The Fed is in the red: Should it still pay CFPB’s bills?

Published in The Hill with Paul Kupiec.

The Fifth Circuit Court of Appeals just ruled that the Dodd-Frank Act’s requirement that the Federal Reserve pays the expenses of the Consumer Financial Protection Bureau is unconstitutional. This important ruling adds to another problematic aspect of the CFPB’s funding scheme — the Federal Reserve no longer has enough earnings to cover the $692 million in checks the CFBP writes each year.

The CFPB’s 2022 “Budget Overview” states that “The CFPB’s operations are funded principally by transfers … from the combined earnings of the Federal Reserve.” But in the fall of 2022, this is not true. There are no such earnings, the Fed is losing money. Making the Fed pay the CFPB’s expenses simply makes those losses larger. It also keeps the CFPB’s expenses out of the federal budget deficit where the court ruling says they rightly belong.

Former Fed Chairman Ben Bernanke has just been awarded the Nobel Prize in economics, but the policy of quantitative easing he championed has left the Fed with market value losses of monumental proportions. We estimate that the Fed’s balance sheet as of mid-October suffers from a $1.3 trillion mark-to-market loss. That is 30 times the Fed’s total capital of $42 billion. To put the size of this loss in perspective, it is nearly equal to Spain’s GDP and larger than the GDP of Indonesia.

The Fed says these mark-to-market losses are not an issue, they are “merely” unrealized losses. It does not include them in the asset valuations or the capital it reports on its financial statements. Since the Fed does not intend to sell any of its underwater investments, it says there is no danger it will experience a cash loss. While the Fed can feign indifference to a $1.3 trillion market value loss on its investment portfolio, imagine your reaction if you opened your 401(k) statement and saw a very large unrealized loss. 

As short-term interest rates increase, the Fed is experiencing both unrealized mark-to-market losses and cash operating losses. Both will continue because of the Fed’s massive interest rate mismatch. The Fed’s investment portfolio has a net position of about $5 trillion of long-term fixed-rate investments, much of them with remaining maturities of more than 10 years. These investments are funded with floating rate liabilities. The Fed is the financial equivalent of a $5 trillion 1980s-vintage savings and loan. When short-term interest rates rise, its profits naturally shrink and then turn into losses.

We estimate that, in round numbers, for each 1 percent that short-term interest rates increase, the Fed’s annual net income falls by $50 billion. Since the interest rate on the Fed’s floating rate liabilities has increased by 3 percent (so far) in 2022, the Fed is now posting substantial losses and will continue to post losses going forward.

In May, we estimated that the Fed would begin losing money when short-term rates exceed 2.7 percent. With the last FOMC rate increase, the Fed is now paying about 3.1 percent on bank reserve balances so the Fed’s operating profits should already be in the red. A comparison of the Fed’s Oct. 19, H.4.1 Report with its report from mid-September shows that, over the past month, the Fed has accumulated an operating loss of about $5 billion. The loss appears in Table 6 in the account, “Earnings remittances due to the U.S. Treasury.” On Oct. 19, the account is negative, which means the Fed is now losing money.

A loss of $5 billion in a month annualizes to a loss of $60 billion. At current short-term interest rates, not only are there no Fed profits to cover the checks CFPB will be writing, but the Fed’s annual operating loss is on a path that will soon exceed the Fed’s total capital. If these operating losses were booked into retained earnings, as required by Generally Accepted Accounting Principles, within a year, the Fed would report negative capital. In other words, using normal accounting standards, the Fed will soon be technically insolvent.

But unlike the banks it regulates, the Fed will not report negative capital and it won’t go out of business as its losses continue to accumulate. In its accounting statements, the Fed will offset operating losses dollar-for-dollar by debiting an intangible (better said, an imaginary) asset account called a “deferred asset.” As long as the Fed has a deferred asset balance, which may be for years, it will make no payments to the Treasury. In the meantime, the Fed will print money to pay its bills, further contributing to inflation.

If interest rates continue to increase, as nearly everyone expects, Fed losses will grow. The Fed’s total cash losses could easily grow to $100 billion or more over time — maybe a lot more — before rates decline. Ironically, the more the Fed fights inflation by increasing short-term interest rates, the bigger its own loss becomes.

From its inception in 1913, the Fed has been structured to make profits from its money printing monopoly and required to send most of its profits to the Treasury to reduce the federal deficit. But today the Fed’s short-funded quantitative easing investments have resulted in losses that exceed its seigniorage profits.

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Accounted for properly, Fed losses increase the federal deficit that ultimately must be paid by future taxes — but Fed losses are currently not counted in federal deficit estimates. As the next Congress considers Fed reforms, it should also require that Fed operating losses also be included in the federal budget deficit.

While the CFPB’s expenses are clearly federal government expenditures, they are currently not counted in the federal budget and have hitherto been set by an unelected CFPB director and evaded congressional appropriations by making the Fed pay the CFPB’s bills. If the Fifth Circuit’s ruling prevails, these expenditures could be put into a normal democratic process, set by the elected representatives of the people in a constitutional fashion, and no longer be increasing the Federal Reserve’s already embarrassingly large losses.

Alex J. Pollock is the co-author of the newly published “Surprised Again!—The Covid Crisis and the New Market Bubble,” and a senior fellow at the Mises Institute.  Paul Kupiec is a senior fellow at the American Enterprise Institute.

Role of the General Manager

By Alex J. Pollock, 8/1989 

Broad Tasks   |  What Works Well 

1. Build the system of communication | Consistent display of integrity - insight into strengths and weaknesses 

2. Put the right people in the right places | Never be threatened by subordinates - appreciate the best - think long and carefully about managerial change 

3. Give an emotional meaning to the enterprise | Repetition of themes - consistency of words and actions 

4. Imagine and form robust approaches to the future | Time to think - study the long past - flexible ideas 

5. Create openness to the outside | Broad interests - not taking self too seriously - customer focus 

6. Insure the development and maintenance of key competences | Always have little experiments running - build as they succeed - honor the old and new key skills and knowledge 

7. Create psychological security, the ground for common action, out of uncertainty and risks  | Self confidence - be an emotional exporter 

8. Balance between the uncaring outside world demanding change, and the emotional inside organization longing for stability. | Perspective - guiding and teaching - getting others to want to do what is needed - patience

Ten Commandments of Leadership

By Alex J. Pollock, 12/24/87 

1. Drama - Giving emotional meaning to the organization and to the efforts and sacrifices of the individual. Appearing a leader so others will believe they should follow. Providing an element of mystery.

2. Physical presence - Being seen and felt by the ranks as at the head. 

3. Empathy with the ranks - Their problems, sacrifices, risks, fears, hopes. 

4. Detachment - Necessary to think above and beyond the traditions, commitments and beliefs of the organization and to make decisions causing suffering (and in the military, death). 

5. Courage - Sharing the risk. Going on in spite of fear and uncertainty. 

6. Imposing sanctions - Required for coordination of large groups. 

7. Knowledge – Both general knowledge and detailed information on the problems at hand. Historical perspective required. 

8. Decision - Setting the right course at the right time with the appropriate level of abstraction or detail. Taking on the burden of turning actual uncertainty into psychological certainty, the ground of common action. 

9. The right inner circle - Those who will tell the truth, are not awed by your drama, and fill in your gaps and mistakes. 

10. Creation of a personal role - A necessary part of drama. The role must both separate the leader and link him to the ranks through its appeal. Possible components: flamboyance, calm, brilliance, drive, speed, good cheer, human touch, wisdom, determination, idiosyncrasies, heroics, visions. 

Adapted from John Keegan, The Mask of Command.

The Political History of Money

Published in Law and Liberty:

Those who fail to study the intellectual debates of the past are condemned to repeat them,” is a variation on Santayana’s famous dictum particularly applicable to economics and monetary theory, where ideas cycle along with events. In The Currency of Politics, Stefan Eich has written a valuable and very interesting review of specific monetary debates in their historical settings during centuries of thought about the nature of money as it is entwined with politics. The author’s own recommendations, however, are sketchy and betray a naïve faith in governments. The historical survey does inexplicably leave out the intense debate of “the money question” at the end of the 19th century in the U.S., starring William Jennings Bryan, which we will fill in at the end of this review.

The Currency of Politics was published in 2022, well timed to be greeted by the Great Inflation in this country, and runaway inflation in other countries as well, which has given rise to a new global debate about central banking, money, and inflation, with the global club of money-printing central banks on the defensive—at least for now. The current arguments and monetary stresses must become a new chapter in any future second edition.

Eich’s principal overall theme is that “money is always already political.” This does seem obviously true. I often point out that the old title, “Political Economy,” was a more accurate term than the current “Economics.” We find economics without politics only in theory, never in reality. Likewise, there is no “Finance,” only “Political Finance.”

One reason this is true is the recurring cycles of financial crises, which inevitably trigger powerful political reactions.

A second reason is that the control of money is extremely convenient to governments, especially to have their own central bank to buy their debt when they are out of money. This was the reason for creating the archetypical Bank of England in 1694. It is an arrangement so advantageous to politicians that virtually every national government has its own central bank now. This is particularly useful in times of war, but also handy in general while running budget deficits.

As George Selgin observed in his 2017 study of the nature of money:

Governments have come to supply currency, and to restrict the private supply of currency and deposits, not to remedy market failures, but to provide themselves with seigniorage and loans on favorable terms. Government currency monopolies…can thus be understood as part of the tax system [and reflect] the preference of the fiscal authorities.

This ability of the government to use its control of money for fiscal purposes is precisely what appeals to practicing politicians when they want to spend more, and to a statist academic like Eich, who wants “more precisely political control over money” and “to reconceive of money as a malleable political institution,” in order to have “more democratic visions,” although the “visions” are fuzzy.

In support of his true, but hardly surprising, theme that money is political, Eich goes back to Aristotle. He says Aristotle thought that “money could be an institution that would contribute to the cohesiveness of the polis—but one that was insufficient, imperfect and laden with potentially tragic consequences.” Indeed, such tragic consequences have been experienced by every victim of the hyperinflations that numerous governments have visited on their populations, and as are being experienced today, for example, with Argentina’s reported 71% inflation rate in July 2022.

From Aristotle, the book leaps two thousand years ahead to another great philosopher, John Locke, and in my view, becomes more interesting. The setting is the debate about the great British recoinage of 1696, two years after the founding of the Bank of England, in which Locke was an original shareholder. Famous for his influential political philosophy and theory of knowledge, Locke, as Eich recounts, was also a key monetary thinker. (That was left out of my philosophy courses, and I’ll bet is equally news to many others. As Eich comments, “today political theorists rarely engage with his monetary writings”—bravo to Eich for doing so.) At the same time, the towering scientific genius, Isaac Newton, was also involved in monetary affairs, as he became Warden of the Royal Mint in 1696. He was made Master of the Royal Mint in 1699, a post he held until his death in 1727.

Locke becomes a principal intellectual antagonist in the book for proposing “that the government call in all the circulating currency [that is to say, coinage] and recoin it to affirm its official silver content as originally set in Elizabethan times,” a century before. Eich writes, “For Locke, a pound sterling was and had to remain neither more nor less than three ounces, seventeen pennyweights, and ten grains of sterling silver.” This was in order “to restore trust in the monetary and political system.” The historical outcome was that “to the surprise of many, Locke’s novel insistence on the unalterability of the [monetary] standard carried the day… Parliament passed the act in January 1696…clipped and worn coins were removed from circulation and replaced by newly minted coins with milled edges…[accompanied by] the new emphasis on coins’ inviolable intrinsic value.”

Eich considers this an attempt to “depoliticize” money, but fairly points out that “Locke’s intervention was itself political.” Indeed, sound money, like inflationary money, is itself a position in Political Economy about what monetary system is best.

After Locke, Eich moves on to the German Idealist and nationalist philosopher, Johann Gottlieb Fichte, a theorist more to his taste. Fichte “set out the most incisive plea for…the political and philosophical implications of the new possibilities of fiat money,” which he believed would require a “closed commercial state” which cuts itself off from all foreign trade “with external commerce banned,” and “commercial autarchy.” Further, it would be “a state that enjoyed the full trust of its citizens had at its disposal the full powers of modern money,” and—an expansive claim by Fichte—“it would ensure for all time the value of the money distributed by it.” Needless to say, in a world of monetary politics, the probability of that is zero. A permanent related question is whether it is ever wise to trust the government in monetary affairs.

Eich is well aware that others doubt (as I do) that the state can or should be so trusted. But could fiat currency work anyway? That it could, at least for a while, was shown by a key historical event: the suspension of the convertibility of its notes by the Bank of England in 1797, in order to help finance England’s war against Napoleon. (A hundred years before, the Bank of England had been set up to finance England’s wars against Louis XIV, and one hundred years later, the Federal Reserve first made its mark financing American participation in the First World War.)

Eich’s discussion of this period is extremely interesting to us denizens of the current pure fiat currency world. Like President Nixon on August 15, 1971, the British government on February 26, 1797 “issued a breathtaking proclamation…The Bank of England had suspended…The pound sterling, still in name referring to the weight measure of silver, had become a piece of paper backed only by the word of the state.” This was “a dramatic opening of a now largely forgotten episode in global monetary affairs…from 1797 until 1821, Britain experimented with the most advanced monetary practice in the world—pure fiat money,” Eich says, “and with it the politics of modern central banking. [This] challenged and transformed not only reigning conceptions of money, but also the nature and role of the modern nation state.”

Like the United States in 1971, Britain in 1797 had little choice about this dramatic move—they were both running out of the gold they had promised to pay on demand to their creditors. Here was the British situation:

“The latter part of 1796 had brought a new wave of failures of mercantile and banking houses all over the country. The apprehension of a French invasion heightened the alarm, and when in February 1797 a single French frigate actually landed 1,200 men in Fishguard in Wales, a run on the Bank of England started.” Think of that. According to Hayek, “[Prime Minister] Pitt, being informed of the state of affairs by a deputation from the Bank…forbade the directors, by an Order in Council [from] issuing any cash payments.” The prohibition lasted more than two decades.

Eich emphasizes that “for the first three years prices stayed almost completely stable.” But they didn’t stay that way after that. You have to go to footnote 85 of his Chapter 3 to find that “Over the next two decades…prices rose overall by about 80%.” Eich comforts himself with the thought that this was only “an annualized rate of less than 4 %.” He apparently did not do the math of compound growth rates. At an inflation rate of 4%, prices will multiply by 16 times in a lifetime of 72 years.

Eich hopes that his history will help “by providing a better language to capture the politics of money, including its promises and limitations.”

Likewise, in our own fiat currency days, after a period of central bank self-congratulation for “price stability,” prices have also not stayed stable, to say the least.

In the historic British case, “a lively debate ensued,” famous to students of monetary history. If we get to footnote 86 of Chapter 3, we find that “The most important English contribution to the debate… was that of Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.” Unfortunately, Thornton does not make it into the book’s main text or appear in its index. We may remedy this lack with two of Thornton’s essential conclusions:

That the quantity of circulating paper must be limited, in order to the due maintenance of its value, is a principle on which it is of especial importance to insist.

To suffer…the wishes of the government to determine the measure of the bank issues, is unquestionably to adopt a very false principle.

At the end of the classic monetary debate in which Thornton played an important part, and with Napoleon well and truly defeated, Britain went back to gold convertibility in 1821.

As the book proceeds, Eich devotes a chapter to his real hero, John Maynard Keynes, and one to the other principal intellectual antagonist of the book, Friedrich Hayek. These chapters have much history of interest—for example, how in 1925 Keynes rightly advised Chancellor of the Exchequer Winston Churchill not to go back on gold at the old, pre-War parity, because the War had destroyed the parities of the old gold standard for good. How Keynes proposed at the Bretton Woods Conference in 1944 the impractical creation of a global central bank and an international fiat currency, “Bancor,” but was representing Britain, which was by then a broke debtor nation and a loser in the argument. The world moved on to the Bretton Woods system based on the U.S. dollar with inter-government gold convertibility, which collapsed in 1971. And on the other side, how Hayek intellectually led “the devastatingly effective politics of the 1970s, which not only paved the way to disinflationary discipline, but also effectively buried Keynes, at least until…2008,” and how Hayek suggested “depriving governments of their monopolistic control of money.” Eich views that as the renewed heresy of “depoliticization” of money.

Eich likes Keynes’ 1930s proposal for zero interest rates which would bring “the euthanasia of the rentier.” However, when in our day central banks imposed zero interest rates, they brought instead the “euthanasia of the saver” and for the rentiers created giant profits by asset price inflation in their bond and stock portfolios.

In the Epilogue to the book, Eich explains, “Following past thinkers…is not meant to produce a catalogue of answers.” Still, he mentions a few suggestions, none spelled out and none, in my view, of much interest, like bringing back postal banking or making the Federal Reserve into a government lending bank. He wants “the greater democratization of money power,” but suggests the anti-democratic need to shield monetary decisions from “the whims of public opinion.”

As a summary thought, he hopes that his history will help “by providing a better language to capture the politics of money, including its promises and limitations.”

The most surprising thing about The Currency of Politics is that the great American monetary debate in which “the money question” dominated national politics, and particularly the presidential election of 1896 with the stirring oratory of William Jennings Bryan, gets not a single mention. Yet its focus was precisely the politics of money in a clear, dramatic, and historic fashion.

Bryan—“that Heaven born Bryan, that Homer Bryan, who sang from the West,” according to the poet Vachel Lindsay—thrilled the Democratic National Convention of 1896 with his “Cross of Gold” speech, the high-flying rhetoric of which was an attack on the gold standard and the promotion of an explicitly inflationist monetary program by the free coinage of silver. One commentator, with some exaggeration, calls it “the most famous speech in American political history.” It is surely the most famous American speech on monetary policy.

Says one history, Bryan “leaped to the speaker’s stand two steps at a time,” and “appeared like a Democratic Apollo.” He proclaimed “that the issue of money is a function of the government, and that the banks should go out of the governing business”—a proposition to which Eich would subscribe. After much more, which I wish we had space to quote, Bryan reached his unforgettable conclusion:

We shall answer their demands for a gold standard by saying to them, “You shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold!”

Bryan got three runs for the U.S. presidency and lost three times. Whatever your views on the substance of his ideas, he certainly gave us notable rhetoric. Eich might add it to his study while he searches for “a better language to capture the politics of money.”

Letter: On this measure, the Fed is already in negative equity

Published in the Financial Times:

“Are central banks going bankrupt?” Robin Wigglesworth asks (FT Alphaville, FT.com, October 10).

He points out that the Federal Reserve has disclosed a $720bn unrealised loss on its investments as of June 30 of this year. By now, this loss is much bigger.

Paul Kupiec and I have estimated it at about $1tn — an especially remarkable number when compared to the Fed’s total capital of $42bn.

Moreover, the mark-to-market loss presages cash operating losses on the way, as the Fed will be funding low-yielding fixed rate investments with expensive floating rate liabilities, generating negative net interest income — just like a 1980s savings and loan.

Depending on the path of interest rates, these operating losses could go on for some years. “Central bank negative equity,” Wigglesworth writes, “coming to a Fed or BoE or ECB near you soon?”

On a mark-to-market basis, Federal Reserve negative equity in size is already here. Alex J Pollock Senior Fellow, Mises Institute Auburn, AL, US

Economic Truths, Perennially Forgotten

A review of Surprised Again! The Covid Crisis and the New Market Bubble, written by William M. Briggs and published in Law & Liberty.

In 2021, Treasury Secretary Janet Yellen assured Americans that recent inflation was “transitory.” Back in 2017, Yellen, then Chairman of the Federal Reserve Board, hinted there would not be another financial crisis “in our lifetimes.”

Maybe she got that idea from Morgan Stanley boss James Gorman, who in 2013 put the chance of a crisis “in our lifetime” as “close to zero” as he could imagine. Well, imagination, as the song says, is crazy. “Your whole perspective gets hazy.”

These two experts, as Alex J. Pollock and Howard B. Adler tell us in Surprised Again! The Covid Crisis and the New Market Bubble, are far from alone. Economic experts, they confirm, have a collective accuracy that would embarrass a busload of blind golfers. Not one expert, they remind us, saw the Great Depression coming. And none foresaw the Calamitous Coronadoom Panic of 2020. Which lasted until now.

What is fascinating is that being wrong in no way dents the awesome armor of assurance donned by our experts. Whatever they do when given power, they do it boldly and without doubt. Whether this lack of humility is caused by amnesia or hubris can be debated. But no one can doubt  the astonishing effects of the economic “solutions” foisted upon us by a string of experts during the panic, each trying to correct the ill effects of the other “solutions.”

Read the rest here.

The historical waning of the U.S. Savings & Loans

Published in Housing Finance International Journal.

At its founding in 1914, the original name of the association which publishes Housing Finance International was the “International Union of Building Societies and Savings & Loan Associations.” This narrow focus fit the times; the name got the unattractive acronym of “IUBSSA.” When it was 75 years old, and after the disastrous number of failures in the U.S. savings & loan industry during the 1980s, a broader perspective was reflected in a new name for the association in 1989: the “International Union of Housing Finance Institutions” (“IUHFI”). Fundamental change in housing finance markets continued, notably the great expansion of mortgage securitization, and showed this was still too narrow an idea. So 1997 brought a yet broader and still current name: the “International Union for Housing Finance.”

I had the honor of co-chairing the committee which proposed the by-law revisions of 1997 that included changing the name, symbolizing that the IUHF is interested in and welcomes participation from all forms of the essential, worldwide activity of housing finance, one of the largest credit markets in the world, as well as one of the most politically and socially most important. Financial evolution, as it has continued in the 25 years since then, shows that wider perspective to be the correct approach.

A fundamental idea governing the shape of housing finance in its historical form of building societies and savings and loans was what was called the “special circuit” of funding for housing finance. As Michael Lea, a former Director of Research for the IUHF, and Douglas Diamond, Jr. wrote in 1992:

“Housing finance traditionally has been an area of intervention by governments, especially through the creation of special circuits for [mortgage] funding flows. … In many countries, governments intervened in the market to set up special circuits, characterized by a significant degree of regulation, segmentation from the rest of the financial markets, and often substantial government subsidy.”1

American savings & loan associations were a large and perfect example of such a special circuit, with savings accounts, which received regulatory advantages, directly linked to mortgage loans, both of which got a lot of favorable political attention. In the U.S. case, the savings & loans were required by law and regulation to make principally very long mortgage loans, with the interest rate fixed for 20 or 30 years. A special circuit was also represented by building societies in the United Kingdom and other countries, thus making up the two parts of the original name and membership of the International Union of Building Societies and Savings & Loans. As Lea also wrote:

“Specialist-deposit funded institutions… traditionally dominated the provision of housing finance in Anglo-Saxon countries (for example, Australia, Canada, South Africa and the United States) as well as Commonwealth countries… Through most of the 20th century, the building societies/savings & loan model dominated housing finance in the English-speaking world.”2 In the U.S., the specialist institutions included, in addition to the savings & loans, their close cousins, the mutual savings banks, known together as “thrift institutions.” In 1980, there were 5,073 thrift institutions in the United States.

As Lea observes, “Starting in the 1980s, this model began to lose influence and market share to commercial banks.” In the U.S., they also lost massive market share to the government-sponsored enterprises, Fannie Mae and Freddie Mac, as that duopoly’s government-guaranteed securitization replaced the balance sheets of thrifts for mortgage funding. By the late 1980s, one housing finance expert could write, “Mortgage-backed securities have forever blown apart thrift balance-sheet compartmentalization.”3

The decline of the special circuit was especially marked in the United States by the collapse of much of the thrift industry. There were failures by the hundreds. Between 1982 and 1992, 1,332 U.S. thrift institutions failed. That is on average 121 housing finance institution failures per year continuing over eleven years, or a rate of more than two failures per week for a decade.

The savings & loan industry as a whole became insolvent on a mark-to-market basis. The government’s deposit insurance fund for the savings & loans, the Federal Savings & Loan Insurance Corporation (FSLIC), itself became completely broke. In 1989, the same year IUBSSA was renamed IUHFI, all these failures resulted in a $150 billion U.S. taxpayer bailout under the emergency Financial Institutions Reform, Recovery and Enforcement Act. Expressed in inflation-adjusted 2022 dollars, that is a bailout of $350 billion.

This was a crisis indeed: the collapse of an entire housing finance structure of a special circuit promoted and guaranteed by the U.S. government. The thrifts had total assets of $796 billion in 1980, or $2.8 trillion in 2022 dollars.

Since the savings & loans had unwisely been required by the government to make primarily long-term fixed rate mortgage loans with their short term, variable rate deposits, when the Great Inflation of the 1970s resulted in double-digit interest rates—with 3-month Treasury bill rates reaching 15% in 1981—such a balance sheet was an obvious formula for disaster.

The savings & loans and other thrifts were, for example, financing assets yielding 6% with liabilities costing 10% or more, spilling an ocean of red ink. The savings & loan regulator of the time, the Federal Home Loan Bank Board (FHLBB), tried earnestly, frantically, and unsuccessfully to avoid the fate of the industry, but it was too late.

Thomas Vartanian, a General Counsel of the FHLBB during the 1980s crisis, looking back from 2021, reflected on the culpability of the government, which had promoted and tried to protect the thrifts, but ended up first trapping them and then charging the taxpayers for their losses.

“In this government-made economic biosphere,” Vartanian wrote, “Savings & loans generally had portfolios of thirty-year fixed-rate that they normally held to maturity. Variable rate mortgages were disfavored and actually prohibited under federal law until 1981”—that applied to federally-chartered savings & loans. “A few states did permit state-chartered savings & loans to make variable rate mortgages…but most savings & loans were compelled by law to do what no sane businessperson would ever advocate: borrow short…and lend long”—very long.

Vartanian concluded, perhaps not too diplomatically, “This financial gross negligence had been imposed on savings & loans by federal law.”4 Of course it was all imposed with good intentions and with cheering from housing interest groups.

By 2000, the more than five thousand thrift institutions had shrunk to 1,589, a nearly 70% attrition. By 2022, the total had been reduced to 602, 88% fewer than as the 1980s began.

This was a dramatic shift in industrial structure from the days of the great post-World War II American housing boom, when savings & loans were the most important mortgage lenders. In this golden age of the savings & loans, the American home ownership rate increased dramatically, from about 50% in 1944 to over 64% in 1980. Waving the banner of housing and home ownership, the savings and loans were politically potent. Their national trade association, the U.S. League for Savings, was a political lobbying force to be reckoned with.

They had their own government deposit insurance fund and their own governmentsponsored liquidity facility, the Federal Home Loan Banks.

The list of the 25 biggest savings & loans in America in 1983 contained many names famous in housing finance circles in those days. How many do you think still exist, thoughtful Reader? Make your guess before you read the answer.

The answer is that of these 25 formerly industryleading institutions, the number still existing as independent companies is zero. Of the 25, 17 failed or were acquired by institutions that later failed. The other eight were acquired and became just a part of much bigger commercial banks. These 25 formerly well-known names are unheard of now, a good lesson for the young in the fragility of institutions and a source of nostalgia, perhaps, for old housing finance veterans.5

The U.S. League for Savings no longer exists, having first changed its name to the Savings and Community Bankers of America, then to America’s Community Banks, then joining with the commercial banks by becoming part of the American Bankers Association.

The Federal Home Loan Bank Board was abolished by Congress and replaced by the Office of Thrift Supervision (OTS). The OTS was subsequently abolished, and its responsibilities moved to regulator of national commercial banks, the Comptroller of the Currency.

FSLIC was abolished by Congress and its deposit insurance fund first taken over by, and then merged into, the Federal Deposit Insurance Corporation, the guarantor of commercial bank deposits.

The Federal Home Loan Banks (FHLBs) remain large and active, but the thrifts, which used to represent all of the FHLB stockholding members, now are only 9% of the members, while commercial banks are 58%.

Lea and Diamond concluded that “Political and market forces seem to have eroded the reasons for having special circuits and the ability to maintain them.” In the U.S. savings & loan case, they certainly did.

Applying Volcker's Lessons

Published in Law & Liberty:

The year 2022 has certainly been a tough one for the Federal Reserve. The Fed missed the emergence of the runaway inflation it helped create and continued for far too long to pump up the housing bubble and other asset price inflation. It manipulated short- and long-term interest rates, keeping them too low for too long. Now, confronted with obviously unacceptable inflation, it is belatedly correcting its mistake, a necessity that is already imposing a lot of financial pain. 

Sharing the pain of millions of investors who bought assets at the bloated prices of the Everything Bubble, the Fed now has a giant mark-to-market loss on its own investments—this fair value loss is currently about $1 trillion, by my estimation. It is also facing imminent operating losses in its own profit and loss statement, as it is forced to finance fixed-rate investments with more and more expensive floating rate liabilities, just like the 1980s savings and loans of Paul Volcker’s days as Fed Chairman.

In short, the Fed, along with other members of the international central banking club, sowed the wind and is now reaping the whirlwind. Comparing the current situation with the travails of the Volcker years grows ever more essential.

Samuel Gregg, Alexander Salter, and Andrew Stuttaford have provided highly informed observations about the past and present, and offer provocative recommendations for the future of the “incredibly powerful” (as Gregg says) Federal Reserve—the purveyor of paper money not only to the United States, but also to the dollar-dominated world financial system. 

Stuttaford considers the issue of “Restoring the Fed’s Credibility?” with a highly appropriate question mark included. He points out that Volcker did achieve such a restoration of credibility and ended up bestriding “the [wide] world like a colossus,” although, we must remember, not without a lot of conflict, doubt, and personal attacks on him along the way.

But is it good for the Fed to have too much credibility? Is it good for people to believe that the Fed always knows what it is doing, when in fact it doesn’t—when it manifestly does not and cannot know how to “manage the economy” or what longer-run effects its actions will have and when? Is it good for financial actors to believe in the “Greenspan Put,” having faith that the Fed will always take over the risk and bail out big financial market mistakes? It strikes me that it would be better for people not to believe such things—for the Fed not to have at least that kind of “credibility.”

Stuttaford elegantly and correctly, as it seems to me, suggests that “the price of a fiat currency is—or more accurately, ought to be—eternal vigilance against inflation.” Such eternal vigilance requires that we should never simply trust in the Fed and poses the central question of who is to exercise the eternal vigilance.

It is often argued, especially by economists and central bankers, that central banks should be “independent,” thus presumably practicing by themselves the vigilance against inflation, making them something like economic philosopher-kings. Indeed, inside most macro-economists and central bankers there is a philosopher-king trying to get out. But the theory of philosopher-kings does not fit well with the theory of the American constitutional republic.

Those who support central bank independence always argue that elected politicians are permanently eager for cheap loans and printing up money to give to their constituents, so can be depended on to induce high inflation and cannot be trusted with monetary power. But if the central bank also cannot be trusted, what then? Suppose the central bank purely on its own commits itself to perpetual inflation—as the Fed has! Should that be binding on the country? I would say No. The U.S. Constitution clearly assigns to the Congress, to the elected representatives, to the politicians, the power “to coin money [and] regulate the value thereof.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Salter suggests we should follow this constitutional logic. “The Fed should have a single mandate,” he recommends, that of price stability, and “Congress should pick a concrete inflation target.” The Fed wouldn’t get to set its own target: “Since the Fed can’t make credible commitments with a self-adopted rule, the target’s content and enforcement must be the prerogative of the legislature, not the central bank.” In sum, “As long as we’re stuck with a central bank, we should give it an unambiguous mandate and watch it like a hawk. Monetary policymakers answer to the people’s representatives, in Congress assembled.” 

Along similar lines, I have previously recommended that Congress should form a Joint Committee on the Federal Reserve to become highly knowledgeable about and to oversee the Fed in a way the present Banking committees are not and cannot. I argued:

“The money question,” as fiery historical debates called it, profoundly affects everything else and can put everything else at risk. It is far too critical to be left to a governmental fiefdom of alleged philosopher-kings. Let us hope Congress can achieve a truly accountable Fed.

This still seems right to me. As I picture it, however, neither the Federal Reserve nor the Congress by itself would set an inflation target. Rather, on the original “inflation target” model as invented in New Zealand, the target would be a formal agreement between the central bank and the elected representatives. New Zealand’s original target was a range of zero to 2% inflation—a much better target than the Fed’s 2% forever. Since an enterprising, innovative economy naturally produces falling prices through productivity, we should provide for the possibility of such “good deflation.” Hence my suggested inflation target is a range of -1% to 1%, on average about the same target Alan Greenspan suggested when he was the Fed Chairman, of “Zero, properly measured.”

In his insightful history of the Fed, Bernard Shull considered how the Fed is functionally a “fourth branch” of the U.S. government. The idea is to put this additional branch and the Congress into an effective checks-and-balances relationship.

Among other things, this might improve the admission of mistakes and failures by the Fed, and thus improve learning. As Gregg observes, “Admitting mistakes is never something that policymakers are especially interested in doing, not least because it raises questions about who should be held accountable for errors.” And “central bankers do not believe that now is the time for engaging in retrospectives about where they made errors.” Of course they don’t.  But are you more or less credible if you never admit to making the mistakes you so obviously made?

Gregg is skeptical of the ability to control central banks by defined mandates, since we are always faced with “the ability of very smart people to find creative ways around the strictest laws (especially during crises).” The politicians, he points out, often want the central banks to use creative rationales for stretching and expanding their limits, and this is especially true during crises. As a striking example, “the European Central Bank has engaged in several bailouts of insolvent states and operated as a de facto transfer union.” But “governments…say as little as possible about such ECB interventions (and never question their legality),” and this “has everything to do with European governments wanting the ECB to engage in such activities.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Another Roman, Velleius Paterculus, expressed another fundamental central banking problem: “The most common beginning of disaster was a sense of security.” It is most dangerous when the public and the central bankers become convinced of the permanent success of the latest central banking fashion, especially, as Volcker pointed out in his autobiography, if that involves accommodating ever-increasing inflation.

We can conclude our review by stressing that the price of having fiat money is indeed eternal vigilance against inflation. But we don’t know very well how to carry out that vigilance and we can’t count on a new Volcker appearing in time to prevent the problems, or belatedly to address them, or appearing at all.

Freedom Adventure Podcast 471: Volker and the Great Inflation

Published by Freedom Adventure. Click here to listen.

Alex J. Pollock discusses Paul Volker and the great inflation and the similarities to today. Volker raised interest rates to an all time high and defeated run away inflation. His predecessor Arthur Burns anguished over inflation and central bankers are facing a similar anguish today.  We discuss the knowledge problem and how central planners are a menace to society.

article discussed

Alex’s website

Finance and Philosophy

Boom and Bust

The government is not only spending trillions — it’s losing trillions

Published in The Hill with Paul Kupiec. Also in RealClear Markets.

Lately, no matter if the federal government is spending taxpayer dollars or losing them, it doesn’t mess around with small change.  

The government allocated $4.6 trillion just in COVID relief spending, tens of billions of which have been siphoned off by fraud. And when it comes to losing taxpayers’ hard-earned dollars, we’ve calculated that losses tallied at the Federal Reserve and Department of Education together will top $2 trillion. No telling how much it will cost when the government losses accumulate on the $370 billion green energy loan and loan guarantee programs included in the Inflation Reduction Act, but if Obama-era green energy loan guarantee costs are any guide, they will be large. 

Let’s start with Fed. By the end of May of this year, we estimated that the Fed’s mark-to-market loss on its huge portfolio of Treasury bonds and mortgage securities had grown to the staggering sum of $540 billion. The Fed’s losses have continued to build and today are, we now estimate, quickly approaching $1 trillion. Thus the Fed’s investing losses match the estimated loss the Department of Education is about to foist on U.S. taxpayers should President Biden’s student loan forgiveness plan survive legal challenges.

The government spends trillions of taxpayer dollars here and loses trillions more there, but it hardly seems to make the news. Congress has passed so many new giant spending bills in the past three years, much of it financed on the Fed’s balance sheet, that the public has become desensitized to the magnitude of the taxpayer dollars involved. 

Consider this: One million seconds is about 11.5 days; a billion seconds is about 32 years; a trillion seconds is 32,000 years!

In the footnotes of the Fed’s recently released financial statement of the combined Federal Reserve Banks for the second quarter of 2022, you can find this startling disclosure: The mark-to-market loss on the Fed’s system open market account portfolio on June 30 reached $720 billion, $180 billion more than our end-of-May estimate.

Since June 30, interest rates have continued rising and the market value of the Fed’s massive investment portfolio has shrunk even more. Using the interest rate sensitivity that the market value of the Fed’s portfolio displayed over the first six months of 2022, we estimate that the market value loss since June 30 has increased by $275 billion, bringing the Fed’s total investment portfolio mark-to-market loss to about $995 billion, which is 17 times the Federal Reserve System total capital. 

If interest rates continue to rise, as we expect they will, Fed market value losses will easily exceed $1 trillion. The irony, of course, is that the Fed was buying heavily to build its $8.8 trillion portfolio at top-of-the-market prices the Fed itself created with its extended near zero-interest rate monetary policy. In addition, the Fed is moving toward generating large operating losses, even if it never sells any of its underwater bonds and mortgage securities, because it must finance its long-term fixed rate assets with floating rate liabilities at ever-higher interest rates. The federal budget deficit will be bigger still, and possibly for a very long time because it will be short the billions of dollars of revenue the Treasury has been receiving from the Federal Reserve System’s remitted profits.

In the very same eventful quarter that Fed losses reached almost $1 trillion, President Biden issued an executive order (of dubious legality) that ordered the government to fully forgive, at taxpayer expense, hundreds of billions of dollars of defaulted student loans it had made, and to partially forgive over time billions more in unpaid student loan balances at taxpayer expense. Estimates of the cost to the taxpayer of writing off these loans run up to $1 trillion. 

Considered as a lending program, as it was enacted to be, the federal student loan program is nothing if not an utter and egregious failure. The loss is especially ironic since a decade ago it was claimed that student loans would be a big source of profits for the government and help to offset the cost of Obamacare subsidies.

According to a Congressional Budget Office report in March 2010, the federal government takeover of the student loan program would save $68 billion. These savings, it was claimed, would provide funding for an additional $39 billion of grants and make available the remainder to theoretically pay for Obamacare subsidies. A dozen years after the CBO produced this wildly overoptimistic estimate, the federal government student loan program is costing taxpayers $1 trillion, not generating $68 billion in additional revenues.

Considering the federal government’s propensity for producing unreliable forecasts, simultaneously authorizing trillions in new spending, and losing trillions of taxpayer dollars in off-budget government loans and investments, it certainly makes one doubt the acumen of the federal government as a financial manager.

The Fed’s Mark to Market Loss Approaches $1 trillion, while the write-off of student loans hits $420 billion

Published in the Federalist Society:

In May of this year, Paul Kupiec and I estimated that the Federal Reserve’s mark to market loss on its unprecedented portfolio of Treasury bonds and mortgage securities had grown to the staggering amount of $540 billion. Now we have the Fed’s official numbers for the end of June, which by then, it turns out, were much worse than that.

Down in the footnotes of the recently released financial statements of the combined Federal Reserve Banks for the second quarter of 2022, we find this startling disclosure: the mark to market loss on June 30 had increased to $720 billion. That’s a number to get your attention, even in these days of counting in billions, especially when compared to the Fed’s reported total capital on the same date of only $42 billion. The Fed’s mark to market or economic loss at the end of the second quarter was thus 17 times its total capital, making it deeply insolvent on a mark to market basis. (Woe to any bank supervised by the Fed which gets itself in the same situation! Oh yes, we know the Fed will earnestly insist that it is different, but that doesn’t change the fact of the market value losses.)

Since the reporting date at the end of June, interest rates have gone higher, the market value of the Fed’s massive investment portfolio has shrunk even more, and the mark to market loss has gotten even more huge. Using the price sensitivity the Fed’s portfolio displayed in the first six months of 2022, we estimate that the market value loss has during the third quarter increased by $275 billion, bringing it to about $995 billion.

The loss is $995 billion now, we guess, but if interest rates rise further toward more normal levels from their previously suppressed lows, the Fed’s mark to market loss will easily reach and exceed $1 trillion. The irony of course is that the Fed was buying heavily to build its $8.8 trillion portfolio at a market top created by its own actions. In addition, the Fed is moving toward generating operating losses, even if it never sells any of its underwater bonds and mortgage securities, because it must finance its long-term fixed rate assets with floating rate liabilities at ever-higher interest rates. These operating losses will mean the federal budget deficit will be bigger since it will lack the normal contributions from Fed profits, possibly for a long time.

In the very same eventful quarter, President Biden ordered (with dubious legality) the government not to even try to collect on hundreds of billions of dollars of defaulted student loans it had made and instead to write them off. The Congressional Budget Office estimates the cost to the budget of writing off these bad debts to be $420 billion. One must conclude that, considered as a lending program, as it was enacted to be, the federal student loan program is an utter and egregious failure. It has its own deep irony, since a decade ago the CBO claimed the program would be a big source of profits to the government.

Consider these two losses together—one in the Fed’s investing and one in making government student loans. It certainly makes one doubt the acumen of the federal government as a financial manager.

Mises Institute's Alex Pollock: The Fed’s Tough Year

From Chicago’s Morning Answer. Click here to listen.

Restoring The Fed's Credibility?

Published in Law & Liberty by Andrew Stuttaford.

If any central banker, both literally and figuratively, bestrode, in Shakespeare’s phrase, “the…world like a colossus,” it was the 6-foot-7 Paul Volcker.  But, perversely, the giant shadow he cast helps explain our not-so-transitory inflationary mess.

Alex Pollock offers a brisk, deft analysis of Volcker’s battle against inflation. He sets the stage with a 1979 speech by Arthur Burns, Volcker’s not quite immediate predecessor as Fed Chairman. In what Pollock describes as an “agonizing reappraisal,” Burns conceded (he could hardly do otherwise) that central banks had failed to rein in inflation. Running through his lament was an acknowledgment that the Fed had gone along with “the philosophic and political currents that were transforming American life and culture,” currents that had also swept away traditional notions of fiscal and monetary discipline.

Read the rest here.

Don’t Let Colleges Off the Hook for Loan Debt

Published in The Wall Street Journal:

Mitch Daniels makes many insightful points in his indictment of the utterly failed and, as he says, “bankrupt” system of federal student loans (“Student Loans and the National Debt,” op-ed, Sept. 2). Among the most important is that the colleges “encouraged students to borrow.” The colleges played the same role in this credit disaster as subprime-mortgage brokers did in the housing bubble: inducing excessive debt while sticking somebody else with all the risk.

Alex J. Pollock

Event Sept 14: What’s Next for Crypto: Implications of Deflated Prices and Turmoil in Cryptocurrency Markets

Teleforum hosted by the Federalist Society.

Events of 2022 brought a "crypto winter," with average prices of cryptocurrencies falling about 70% from their 2021 highs, the bankruptcy of several crypto companies, the complete collapse of a popular so-called "stable" coin, unexpected suspensions of withdrawals by some crypto issuers, large losses by individual investors, and heightened efforts toward expanded regulation and legislation.  What does this all mean going forward?  Was this simply the end of another bubble and popular delusion which will now wither?  Or was it the winnowing out of a typical innovative overexpansion, with a more mature ongoing cryptocurrency industry continuing, perhaps one with significant regulation?  This webinar will examine where crypto will go from here.

Featuring:

Bert Ely, Principal, Ely & Company, Inc.

Alexandra Gaiser, Director of Regulatory Affairs, River Financial

Steven Lofchie, Corporate Partner, Fried Frank

J.W. Verret, Associate Professor of Law, Antonin Scalia Law School, George Mason University

Moderator: Alex Pollock, Senior Fellow, the Mises Institute

Register here.

Federal Reserve Operating Losses and the Federal Budget Deficit

Published in AIER and RealClear Markets by Alex J. Pollock Paul H. Kupiec.

The Federal Reserve remits most of its operating profits to the US Treasury. Federal Reserve remittances are government revenues that directly reduce the federal budget deficit. But what is the budgetary impact of Federal Reserve System losses? The Federal Reserve System has not had an operating loss since 1915, so history provides no guidance as to how these losses will impact the official federal government deficit.

In 2023, the Fed will likely report tens of billions of dollars in operating losses as it raises interest rates to combat raging inflation. Will Fed losses increase the budget deficit as logic dictates they should, or will they be treated as an off-budget expenditure? Given the “transparency” of federal budgetary accounting standards, it is not surprising that a recent Congressional Budget Office (CBO) report suggests Federal Reserve operating losses will be excluded when tallying the official federal budget deficit.

The Federal Reserve earns interest on its portfolio of Treasury and federal government agency securities and receives revenues for the payments system services it provides.  Offsetting Fed revenues are the interest the Fed pays on bank reserve balances and reverse repurchase agreements, dividend payments to Fed member banks, contributions (if any) to the Fed surplus account, and the operating expenses of the Board of Governors, the 12 Federal Reserve district banks and their branches. Since 2012,  expenses also include the Consumer Financial Protection Bureau. Any remaining earnings are transferred to the US Treasury and counted as federal government receipts for federal budget purposes. 

The annual amount of Federal Reserve operating income remitted to the Treasury since 2001 is plotted in Figure 1. Also shown are estimates of the reductions in the reported federal deficits attributable to the remittances. (The Fed reports remittances on a calendar-year basis, while the federal deficit is calculated for a fiscal year ending September 30. The deficit reduction estimates in Figure 1 do not correct for this timing difference.)

Source: Various US Treasury monthly statements, Federal Reserve Annual Board Reports, and the authors’ calculations

In crisis years (2009-2011, 2020-2021) the federal budget deficit is bloated by congressionally appropriated stimulus outlays and reduced tax receipts. In these years, even very large Fed remittances offset only a fraction of the combined federal budget deficit. In years unburdened by massive federal stimulus expenditures, however, Fed remittances offset a substantial portion of the reported deficit.

By the FOMC’s own estimates, short-term policy interest rates will approach 3.5 percent by year-end 2022. As the Fed raises short term interest rates to fight inflation, its interest expense increases. The Fed’s interest expenses and operating expenditures, including about $630 million per year in off-budget funding it is required to provide to the Consumer Financial Protection Bureau, will soon exceed its revenues.

Our back-of-the envelope estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent, assuming the Fed has no realized losses from selling its SOMA securities. If short-term rates reach 4 percent, our estimates suggest that annualized operating losses could exceed $62 billion. As discussed below, these loss estimates are consistent with the Fed Board of Governors’ own public estimates. 

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

[I]n the unlikely [sic] 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.

Among financial institutions, the Fed has the unique privilege of setting its own accounting standards, and the Fed has decided that, unlike for all its regulated banks, operating losses will not reduce the Federal Reserve’s reported capital and surplus. The Fed will maintain a positive reserve surplus account in the event it books operating losses by offsetting its operational losses, one-for-one, with an imaginary “deferred asset” account, no matter how large the loss. Unless Congress intervenes, the Fed will not remit any revenues to the US Treasury—even as it continues paying dividends to its member banks—as long as this deferred asset account has a positive balance. 

Instead of issuing a new marketable Treasury security, which would count towards the deficit, the Fed will cover its losses with a nonmarketable receivable called deferred assets recorded on the Fed’s balance sheet. The economic reality, of course, is that Fed losses increase the government’s deficit.

Federal Reserve Board estimates of the system’s potential cumulative operating losses are mirrored in estimates of its deferred asset balance pictured in Figure 2. The Federal Reserve Board’s own estimates suggest that its cumulative operating losses (in the estimated “90 percent interval” case) could approach $200 billion by 2026, Moreover, the Fed projects that it may not resume making any Treasury remittances until 2030 or later. Keep in mind that these projections assume the Fed can reduce inflation with fairly modest increases in short-term interest rates with the expected short-term rate path peaking at less than 4 percent in 2023, before slowly declining toward 2.5 percent in 2026. 

Figure 2: Federal Board of Governors Projection of Treasury Remittances and System Deferred Asset Account Balances 2023-2030

Source: FEDs Notes, 2022

While the Board of Governors fully anticipates operating losses beginning in 2023, the CBO did not get that memo. In its most recent forecast, the CBO projects that the Fed will continue making positive remittances to the Treasury every year between 2022 and 2032. While the CBO forecast anticipates a sharp decline in remittances in 2023 through 2025, it expects a recovery toward 2021 remittance levels thereafter, with the Fed reducing interest rates as inflation returns to targeted levels. 

While the CBO does not project any Fed operating losses, its explanation of budget accounting suggests any such losses would be excluded from budget deficit calculations: “Although it remits earnings to the Treasury (which are recorded as revenues in the federal budget), the Federal Reserve’s receipts and expenditures are not included directly in the federal budget…” Operating losses will be a Federal Reserve expenditure, so this CBO statement would appear to exclude Fed operating losses from the federal deficit calculation. It is strange not to count the Fed’s losses in the budget accounting, considering that the Fed’s profits are counted. Perhaps because the CBO does not anticipate Federal Reserve losses, it has failed to consider them explicitly in its description of deficit accounting. 

Simple accounting logic suggests that if the federal budget deficit is reduced when the Fed earns revenues in excess of expenses and remits these profits to the US Treasury, Fed losses should increase the reported federal budget deficit. This is especially true since Federal Reserve System losses now include the hundreds of millions of dollars of off-budget funding it is required to transfer to run the Consumer Financial Protection Bureau. If the current accounting rules remain unchallenged, the Congress could pass new legislation requiring the Federal Reserve to fund any number of activities off-budget without any impact on the reported federal budget deficit.

Volcker and the Great Inflation: Reflections for 2022

Published in Law & Liberty and also in RealClear Markets.

The celebrated Paul Volcker (1927-2019) became Chairman of the Federal Reserve Board 43 years ago on August 6, 1979. The 20th-century Great Inflation, stoked by the Federal Reserve and the other central banks of the day, was in full gallop in the U.S and around the world. In the month he started as Chairman, U.S. inflation continued its double-digit run—that August suffered a year-over-year inflation rate of 11.8%. On August 15, the Federal Reserve raised its fed funds mid-target range to 11%, but that was less than the inflation rate, so a nominal 11% was still a negative real interest rate. How bad could it get? For the year 1979, the December year-over-year inflation was an even more awful 13.3%. At that compound rate, the cost of living would double in about five years.

Everybody knew they had an inflationary disaster on their hands, but what could be done? They had already tried “WIN” (“Whip Inflation Now”) buttons, but inflation was whipping them instead. In this setting, “The best professional judgment among leading economists was that Americans should view the problem of inflation as being…intractable,” wrote Volcker’s biographer, William Silber. Leading Wall Street forecaster Henry Kaufman, for example, was pessimistic in 1980, opining “that he had ‘considerable doubt’ that the Fed could accomplish its ultimate objective, which is to tame inflation. He added for good measure that the Fed no longer had ‘credibility in the real world.”

Those days are now most relevant. Although Silber could write in 2012, “Inflation is ancient history to most Americans,” today it is upon us once again. What can we re-learn?

From Burns to Volcker

In September 1979, Arthur Burns, who had been Fed Chairman from 1970 to 1978, gave a remarkable speech entitled “The Anguish of Central Banking.” Discussing “the reacceleration of inflation in the United States and in much of the rest of the word,” “the chronic inflation of our times,” and “the world wide disease of inflation,” he asked, “Why, in particular, have central bankers, whose main business one might suppose is to fight inflation, been so ineffective?”

We may observe to the contrary that they had been very effective—but in producing inflation instead of controlling it, just as their 21st-century successors were effective in producing first the asset price inflation of the Everything Bubble, which is now deflating, and then destructive goods and services inflation, much to their own surprise. In both centuries, inflation was not an outside force attacking them, as politicians and central bankers both then and now like to portray it, but an endogenous effect of government and central bank behavior.

In what one might imagine as a tragic dramatic soliloquy, Burns uttered this cri de coeur: “And yet, despite their antipathy to inflation and the powerful weapons they could wield against it, central bankers have failed so utterly in this mission in recent years. In this paradox lies the anguish of central banking.”

I suspect the central bankers of 2022 in their hearts are feeling a similar anguish. Their supporting cast of government economists should be, too. “Economists at both the Federal Reserve and the White House were blindsided,” as Greg Ip wrote. “Having failed to anticipate the steepest inflation in 40 years,” he mused, “you would think the economics profession would be knee-deep in postmortems”—or some confessions of responsibility. But no such agonizing reappraisals as Burns’ speech seem forthcoming.

Reflecting that “Economic life is subject to all sorts of surprises [which] could readily overwhelm and topple a gradualist timetable,” in 1979 Burns announced that “I have reluctantly come to believe that fairly drastic therapy will be needed to turn the inflationary psychology around.” This was correct except for the modifier “fairly.” But, Burns confessed, “I am not at all sure that many of the central bankers of the world…would be willing to risk the painful economic adjustments that I fear are ultimately unavoidable.”

In our imagined drama of the time, enter Volcker, who was willing. He proceeds with firm steps to center stage. Burns fades out.

“If Congress had doubts about Volcker’s intentions,” says Allan Meltzer’s A History of the Federal Reserve, “they should have been dispelled by his testimony of September 5 [1979]”—one month after he took office. “Unlike the Keynesians, he considered the costs [of inflation] higher than the costs of reducing inflation.” Said Volcker to Congress, “Our current economic difficulties…will not be resolved unless we deal convincingly with inflation.”

In a television interview later that month, he was equally clear: “I don’t think we can stop fighting inflation. That is the basic, continuing problem that we face in this economy, and I think until we straighten out the inflation problem, we’re going to have problems of economic instability. So it’s not a choice….”

But what would it take to put into reverse the effects of years of undisciplined money printing, which accompanied oil supply and price shocks and other bad luck? Under the cover of restricting the growth in the money supply, Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%.

It is not clear whether Volcker ever took seriously the monetarist doctrine of focusing on the money supply, which he later abandoned, or simply used it as a pragmatic way to do what he wanted, which was to stop the runaway inflation. It is clear that he firmly rejected the Keynesian Phillips Curve approach of trying to buy employment with inflation. That had led central banks into inflationary adventures and resulted in simultaneous high inflation and high unemployment—the “stagflation” of the late 1970s, to which many think we risk returning in 2022.

The Double Dip Recessions

The Volcker program triggered a sharp recession from January 1980, five months after he arrived, to July 1980, and then a very deep and painful recession from July 1981 to November 1982—“double dip recessions.” Both hit manufacturing, goods production, and housing particularly hard, and generated the hard times of the “rust belt.” In 1982, unemployment rose to 10.8%, worse than the “Great Recession” peak unemployment of 10.0% in 2009.

“The 1981-82 recession was the worst economic downturn in the United States since the Great Depression,” says the Federal Reserve History. “The nearly 11% unemployment reached in late 1982 remains the apex of the post-World War II era [until surpassed in the Covid crisis of 2020]…manufacturing, construction and the auto industries were particularly affected.”

There were thousands of business bankruptcies. “The business failure rate has accelerated rapidly,” wrote the New York Times in September 1982, “coming ever closer to levels not seen since the Great Depression.” The total of over 69,000 business bankruptcies in 1982 was again worse than in the “Great Recession” year of 2009, which had 61,000.

The extreme interest rates wiped out savings and loan institutions, formerly the backbone of American mortgage finance, by the hundreds. The savings and loan industry as a whole was insolvent on a mark-to-market basis. So, in 1981, was the government’s big mortgage lender, Fannie Mae. A friend of mine who had a senior position with the old Federal Home Loan Bank Board recalls a meeting with Volcker at the time: “He was telling us he was going to crush the savings and loans.” There were securities firm and bank failures and then the massive defaults on the sovereign debt of “less developed countries” (“LDCs” in the jargon of the time), starting in August 1982. These defaults put the solvency of the entire American banking system in question.

This was a really dark and serious downer, but Volcker was firm about what he was convinced was the long-run best interest of the country. Was it debatable? Certainly.

There was plenty of criticism. Volcker wrote: “There were, of course, many complaints. Farmers once surrounded the Fed’s Washington building with tractors. Home builders, forced to shut down, sent sawed-off two-by-fours with messages…. Economists predictably squabbled.… Community groups protested at our headquarters….My speeches were occasionally interrupted by screaming protestors, once by rats let loose in the audience….” And “the Fed insisted I agree to personal security escort protection.”

In the government, Congressman Henry Reuss “reminded Volcker that the Constitution gave the monetary power to Congress”—as it does. “Congressman Jack Kemp called for Volcker’s resignation.” At the U.S. Treasury, “Secretary Donald Regan, a frequent critic, considered legislation restoring the Treasury Secretary to the [Federal Reserve] Board.” “Senator [Robert] Byrd introduced his bill to restrict Federal Reserve independence by requiring it to lower interest rates.” Inside the Federal Reserve Board, Governor Nancy Teeters, citing failures, the economy, high long-term interest rates, and high unemployment, objected in May 1982, “We are in the process of pushing the economy not just into recession, but into depression…I think we’ve undertaken an experiment and we have succeeded in our attempt to bring down prices…But as far as I’m concerned, I’ve had it.”

The minutes of the Federal Open Market Committee consistently display the intense uncertainty which marked the entire disinflationary project. “Volcker expressed his uncertainty frequently,” Meltzer observes, as he told the FOMC, for example: “I don’t know what is going to happen in the weeks or months down the road, either to the economy or to the aggregates or these other things,” or as he told Congress, “How limited our ability is to project future developments.” To his perseverance, add honesty. The same deep uncertainty will mark the Fed’s debates and actions in 2022 and always.

The 1982 recession finally ended in November. Inflation in December 1982 was 3.8% year-over-year. The fed funds rate was 8.8%. The year 1982 also saw the start of the two-decade bull market in stocks, and the 40-year bull market in bonds.

Meltzer speculated that the recession was more costly and “probably lasted longer than necessary.” Could a less severe recession have achieved the same disinflation? About such counterfactuals we can never know, but the current Fed must certainly hope so.

In 1983, President Ronald Reagan reappointed Volcker as Fed Chairman. In 1984, Reagan was re-elected in a landslide, the economy was booming, and inflation was 3.9%.

When Volcker left office in August 1987, inflation was still running at 4%, far from zero, but far below the 13% of 1979 when he had arrived as Fed Chairman. Real GDP growth was strong; fed funds were 6.6%. “The Great Inflation was over, and markets recognized that it was over.” Endemic inflation, however, was not over.

Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent.

Volcker’s Legacy

On top of the pervasive uncertainty, the Federal Reserve worried constantly during the Volcker years, as it must now, about its own credibility. Meltzer believed Volcker’s lasting influence was to “restore [the Federal Reserve] System credibility for controlling inflation.” But a generation after Volcker, the Fed committed itself to perpetual inflation at the rate of 2% forever. At the 2% target rate, prices would quintuple in an average lifetime. That is obviously not the “stable prices” called for in the Federal Reserve Act, but the Fed kept assuring everybody it was “price stability.” Volcker made clear his disagreement with this 2% target, writing of it in 2018, “I know of no theoretical justification. … The real danger comes from encouraging or inadvertently tolerating rising inflation.”

The classic monetary theorist Irving Fisher had warned, as have many others, that “Irredeemable paper money has almost invariably proved a curse to the country employing it.” Silber reflects that “The 1970s nearly confirmed Irving Fisher’s worst fears.” I would delete the word “nearly” from that last sentence.

The inflationary problems of Volcker’s days and ours are fundamentally linked to the demise of the Bretton Woods system in 1971, when the United States reneged on its international commitment to redeem dollars in gold. This put the whole world on pure fiat money instead, with fateful results. According to Brendan Brown, “Volcker considered the suspension of gold convertibility…’the single most important event of his career.’”  Indeed, it created the situation which put him on the road to future greatness. Ironically, Volcker began as a strong supporter of the Bretton Woods system, but then helped dismantle it. Of course, he was always an ardent anti-inflationist. “Nothing is more urgent than the United States getting its inflation under control,” he had already written in a formal Treasury presentation in 1969.

“Inflation undermines trust in government,” Volcker said. That it does, and such loss of trust is justified, then and now. Putting the thought another way, Volcker deeply believed that “Trust in our currency is fundamental to good government.” Throughout his life, he did his best to make the U.S. dollar trustworthy.

In retrospect, Volcker became “an American financial icon.” He elicits comments such as this one: “I knew Paul Volcker (who slew the Great Inflation). Volcker stopped inflation in the 1980s….” Or: “Volcker was the Federal Reserve knight who killed inflation.” Or: “Volcker and his FOMC…did what they thought was necessary, generating enormous pain but finally stamping out inflation. I hope Jerome Powell will find his inner Volcker.” As we have seen, Volcker didn’t actually stop or kill or stamp out inflation, but he brought it down from runaway to endemic.

His successor as Fed Chairman, Alan Greenspan, said “We owe a tremendous debt of gratitude to Chairman Volcker and the Federal Open Market Committee for…restoring the public’s faith in our nation’s currency.”

In 1990, Volcker spoke in the same Per Jacobsson Lecture series which had been the site of Arthur Burn’s anguish eleven years before. A similar audience of central bankers and finance ministers this time was treated to “The Triumph of Central Banking?” This included “my impression that central banks are in exceptionally good repute these days.”

However, he pointed out the question mark. “I might dream of a day of final triumph of central banking, when central banks are so successful in achieving and maintaining price and financial stability that currencies will be freely interchangeable at stable exchange rates” (shades of his earlier commitment to Bretton-Woods). “But that is not for my lifetime—nor for any of yours.” About that he was right, and also right about a more important point: “I think we are forced to conclude that even the partial victory over inflation is not secure.” There he was wiser than his many eulogists, as is obvious in 2022.

In discussions of the current inflation, including similarities to the 1970s, references to Volcker are frequent and laudatory. For example, “Federal Reserve Chairman Jerome Powell has taken of late to praising legendary Paul Volcker, as a signal of his new inflation-fighting determination.” Or “Powell tried to engage in some plain speaking, by telling the American people that inflation was creating ‘significant hardship’ and that rates would need to rise ‘expeditiously’ to crush this. He also declared ‘tremendous admiration’ for his predecessor Paul Volcker, who hiked rates to tackle inflation five decades ago, even at the cost of a recession.”

No Permanent Victories

With the model of Volcker in mind, will we now experience parallels to the 1981-82 recession, as well? This is the debate about whether a “soft landing” is possible from where the central banks have gotten us now. If we repeat the pattern of the 1980s, it will not be a soft landing and the cost of suppressing inflation will again be high, but worth it in the longer run. It should rightly be thought of as the cost of the previous central bank and government actions that brought the present inflation upon us.

Silber concluded that in the 1980s, “Volcker rescued the experiment in fiat currency from failure.” But experimentation with fiat currency possibilities has continued, including the creation of a giant portfolio of mortgage securities on the Fed’s own balance sheet, for example. When politicians and central bankers are hearing the siren song of “just print up some more money”—a very old idea recently called modern in “modern” monetary theory— in whatever guise it may take, who will provide the needed discipline, as Volcker did? Under various versions of the gold standard, it might be a matter of “what” provides monetary discipline, but in the fiat currency world of Volcker’s time and now, it is always and only a question of “who.”

Volcker wrote that “Bill Martin [William McChesney Martin, Fed Chairman 1951-70]… is famous for his remark that the job of the central bank is to take away the punch bowl just when the party gets going.” Unfortunately, Volcker continued, “the hard fact of life is that few hosts want to end the party prematurely. They wait too long and when the risks are evident, the real damage is done”—then it is already too late and the problem has become a lot harder. Like now.

As has been truly said, “In Washington, there are no permanent victories.” Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent. In 2021-22, we are back to disastrously high inflation, recognize the need to address it, and feel the costs of doing so. And Chairman Powell is citing Chairman Volcker.

But are there factors, four decades later, making the parallels less close? For example, international investor Felix Zulauf “thinks the Powell Fed is quite different from the Volcker Fed, and not just because of the personalities. It’s in a different situation and a different financial zeitgeist [and different political zeitgeist]. He doesn’t think the Fed, or any other central bank can get away with imposing the kind of pain Volcker did and will stop as soon as this year.” (italics added)

Suppose that is right—what then? Then the pain will come from continued inflation instead. There is now no avoiding pain, which will come in one way or the other.

A similar, though more strident, argument from June 2022 is this: “It will be politically impossible to raise rates enough to stop inflation. … Volcker raised rates to 19%. There is no way the Fed is going anywhere near that.…You may recall the Fed not long ago said they…were just talking about raising rates.” And echoing Henry Kaufman in 1980, “None of them has any credibility anymore.”

We must admit that the current fed funds rate of 1.75% with an inflation of 8.5%, for a real fed funds rate of negative 6.75%, is hardly Volckeresque. Indeed, there is nothing Volkeresque yet. Interest rates in 1980-81 went far higher than most people imagined possible—perhaps they will again go higher than now thought possible and maybe we will even see positive real interest rates again.

Chairman Powell was a Fed Governor and Chairman while the wind of the present inflation was being sown, and he is there to reap the whirlwind. Will the Fed under his leadership tame it and at what cost, as all the maladjustments and the financial dependence of both the government and private actors on negative real rates and cheap leverage during the last decade must now be corrected?

We might imagine a hypothetical case in which Paul Volcker was 40 years younger, and with his unyielding commitment to trustworthy money and his insistence that achieving it is worth the cost, had become the new Fed Chairman in 2022. We can speculate about what he would be and could be doing now.

But in the real case, just as Volcker did beginning in 1979, Chairman Powell has now stepped to center stage in the current drama. We cannot yet say whether his future valedictory lecture will be about the Anguish or the Triumph of central banking.

SHEFFIELD: Democrats And The Fed — A Tale Of Two Realities

Published in the Daily Caller:

“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,” American Enterprise Institute scholars Paul H. Kupiec and Alex J. Pollock wrote in late June. “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 … 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.”

Surprised Again!: The COVID Crisis and the New Market Bubble Paperback

Published by Paul Dry Books.

by Alex J. Pollock and Howard B. Adler

Order here.

About every ten years, we are surprised by a financial crisis. In 2020, we were Surprised Again! by the financial panic of the spring triggered by the COVID-19 pandemic. Not one of the more than two dozen official systemic risk studies diligently developed in 2019 had even hinted at this financial crisis as a possibility, or at the frightening economic contraction which resulted from the political responses to control the virus. In response came the unprecedented government fiscal and monetary expansions and bailouts. Later 2020 brought a second big surprise: the appearance of an amazing boom in asset prices, including stocks, houses and cryptocurrencies.

Alex Pollock and Howard Adler lived through this historic instability while managing analytical support offices for the U.S. Financial Stability Oversight Committee. Their book lays out the many elements of the panic, the massive elastic currency operations which rode to the rescue, financing the bust with unprecedented government debt, the second surprise of the boom in asset prices, including a renewed apparent bubble in house prices financed by government guarantees, as well as considering key leveraged sectors such as commercial real estate, student loans, pension funds, banks, and the government itself. It reflects philosophically on how to understand these events in retrospect and prospect.

The Fed’s Tough Year

Published in Law & Liberty and republished in RealClear Markets.

The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:

• It has failed with inflation forecasting and performance;

• It has giant mark-to-market losses in its own investments and looming operating losses;

• It is under political pressure to do things it should not be doing and that should not be done at all.

Forecasting Inflation

As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.

The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25%, so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.

In short, the Federal Reserve cannot reliably forecast economic outcomes, or what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.

It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.

We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended “QE” strategy in 2012 as “a shot in the proverbial dark.” That was an honest admission, although unfortunately he admitted it only within the Fed, not to the public.

The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing.” Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.

Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.

Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.

A Mark-to-Market Insolvent Fed

Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of March 31, 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330 billion on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8 trillion of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200 billion in round numbers, bringing the Fed’s total MTM loss to over $500 billion.

Compare this $500 billion loss to the Fed’s total capital of $41 billion. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question—most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?

The Fed’s first defense of its huge MTM loss is that the loss is unrealized, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5 trillion of floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come, if the higher short-term interest rates implied by current market prices come to pass.

The Fed’s second defense is that it has changed its accounting so that realized losses on securities or operating losses will not affect its reported retained earnings or capital. Instead, the resulting debits will be hidden in a dubious “deferred asset” account. Just change the accounting! (This is exactly what the insolvent savings and loans did in the 1980s, with terrible consequences.)

What fun it is to imagine what any senior Federal Reserve examiner would tell a bank holding company whose MTM losses were 12 times its capital. And what any such examiner would say if the bank proposed to hide realized losses in a “deferred asset” account instead of reducing its capital!

Here is a shorthand way to think about the dynamics of how Fed operating losses would arise from their balance sheet: The Fed has about $8 trillion in long-term, fixed-rate assets. It has about $3 trillion in non-interest-bearing liabilities and capital. Thus, it has a net position of $5 trillion of fixed rate assets funded by floating rate liabilities. (In other words, inside the Fed is the financial equivalent of a giant 1980s savings and loan.)

Given this position, it is easy to see that pro forma, for each 1% rise in short-term interest rates, the Fed’s annual earnings will be reduced by about $50 billion. What short-term interest rate would it take to wipe out the Fed’s profits? The answer is 2.7%. If their deposits and repo borrowings cost 2.7%, the Fed’s profits and its contribution to the U.S. Treasury will be zero. If they cost more than 2.7%, as is called for in the Fed’s own projections, the Fed starts making operating losses.

How big might these losses be? In the Fed staff’s own recent projections, in its most likely case, the projected operating losses add up to $60 billion. This is 150% of the Fed’s total capital. In the pessimistic case, losses total $180 billion, over 4 times its capital, and the Fed makes no payments to the Treasury until 2030.

In such cases, should the Fed’s shareholders, who are the commercial banks, be treated like normal shareholders and have their dividends cut? Or might, as is clearly provided in the Federal Reserve Act, the shareholders be assessed for a share of the losses? These outcomes would certainly be embarrassing for the Fed and would be resisted.

The central bank of Switzerland, the Swiss National Bank (SNB), did pass on its dividends in 2013, after suffering losses. The SNB Chairman gave a speech at the time, saying in effect, “Sorry! But that’s the way it is.” Under its chartering act, the SNB—completely unlike the Fed—must mark its investment portfolio to market in its official profit and loss statement. Accordingly, in 2022 so far, the SNB has reported a net loss of $31 billion for the first quarter and a net loss of $91 billion for the first six months of this year.

The Swiss are a serious people, and also serious, it seems, when it comes to central bank accounting and dividends.

In the U.S., the Federal Reserve Bank of Atlanta did pass its dividend once, in 1915. As we learn from the Bank’s own history, “Like many a struggling business, it suspended its dividend that year.” Could it happen again? If the losses are big and continuing, should it?

A third Fed defense is that its “mandate is neither to make profits nor to avoid losses.” On the contrary, the Fed is clearly structured to make seigniorage profits for the government from its currency monopoly. While not intended by the Federal Reserve Act to be a profit maximizer, it was also not intended to run large losses or to run with negative capital. Should we worry about the Fed’s financial issues, or should we say, “Pay no attention to the negative capital behind the curtain!”

The Fed is obviously unable to guarantee financial stability. No one can do that. Moreover, by trying to promote stability, it can cause instability.

What the Fed Can and Can’t Do Well

The Federal Reserve is also suffering from a push from the current administration and the Democratic majority in the House of Representatives to take on a politicized agenda, which it probably can’t do well and more importantly, should not do at all.

This would include having the Fed practice racial preferences, that is, racial discrimination, and as the Wall Street Journal editors wrote, “Such racial favoritism almost certainly violates the Constitution. So does the [House] bill’s requirement that public companies disclose the racial, gender identity and sexual orientation of directors and executives.” The bill would “politicize monetary policy and financial regulation.” A lot of bad ideas.

Moreover, the Federal Reserve already has more mandates than it can accomplish, and its mandates should be reduced, not increased.

As has been so vividly demonstrated in 2021 and 2022, the Fed cannot accurately forecast economic outcomes, and cannot know what the results of its own actions, or its “shots in the proverbial dark,” will be.

Meanwhile, it is painfully failing to provide its statutory mandate of stable prices. Note that the statute directs the goal of “stable prices,” not the much more waffly term the Fed has adopted, “price stability.” It has defined for itself that “price stability” means perpetual inflation at 2% per year.

The Fed cannot “manage the economy.” No one can.

And the Fed is obviously unable to guarantee financial stability. No one can do that, either. Moreover, by trying to promote stability, it can cause instability, an ironic Minskian result—Hyman Minsky was the insightful theorist of financial fragility who inspired the slogan, “stability creates instability.”

There are two things the Fed demonstrably does very well.

The first is financing the government. Financing the government of which it is a part is the real first mandate of all central banks, especially, but not only, during wars, going back to the foundation of the Bank of England in 1694. As the history of the Atlanta Fed puts it so clearly:

During the war [World War I], the Fed was introduced to a role that would become familiar…as the captive finance company of a U.S. Treasury with huge financing needs and a compelling desire for low rates.

This statement is remarkably candid: “the captive finance company of [the] U.S. Treasury.” True historically, true now, and why central banks are so valuable to governments.

The second thing the Fed does well is emergency funding in a crisis by creating new money as needed. This was its original principal purpose as expressed by the Federal Reserve Act of 1913: “to furnish an elastic currency,” as they called it then. This it can do with great success in financial crises, as shown most recently in 2020, and of course during wars, although not without subsequent costs.

However, the Fed is less good at turning off the emergency actions when the crisis is over. Its most egregious blunder in this respect in recent years was its continuing to stoke runaway house price inflation by buying hundreds of billions of dollars of mortgage securities, continuing up to the first quarter of 2022. This has severe inflationary consequences as the cost of shelter drives up the CPI and erodes the purchasing power of households. Moreover, it now appears the piper of house price inflation is exacting its payment, as higher mortgage rates are resulting in falling sales and by some accounts, the beginning of a housing recession.

Among the notions for expanding the Fed’s mandates, the worst of all is to turn the Fed into a government lending bank, which would allocate credit and make loans to constituencies favored by various politicians. As William McChesney Martin, the Fed Chairman 1951-1970, so rightly said when this perpetual bad idea was pushed by politicians in his day, it 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.”

It is a natural and permanent temptation of politicians to want to do just that—to use the money printing power of the central bank to give money to their political supporters without the need for legislative approval or appropriation, and to surreptitiously finance it by imposing an inflation tax without legislation.

One way to achieve this worst outcome would be to have the Fed issue a “central bank digital currency” (CBDC) that allows everybody to have a deposit account with the Fed, which might then become a deposit monopolist as well as a currency monopolist.

Should that happen, the Fed would by definition have to have assets to employ its vastly expanded deposit liabilities. What assets would those be? Well, loans and securities. The Fed would become a government lending bank.

The global experience with such government banks is that they naturally lend based on politics, which is exactly what the politicians want, with an inevitable bad ending.

On top of that, with a CBDC in our times of Big Data, the Fed could and probably in time would choose to know everybody’s personal financial business. This could and perhaps would be used to create an oppressive “social credit system” on the model of China which could control credit allocation, loans, and payments. Given the urge to power of any government and of its bureaucratic agencies, that outcome is certainly not beyond imagining, and is, in my view, likely.

The current push to expand the Fed’s mandates is consistent with Shull’s Paradox, which states that the more blunders the Fed makes, the more powers and prestige it gets. But we should be reducing the Fed’s powers and mandates, not increasing them. Specifically:

• The Fed should not hold mortgage securities or mortgages of any kind. It should take its mortgage portfolio not just to a smaller size, but to zero. Zero was just where it was from 1914 to 2008 and where it should return.

• The Fed should not engage in subsidizing political constituencies and the proposed politicized agenda should be scrapped.

• Congress should definitively take away the Fed’s odd notion that the Fed can by itself, without Congressional approval, set a national inflation target and thereby commit the country and the world to perpetual inflation.

• Congress should repeat its instruction to the Fed to pursue stable prices. As Paul Volcker wrote in his autobiography, “In the United States, we have had decades of good growth without inflation,” and “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”

• The Fed should be required to have sound accounting for its own financial statements, with no hiding losses in the former savings and loan style allowed. This requires taking away from the Fed the power to set its own accounting standards, which nobody else has.

• The Fed should be prohibited from buying TIPS (Treasury Inflation-Protected Securities), because this allows it to manipulate apparent market inflation expectations.

• The funding of the Consumer Financial Protection Bureau expenses out of Fed profits should be terminated. This is an indefensible use of the Fed to take away the power of the purse from Congress and to subsidize a political constituency. It would be especially appropriate to end this payment if the Fed is making big losses.

• Finally, and most important of all, we must understand the inherent limitations of what the Federal Reserve can know and do. There is no mystique. We must expect it to make mistakes, and sometimes blunders, just like everybody else.

Knowing this, perhaps the 2020s will give us the opportunity to reverse Shull’s Paradox.

This paper is based on the author’s remarks at the American Enterprise Institute conference, “Is It Time to Rethink the Federal Reserve?” July 26, 2022.