The government triangle at the heart of U.S. housing finance

Published by Housing Finance International.

The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system.

In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. “The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,” with “endless pleadings of self-interest.”

Such pleadings have characterized the U.S. housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt. That’s $8 trillion. This sum is about 70% of the $11 trillion of mortgages in the country. Does it make sense for the U.S. government to guarantee 70% of the whole market? It does not. But so it has evolved in the politics of U.S. housing.

As part of this evolution, U.S. mortgage finance has become dominated by a tightly linked government triangle. The first leg of the triangle is composed of Fannie, Freddie and Ginnie (with its associated Federal Housing Administration). This leg we may call the Government Housing Complex.

The second leg in the government mortgage triangle is the United States Treasury. The Treasury is fully liable for all the obligations of the 100% government-owned Ginnie. The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too. Through clever financial lawyering, it is not a legal guarantee, however, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total U.S. government debt. Unsurprisingly, this is not politically desired.

The same politically undesired, but honest, accounting result would follow if, on top of owning 100% of Fannie and Freddie’s $270 billion of senior preferred stock, the Treasury controlled 80% of their common stock. Government accounting rules require that at 80% the entity's debt must be consolidated into the government debt. That is why Treasury controls 79.9%, not 80%, of their common stock, which is done through warrants with an exercise price that rounds to zero. This is historically consistent, since to get Fannie’s debt off the government’s books was the main reason for its 1968 restructuring it into a so-called “government-sponsored enterprise,” so that President Lyndon Johnson’s federal deficit did not look as big.

The Federal Reserve didn’t used to be, but it has become the third leg of the government mortgage triangle, as the single biggest funder of mortgages by far. Its $2.7 trillion of mortgage securities holdings are limited to those guaranteed by Fannie, Freddie and Ginnie. But those guarantees are only credible because they are in turn backed by the credit of the Treasury.

However, there is another curious circle here. How can the Treasury, which runs huge continuing deficits and runs up its debt year after year, be thought such a good credit? It turns out that an essential support of the credit of the Treasury is the readiness of the Federal Reserve always to buy government debt by printing up the money to do so. This is why having a fiat currency central bank of its own is so very useful to any government. The intertwined credit of the Treasury and of the Federal Reserve are intriguingly dependent on each other, and they both support the credit of the government mortgage complex of Fannie, Freddie and Ginnie.

In this sense, it is helpful to think of the Federal Reserve and the Treasury as one thing – one combined government financing operation, whose financial statements should be consolidated. In such consolidated statements, the $5.8 trillion of Treasury debt owned by the Federal Reserve would be a consolidating elimination. With this approach, we could see the reality more clearly. The Federal Reserve buys and monetizes Treasury debt. Consolidate the statements. The Treasury bonds disappear. What is really happening? The consolidated government prints up money and spends it. In order to spend, it is taxing by monetary inflation, without the need to vote on taxes and without the need for the legislature to act at all.

We should then bring Fannie, Freddie and Ginnie into the consolidation. The government mortgage complex issues mortgage securities, then the Federal Reserve buys and monetizes them. Consolidate the statements, and the mortgage securities held by the Federal Reserve also disappear as a consolidating elimination. What reality is left? The consolidated government prints up “free” money and uses it to make mortgage loans, inflating the price of houses. This arrangement suits housing lobbyists, to be sure, and the proponents of “modern monetary theory” who wish to have no limits on the government’s ability to spend. Of course, this theory is an illusion. The reality, and the most fundamental of all economic principles is: Nothing is free. Free printed money becomes very expensive indeed when it turns into destructive inflation.

In principle, a fiat currency central bank can buy and monetize not just bonds and mortgages, but any asset. For example, the Swiss National Bank (the central bank) includes a large portfolio of U.S. stocks in its investments. It recently reported a net loss of $33 billion for the first quarter of 2022, caused by its $37 billion in investment losses. In the U.S. case, the Federal Reserve in the Covid financial crisis, in cooperation with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent state of Illinois as investments for the central bank.

Further back in history, in the 1960s, some members of the U.S. Congress thought, with the encouragement of the savings & loan industry, that the Federal Reserve ought to buy bonds to provide money to housing. Federal Reserve Chairman William McChesney Martin resisted, arguing that this would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That was the right answer, consistent with Economics in One Lesson. But it did not please the politicians. Senator William Proxmire pointedly threatened the Fed:

“You recognize, I take it” he said to the Fed Vice Chairman in 1968, “that the Federal Reserve Board is a creature of the Congress? [That] the Congress can create it, abolish it, and so forth?... What would Congress have to do to indicate that it wishes…greater support to the housing market?”

A new Federal Reserve Chairman, Arthur Burns, arrived in 1971, and decided it would be a good idea to “demonstrate a cooperative attitude.” So, the Federal Reserve began to buy the bonds (not mortgages) of federal housing and other government agencies. It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks of Cooperatives, and – believe it or not – the debt of the Washington DC subway system. There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.

The Federal Reserve fortunately managed to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s. Will it be able to get out of its vastly bigger mortgage program now?

In 1978, Hazlitt wrote in The Inflation Crisis, And How to Resolve It: “Inflation, not only in the United States but throughout the world, has… not only continued, but spread and accelerated. The problems it presents, in a score of aspects, have become increasingly grave and urgent.”

In 2022, with U.S. inflation is running at over 8%, here we are again.

As the Federal Reserve now moves to address the inflation, interest rates on the standard American 30-year fixed rate mortgage have gone from their suppressed level of 3% in 2021 to about 5½% in May 2022. Although historically speaking, that is still rather low, it will make many houses unaffordable for those who need a mortgage loan to buy. The interest expense for the same-sized mortgage for the same-priced house has increased by about 80%. How much higher might mortgage interest rates go? With higher mortgage rates, how quickly will the runaway house price inflation end? Will that be followed by a fall in U.S. house prices from their current bubble heights? We are waiting to see.

Letter: Raising a family is economically productive

Published in the Financial Times.

On page 1 of your June 20 edition is a graph which shows women who are “looking after family” as “economically inactive”. What nonsense.

Keeping a household going, raising children and caring for family members is a most productive economic activity — far more productive than, say, marketing cryptocurrencies.

Your mistaken graph is part of the same confusion that thinks cooking in a restaurant is production, but cooking at home isn’t; that working in a day care centre is production, but bringing up your own children isn’t; that growing food to sell is production, but growing your own food isn’t; that painting a room for money is production, but painting your own room isn’t. It’s a pretty silly conceptual mistake. The Financial Times apparently has forgotten that the root meaning of “economics” in Greek is “management of a household.”

Alex J Pollock

Senior Fellow, Mises Institute

Lake Forest, IL, US

Also cited in a following letter:

Letter: At last some recognition for the housewife

In response to the letter by Alex J Pollock (“Raising a family is economically productive”, June 27) I say “hear, hear” and “thank you”!

At last, women who’ve been or are full-time housewives for years are being given recognition as being valuable contributors to the economics of everyday life.

It seems we have saved the “breadwinners” a fortune by rearing the children, doing the cooking, the gardening, painting, walking the dogs, doing the laundry and being a chauffeur.

We also have the time to help with non-profit-making activities in the community. I remember a quote from the late Anita Roddick: “If a woman can run a home, she can run a business”.

It’s a good life too; we are our own bosses, every day is different and it’s up to us to use our free time well.

Sarah Tilson

Kilternan, Ireland

Who owns the Fed’s massive losses?

Published in The Hill and RealClear Markets.

By Paul H. Kupiec and Alex J. Pollock

We estimate that at the end of May, the Federal Reserve had an unrecognized mark-to-market loss of about $540 billion on its $8.8 trillion portfolio of Treasury bonds and mortgage securities. This loss, which will only get larger as interest rates increase, is more than 13 times the Federal Reserve System’s consolidated capital of $41 billion.

Unlike regulated financial institutions, no matter how big the losses it may face, the Federal Reserve will not fail. It can continue to print money even if it is deeply insolvent. But, according to the Federal Reserve Act, Fed losses should impact its shareholders, who are the commercial bank members of the 12 district Federal Reserve banks.

Among Federal Reserve officials and many economists, it is fashionable to argue that any losses the Federal Reserve should suffer, no matter how large, will have no operational consequence. Now that the Fed has already experienced mark-to-market losses of epic proportions and will soon face large operating losses, something it has never seen in its 108-year history, we are about to see if this is true.

Member banks must purchase shares issued by their Federal Reserve district bank. Member banks only pay for half the par value of their required share purchases “while the remaining half of the subscription is subject to call by the Board.”

In addition to potential calls to buy more Federal Reserve bank stock, under the Federal Reserve Act member banks are also required to contribute funds to cover any district reserve bank’s annual operating losses in an amount not to exceed twice the par value of their district bank stock subscription. Note especially the use of the term “shall” and not “may” in the Federal Reserve Act:

“The  shareholders  of every  Federal  reserve  bank shall  be  held  individually responsible,  equally  and  ratably,  and  not  one  for  another,  for  all  contracts, debts,  and  engagements  of  such  bank  to  the  extent  of  the  amount subscriptions  to  such  stock  at  the  par  value  thereof  in  addition  to  the  amount subscribed.” (bold italics added).

Despite congressional revisions to the Federal Reserve Act over more than a century, the current Act still contains this exact passage.

By the Federal Open Market Committee’s own estimates, short-term policy rates will approach 3.5 percent by year-end 2022. Many think policy rates will go higher, maybe much higher, before the Fed successfully contains surging inflation. Our estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent. This estimate assumes the Fed has no realized losses from selling securities. If short-term rates reach 4 percent, we estimate an annualized operating loss of $62 billion, or a loss of 150 percent of the Fed’s total capital.

This unenviable financial situation — huge mark-to-market investment losses and looming negative operating income — is the predictable consequence of the balance sheet the Fed has created. The Fed is paying rising rates of interest on bank reserves and reverse repurchase transactions while its balance sheet is stuffed with low-yielding long-term fixed rate securities. In short, the Fed’s income dynamics resemble those of a typical 1980s savings and loan.

In 2011, the Federal Reserve announced its official position regarding realized losses on its investment portfolio and system operating losses:

“In the unlikely scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.”

Under this unique accounting policy, operating losses do not reduce the Federal Reserve’s reported capital and surplus. A positive reserve bank surplus account is ensured by increasing an imaginary “deferred asset” account district reserve banks will book to offset an operating loss, no matter how large the loss. Among other things, this accounting “innovation” ensures that the Fed can keep paying dividends on its stock. Similar creative “regulatory accounting” has not been utilized since the 1980s when it was used to prop up failing savings institutions.

The Fed’s stated intention is to monetize operating losses and back any newly created currency with an imaginary “deferred asset.” It is impossible to imagine that the authors of the Federal Reserve Act would have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks dividends and interest on their reserve balances, when the act itself makes member banks as stockholders liable for Federal Reserve district bank operating losses.

Clearly, if the Fed is required to comply with the language in the Federal Reserve Act and assess member banks for its operating losses it could impact monetary policy. The prospect of passing Fed operating losses on to member banks could create pressure to avoid losses by limiting the interest rate paid to member banks or discouraging asset sales needed to shrink the Fed’s bloated balance sheet. Moreover, if the Fed’s losses were passed on, some member banks may face potential capital issues themselves.  

Will the Fed ignore the law, monetize its losses, and create a new source of inflationary pressure? Or will it pass its losses on to its shareholders? Stay tuned.

Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?

Published by the American Enterprise Institute.

By Paul H. Kupiec and Alex J. Pollock

Abstract

For the first time in its 108-year history, the Federal Reserve System faces massive and growing mark-to-market losses and is projected to post large operating losses in the near future. In a 2011 policy statement, the Federal Reserve Board outlined its plan to monetize system operating losses notwithstanding the (apparently) little-known fact that the Federal Reserve Act requires Federal Reserve member banks (the stockholders who own the Federal Reserve district banks) to share at least a portion of district reserve bank operating losses. Contrary to opinions expressed by Federal Reserve system officials, should the Fed abide by the legal requirements in the current version of the Federal Reserve Act, operating losses could impact monetary policy. If the Fed chooses to ignore the law and monetize operating losses, member banks will be in the enviable (if difficult to justify) position of directly benefiting from the current inflation. Because they are now paid interest on their reserve balances and receive guaranteed dividends on their Federal Reserve stock, member banks will monetarily benefit from the Fed’s policy to fight inflation while the public bears Federal Reserve system losses. Meanwhile, the public at large will also face the costs of higher interest rates, reduced growth and employment and losses in their investment and retirement account balances. Should the public recognize the implications of the Fed’s plan to monetize its operating losses, the Fed could face an embarrassing “communication problem”.

Read the full PDF here.

Post page here.

Biden’s Appointments Speak to an Extremist Agenda

Published in TownHall.

Perhaps the most outrageous example of the president’s extremist appointments was his nomination of Saule Omarova to head the Office of the Comptroller of the Currency. A graduate of Moscow State University on the Lenin Personal Academic Scholarship, Omarova tweeted in 2019, “Until I came to the US, I couldn’t imagine that things like gender pay gap still existed in today’s world. Say what you will about old USSR, there was no gender pay gap there. Market doesn’t always 'know best.'” In an academic paper Omarova’s advocated that “central bank accounts fully replace — rather than compete with — private bank accounts.” It’s disturbing that a person who spent much of her academic career deriding capitalist institutions and advocating for unprecedented government management of the economy, was nominated for such a critical economic position. At least the nation can be thankful that Omarova withdrew her nomination in December – as many moderate Democrats made clear they could not support her nomination.

Read the rest here.

The INDEX Act Is a Major Step Forward In Corporate Governance

Published in RealClear Markets. Also published in the Federalist Society.

An unsolved problem in American corporate governance is that a few big asset management firms have through their index funds grabbed dominating voting power in hundreds of corporations by voting shares which represent not a penny of their own money at risk. They have in effect said to the real investors whose own money is at risk, “I’ll just vote your shares.  I’ll vote them according to my agenda.  I don’t want to bother with what you think.”

This obviously opens the door for the exercise of hubris, as has perhaps notably been the case with BlackRock, but more importantly, it violates the essential principle that the principals, not the agents, should govern corporations. This principle is well-established and unquestioned when it comes to broker-dealers voting shares held in street name. The brokers can vote on significant matters only with instructions from the economic owners of the shares. Exactly the same clear logic and rule should apply to the managers of the passive funds which have grown so influential using other people’s money.

Now Senators Pat Toomey (R-PA), the Ranking Member of the Senate Banking Committee, and Dan Sullivan (R-Alaska), with eleven co-sponsors, have addressed the problem directly by introducing an excellent bill: The INDEX (Investor Democracy Is Expected) Act. This bill would apply the longstanding logic for broker-dealer voting to passive fund asset manager voting, which makes perfect sense. As Senator Toomey said in announcing the bill, “The INDEX Act returns voting power to the real shareholders…diminishing the consolidation of corporate voting power.” You couldn’t have a goal more basic than that.

This bill ought to be approved by overwhelming bipartisan majorities. To oppose it, any legislator would have to sign up to the following pledge: “I believe Wall Street titans should be able to vote other people’s shares without getting instructions from the real owners.” That does not sound like a political winner.

The asset management firms themselves seem to be feeling the force of the INDEX Act logic. BlackRock said it looks forward “to working with members of Congress and others on ways to help every investor—including individual investors—participate in proxy voting.” Vanguard said it “believes it is important to give investors more of a voice in how their proxies are voted.”

If enacted, as it should be, the INDEX Act will require these nice words to be put into action.

Western Economic Association International: 97th Annual Conference

Conference information here.

June 29-July 3, 2022, in Portland, Oregon

Panel: Stablecoin That Might Work

Date: 6/30/2022
Time: 2:30 PM to 4:15 PM

Organizer

Walker F. Todd, Middle Tennessee State University

Chair

Walker F. Todd, Middle Tennessee State University

Papers

The Chicago Plan and CBDCs (Virtual)

• Presenter(s): Ronnie Phillips

Proposal for a U.S. National Stablecoin System (In Person)

• Presenter(s): Franklin Noll, Noll Historical Consulting, LLC

Which was the Better Design: National Banks of the 19th Century or Stablecoins of the 21st? (Virtual)

• Presenter(s): Alex J. Pollock, Ludwig von Mises Institute

Replacing the Dollar with the SDR in International Reserves (In Person)

• Presenter(s): Warren Coats, International Monetary Fund

Event: Central Bank Digital Currency--Efficient Innovation or the End of the Private Banking System?

Hosted by the Federalist Society.

Central Bank Digital Currencies (CBDC) are the subject of a global debate.  In one version, individuals and businesses would hold deposits directly with the central bank.  Critics point out that the Federal Reserve would then control how these deposits are used, allocating credit to private-sector borrowers and to government spending, arguing that CBDCs would eviscerate the private banking industry and create government surveillance of all financial transactions in the accounts. An alternate version is that CBDCs take the form of a tokenized dollars, distributed through the banking system and operating in parallel with paper currency and bank accounts.  Supporters say this could yield lower transaction costs and more rapid settlement of payments, and could strengthen the international role of the U.S. dollar.

Featuring:

Bert Ely, Principal, Ely & Company, Inc.

Chris Giancarlo, Senior Counsel, Willkie Digital Works LLP; Former Chairman, US Commodity Futures Trading Commission

Greg Baer, President & Chief Executive Officer, Bank Policy Institute

Moderator: Alex J. Pollock, Senior Fellow, the Mises Institute

Letter: Central banker chattiness is a flawed PR strategy

Published in the Financial Times.

Gary Silverman observes that “US central bankers . . . have become relentlessly chatty, appearing on stage and screen” in contrast to “opaqueness in the old days” (“The Fed transforms into reality TV show”, On Wall Street, FT Weekend, April 9).

The former opacity had a huge advantage for central bankers: it hid the fact that they did not know what was going to happen or what they would be doing about it.

Transparency has a corresponding big disadvantage. It makes obvious to all that they have no more knowledge of the future than anybody else.

They cannot escape this problem because the financial and economic future always displays what economists call the “Knightian uncertainty” after Frank Knight’s book Risk, Uncertainty and Profit (1921) and his theory that the future is not only unknown but unknowable.

Given this fact, the Federal Reserve and all central bankers have a public relations problem. Opacity looks like a superior strategy to chattiness.

Why You Can Bet on Another Bubble Popping

Published by Gold Newsletter.

Why do bubbles still prevail in an era of ubiquitous information? Alex J. Pollock, a senior fellow with the Mises Institute, makes the case that fundamental uncertainty in finance and economics is unavoidable.

Recommended Links

• Visit Alex’s website.

• Purchase his books:

  • Finance and Philosophy: Why We’re Always Surprised.

  • Boom and Bust: Financial Cycles and Human Prosperity.

• “What Intellectuals Resent about Laissez Faire,” by Fergus Hodgson.

• “Why Financial Genius Will Fail Again,” by Fergus Hodgson.

• Purchase the book: Manias, Panics, and Crashes: A History of Financial Crises.

Can the Federal Reserve Stop Being the World’s Biggest Savings & Loan?

Published in Housing Finance International Journal. Also published in HCWE.

The Federal Reserve’s huge monetization of residential real estate mortgages is one of the radical developments in the history of American housing finance, central banking, money creation, and credit inflation.

Through this investment, the Federal Reserve has become a new element in the massive interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt, which represents about 70% of the country’s total mortgage loans. In addition, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve. Getting mortgages on the central bank’s balance sheet was a fateful step.

To summarize the story: Into the American financial system strode the Federal Reserve, its pockets filled with newly printed dollars and its printer handy to create more. It bought up the biggest pile of mortgage assets than anybody ever owned. It bought even more Treasury securities, too, accumulating $5.8 trillion of them, so that its balance sheet has reached the memorable total of $8.9 trillion. This is a development not imagined by anyone beforehand, including the Fed itself.

As of March 2022, the Fed owns $2.7 trillion of mortgage securities – in other words, about 23% of all the mortgages in the country are on the central bank’s balance sheet. Moreover, mortgages have become 30% of the Fed’s own inflated total assets. These are truly remarkable numbers, which would certainly have astonished the founders of the Federal Reserve System. I enjoy imagining the architects of the Fed in financial Valhalla, in a lively but puzzled discussion of how their creation of 1913 turned into a giant mortgage funder. Nothing could have been further from their intentions.

Since March 2021, one year ago, the Fed has added $557 billion to its mortgage portfolio, increasing the balance by $46 billion a month on average. It had to buy a lot more than that in order first to replace the repayments and prepayments of the underlying mortgages and then increase the outstanding holdings. The Fed has been the reliable Big Bid in the market, buying mortgages with one hand and printing money to make the purchases with the other.

During this time, the giant U.S. housing sector, representing about $38 trillion in current market value of houses, has experienced an amazing price inflation. U.S. house prices shot up 17% in 2021, as measured by the median sales price, and by 18.8%, as measured by the Case-Shiller national house price index. In January 2022, average house prices rose at the rate of 17%. House prices are far over the 2006 peak which was reached during the infamous Housing Bubble (which was followed by six years of falling prices).

Faced with the rapid escalation in house prices, the Fed unbelievably kept on stimulating the housing market by buying ever more mortgage securities. It thus further inflated the asset price bubble, subsidizing mortgages and distorting house and land prices.

By acquiring $2.7 trillion in mortgages on its balance sheet, the Federal Reserve has made itself far and away the biggest savings & loan institution in the world. Like the savings & loans of old, the Fed owns very long-term fixed-rate assets, and it neither marks its investments to market in its financial statements nor hedges it’s extremely large interest rate risk.

Like the saving & loans of the 1970s, it has loaded up on 15 and 30-year fixed rate mortgages, just in time to experience a period of threateningly high inflation.

Will the Federal Reserve withdraw from being a giant savings & loan? On March 16, 2022, the Fed announced that it “expects to begin reducing its holdings of Treasury securities and agency debt securities and mortgage-backed securities.” This move is very late. The specific decision may be made, the Fed said, “at a coming meeting.” For now, it will keep buying to replace the runoff of the current portfolio. However, shrinkage of the investments in the future seems intended and may be “faster than last time.” How far will such shrinkage, especially of the massive mortgage portfolio, go?

The Fed’s $2.7 trillion in mortgage securities is double the level of March 2020, but more to the point, infinitely greater than the zero of 2006.

From 1913 to 2006, the amount of mortgages the Federal Reserve owned was always zero. That defined “normal.” What is normal now? Should the Fed’s mortgage portfolio be permanent or temporary? Can the mortgage market now even imagine a Fed which owns zero mortgages? Can the Fed itself imagine that?

Should the Federal Reserve’s mortgage portfolio not just shrink some, but go back to zero?

In my opinion, it should indeed go back to zero.

In the beginning of its mortgage buying, this was clearly the Federal Reserve’s intent. As Chairman Bernanke testified to Congress about this bond and mortgage buying program (or “QE”) in 2011:

“What we are doing here is a temporary measure which will be reversed so that at the end of the process the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in the money outstanding, or in the Fed’s balance sheet.”

Obviously, that was bad forecast, but that does not mean the intentions were not sincere at the time. “I genuinely believed that it was a temporary program and that our balance sheet would go back [to normal]” said Elizabeth Duke, a Fed Governor from 2008 to 2013.

The recent book, Lords of Easy Money, relates that:

“As far back as 2010, the Fed was debating how to normalize. Credible arguments were made that the process would be completed by 2015, meaning that the Fed would have sold off the assets it purchased through quantitative easing.”

A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed’s investments “would expand quickly during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds. After that, the balance sheet would start to shrink, gradually, as the Fed sold off all the assets it bought, falling to under $2 trillion by 2019.” Obviously, that didn’t happen.

Early on, the Fed realized that if it did sell assets, and interest rates had normalized to higher levels, and the prices of bonds and mortgages had therefore fallen, it could be realizing significant losses on its sales. Of course, the Fed has made no sales as yet.

The yield of the 10-year U.S. Treasury note touched 2.38% on March 22 as I write, and the 30-year fixed rate mortgage rate reached 4.62%. These rates are high compared to recent experience, but they are still very low, historically speaking, especially compared to the current inflation. Historically, more typical rates would be 4% or more for the 10-year Treasury, and 5% to 6% for mortgages, or more. The interest rate on 30-year mortgage loans was never less than 5% from the mid1960s to 2008.

If the Fed stops suppressing mortgage interest rates and stops being the Big Bid for mortgages, how much higher could those interest rates go from their present, still historically very low level? When the mortgage interest rates rise, how quickly will the runaway house price inflation end?

This leads to an interesting question about the Fed itself: As interest rates rise, how big will the losses on the Fed’s vast mortgage portfolio, and on its even vaster portfolio of long-term Treasury bonds, be? Could the losses be big enough to make the Fed insolvent on a mark-to-market basis?

The duration of the Fed’s $2.7 trillion mortgage portfolio is estimated at about 5 years. That means that for each 1% that mortgage interest rates rise, the portfolio loses 5% of its market value. So a 1% rise would be a loss in market value of about $135 billion, and a 2% rise in mortgage rates, a loss of value of $270 billion.

With the $5.8 trillion of Treasury securities on the Fed’s balance sheet, it owns about 24% of all Treasury debt in the hands of the public and a lot of very long bonds. I tried to estimate the duration of the portfolio and came up with about 5 years. Then on a 1% increase in rates, the market value loss to the Fed will be $285 billion and on a 2% rise, $570 billion.

Add the mortgage results and the Treasury portfolio results together and you get these market value losses in round numbers: for a 1% rise in rates, over $400 billion; for a 2% rise, over $800 billion.

Now compare that to the net worth of the consolidated Federal Reserve System, which is $41 billion. A capital of $41 billion is subject to a potential market value loss of $400 billion or $800 billion. It is easy to imagine that the Fed may become insolvent on a mark-to-market basis, just as the savings & loans were in the 1980s.

But does mark to market insolvency matter if you are a fiat currency central bank? Most economists say No. If the Fed were mark-to-market insolvent, probably nothing would actually happen. You would still keep accepting its notes in payments. The Fed would keep accounting for its securities at par value plus unamortized premium, and the unrealized loss, however massive, would not touch the balance sheet or the capital account.

But suppose the Fed actually does sell mortgages and bonds into a rising rate market, and takes realized, cash losses. Suppose they bought a mortgage security for the price of 103, and sell it for 98, for a realized loss of 5, and that 5 is gone forever. Wouldn’t that loss have to hit the capital account, and if such losses were big enough, force the Fed’s balance sheet to report a negative capital – that is, technical insolvency?

It may surprise you to learn, as it surprised me to learn, that the answer is that this realized, cash loss would not affect the Fed’s reported capital at all. No matter how big the realized losses were, the Fed’s reported capital would be exactly the same as before. That ought to be impossible, so how is it possible?

It is because in 2011, while considering how it might one day sell the mortgages and bonds it was accumulating, the Fed logically realized that if interest rates returned to more normal levels, it would be selling at a loss. What to do? It decided to change its accounting. The Federal Reserve has the advantage of setting its own accounting standards. It decided to account for any realized losses on the sale of securities not as a reduction in retained earnings and capital but as an intangible asset! This was clever, perhaps, but hardly upright accounting. I would certainly hate to be the CFO of an SEC-regulated corporation who tried that one.

But here is a great irony: This is precisely what the old savings & loans, facing insolvency, did in the early 1980s. So the new, biggest savings and loan in the world, potentially faced with the same problem as the old ones, came up with the same idea.

Will the Federal Reserve really get out of its “temporary” mortgage program now? Will it ever get back to the formerly normal zero? And if it ever sells mortgage securities, what losses will it realize?

Are Cryptocurrencies the Great Hayekian Escape?

Published in Law & Liberty. Also republished in RealClear Markets.

Practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people,” wrote the great economist Friedrich Hayek. He meant that when governments want to run big deficits, they can take the people’s money through currency depreciation and inflation, without having to pass any tax legislation. For governments to do this, having a central bank is very handy.

To finance government deficits, central banks with a fiat currency monopoly create as much money as desired, whether by literal printing or metaphorical printing by accounting entries, thus, as it is called, monetizing government debt. Since the 1960s, this has led to endemic inflation and continuous depreciation of the currency, sometimes fairly slowly (what used to be called “creeping inflation”), and sometimes very rapidly—like now. This is in sharp contrast to honest or sound money, which would have a stable value on average over time. 

In response, can the people escape the government’s currency monopoly with cryptocurrencies? Cryptocurrencies try to create competitive alternatives to depreciating central bank fiat money. Their development has set off an instructive dialectic between money as a government monopoly and possible private forms of money. 

A fundamental text for the concept of domestic monetary competition is Hayek’s notable essay, “Choice in Currency: a Way to Stop Inflation.” Published in 1976, in the wake of the collapse of the Bretton-Woods monetary system and during the great 1970s inflation, Hayek’s discussion included these provocative thoughts:

What is so dangerous and ought to be done away with is not governments’ right to issue money but the exclusive right to do so and their power to force people to use it.…Why should we not let the people choose freely what money they want to use? … If governments and other issuers of money have to compete in inducing people to hold their money…they will have to create confidence in its long-term stability… I hope it will not be too long before complete freedom to deal in any money one likes will be regarded as the essential mark of a free country.

These ideas or similar ones are echoed by supporters of all the cryptocurrencies that have appeared since the introduction of Bitcoin in 2009, which have had their own truly remarkable bull market. However, are today’s cryptocurrencies true alternatives to government fiat currency of the sort Hayek envisioned?

In 1976, Hayek was not thinking of the cryptocurrencies that have appeared in the last decade. He was thinking about gold. He wondered whether there might still be a rebirth for gold as money, although the last vestiges of the gold standard had just disappeared with the death of Bretton-Woods. This is apparent from the following section of his essay:

Where I am not sure is whether in such a competition for reliability any government-issued currency would prevail, or whether the predominant preference would not be in favor of some such units as ounces of gold. It seems not unlikely that gold would ultimately re-assert its place as ‘the universal prize in all countries’…if people were given complete freedom to decide what to use as their standard.

 One of the great marketing and public relations triumphs of recent years was Bitcoin’s success in convincing people, especially the media, to refer to it as a “coin,” and to publish articles about Bitcoin constantly accompanied by pictures of gold coins with a “B” in the form of a dollar sign stamped on them–just like the picture at the top of this essay. This was PR genius, a psychological reminder of the preference Hayek had expected. But obviously, a nonredeemable electronic entry in a computerized ledger bears no resemblance to an actual gold coin, with or without a ‘B’ stamped on it. The essential fact about Bitcoins is that there is no promise to redeem them with anything—in that sense, they are just like Federal Reserve dollars.

The price of Bitcoins has reached astronomical levels, accompanied in its flight by the idea of trying to escape from the Federal Reserve dollar (and all other central bank fiat currencies). In this way, buyers of Bitcoins and gold are similar. The well-known billionaire investor and speculator Stanley Druckenmiller was reported as explaining that “he finally realized what problem Bitcoin aims to solve—and that problem was called ‘central banks.’” Said Druckenmiller, without excess diplomacy:

The problem was Jay Powell and the world’s central bankers going nuts and making fiat money even more questionable than it already has been when I used to own gold.

Bitcoin, or any other cryptocurrency modeled on it, is equally a fiat currency. In these cryptocurrencies we see the radical attempt to create a private fiat currency. They are tied to no asset and no cash flow, and by definition, have no tie to government power. This is what makes them so intriguing. 

In contrast, the U.S. national bank notes of the 19th and early 20th centuries were tied to U.S. Treasury bonds as collateral, and state bank notes to the general assets of the issuing bank. It seems dubious that with no tie at all to any assets or cash flow, you can get a private currency reliably useful for ordinary exchange and as store of value. (Even with the infamous tulip bubble, there was a real tulip bulb involved. Although you might have lost a lot of money, at least you could still grow a tulip.) 

Nonetheless, the Bitcoin model has, without doubt, created a fascinating intangible object of speculation which displays extreme price volatility, with startling ascents and free-fall drops. It is often said, which seems right to me, that this volatility makes it unsuitable or unusable for ordinary, legal, everyday payments and exchange, since you have no idea from day to day what its value will be. Therefore, cryptocurrencies on the Bitcoin model create, as the Bank for International Settlements put it in 2021, “speculative assets rather than money.” While notably successful at becoming speculative assets, they thus fail to be a Hayekian competitor to central bank fiat money as money.

Trying to solve the problem of price volatility led to the development of a variety of stablecoins, which target a constant value in terms of the U.S. dollar (or other national currency), are backed by a “reserve” of dollar-denominated assets held by the issuer to support the value, and promise to various extents redemption in dollars. It is apparent, as many financial regulators have observed, that such a stablecoin looks very much indeed like a deposit in a bank, backed by the assets of the bank, and is equally dependent on the quality, riskiness, and liquidity of those assets for the ability to redeem it at par value.

But in terms of the grand objective of creating a Hayekian competitor to central bank fiat currency, there is a much more fundamental problem. A moment’s thought makes the deeper issue obvious: if the stablecoin gives itself stability and currency by linking itself to the U.S. dollar (or any other national currency), it has completely failed to escape the government’s central bank, and is instead entirely dependent on it.

If the Federal Reserve steadily depreciates the purchasing power of the dollar, the purchasing power of the stablecoin automatically goes down accordingly. If the dollar suffers rapid inflation, so will the stablecoin. If the dollar succumbs to hyper-inflation, so will the stablecoin. Thus, the stablecoin may represent a variation or perhaps an improvement on payments technology, but it does not, and cannot by design, represent a new currency. As long as it is linked to a national currency, it is part of the central bank fiat currency system, just as a bank deposit is, and fails to be a Hayekian competitive currency.

In a striking historical irony, the libertarian idea to free people from central bank monopoly money through cryptocurrencies has dialectically given rise to the idea of a central bank issuing its own cryptocurrency, with the more dignified name of “central bank digital currency.” If this should happen the central bank could become the bank for everyone, with the potential to be the monopolist of deposits, loans, and personal financial information, as well as the monopolist of money. This highly undesirable dialectical reversal would make the monetary system vastly more centralized and the central bank vastly more powerful than before. China, and more recently Canada, have shown us the direction that political control of your personal account can take. This would certainly be a non-Hayekian outcome!

Can there be a true alternative in Hayek’s sense to central bank fiat currencies, other than currency redeemable in gold? One of my friends has suggested a digital currency in which the unit is a real dollar—that is, a dollar adjusted for changes in the Consumer Price Index, so that the central bank cannot dilute its purchasing power (at least as captured by the CPI). It would resemble in this sense the Series I U.S. savings bond, which today pays its holders whatever the increase in the CPI turns out to be. But unlike the savings bond, the real dollar currency would need to be freely exchangeable, and available in large amounts. It would be an echo of the 1920s proposal of Irving Fisher, a famous economist in his day, to have a “compensated dollar,” which would automatically increase in value to offset inflation.

With today’s financial technology, would it be possible to create such a collateralized private currency, redeemable in inflation-adjusted dollars of steady purchasing power? Could an asset portfolio to back it be designed? Perhaps not, but it is an interesting thought experiment, in the spirit of Hayek, while we keep looking for a form of money to compete with the constantly depreciating, and now rapidly depreciating, Federal Reserve dollar and other central bank fiat currencies.

Hazlitt, Hayek, and How the Fed Made Itself into the World's Biggest Savings and Loan

Hosted by the Mises Institute and full text also available here.

Recorded at the 2022 Austrian Economics Research Conference hosted at the Mises Institute in Auburn, Alabama, March 18–19, 2022.

The Henry Hazlitt Memorial Lecture, sponsored by Yousif Almoayyed.

The Austrian Economics Research Conference is the international, interdisciplinary meeting of the Austrian School, bringing together leading scholars doing research in this vibrant and influential intellectual tradition. The conference is hosted by the Mises Institute at its campus in Auburn, Alabama, and is directed by Joseph Salerno, professor of economics at Pace University and academic vice president of the Mises Institute.

Transcript:

Many thanks to the Mises Institute and to sponsor Yousif Almoayyed for this opportunity to be with you all today, as we consider one of the truly remarkable developments in the history of American central banking, money printing, and credit inflation.

On a personal note, “the pursuit of clarity” has long been a goal of mine, and it’s a particular pleasure to present a lecture in honor of Henry Hazlitt, whose work is marked by such clarity of style, meaning and logic.

Taking up our topic, “Hazlitt, Hayek and How the Fed Made Itself into the World’s Biggest Savings & Loan,” we begin with Hazlitt’s Economics in One Lesson.  Central to this book is the key problem of government policies which “benefit one group only at the expense of all other groups.”

The Federal Reserve’s huge investment in, and monetization of, residential real estate mortgages is a striking example of this eternal political propensity.

“The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently.  It will hire the best buyable minds”—a great phrase that: “the best buyable minds”—“to devote their whole time to presenting its case,” with, he adds, “endless pleadings of self-interest.”

Such pleadings have characterized the housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the U.S. government in housing finance.  Through Fannie Mae, Freddie Mac and Ginnie Mae, the government guarantees about $8 trillion of mortgage debt. (That’s $8 trillion of credit risk for account of the taxpayers.) In the latest radical expansion of this involvement, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve.  Getting mortgages into the central bank’s balance sheet was a fateful step.

As of March, 2022, the Fed owns $2.7 trillion of mortgage securities.  This means about 23% of all the mortgages in the country are on the central bank’s balance sheet--23% of the residential mortgages, which are the biggest loan market in the world.  Moreover, mortgages have become 30% of the Fed’s own inflated total assets.  These are truly remarkable numbers, which would certainly have astonished the founders of the Federal Reserve System.  (I am enjoying imagining the architects of the Fed in financial Valhalla, in a lively but puzzled discussion of how their creation came to be a giant mortgage funder.)  These developments are not astonishing, however, to students of Hazlitt, Hayek and Mises, who expect governments and central banks always to try to expand their power.

Since March 2021, one year ago, the Fed has added $557 billion to its mortgage portfolio, increasing the balance by $46 billion a month on average.  It had to buy a lot more than that in order first to replace the repayments and prepayments of the underlying mortgages and then increase the outstanding holdings.  The Fed has been the reliable and market-distorting Big Bid in the market, buying mortgages with one hand and printing money to make the purchases with the other.

During this time, there has been in an amazing house price inflation.  U.S. house prices shot up 17% in 2021, as measured by the median sales price, and by 18.8%, as measured by the Case-Shiller national house price index.  In January 2022, average house prices rose at the rate of 17%.  House prices are far over the 2006 peak which was reached during the infamous Housing Bubble. When adjusted for consumer price inflation, they are still over that previous peak, following which, house prices fell for six years, from 2006 to 2012.

So the giant U.S. housing sector, representing perhaps $38 trillion in current market value of houses, again has runaway asset price inflation.  Faced with this rapid escalation in house prices, the Fed unbelievably kept on stimulating the housing market by buying ever more mortgage securities. It thus further inflated the asset price bubble, subsidizing mortgages and distorting house and land prices.   This makes a perfect example of the dangers of central bank behavior and its effects as seen by Austrian economics.

By acquiring $2.7 trillion in mortgages on its balance sheet, the Federal Reserve has made itself far and away the biggest savings & loan institution in the world.  Like the savings & loans of old, the Fed owns very long-term fixed-rate assets, and it neither marks its investments to market in its financial statements nor hedges its extremely large interest rate risk.

Like the saving and loans of the 1970s, it has loaded up on 15 and 30-year fixed rate mortgages, just in time to experience a period of threateningly high inflation, principally of its own making, in which the increases to the cost of living include the effects of the high house prices it has induced.  These prices make their way into the Consumer Price Index through the “Owners’ equivalent rent of the primary residence.”

Were he with us in 2022, with inflation running at almost 8%, Hazlitt would not be surprised that we again face the problem so prominent during his own lifetime.  In spite of recurring costly inflationary experiences, as he observed:

          “The ardor for inflation never dies.”

Here, by the word “inflation” the ardor for which never dies, he means inflation in the sense of excessive credit and monetary expansion, the cause of the subsequent inflation in the sense of a rapid rise in prices, which is the effect.  Human nature being what it is, central banks and politicians think maybe they can have the cause without the effect.  They can’t, but they try, alas.

Writing in 1978, in his book, The Inflation Crisis, And How to Resolve It, republished by the Mises Institute, Hazlitt wrote:

          “Inflation, not only in the United States but throughout the world, has…not only continued, but spread and accelerated.  The problems it presents, in a score of aspects, have become increasingly grave and urgent.”  

Sounds familiar.

Hazlitt pointed out a central irony which has often struck me:

          “No subject is so much discussed today…as inflation,” he wrote.  “The politicians in Washington talk of it as if it were some horrible visitation from without…something they are always promising to ‘fight.’ … Yet the plain truth is that our political leaders have brought on inflation by their own monetary and fiscal policies.”  

I think also of Friedrich Hayek, who in his lecture upon accepting the Nobel Prize in economics in 1974, observed:

           “Economists are at the moment called upon to say how to extricate [us] from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue.”

And now, here we are again. 

It is superfluous to say, while speaking at the Mises Institute, that among the economists urging inflationary policies were not those of the Austrian school, then or now.

The people with the hottest ardor for inflationary policies in recent times have been the advocates of so-called Modern Monetary Theory or MMT.  In my view, this needs to be written, “Modern” Monetary Theory, or “M”MT, because it is far from a new thought— there is no notion older than that if the government is running short of money, it should just print some up.  This MMT might equally, of course, be called ZMT, for Zimbabwe Monetary Theory, or reflecting classic monetary adventures, JLMT—that’s John Law Monetary Theory.

Hazlitt has a fine term for those of this persuasion, “the paper money statists.”  Indeed, the real agenda of “M”MT is a political one: to have no limits on the government’s ability to spend.  Needless to say at the Mises Institute, this is an illusion.  The most fundamental of all economic principles is:  

          Nothing is free.  

We know it, but it is good to repeat it.  “Nothing is free” ought to be put up over the door of every economics department.  Printing up vast amounts of money has a heavy cost indeed.  

With the galloping inflation we’ve got now, we shouldn’t be hearing too much from the MMT rooters, and I hope that we can write, at least for this political-economic cycle:  “MMT, RIP.”

Combine the current 7.9% year-over-year inflation to nominal interest rates on savings accounts of 0.1% or so, the real interest rate on savings is negative 7.8%.   The Federal Reserve is expropriating 7.8% a year of your savings or your money market fund account.

Compared to that, in a true market, what would the real interest rate on savings be?  We don’t know, because you need a free money market to find out, and we don’t have one.  But it would most assuredly not be minus 7%.  To get that, you must have a central bank.

Of course, the inflation is being made worse by the effects of the war in the Ukraine—the kind of war that many people thought could not happen again in Europe. Unfortunately in this case, “Many things which had once been unimaginable, nevertheless came to pass,” in physicist Freeman Dyson’s memorable epigram.

The United States is waging a pervasive economic war to accompany the shooting war, with tumultuous volatility in financial markets and as yet developing, but surely very large, economic effects.  We know that increases in the prices of energy, wheat and other commodities will push essential consumer prices up even further.  The spike in the price of nickel has caused a crisis on the London Metal Exchange, and many people expect that defaults on Russian government debt are coming.

Big wars are the single most important financial events in history and the most important source of runaway inflation.  Thinking of this history, I found this vivid description the post-World War I economic world when Hayek was in his early 20s and Mises about 40:

     “Austria lost everything in the war; Vienna became a capital without an empire. … There was no way to measure effectively the cost of all the conflicting financial claims”—which later resulted in massive defaults.  “[There] was rampant inflation—hyperinflation in Germany and Austria which ruined the holders of bonds, particularly the class to which Hayek belonged--followed by a steep deflation, especially in the United States, which left commodity prices and production in disarray throughout the world.”

Long before the present war began, the Fed was completely surprised by the emergence of the inflation its own actions had created.  A far better forecast of what was coming was made by Charles Goodhart and Manoj Pradhan, who based on the analogy of war finance, wrote in 2020:

     “What will then happen as the lock-down gets lifted and recovery ensures, following a period of massive fiscal and monetary expansion?  The answer, as in the aftermaths of many wars,” they said, “will be a surge in inflation, quite likely more than 5%, or even on the order of 10% in 2021.”  5% to 10% inflation for 2021—an excellent forecast, while the Fed was forecasting 1.8%, an egregious miss.  

Goodhart and Pradhan went on to say:  “What will the response of the authorities be?  First and foremost, they will claim this is a temporary, once-for-all blip.”  This was a perfect prediction of the by-now embarrassing “transitory” line taken by the Fed and the administration.

This raises a much larger issue about central banks in general, and the Fed in particular—a question very much in the Austrian spirit:  

     Does the Fed know what it’s really doing?

The answer is of course No.  The Fed does not know with any confidence what the results of its own actions will be. 

Let us go further:

     Can the Fed know what it’s really doing?

Again the answer is No.  The Fed will always have the central banking theory currently in fashion, as central banking fashions change, it will have hundreds of economists, and as many computers as it wants, but it cannot ever have the knowledge it would need to be the centralized manager of a complex financial system, let alone of an enterprising market economy.  The inevitable lack of knowledge, combined with great power, is why the Federal Reserve the most dangerous financial institution in the world.

The father of the Fed’s giant mortgage portfolio is Ben Bernanke.  In 2012, when he had been Chairman of the Fed for six years, Bernanke expressed its knowledge problem with admirable intellectual honesty:

      “The fact is that nobody really knows precisely what is holding back the economy, what the correct responses are, or how our tools will work,” he told his Fed colleagues, furthermore characterizing the next round of asset purchases he was recommending as “a shot in the proverbial dark.”  

Of course, this was an inside communication, not a candid confession to the outside world.

One needs hardly say to this audience that this nicely portrays the inescapable problem of knowledge, the lesson of the impossibility of centralized possession of the requisite knowledge, and therefore the impossibility of successful socialism—or of dirigiste central banking-- immortally taught by Mises and Hayek.  To maintain otherwise requires, in Hayek’s fine phrase, a “pretense of knowledge.”

Let’s think for a minute about the metaphor of a “mechanism.” Central to the knowledge problem is the fact that an economy with its intertwined financial system is not a mechanism, and cannot be predicted and controlled as a mechanism. It is notable how widespread the misleading metaphor of a machine is in economics—economists talk of the “monetary policy transmission mechanism,” or the “European financial stability mechanism,” for example. Yet in fact we are not dealing with mechanisms, but with a different order of reality, a different kind of reality.  But what kind of reality is it then?  Well, as many of you know already, it’s a Catallaxy.

Naming that which is not a mechanism, Hayek wrote in 1968:

“It seems necessary to adopt a new technical term to describe the order of the market which spontaneously form itself.  By analogy with the term catallactics [used by Mises in Human Action, for example] we could describe the order itself as a catallaxy.”  Hayek’s footnote adds, “The ends which a catallaxy serves are not given in their totality to anyone”—not to any economic actor, to any macroeconomist, to any central bank or to any other would-be philosopher-king. 

This proposal for a profound and useful new word was made more than 50 years ago.  It has obviously not succeeded in becoming popular and would elicit in most companies blank stares.  We must admit it has a rather unattractive sound and seems obscure.  But what is the fundamental reality we are trying to name?  An infinitely complex, recursive, expectational interaction of human actions and values, shot through with feedback and reflexivity, self-referential, marked by fundamental uncertainty, in which ideas become reality, previously unimaginable innovations appear, and experts are frequently surprised, cannot be thought of in any simple way.  It is much easier to think of a mechanism or an algebraic formula than to picture or intellectually grasp a catallaxy.  Too bad the word hasn’t caught on to express this fascinating type of reality we all work to understand.

Back to our story: Into the American catallaxy strode the Federal Reserve, its pockets filled with newly printed dollars and its printer handy to create more, and bought up the biggest pile of mortgage assets than anybody ever owned.  It bought even more Treasury securities, too, accumulating $5.8 trillion of them, so that its balance sheet has reached the memorable total of $8.9 trillion.  This is another development not imagined by anyone beforehand, including the Fed itself.

$8.9 trillion is twice the Fed’s total assets at the beginning of March 2020, and ten times the $875 billion in December 2006.  The Fed’s $2.7 trillion in mortgage securities is double the level of March 2020, but more to the point, infinitely greater than the zero of 2006.  

From the organization of the Federal Reserve in 1914 to 2006, the amount of mortgages it owned was always zero.  That defined “normal.”  What is normal now?  Should a Federal Reserve mortgage portfolio be permanent or temporary?   Can the mortgage market now even imagine a Fed which owns zero mortgages?  Can the Fed itself imagine that?

Should the Federal Reserve’s mortgage portfolio not just shrink some, but go back to zero?

I would say, and I suspect most of you would, too, that it should go back to zero. 

In the beginning of its mortgage buying, this was clearly the Fed’s intent.  As Chairman Bernanke testified to Congress about his bond and mortgage buying program (or “QE”) in 2011:

     “What we are doing here is a temporary measure which will be reversed so that at the end of the process the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in the money outstanding, or in the Fed’s balance sheet.”

Obviously, that was bad forecast, but that does not mean the intentions were not sincere at the time.  “I genuinely believed that it was a temporary program and that our balance sheet would go back [to normal]” said Elizabeth Duke, a Fed Governor from 2008 to 2013. 

The recent book, Lords of Easy Money, relates that:

     “As far back as 2010, the Fed was debating how to normalize.  Credible arguments were made that the process would be completed by 2015, meaning that the Fed would have sold off the assets it purchased through quantitative easing.”  

A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed’s investments “would expand quickly during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds.  After that, the balance sheet would start to shrink, gradually, as the Fed sold off all the assets it bought, falling to under $2 trillion by 2019.”

Any of us, certainly including me, who have tried our hand at financial forecasts will not be too hard on these mistaken projections, having made so many mistakes ourselves. But how clear it is that the Fed has no greater ability than the rest of us to foresee the financial and economic future, including where its own actions are headed.

Early on, the Fed realized that if it did sell assets, and interest rates had normalized to higher levels, and the prices of bonds and mortgages had therefore fallen, it could be realizing significant losses on its sales.  We will come back to this problem.  Of course, the Fed has made no sales as yet.

Over the last few decades, U.S. financial actors have believed in, and experienced, the “Greenspan Put,” the “Bernanke Put,” the “Yellen Put,” and the “Powell Put.”  This is the belief that the Fed will always manipulate money to save the day for financial markets and leveraged speculators.  These “puts” of risk to the Fed have themselves over time induced higher debt and inflated asset prices, including house prices, making the whole system riskier and more in need of the “puts.”

Speaking of needing puts, two years ago today, on March 18, 2020, we were in the midst of the Covid financial panic.  As everyone will remember, prices of all kinds of assets were dropping like so many rocks.  Fear and uncertainty were rampant.  The Federal Reserve and all other major central banks, having adopted Walter Bagehot’s famous theory that central banks need to lend freely to financial actors to stem a panic, applied Bagehot’s theory to the max.  The central banks also monetized the huge fiscal deficits run by governments to offset the steep economic contraction which followed their lockdowns.  They printed however much money it took.

The panic did end, normal financial functioning was restored, and bull markets resumed in mid-2020, fueled by the monetary expansion.  Then came, as it always does, the question:  What do you do when the crisis is over?  What the Fed did was to keep right on buying mortgage securities and Treasury bonds by the hundreds of billions of dollars.

This demonstrates an abiding problem.  How do you reverse central bank emergency programs, originally thought and intended to be temporary, after the crisis has passed?  The principle that interventions made to survive in times of crisis, should be withdrawn in the renewed normal times which follow, I call the Cincinnatian Doctrine.

You may recall the ancient Roman hero, Cincinnatus, who was, as it is said, “called from his plow to save the State,” made temporary Dictator, did save the State, and then, mission accomplished, left his dictatorship and went back to his farm.  Similarly, two millennia later, George Washington, a victorious general and hero who saved the new United States, and could perhaps have made himself King, instead in a deservedly celebrated moment, resigned his commission and went back to his farm, thereby becoming “the modern Cincinnatus.”

In contrast, emergency central bank interventions, however sincere the original intent that they would be temporary, can build up economic and political constituencies who profit from them and want them to be continued.  For central bank monetization of government debt to finance deficits, the biggest such constituent of all is the government itself.

The difficulty of winding emergency actions back down, once they have become established and profitable to their constituencies, is the Cincinnatian Problem.  There is no easy answer to this problem.  How, so to speak, do you get the Fed to go back to its farm when it has become the dominant bond and mortgage investor in the world?

Will it go back to the farm and withdraw from being a giant savings & loan?  Two days ago, on March 16, the Fed announced that it “expects to begin reducing its holdings of Treasury securities and agency debt securities and mortgage-backed securities at a coming meeting.”  For now, it will keep buying to replace the runoff of the current portfolio, but shrinkage may be “faster than last time.” The Fed is already very late.

The 10-year Treasury yield touched 2.2% this week and long-term mortgage rates are up to about 4.25%.  These rates now seem high, but they are still very low rates, historically speaking, especially compared to the current inflation.  Historically, more typical rates would be at least 4% for the 10-year Treasury, or more, and 5% to 6% for mortgages, or more.  The interest rate on 30-year mortgage loans was never less than 5% from the mid-1960s to 2008.

If the Fed stops suppressing mortgage interest rates and stops being the Big Bid for mortgages, how much higher could those interest rates go from their present, still historically very low level?  When the mortgage interest rates rise, how quickly will the runaway house price inflation end?   

This leads to an interesting question about the Fed itself: As interest rates rise, how big will the losses on the Fed’s vast mortgage portfolio, and on its even vaster portfolio of long-term Treasury bonds, be?  Could the losses be big enough to make the Fed insolvent on a mark-to-market basis?  Yes, they could.

Let’s take a minute to do a little bond math.

The duration of the Fed’s $2.7 trillion mortgage portfolio is estimated at about 5 years.  That means that for each 1% that mortgage interest rates rise, the portfolio loses 5% of its market value.  So a 1% rise would be a loss in market value of about $135 billion, and a 2% rise in mortgage rates, a loss of value of $270 billion.

With the $5.8 trillion of Treasury securities on the Fed’s balance sheet, it owns about 24% of all Treasury debt in the hands of the public.  Remarkable.  Of these securities, only $326 billion, or 6%, are short-term Treasury bills.  On the other end of the maturity spectrum, it owns $1 trillion with maturities of 5 to 10 years, and $1.4 trillion with maturities of more than 10 years.  I tried to estimate the duration of the portfolio and came up with about 5 years.  A Wall Street contact said 7 years, but let’s use 5. Then on a 1% increase in rates, the market value loss to the Fed will be $285 billion and on a 2% rise, $570 billion.

Add the mortgage results and the Treasury portfolio results together and you get these market value losses in round numbers: for a 1% rise in rates, over $400 billion; for a 2% rise, over $800 billion.

Compare that to the net worth of the consolidated Federal Reserve System.  Does anybody know what it is?  The answer is $41 billion. Compare $41 billion to a potential market value hit of $400 billion or $800 billion. It is easy to imagine that the Fed may become insolvent on a mark-to-market basis.

But does mark to market insolvency matter if you are a fiat currency central bank?  Most economists say No, and maybe they are right.  If the Fed were mark-to-market insolvent, probably nothing would actually happen. You would still keep accepting its notes in payments. The Fed would keep accounting for its securities at par value plus unamortized premium, and the unrealized loss, however massive, would not touch the balance sheet or the capital account.

Now suppose the Fed actually does sell mortgages and bonds into a rising rate market, and takes realized, cash losses.  Suppose they bought a mortgage security for the price of 103, and sell it for 98, for a realized loss of 5, and that 5 is gone forever.  Wouldn’t that loss have to hit the capital account, and if the losses were big enough, force the Fed’s balance sheet to report a negative capital—that is, technical insolvency?

It may surprise you to learn, as it surprised me to learn, that the answer is that this realized, cash loss would not affect the Fed’s reported capital at all.  No matter how big the realized losses were, the Fed’s reported capital would be exactly the same as before.  That ought to be impossible, so how is it possible?

It is because in 2011, while considering how it might one day sell the mortgages and bonds it was accumulating, the Fed logically realized that if interest rates returned to more normal levels, it would be selling at a loss.  What to do?  It decided—do you know what?-- to change its accounting.  The Fed has the advantage of setting its own accounting standards.  It decided to account for any realized losses on the sale of securities not as a reduction in retained earnings and capital but as an intangible asset!  This was clever, perhaps, but hardly upright accounting.  I would certainly hate to be the CFO of an SEC-regulated corporation who tried that one.

But here is a great irony:  This is precisely what the old savings & loans, facing insolvency, did in the early 1980s.  So the new, biggest savings and loan in the world, potentially faced with the same problem as the old ones, came up with the same idea.

Let us shift to how the Federal Reserve fits into the whole American mortgage finance system, a market with about $11 trillion in residential mortgage loans. As mentioned, about $8 trillion or 70% of these loans are guaranteed by the government in some way, principally by Fannie Mae, Freddie Mac and Ginnie Mae.  Does the government have to guarantee 70% of all mortgage credit risk?  Does that make sense?  Of course it doesn’t. But so it is.

American mortgage finance is dominated by a tightly linked government triangle.  The first leg of the triangle is composed of Fannie, Freddie and Ginnie (with its associated Federal Housing Administration), what we may call the Government Housing Complex.

The second leg in the government mortgage triangle is the United States Treasury, which is fully on the hook for all the obligations of the 100% government-owned Ginnie.  The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too.  Through clever financial lawyering, it is not a legal guarantee, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total U.S. government debt.  It does not surprise us that this was and is not politically desired.

The same politically undesired, but honest, accounting result would follow if, in addition to owning 100% of Fannie and Freddie’s senior preferred stock, the Treasury owned 80% of their common stock.  That is why Treasury controls 79.9%, not 80%, of the common stock through warrants with an exercise price of nearly zero.  For historical perspective, to get Fannie’s debt off the government’s books was the main reason for restructuring it into a so-called “government-sponsored enterprise” in 1968, so that Lyndon Johnson’s federal deficit did not look as big.

The Fed didn’t used to be, but it has become the third leg of the government mortgage triangle, as the single biggest funder of mortgages.  Its mortgage security holdings are limited to those guaranteed by Fannie, Freddie and Ginnie, but those guarantees are only credible because they are in turn backed by the credit of the Treasury.

However, there is curious circle here. How can the Treasury, which runs constant deficits and runs up its debt year after year, be such a good credit?  An essential element in the credit of the Treasury itself is the willingness of the Fed always to buy government debt by printing up the money to do so.  This is why having a fiat currency central bank of its own is so useful to any government.  The credit of these two financial behemoths is intriguingly mutually dependent on each other, while they both support Fannie, Freddie and Ginnie. 

It is most helpful to think of the Fed and the Treasury as one thing—one combined government financing operation, whose financial statements should be consolidated.  Then all the government debt owned by the Fed would be a consolidating elimination.  With this approach, we can see the reality more clearly.  The Fed buys and monetizes Treasury debt.  Consolidate the statements. The Treasury bonds disappear. What do we have?  The consolidated government prints up money and spends it.  It is still taxing to spend, but taxing by inflation, without the need to vote in taxes.  This arrangement must be loved by, to use Hazlitt’s term again, paper money statists.

We need to bring Fannie, Freddie and Ginnie into the consolidated picture. They issue mortgage securities and the Fed buys and monetizes them.  Consolidate the statements, and the mortgage securities bought by the Fed also disappear as a consolidating elimination.  What do we have?  The consolidated government prints up money and uses it to make cheap mortgage loans, inflating the price of houses.  This arrangement must be loved by paper money housing lobbyists.

In principle, there is no limit to the kinds of assets a fiat currency central bank can buy and monetize, although there are limits of law and policy.  The Swiss National Bank has a large portfolio of U.S. stocks, for example.  The Fed in the Covid financial crisis, along with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent state of Illinois.

Another good example is that in the 1960s, some members of Congress thought, with the encouragement of the savings & loan industry, that the Fed ought to buy bonds to provide money to—you’ll never guess—housing.  Fed Chairman William McChesney Martin pointed out that this was a bad idea:

     It would, he testified, “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That was the right answer, entirely consistent with Economics in One Lesson.  But it did not please the politicians involved.  Senator William Proxmire threatened the Fed:

     “You recognize, I take it” he said to the Fed Vice Chairman in 1968, “that the Federal Reserve Board is a creature of the Congress?... the Congress can create it, abolish it, and so forth?...What would Congress have to do to indicate that it wishes…greater support to the housing market?”

Proxmire died in 2005.  He’d be very surprised, I imagine, at how much money the later Fed put into the housing market.

Following the 1960s discussions, a new Fed Chairman, Arthur Burns, arrived. In 1971, he decided it would be a good idea for the Fed to “demonstrate a cooperative attitude.”  The Fed bought no mortgages in those days, but it did begin to buy the bonds of federal housing and other government agencies.  It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks of Cooperatives, and—believe it or not—the debt of the Washington DC subway system.  There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.

The Fed fortunately managed (under the leadership of Paul Volcker) to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s.  Will it really get out of its vastly bigger mortgage program now? 

In sum, we have a Federal Reserve which at the amazing size of $8.9 trillion is also the biggest savings & loan in the world, in addition being the most dangerous financial institution in the world, which does not and cannot know what the results of its own actions will be, and which faces the Cincinnatian Problem in the midst of runaway inflation, and is always, to use a typical quote from Hazlitt as our last word, “swindling its own people by printing a chronically depreciating paper currency.”

Thank you.

Ukraine and the cost of war

Published in the Washington Examiner.

In an example unrelated to war, consider former President Richard Nixon’s 1971 decision to abandon the gold standard and impose wage and price controls and tariffs to calm inflationary forces. This was primarily a response to France’s effort to convert dollars to gold.

Letter: Here are two steps to reform cryptocurrencies

Published in the Financial Times.

Your editorial “Crypto’s rise requires a global response” (FT View, February 21), which backs the US Financial Stability Board’s proposal for “accelerated monitoring”, is good as far as it goes. Yet when it comes to stablecoins, there is another simple and obvious reform that needs to be made immediately. Whether you think stablecoins are more like a bank, a money-market fund or an exchange traded fund, the indubitable fact is that they are putting their liabilities as assets into the hands of the public. Like everybody else who does this, they need to publish full audited financial statements. Of course the statements would also include their profit and loss statement. This is a minimum requirement for the public to have an idea of what they are buying. A second simple requirement would be the publication of a clear description in plain English of the conditions and processes to redeem each stablecoin, since they all make so much of their “stable” character, and that stability depends on what happens when you want out. By all means, keep monitoring along with the Financial Stability Board, but get these two steps done in the meantime.

Alex J Pollock

Senior Fellow, Mises Institute

Auburn, AL, US

It's Another Housing Bubble And The Fed Is Holding The Pin

Published in Zero Hedge:

As economist Alex Pollock put it in an article published by the Mises Wire earlier this year, the Fed “continues to be the price-setting marginal buyer or Big Bid in the mortgage market, expanding its mortgage portfolio with one hand, and printing money with the other.”

In 2006, the Fed owned zero mortgages. Today, The central bank holds about $2.6 trillion in mortgage-backed securities on its balance sheet. According to Pollock, about 24% of all outstanding residential mortgages in the US reside in the central bank. That makes the Fed, by far, the largest savings and loan institution in the world.

William Isaac Announcements: February 15, 2022

February 15, 2022

My long-time friend and brilliant scholar, Alex Pollock, has written an essay on the probable impact of inflation currently gathering steam due to fiscal policies being pursued by Congress and the Administration and monetary policies being pursued by the Federal Reserve. I'm sure the article will resonate and bring back troubling memories of the 1970s and 1980s:

• 'Biden Inflation' made simple: Borrow from the Fed, take away from the rest of us by Alex J. Pollock published by The Hill.

The full article can be found at williamisaac.com. Be safe and be well.

All the best,

Upcoming March 30 event: The Federal Reserve and the everything bubble

Hosted by the American Enterprise Institute (AEI). Register here.

In response to the COVID-19 crisis, the Federal Reserve has expanded its balance sheet at an unprecedented rate, buying almost $5 trillion in US Treasury bonds and mortgage-backed securities in a single year. That buying has occurred in frothy equity, housing, and credit markets, and inflation has surged to levels not seen in almost four decades. With the Federal Reserve set to begin policy normalization this spring, questions remain on how the Fed will balance financial market stability and a brewing inflation crisis.

Please join AEI for a discussion on the constraints that elevated asset and credit market prices place on the Federal Reserve’s ability to regain control over inflation. The panelists will examine what might be done to break the recurrent boom-bust asset price and credit market cycle.

LIVE Q&A: Submit questions to John.Kearns@aei.org or on Twitter with #AskAEIEcon.

Agenda

2:00 PM
Introduction:
Desmond Lachman, Senior Fellow, AEI

2:05 PM
Panel discussion

Panelists:
Jason Furman, Aetna Professor of the Practice of Economic Policy, Harvard University
Desmond Lachman, Senior Fellow, AEI
Kevin Warsh, Shepard Family Distinguished Visiting Fellow, Hoover Institution

Moderator:
Alex J. Pollock, Senior Fellow, Mises Institute

3:15 PM
Q&A

3:30 PM
Adjournment

Contact Information

Event: John Kearns | John.Kearns@aei.org
Media: MediaServices@aei.org | 202.862.5829

Register here.

World’s biggest S&L

Published in Grant’s Interest Rate Observer.

Yes, agreed Alex J. Pollock, the Federal Reserve might well go broke, or, we should say, “broke.” The quotation marks acknowledge the Treasury’s standing guarantee of the central bank’s solvency. Then again, Pollock pointed out, where would the Treasury be without the Fed to buy its bonds?

So a relationship of codependency, as Dr. Phil might put it, is a foundational element of today’s federal finances. “It’s a paradoxical situation,” mused Pollock, author, think-tank scholar (currently at the Mises Institute) and, most relevantly for the purposes of this discussion, past president and CEO of both the Federal Home Loan Bank of Chicago and Community Federal Savings and Loan Association, St. Louis.

Your editor and Pollock were comparing notes on a Jan. 5 comment by J.P. Morgan Securities titled, “The case for an earlier start to QT.” In it, Morgan’s Fed watcher, Michael Feroli, speculates that so-called quantitative tightening might get a head start to spare the central bank the embarrassment of having to report an operating deficit. He reckoned that a funds rate higher than 2¼% could pitch the Bank of Powell into a loss.

…

Reviewing the Fed’s financials (including the Sept. 30, 2021 edition of the “Federal Reserve Banks Combined Quarterly Financial Report”), Pollock says that they only confirm his view that “the Federal Reserve has made itself into the world’s largest savings and loan, with all of the problems of being a savings and loan.”

Besides his 15 years spent at the head of the Chicago Federal Home Loan Bank, 1991–2014, Pollock led an unsuccessful attempt to rescue a failing S&L, Community Federal, St. Louis, in 1988– 1990. “We got the ball late in the fourth quarter on our own 1-yard line,” Pollock lightly told the St. Louis Post-Dispatch following the forced sale of Community in 1990. “We got it to the 20-yard line and time ran out, but it was one great drive.”

Now, then, Pollock observes, as of Sept. 30, 2021 the Fed showed $143.1 billion in cumulative unrealized gains on its portfolio holdings, down from $354 billion on Dec. 31, 2020. Probably, he speculates, four months of mainly rising interest rates have turned the positive September 2021 mark negative, and “maybe by a lot.”

Of course, the mark forces no action, the Fed being exempt from the regulatory rules governing regulated financial institutions. But if the central bank were not so privileged, and if you, Alex Pollock, were the CEO that had parachuted in to effect a miracle turnaround, what would you do?

Wisco Weekly Podcast: MMT...RIP (Market Booms & Busts, Austrian Economics) with Alex Pollock

Episode #201 features Alex J. Pollock.

Listen on: Spotify, Apple, Google, Amazon.

Alex J. Pollock is a student of financial systems. His work includes cycles of booms and busts, financial crises with their political responses, housing finance, government-sponsored enterprises, risk and uncertainty, central banking, banking and financial regulation, corporate governance, retirement finance, student loans, and the politics of finance.

Pre-order Alex Pollock's upcoming book Surprised Again!: The COVID Crisis and the New Market Bubble.