And they have these problems, like, if it's just up to the central banks, as part of the governments that they are, to print up however much money they want, well, where does the discipline come from? Why don't you print up any amount and have as much inflation as somebody might be surprised by? But you caused it anyway. And there's, of course, the temptation of politicians who always want to spend to make their constituents happy. Suppose you can spend without taxing. It's kind of a political dream to just have the central bank print up what you need.

      Borrow the money from the central bank, which is really just borrowing the money from yourself, which is really not borrowing at all. It's printing it up. This opens the temptation to so-called modern monetary theory. I write that "modern" monetary theory because printing up the money is an exceptionally old financial idea. And so we have all these temptations. We're living them now. How much printing can there be without doing serious damage? And it all goes back to Sunday evening, August 15, 9:00 p.m. Eastern time, President Nixon's famous announcement, which we need to remember because it's so important for now and in the future. Thanks, Wayne.

Hon. Wayne A. Abernathy:  Thank you, Alex. Plenty of interesting things there. And not knowing quite where to begin, let me go back to a historical question to help this conversation go forward. And I want to really go back to the Bretton Woods system. This was created -- the system -- in the midst of World War II. And it was, supposedly, to be something that was going to last as far as the eye could see. It was supposed to be a new way of dealing with the issues of how the countries exchanged with one another and traded with one another, and so forth.

      And so the question I have -- was the Bretton Woods system doomed to, eventually, the kind of failure where you would get a significant country like the United States -- or maybe a France or another country -- that would have its currency so far out of whack that the only way that you could address the problem would be to suspend that system? Or could they actually have muddled along?

Alex J. Pollock:  Bretton Woods, as you say, Wayne -- and that's a really good question -- was created -- it wasn't quite in the middle of the war. It was 1944 when they could see the end coming. And they wanted to avoid the mistakes that had been made after the First World War and then led into the 20s and the 30s. And I think they did a pretty good job. When you think Bretton Woods didn't last very long, as a historical idea -- I mean, it was approved by the Congress and became law, or became an agreed-upon international treaty, in 1945. It lasted until 1971. So that's 26 years—not very long. But on the other hand, as a human creation, maybe 26 years is pretty good.

      It survived through the amazing rebirth of economic growth and rebuilding of the world after the unbelievable destruction of World War II. So it had a good day. But did it have a fatal flaw? The fatal flaw -- you said that some country -- they knew that any time you set parities -- because under Bretton Woods, you had a fixed exchange rate between major currencies -- everybody had a say. Alright, it's four pounds to the dollar -- four dollars to the pound, or four Deutschmarks to the dollar, as it was, or four Swiss francs, and so on. But they knew that those would need to be adjusted from time to time, that things would change, some people would do better than others, some people would have more inflation, some would be more competitive, and you'd have to change them. And so they built the changing the parities into the system.

      And then they built in, through the original meaning of the international monetary fund, a kind of bank to finance the period of tension when things had to be changed. But what couldn't be changed in Bretton Woods was the unique position of the United States. Everybody pegged their currency to the US dollar, and the US promised to redeem dollars in gold. And that, as it became clearer -- as the 1950s and 1960s progressed -- and it seemed especially clear to the French who described this arrangement as the exorbitant privilege given to the United States because it meant the United States could run up its foreign debt the way no one else was allowed to. And the French resented this greatly. And perhaps others did as well, but the French were very vocal about it.

      Anyway, so you had this unique position of the United States. Now, did that mean the system had to fail? I don't -- it certainly meant that you’d have to have a big change someday when it turned out that the parity set for the dollar was not sustainable. Would that have happened without the Vietnam War and the Lyndon Johnson guns and butter inflation? Maybe not. So it depended on the -- you might say on the international geopolitics of the world and the American role. But it certainly did give a unique role for the United States. As I said before, could it have been fixed by just adjusting the parity—the dollar—so you depreciated the dollar against gold? After all, whether you have enough gold or not depends on the price. I mean, if you make the exchange rate in dollars -- on enough dollars per ounces of gold, you'll always have enough gold. Those are all imponderables. But it certainly had -- Bretton Woods, like all human creations, had built-in tensions and problems just like the current Nixonian system does.

Hon. Wayne A. Abernathy:  It sounds like, from what you're saying, Alex, that the Bretton Woods system, as it was put in place, given the prominent role of the United States, was that it was to act as a discipline on United States economic policy.

Alex J. Pollock:  Yes, that's true. Yes.

Hon. Wayne A. Abernathy:  And Nixon, in essence, decided, rather than face that discipline, "I'm going to throw it off." Is that correct? Would you say that's right?

Alex J. Pollock:  I think that's right, although it was too late by then. By the time Nixon was looking at this problem -- and his very smart and top-class set of advisors all gathered out there at Camp David -- by that time, it was too late to face that this would -- the dollar was going to go down one way or another because the lack of discipline all happened during the 1960s with the run-up of US foreign obligations and US inflation. But yes -- and that's, of course, one of the things the French really resented was that everybody else was disciplined by the system, but not the United States in the short run although the system was intended, as you so rightly say, to be a discipline in the long run. And the redeemability of a currency is always a discipline on the central banks printing, and on the government spending.

      Well, of course, governments and central banks don't like to be disciplined by something outside themselves, like a need to redeem. And the United States didn't either. And as I said, you have to think about it in the context -- the Cold War is on, there’s world geopolitical competition going on, you have the amazing recovery of the European and Japanese, in particular, economies by this time. So there are going to be these stresses. I don't think Bretton Woods could have survived without major changes, like in the US dollar parity. Whether it could have been adjusted, of course, is one of those things that you can always debate because no one knows what the true counterfactual would have been.

Hon. Wayne A. Abernathy:  Taking a step from then into today -- still, the significant role of the United States -- the United States dollar in the global economy continues, maybe not quite as much as it was in '71, but it still predominates. What is the discipline on the US dollar today? Or on US economic policy, vis-à-vis the global community? We understand the disciplines we have within the United States. What acts as a discipline globally? Or does the rest of the world basically just have to take how US economic policy is affecting the dollar and affecting them?

Alex J. Pollock:  Yes. That is a key point. I think one of the surprises out of 1971 and the cutting off of redeemability was the dollar continued right on as the world's dominant currency in spite of the fact that it depreciated a lot. I mentioned -- well let's think of the Swiss franc, since it didn't turn into the euro -- four Swiss francs to the dollar in 1971. Today, less than one Swiss franc will buy you a dollar; 360 Japanese yen in 1971 -- today, less than a hundred or so. So the dollar did have tremendous depreciation. But its amazing role as dominant international currency continues. And along with that, the ability -- the exorbitant privilege, as the French said, to get other people to finance you by holding your liabilities, continues.

      Well, the reason for that is the underlying, enterprising strength of the American market economy and its huge size relative to other people. But note -- put all the euro countries together; they're about as big as the United States. They don't have that dollar, so there are some other things in there as well like the deficit in the financial markets. But I think it is a surprise that, having cut off what -- at least if you were Harry Dexter White -- you thought was an essential idea, as did most people at this time -- this link of gold to the dollar -- now suddenly, that went away. But the dollar is still dominant, and we still maintain our exorbitant privilege. So now believers in cryptocurrencies and bitcoins think that those might change it, but that's another discussion.

Hon. Wayne A. Abernathy:  That is another discussion, and certainly one that we can look at another time. I do note, though, that at least for the last several years, there's been, at least, talk at the European community that they would like to see the euro be something of a challenge to the dollar in terms of its international role. So far, that hasn't gone very far. I was at a meeting a few years ago in Beijing where we had -- through translation, I heard -- I presume the translation was fair -- we had a speaker from the Chinese Communist Party, making a very impassioned speech about how the role of the US dollar had to end. But I haven't seen anything that's really done that. But I think, to the extent the Bretton Woods system assumed that the US role was permanent, is it a mistake to assume that the US dollar role today is a given, or can't actually -- or could actually become a troubled thing?

Alex J. Pollock:  Well, if we were having this webinar in, let's say, July 1914, instead of August 1914 -- in July 1914, we would’ve assume that the dominant worldwide role of the pound sterling -- which was the king currency of the whole world and the currency of the capital markets capital of the world, namely London -- looked pretty solid. And it wasn't, as it turned out. It was basically destroyed by the First World War, which gave the dollar the chance to assume its then-dominant role in New York to replace London, basically, all as a result of the printing that all of the countries involved in the First World War did to finance the war and to destroy the value of their currencies while they were at it.

      So no, nothing is permanent. We know that. All things are tradeoffs. And certainly, both Chinese and Europeans and bitcoin enthusiasts and whatnot think, "Well, couldn't we replace the role of the dollar?" And I don't think you should always -- you should never assume such things can't happen because the world has a way of surprising us. As an author of a book once said, "We’re always surprised." And our imaginations do not limit the possibilities of the world, just like, I think, the world was surprised by Nixon's action in 1971 -- still with us today. I don't think there's much chance we're going back to pre-1971, but in the fullness of time, it seems to me, we certainly could go to something other than we've got.

      You asked me before, Wayne, and I didn't answer, "What is the limit, or what is the discipline?" And of course, the limit of money-printing -- whether you call it modern monetary theory or something else -- is always destruction of the value of the currency, otherwise known as rapid inflation. And that will destroy wages and destroy savings. It does it slowly if the inflation is fairly low. But it does it rapidly and noticeably if the inflation is high. The Federal Reserve, in December last year, predicted 2021 inflation would be 1.8 percent. That was another of their completely mistaken forecasts, of which there are many over the years.

      And one of the reasons why it's so hard to have discipline on central banks is that nobody, including the central banks themselves, really knows what the results of their actions will be. But the discipline is, I believe -- and the most important one -- the [inaudible 00:36:19] between, as I said, what they used to call "honest money" -- that is to say, money that maintained its value versus a money -- which it becomes clear, both to the domestic population and to the international holders -- is rapidly depreciating in value. And that is an ongoing discipline, which, I believe, cannot be avoided.

Hon. Wayne A. Abernathy:  That brings me to the other question I'd like to ask. And perhaps, as I ask this question, and Alex answers it, you may have some questions you wish to point. But this is -- as you're mentioning, the discipline sounds like there is, in a sense, a market discipline there, that whatever you try to do to avoid the markets, the markets assert themselves. And I'm wondering, wasn't it better to replace the Bretton Woods system of government-pegged values with a system where the markets, by and large, decided the values of currency? We, in essence, have that domestically, but we didn't have that internationally. But now, don't we have both?

Alex J. Pollock:  Well, domestically, we have, of course, vibrant markets. We hope to keep them vibrant under the various pressures of the day. But we also have a mandated single currency. Now, if you were really a total free-market thinker, you might like to have, as Friedrich Hayek proposed in 1974, multiple currencies operating within a domestic economy, as well. That’s one of the foundational ideas of the cryptocurrency -- the multiple competing currency.

      Now, at the time, in 1971, of course there were strong voices. Milton Friedman was the leading thinker of this, saying, "Well, of course you have to have floating exchange rates because nobody knows what the right exchange rate is." George Schultz, who was one of the principal advisors at the Camp David meetings leading up to Nixon's announcement, favored floating exchange rates. And theoretically, it's appealing, isn't it? You say, "Well, we don't know what it should be, so we'll let the market decide." And that's what most people still think. As I said in the article, if you ask almost any economist, "Was this a good thing that Nixon did in 1971?" they say, "Absolutely. Get rid of this outmoded link to the barbarous relic, as Keynes called gold, and we just have a market."

      And you know, that's an argument, but it doesn't get you to the point I'd like us all to understand. It doesn't get us to the ideal world. It gets us to a world where there's still plenty of problems -- like, where, then is the discipline because it really isn't just a market. It's a market plus the manipulations of the central banks. That's what the exchange market is, just like interest rates. We don't have an interest-rate-free market. In fact, everyone runs around saying, "Well, the Federal Reserve sets interest rates." That's the opposite of a market idea. You don't have the market setting interest rates. Same is true of exchange rates. There is a market, but there is also the interventionist manipulative activities of all the various central banks in this market. And that's one reason why we can be sure that we won't ever reach the ideal world.

Hon. Wayne A. Abernathy:  One of our participants has a question now, if I can put that to you. And I think it ties into this discussion where we are. It reads as follows, "Some historians to Roman times link debasing the currency -- Roman times of printing money, or as they would make impure gold -- to the need to tax capital to tackle inequality. Do you see any linkage to these three issues—inequality, capital taxation, and the non-gold free printing of money by the global superpower?" That's the question.

Alex J. Pollock:  Well, I'll just start off by saying, I mentioned that "modern" monetary theory is one of the oldest ideas. And this questioner, by bringing up the Romans -- and before that, the Greeks -- depreciating the currency was an idea that was already there. I have to just take a minute to tell one of my favorite stories, which is the story of the tyrant Dionysius of Syracuse, who borrowed money from his subjects, found that he was unable to pay in silver, as he had promised. So his response was simply to expropriate all the silver coinage—the drachmas—from the citizens. They had to turn them in to the government on pain of death. And after they turned them in, he melted them down, and restamped, according to the story, each one drachma coin, two drachmas, and then paid off the debt. Well, that's exactly what governments and central banks do now. And that's a form of taxation.

      So if your idea is that you want to take money from some people and give it to other people, well, debasing the currency is one way to do it. It's a very handy way for politicians to do it because you don't have to enact any legislation. You just do it through your central bank. It's a sneaky way of taking some people's money and giving it to the people who vote for you. I have to tell, in this context -- thank you, whoever you are, for the great question -- do you know the difference between banking and politics? You may have heard this before, Wayne. I don't know. What's the difference between banking and politics? 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. And debasing the currency is one way to do that.

Hon. Wayne A. Abernathy:  Another question, here. And actually, this is -- if you're willing to take something -- a cryptocurrency question, if I may.

Alex J. Pollock:  Oh, sure.

Hon. Wayne A. Abernathy:  Someone has asked that.

Alex J. Pollock:  Sure.

Hon. Wayne A. Abernathy:  Here's the question. "So, are cryptocurrencies a new step away from monetary discipline, or a step back toward them? And depending upon the nature of the cryptocurrencies to those which countries would benefit, and so forth, under what we see out there, are there certain countries that benefit more than others?"

Alex J. Pollock:  Well, I think that a pure cryptocurrency, like Bitcoin, is an ultimate fiat currency because although we have fiat currencies pure paper, they are hooked to governments who have armies and force and the ability to make people do things. A Bitcoin is a pure fiat currency. It isn't redeemable in anything. It gives its holder no right to any collateral or redemption, and also, it doesn't have any force behind it. So, that's maybe even a purer fiat currency, a privately issued -- a key theoretical point in all this is, can a privately-issued fiat currency, as opposed to a government-issued fiat currency, actually serve as a currency? And I think the answer to that, actually, is no, but we're still experimenting with that in the market.

      So-called stable-value currencies are, themselves, backed by other fiat currency. They're just a dollar substitute—a kind of payments mechanism. And some of them, at least, say, "Well, we are backed by the so-called dollar reserves." But they're pretty reticent about saying what those dollar reserves consist of. But note, the currency does not give you the right to redeem in dollar reserves, at least in some cases. And depending on what reserves -- as so-called -- you choose to hold -- let's say you'd like to have some junk bonds in your reserves, or Russian debt, or whatnot, what you have is exactly a bank, and the problems of any fractional reserve bank. Maybe the assets won't be sufficient to cover your liabilities. And there -- you're just going to repeat banking.

      Now, as to what countries could benefit -- I think if you talk about cryptocurrencies and countries, then you shift into this very current debate, on which I have written, about whether central banks themselves should issue cryptocurrencies or digital currencies. I guess you can't call them, really, cryptocurrencies if they're issued by the central bank, but it's the same idea. Should there be a pure digital currency issued by various central banks? And then some people say, "Well, this is another way that China wants to create a more powerful currency for itself, and therefore, a more powerful government, by having a Chinese popular central bank or government-issued digital currency." Should the Federal Reserve issue its own digital currency?

      What you might think -- just build on the -- if it succeeded -- on the already existing dominance of the US dollar in international payments. It would certainly make the central banks more dominant than the private banks, which is one of the big drawbacks to them. Remembering that, a long time ago, central – I say, take the Bank of England -- was set up as a special bank with special privileges, but it was a general bank. It did business with the public and made loans. Well, a central bank, which became the dominant deposit-taker through its digital currency, and thereby had all this money, which it had to do something with, and so it made loans. It would be kind of a retrogressive movement backwards in central bank history to central banks, which are competitive with all the private banks as opposed to having a particular role.

      So none of these things are clear, as always, in economics and finance. And I have a saying, which is, "In every economic question, you can always find numerous economists on both sides, or perhaps on all sides, of the issue." Which only shows, it's not a science. It's a kind of philosophical theory. And that's certainly true of all these questions of cryptocurrencies and how this will or should play out.

Hon. Wayne A. Abernathy:  I think it also shows that, really, many of these questions -- certainly with regard to currencies and money and so forth -- they aren't as new as we may think them to be.

Alex J. Pollock:  Oh, for sure.

Hon. Wayne A. Abernathy:  They are really quite old, aren't they?

Alex J. Pollock:  Yes, for sure.

Hon. Wayne A. Abernathy:  Here's a question I think relates to that. "Would you be in favor" -- this is one we've received here from one of our participants -- "Would you be in favor of a return to a gold-based monetary system if it ever became politically possible. And would this require a change in legal tender laws to allow gold to legally compete with the central bank fiat money?"

Alex J. Pollock:  Yes. Well, I think what I would be in favor with, in lines of Hayek's theory, is competitive currencies. If you had a currency, redeemable in gold at a given rate -- you know, get such and such an ounce of gold for whatever unit of this currency is -- that might be a very interesting experiment to let it compete with the fiat currency issued by the government in the form of its central bank -- and used to finance potentially limitless deficits through monetization, as I said before, let alone mortgages, through monetization.

      However, there's very little chance that any government would like this idea of allowing competitive currencies. On the issue of legal tender, that's a really important one, historically. At one time, 150 years ago in this country, the issue of legal tender was one of the hottest topics. And there were a series of interesting cases which ended up in the Supreme Court about whether it was constitutional for the United States government to have made its non-redeemable paper currency during the Civil War a legal tender that you had to take if you had previously entered into a contract requiring payment in gold. And as you may remember, the Supreme Court first held that it was unconstitutional, and then President Grant appointed a couple more justices, and the next time around, they held that it was constitutional. But it was a big issue in the day.

      And that's an issue we've sort of forgotten about, the forcing of currency on the public -- which is a fiat currency through legal tender. Of course, that had a rerun in the 1930s, when the United States government -- what seems amazing now -- confiscated all the gold of its citizens, gave them paper money -- depreciated paper money, instead. It happened in 1933. That ended up in the Supreme Court, too. And the Supreme Court held, by a vote of 5-4, that the government, being a sovereign, had the power to do this because if you're a sovereign, you can do these sorts of things.

Hon. Wayne A. Abernathy:  As I recall, then --.

Alex. J. Pollock:  Even for The Federalist Society, a fundamental philosophy, Wayne.

Hon. Wayne A. Abernathy:  Oh, absolutely. And I think these constitutional questions are important. That's why you have a constitution, is to try to deal with these perennial questions. And in that case that you mentioned, I think there is also the issue of whether the paper, or debt, of the government, that said it was to be paid in gold -- and the government said, "Well, we're not going to pay that in gold anymore" -- whether that was unconstitutional. As I recall, the courts upheld that as well.

Alex J. Pollock:  No, you're absolutely right. That was. They used the same cases. And you're absolutely right. Nobody disputed, including the government itself, that the clear and unambiguous commitment of the government to pay in gold on its bonds had been made. But I like to summarize this in the following saying, "What does it mean to be sovereign when it comes to debt? It means if you don't feel like paying, you don't have to. You just default, just like Nixon in '71." Well, I know we entered into these Bretton Woods agreements saying we would redeem these dollars, if you're a foreign government, for gold. But by the way, we're not doing it.

      And of course, this was extremely controversial at the time. A lot of other foreign countries and their governments were up in arms about this. And you may remember, there's a well-known -- I was going to say famous, but maybe it's notorious -- statement of the Secretary of the Treasury, John Connally, at the time, who said to the Europeans, who were upset, "It's our currency, but it's your problem."

Hon. Wayne A. Abernathy:  That reminds me of the Pollock law of finance, as I recall, which is, "Debts that cannot be repaid, will not be repaid."

Alex J. Pollock:  Thank you. Absolutely right.

Hon. Wayne A. Abernathy:  It's a matter of who bears the loss, really.

Alex J. Pollock:  That's exactly right. Exactly right. And we're going through that again now, in the aftermath of the Covid crisis and its financing. Now, it's going to be all about who bears the loss. Well, one of the ways you force people to bear the loss is by inflating, is by monetization, and putting the loss on the holders of your currency or savings denominated in your currency.

Hon. Wayne A. Abernathy:  And now, a question here. As we've been talking about the role of gold, one of our participants asked this question, "What about other commodities being the support for currency? Doesn't a floating exchange rate system just replace gold as a reference commodity with currency itself, or are there other commodities that could compete with gold and be, maybe, more broadly accepted domestically or internationally?"

Alex J. Pollock:  That's a classic question, as well, and a good one. And many people have proposed some kind of a basket of commodities that might be a basis for a currency. Theoretically, you could certainly imagine it. You know, you get some kind of a generalized commodity index or something. It's hard to do practically because how do you form the index? And what are the weightings? And the world changes and -- just like it did for the Bretton Woods parities -- but it’s certainly, theoretically, conceivable. Gold is handy, as we know, because it lasts forever and it doesn't rust, and it's fairly small, if you want to carry some coins around as one family of famous investment bankers who got out of Germany in time -- 1938 or so -- said, "The only real wealth is what you can take with you inside a toothpaste tube or sewed inside your clothes." And gold qualifies there.

      But this is a classic and perfectly sensible idea. As I remember, Irving Fischer, who wrote a wonderful book on the money called The Money Illusion -- the difference between the real inflation-adjusted value of money and the nominal value of money -- back in, I don't know, 1910, or something like that, later on, was one of the followers of central banks trying to stabilize prices, as they used to do, as opposed to constantly inflating prices. And he, as I recall, had some kind of an idea like this, of a basket of commodities you're trying to stabilize against. I think it's one of those things it's harder to do in practice than in theory.

Hon. Wayne A. Abernathy:  And I have a short question that's been asked here, but I presume the answer is not short. But, "Do you have a definition of 'the dollar?'"

Alex J. Pollock:  Well, yeah. That's an easy definition. It's a unit of account on the books of the Federal Reserve. It's sometimes represented by a piece of paper that says, "This is one dollar." Or you can exchange that piece of paper. It interchanges with the books in the Federal Reserve for an accounting entry called "the dollar," whereas, of course, before, at least if you were a foreigner, the definition of a dollar was 1/35 of an ounce of gold.

Hon. Wayne A. Abernathy:  In essence, what fiat currency has done is made it a flexible definition.

Alex J. Pollock:  Yes. Well, and of course, if you're a central banker or a politician, that's what you like. You know that, Wayne, having worked on legislation.

Hon. Wayne A. Abernathy:  We're getting near the end of our time, but I do want to -- this further question, which goes to one that I've had for a while. As you know, a question I've had is, "When the Bretton Woods system disappeared, why did the Bretton Woods institutions remain?" And someone -- one of our participants is asking the question -- is maybe the IMF special drawing rights work as some kind of basis for global currencies?

Alex J. Pollock:  Well, that's what they thought in the 1960s, when these were created, the special drawing. Of course, the special drawing rights are only a basket of fiat currencies. But that's what they were hoping at the time because, already in the 60s, one of the things that President Nixon said in his speech in 1971 was, "We keep having these dollar crises, one a year." And this was all during the 60s as the US deficits were higher and inflation was higher, and the dollar was under pressure, and people were building up large-dollar claims in foreign hands. And SDRs were meant to be a potential way around it. It never seemed to have worked too well, but it definitely was the theory at the time.

      Can I just stick in one more comment? I meant to say this before. In the 1971 speech, of course, it wasn't only about stopping to redeem dollars for gold. It was also an amazing thing, really, for what you would have thought a basically market-oriented administration to do -- was to put in wage and price controls. And you, before, Wayne, said something -- "Well can't you just control these things? But does the market ultimately overcome them?" And of course, that's what happened in the early 70s. They put in wage and price controls. It turned into a vast bureaucracy. It didn't succeed in the end. And when they finally had to be taken off, then the inflation exploded in the mid-1970s and on. So, yes, you try these control mechanisms, but in the end, they won't work either.

Hon. Wayne A. Abernathy:  Well, as with all very fascinating conversations, the clock is against us. And it would pretty much run out of the time we've allocated. But this conversation, of course, will continue. One that we really didn't get into as much, and we'll certainly save that for another day, is how the end of Bretton Woods opened up the door for just, almost, limitless deficit spending all around the world, for economies all around the world.

Alex J. Pollock:  Oh, yes. And what we have today -- that's why this is so relevant. What we have today -- deficit spending is made possible by monetization, which is the freedom of the central banks, which as I suggested, you should not foolishly have faith in -- all created by the action of President Nixon 50 years ago. So this is history, but it's also very lively today and going forward. We’re living in this Nixonian world with all of the problems that go along with it.

Hon. Wayne A. Abernathy:  Where do we find the discipline? And that's, of course, the question.

Alex J. Pollock:  Yes.

Hon. Wayne A. Abernathy:  Any final words before we conclude?

Alex J. Pollock:  Well, that's a great final question. So let's work on that. Where do we find the discipline? We know that under the Constitution of the United States, the discipline is supposed to come from the Congress. The money power is clearly vested in the Congress. And one of the astonishing acts of arrogance, really, was the Federal Reserve saying, on its own, it could set an inflation target, and depreciate the currency infinitely. Now, can we get such discipline from the current Congress? Doesn't seem too likely. But one might hope that there would be a Congress, someday. These are deep and hugely important, but classical, problems. Unfortunately, answers aren't that easy.

Hon. Wayne A. Abernathy:  Thank you very much. Wonderful discussion. And certainly, as we say, the conversation will continue. Evelyn, I think the time is back to you— Evelyn Hildebrand, from The Federalist Society.

Evelyn Hildebrand:  Yes. Thank you very much to you, Wayne and Alex, for this great discussion. Thank you to our audience. You sent in questions and comments and participated. Very grateful for everyone's time this afternoon. If you have any questions or comments for The Federalist Society, please send those to us at info@fed-soc.org. And we welcome your comments. And I would only add our gratitude to our speaker and our moderator this afternoon. And with that, we are adjourned. Thank you, everyone.

[Music]

Dean Reuter:  Thank you for listening to this episode of Teleforum, a podcast of The Federalist Society’s practice groups. For more information about The Federalist Society, the practice groups, and to become a Federalist Society member, please visit our website at fedsoc.org.

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.