The ‘Insolvency’ of the Fed

Published in the New York Sun:

“A bad balance sheet killed Silicon Valley Bank,” Mr. Coy writes. “You know what other bank has a similar balance sheet?” he asks. “The Federal Reserve,” is the reply. An ex-Treasury official, Alex Pollock, goes further, telling us the Fed’s balance sheet “looks just like a Savings & Loan in 1980.” It echoes the worst banking crisis since the Depression. It’s a reminder that while we may be in a banking crisis, the real emergency is fiat money.

It was abandoning the gold standard, after all, that allowed central banks like the Fed to veer into monetary experiments like its Quantitative Easing, buying up trillions in assets while keeping interest rates artificially low. Now that rates are rising, a reckoning is at hand. The Fed’s QE assets “yield 2 percent or 3 percent, but the cost of funding them is now over 4 ½ percent,” Mr. Pollock notes — “a guaranteed way to lose money.” 

…

Mr. Pollock, who directed financial research at Treasury, sums up the Fed’s view as “It doesn’t matter and no one cares.” There may be some truth to this, given the deference the press shows the Fed and the Fed’s own obfuscation of its work via the PhD-inflected language known as FedSpeak. Yet the bank runs could raise scrutiny on the Fed. Asked how Silicon Valley Bank’s balance sheet compares to the Fed’s, Mr. Pollock says “it’s worse.” 

How Should We Regulate Crypto?

Published by David G.W. Birch:

Meanwhile, Howard Adler, a former deputy assistant secretary of the Treasury for the Financial Stability Oversight Council, and Alex Pollock, a former Principal Deputy Director of the Treasury’s Office of Financial Research, advocate a more laissez-faire approach: Why regulate crypto at all?Their view is that we should allow investors to proceed at their own risk under the protections of general commercial law and existing anti-fraud and criminal laws. As they point out, since cryptocurrency originated as a libertarian revolt against the government monopoly on money, this approach is consistent with its founding ideas.

How the Fed’s 2008 mortgage experiment fueled today’s housing crisis

Published in The Hill with Paul H. Kupiec.

How should Congress assess the Federal Reserve’s track record as an investor in residential mortgage-backed securities (MBS)?  Regardless of Fed spin, it merits a failing grade. 

The Fed’s COVID-era intervention in the mortgage markets fueled the second real estate bubble of the 21st century. The bubble ended when the Fed stopped purchasing MBS and raised rates to fight inflation. While time will tell whether recent increases in home prices are reversed, the end of the bubble has already cost the Fed over $400 billion in losses on its MBS investments.

From 1913 until 2008, the Fed owned precisely zero mortgage-backed securities. While the Fed’s monetary policy decisions still impacted conditions in the housing and mortgage markets, they did so indirectly through the influence the Fed’s purchases and sales of Treasury securities had on market interest rates. 

In a radical “temporary” policy response to the 2008 financial crisis, the Fed began intervening directly in the mortgage market. Through a series of MBS purchases, the Fed’s MBS portfolio ballooned from $0 to $1.77 trillion by August 2017. The Fed subsequently altered policy and slowly reduced its MBS holdings. By March 2020, it held about $1.4 trillion in MBS.

When the COVID crisis hit in March 2020, the Fed decided to reinstate its 2008 financial crisis rescue plan. It resumed purchasing MBS as well as Treasury notes and bonds. By the time it stopped its purchases in the spring of 2022, it owned $2.7 trillion in MBS. The Fed had become the largest investor in MBS in the world. By spring 2022, it owned nearly 22 percent of all 1-to-4 family residential mortgages in the U.S. By Sept. 30, the date of the last available quarterly Fed consolidated financial statement, the Fed had lost $438 billion on its MBS investments. These losses will increase if the fight to subdue inflation requires still higher interest rates.

Because most buyers borrow 80 percent or more of the purchase price of a home, house prices are sensitive to the level of mortgage interest rates. Low mortgage rates increase the pool of potential buyers, stimulating housing demand. If the interest rate stimulus is overdone, excess demand will push up home prices. High mortgage interest rates have the opposite effect. They dampen demand, dissipate upward pressure on home prices, and in some cases, lead to home price declines. 

As one might predict, the Fed’s massive MBS purchases coincided with large reductions in mortgage interest rates. During the Fed’s COVID MBS purchase campaign, the national average 30-year mortgage interest rate fell to a low of 2.65 percent in January of 2021. Today, with the Fed’s campaign of higher interest rates to battle inflation, 30-year mortgage interest rates are hovering around 7 percent. This change in the mortgage interest rate alone would cause monthly principal and interest payments on a same-sized mortgage loan to increase by 65 percent.

Predictably, the decline in mortgage interest rates stimulated housing demand and pushed up home prices. Government statistics report that, from January 2018 to this January, the median new home price in the United States rose from $331,800 to $467,700 — an increase of 41 percent. Interestingly, from January 2018 through March 2020, before the Fed renewed its MBS purchases, the median price of a new house actually declined to $322,600. From April onwards, the national median house price rose steadily, reaching a peak of $468,700 by the end of June 2022.

In 2018, purchasing a new median-price home with 20 percent down and the then prevailing average 30-year mortgage rate of 3.95 percent required $1,259 in monthly principal and interest payments. In January, purchasing the $467,700 median-priced new home with 20 percent down required monthly payments of $2,360 given the 6.48 percent rate on a 30-year mortgage. In only 5 years, because of house price inflation and higher mortgage interest rates, the monthly principal and interest payment needed to purchase a median-priced new house increased by 87 percent!   

The Fed’s foray into the MBS market will have a long-lasting impact on real estate markets. Not only has demand for homes been softened by home price inflation and 7 percent mortgage rates, but current homeowners with favorable mortgage interest rates are reluctant to sell, reducing the inventory of homes available for sale in a market that is already starved for listings. This unfavorable balance is clearly reflected in the National Association of Realtors housing affordability index which has fallen from a cyclic high of 180 in July 2021, to recent readings below 100, indicating affordability challenges not seen since the double-digit mortgage interest rates of the 1980s.

The end of Fed MBS purchases and the increase in Fed policy rates have put an end to the COVID housing bubble. While home prices are showing declines in some areas, prices in other areas remain elevated due to historically low inventories of homes for sale and strong job markets.

Any realistic review of the impact of the Federal Reserve’s experiment investing in MBS would conclude that the Fed should stop buying mortgages. Its decision to invest trillions of dollars in MBS has helped to push the cost of home ownership beyond the reach of many. Others will find themselves locked into homes they cannot afford to sell because of the artificially low rates on their current mortgages. 

From either perspective, the Fed’s MBS experiment has whipsawed housing markets and cost the Fed over $400 billion in MBS losses. It’s hard to see how this experiment merits anything but a failing grade.

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

WRAL: Fact check: Has the U.S. ever defaulted on its debt?

From WRAL:

Possible precedents for defaults

In a 2021 op-ed in The Hill, a political news outlet, Alex J. Pollock, a former Treasury Department official, argued that there are four precedents for U.S. defaults. Pollock cited cases of the U.S. Treasury: Resorting to paper money largely not supported by gold during the Civil War in 1862; Redeeming gold bonds with paper money rather than gold coins during the Great Depression in 1933; Not honoring silver certificates with an exchange of silver dollars in 1968; and Abandoning the Bretton Woods Agreement in 1971, which included a commitment to redeem dollars held by foreign governments for gold. Also, a 2016 analysis by the nonpartisan Congressional Research Service noted that in 1979, the Treasury failed to make on-time payments to some small investors because of technical glitches. Most were paid within days or a week. The research service concluded that although the temporary payment delays "inconvenienced many investors, the stability of the wider market in Treasury securities was never at risk." But multiple economic specialists agree that although these were notable episodes, they do not mirror the type of default to which Jeffries was referring.

FHLBs—Mission and Possible Improvements

Based on long experience and extensive study of various systems of housing finance and of financial systems generally, I respectfully offer the following thoughts on the mission of and possible improvements in the Federal Home Loan Banks (FHLBs).

Mission

I think the mission of the FHLBs is to support, in key words of the Federal Home Loan Bank Act, “sound and economical home finance,” by linking sound home finance nationwide to the bond market.  FHLBs’ principal activities should always be clearly tied to this mission, which should benefit tens of millions of mortgage borrowers throughout the country.

FHLB member institutions should be those which provide sound and economical home finance.  As markets evolve over time, which types of institutions are eligible membership should adapt to appropriately reflect this evolution.  For example, as commercial banks, originally excluded from FHLB membership, largely supplanted savings and loans in home finance, they were logically made eligible for FHLB membership by the Financial Institutions Reform, Recovery and Enforcement Act of 1989.

In my view, the FHLBs should take minimum credit risk, and all the credit risk of the mortgages they link to the bond market should be borne in the first place by the FHLB member financial institutions.  This is true of both FHLB advances, in which all the underlying assets stay on the books of the member, and for the fundamental concept of the FHLB Mortgage Partnership Finance program, in which the mortgage loan moves, but a permanent credit risk “skin in the game” stays for the life of the loan with the member institution, where it belongs.  Note that this is the opposite of selling loans to Fannie Mae and Freddie Mac, in which the lending institution divests the credit risk of its own customer that results from its own credit decision.

Since the mission of the FHLBs is sound and economical home finance, their subsidizing affordable housing projects is secondary. In an economic perspective, these programs may be seen as a tax on the FHLBs, and in a political perspective, a tactic which allows members of Congress the convenience of creating subsidies without having to approve or appropriate the expenditures.

FHLBs without doubt have important benefits from their government sponsorship.  These benefits should primarily go to supporting sound and economical home finance provided by member institutions throughout the country.  To assert that all or most of these benefits must go to subsidizing affordable housing is obviously disproportionate.

In the “mission” discussions, we can usefully distinguish between two groups of FHLB beneficiaries.  First are those who have also have skin in the game through having put their own money at risk by capitalizing, funding or financially backing FHLB operations.  They are the stockholder-members, the bondholders, and the U.S. Treasury.  Second are those who only receive subsidies from the FHLBs.

Suggested Improvements

1. The FHLBs should be given the formal power to issue mortgage-backed securities, provided these securities are always designed so that serious credit risk skin in the game remains with the member institutions.  This would give the FHLBs a very important additional method to carry out their mission and would be a long-overdue catching up with financial market evolution.

2. The Federal Home Loan Bank Act should be amended specifically to authorize the FHLBs to form a joint subsidiary to carry out functions best provided on a combined, national basis.  The participating FHLBs should own 100% of this joint subsidiary.  This addition to the FHLB Act is needed because of the requirements of the Government Corporations Control Act of 1945, when the U.S. Treasury still owned some FHLB stock.  It has not owned any for 70 years, but the 1945 statutory requirement is still there.

3. The prohibition of captive insurance companies from being FHLB members should be promptly withdrawn.  In my view, this was not only a mistake, but inconsistent with the FHLB Act, which has provided from July 1932 to today that “insurance companies” in general, with no distinctions among them, are eligible for FHLB membership.  I believe to change that required Congressional action, which was not taken.  Any insurance company, including a captive insurance company, which provides sound and economical home finance should be eligible for FHLB membership.

I hope these ideas will be helpful for the ongoing success of the FHLBs.

Alex J. Pollock is a Senior Fellow of the Mises Institute and co-author of the new book, Surprised Again!—The Covid Crisis and the New Market Bubble.  He was previously president and CEO of the Chicago FHLB, president of the International Union for Housing Finance, and Principal Deputy Director of the U.S. Office of Financial Research.

The Fed's Capital Is Rapidly Heading to Zero, and Below

Published in RealClear Markets.

Since September 2022, the Federal Reserve has lost about $36 billion.  A big number!—and notably big compared to the Fed’s stated capital of $42 billion. Thus the Fed has already run through about 85% of its capital and has only $6.6 billion (0.07 % of its total assets) left as of February 22. How long will it take to burn through that?  Less than three weeks.

So the Fed’s real capital will hit zero in mid-March. By April Fools’ Day, it will be proceeding into ever more negative territory.

What does negative capital mean for the world’s top central bank?  As for any entity, it means that its liabilities exceed its assets, and that it is technically insolvent.

Here we are dealing with the Fed’s real capital, in contrast to the stated capital its financial statements report.  For every organization, everywhere and necessarily, losses reduce retained earnings and thus total capital.  Nothing could be more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses of $36 billion. But the Fed wishes to exempt itself from this law of accounting, by treating its losses as an asset, which they aren’t.  It wishes us to believe that if it loses $100 billion, as it probably will in 2023, or $200 billion, or even $1 trillion, that its capital would always be the same.  “LOL,” as people text these days. The situation may make you think of the cynically realistic remark of Jean-Claude Juncker, when he was the head of the European finance ministers: “When it becomes serious, you have to lie.”

The Fed itself and most economists claim about the losses and the looming negative capital that “It doesn’t matter and no one cares.” They point out that the Fed can continue to print up more money to pay its obligations, no matter how much it has lost or how much less its assets are than its liabilities.  

Nonetheless, it is surely embarrassing to have lost all your capital, let alone twice or three times your capital, as the Fed will have done by the end of this year.  Whether it did this intentionally or unintentionally, it raises pointed questions about whether the Fed correctly anticipated such huge losses and how negative its capital would become, and, if it did, whether it informed Congress of what was coming.

A second argument the Fed and its supporters make is that “Central banks are not supposed to make profits.”  This is not correct.  All central banks, including the Fed, are designed precisely to make profits for the government through their currency monopoly.  They issue non-interest bearing currency, and make interest bearing investments.  This makes profits automatically and thereby reduces the Treasury’s deficit.  But no more.  The easy profits have been wiped out by the losses on the Fed’s $5 trillion risk position of investing long and borrowing short, now upside down.  The Fed has trillions of long-term “Quantitative Easing” investments it bought to yield 2% or 3 %, but the cost of funding them is now over 4 1/2%-- a guaranteed way to lose money.  And the Fed’s borrowing costs are likely headed still higher, making its losses still bigger. 

Thus the losses are the actualization of the immense financial risk the Fed knowingly took, while not knowing how bad the outcome would be.  The Fed’s losses now make its capital negative, increase the federal deficit and are a fiscal burden on the Treasury.

The Fed is not alone in this problem, since many central banks together set themselves up for losses. “Euro Area Braces for Era of Central-Bank Losses After QE Binge,” in the words of a recent Bloomberg headline. In Great Britain, His Majesty’s Treasury has committed to pay for losses of the Bank of England, and the Canadian Finance Ministry has entered into a contract with the Bank of Canada to offset any realized losses on the Bank’s QE bonds.  

Should the U.S. Treasury recapitalize the Fed by buying stock in the Federal Reserve Banks?  Unlike in most other countries, the U.S. government does not own the stock of its central bank— private banks do.  The Fed does have a formal call on the private banks to require them to buy more stock-- the half of their stock subscription they have not paid in.  This would raise about $36 billion in new capital.

But the Fed certainly does not want to be seen as needing to call this additional capital-- or needing to skip its dividend, as both the European Central Bank and the Swiss central bank have done this year.

Nor does the Fed wish its balance sheet to show its real capital.  But if, as the Fed argues, it doesn’t matter and no one cares, why go through the charade?  Why not simply report the true number?

Hemorrhaging losses, the Fed’s problems are now the taxpayer’s

Published in The Hill with Paul H. Kupiec.

When liabilities exceed assets, equity capital is negative and an entity is technically insolvent. Few institutions in that condition can continue operating at a loss indefinitely, and those that can usually benefit from an explicit government guarantee. Past special cases have included government-backed agencies like the U.S. housing GSEs. 

From mid-March 2023, there will be a new addition to the list of institutions that, while losing billions of dollars a month and technically insolvent, with the benefit of taxpayer support will still be able to issue billions in new interest-bearing liabilities. That institution is the Federal Reserve.

With large projected operating losses and liabilities already in excess of assets, existing creditors are unlikely to be repaid, let alone new creditors. No sensible fiduciary would lend under these conditions unless newly injected funds have seniority in bankruptcy or carry an explicit government guarantee.

Since mid-September, the Federal Reserve has lost about $36 billion and will continue to post billions of dollars a month in losses for many months if not years to come. Fed losses have already consumed about 85 percent of its stated capital of $42 billion. It will take less than 3 weeks for the Fed to burn through the $6.6 billion of its remaining capital. 

The Fed routinely creates new money by purchasing interest-bearing U.S. Treasury securities in exchange for newly created Federal Reserve notes or interest-bearing bank reserves. From mid-March on, the Fed will, for the first time in its history, pay for its accumulating losses by issuing new liabilities without acquiring any new interest-bearing assets. The Fed will pay its bills by printing new money — not just Federal Reserve Notes that pay no interest, but by issuing new reserve balances that pay banks an interest rate higher than can be earned in a savings account.

When the housing GSEs were insolvent and losing money hand-over-fist, the U.S. Treasury used congressional powers in the Housing and Economic Recovery Act of 2008 to inject enough new capital to save the GSEs from defaulting so they could continue to borrow and operate. How can a technically insolvent and loss-hemorrhaging Federal Reserve continue to operate without a similar congressionally-approved bail-out?  Do other central banks have the Fed’s seemingly magical power to continue operations while technically insolvent, and yet still issue billions in new interest-bearing liabilities to cover losses?

The “magic” begins with the fact that, regardless of the size of its accumulated losses, the Fed will always report positive equity capital. By any sensible accounting standard, losses reduce retained earnings and capital. Nothing is more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses. The Fed magically suspends this law of accounting by booking its accumulated losses as an asset. If Fed losses accumulate to $100 billion, as they probably will in 2023, or to $200 billion or more by 2024, the Fed will report that it still has $42 billion in equity capital. Magic.

The Fed and many economists believe that the Fed’s losses and its looming negative capital position are inconsequential. While other central banks shrug-off losses, they are not so cavalier with their accounting treatment of losses, nor do they contend that their capital position is of no consequence.

In reporting its recent losses, the European Central Bank canceled paying dividends and was careful to state that its losses were well covered by its reserves and so had no impact on its capital. The Swiss National Bank’s $143 billion loss in 2022 caused it to cancel its dividend payments and reduce its retained earnings. It still remains well-capitalized by central bank standards. In Great Britain, His Majesty’s Treasury explicitly agreed to offset losses of the Bank of England, and the Canadian Finance Ministry has a contract with the Bank of Canada to offset any realized losses on its QE bonds. Meanwhile, the Dutch central bank alerted its country’s Treasury of the possibility that the bank might need to be recapitalized. For all of these central banks, their equity capital position apparently does matter.

With negative real capital and massive losses accruing, how will the Fed still pay member banks a dividend, interest on their reserves balances, conduct monetary policy and pay its bills? With the benefit of an implicit government guarantee — a guarantee that has so far avoided any mention in congressional hearings.

On a consolidated government basis, the Fed’s accounting treatment — paying for accumulating losses by creating new interest-bearing liabilities — is equivalent to the U.S. Treasury selling new interest-bearing debt and remitting the proceeds to the Fed to cover its losses. If Fed losses were paid and accounted for in this way, the Fed’s losses would count against the Federal budget deficit and the new Treasury debt issued would add to the Federal government’s outstanding debt.

With the Fed counting its accumulating losses as a deferred asset, the losses do not reduce the Fed’s reported equity capital or increase the federal budget deficit. Moreover, the new interest-bearing liabilities the Fed issues to pay bank dividends, interest on bank reserves and to cover other Fed operating costs do not count as part of the U.S. Treasury’s outstanding debt.

The Fed’s accounting trickery allows the Fed to borrow taxpayer money to cover its losses without the borrowing or the losses appearing on the Federal government’s ledgers. The Fed itself decides how much to borrow from taxpayers without any explicit congressional authorization. The current arrangement inadvertently allows the Fed to appropriate, borrow and spend taxpayer dollars on its own authority — an issue that should be addressed in the Fed’s next semi-annual congressional appearance.

The Government Debt Ceiling: What Did Eisenhower Do?

July 27, 2011

Published with Anne C. Canfield in AEIdeas.

“Nothing is ever new, it is just history repeating itself”—at least in finance. In his A History of the Federal Reserve,¹ Allan Meltzer describes what happened during the Eisenhower administration when the Treasury ran out of debt authorization and Congress did not raise the debt ceiling. This was in 1953.

In order to keep making payments, the Treasury increased its gold certificate deposits at the Federal Reserve, which it could do from its dollar “profits” because the price of gold in dollars had risen. The Fed then credited the Treasury’s account with them, thereby increasing the Treasury’s cash balance. Treasury then spent the money without exceeding the debt limit.

By the spring of 1954, Congress had raised the debt ceiling from $275 to $280 billion (2 percent or so of today’s limit), so ordinary debt issuance could continue.

The Secretary of the Treasury still is authorized to issue gold certificates to the Federal Reserve Banks, which will then credit the Treasury’s cash account.² This is correctly characterized as monetizing the Treasury’s gold, of which it owns more than 8,000 tons. An old law says this gold is worth 42 and 2/9 dollars per ounce, but we know the actual market value is about 38 times that, at more than $1,600 per ounce.

Should we follow Eisenhower’s example?

Alex J. Pollock is a resident fellow at the American Enterprise Institute.  Anne Canfield is president of Canfield & Associates, Washington, D.C.

1. Allan Meltzer, A History of the Federal Reserve, Volume 2, Book 1, pp. 110 and 168.

2. Federal Reserve Bank of New York, 2010 Annual Report, p. 39.

Federalist Society virtual event: Cryptocurrency Regulation in the Aftermath of FTX

Hosted by the Federalist Society. Click here for more.

The collapse of FTX has intensified the debate about how cryptocurrencies should be regulated, including proposed federal legislation. With a string of cryptocurrency failures and tens of billions in losses for investors, increased regulation has become a hot topic. As Bloomberg summarized: “Crypto is squarely in the cross hairs of Washington” and “Oversight of digital assets is among the most pressing issues for US financial watchdogs.”

Should cryptocurrency firms be regulated as banks? Should cryptocurrency assets be regulated as securities or as commodities? If so, who is the right regulator? Do we need new federal legislation? With enhanced financial and risk disclosures, should cryptocurrency firms only be subject to standard commercial law and, if they fail, normal bankruptcy proceedings? These issues will be addressed by this fourth in a continuing series of cryptocurrency webinars presented by the Federalist Society’s Financial Services and E-Commerce Practice Group.

Featuring:

The Honorable Cynthia Lummis, United States Senator, Wyoming 

Jerry Loeser, Of Counsel, Winston & Strawn LLP (Retired)

Steve Lofchie, Partner, Financial Services, Fried Frank

Alex J. Pollock, Senior Fellow, Mises Institute

Moderator: J.C. Boggs, Partner, Government Advocacy and Public Policy, King & Spalding

Opening remarks:

Empire Salon | Alex Pollock & Howard Adler

Hosted by Committee for the Republic. Full video here.

The Committee for the Republic seeks to restore Congress as the exclusive custodian of the war power under the U.S. Constitution. Since the Korean War, American foreign policy has operated extra-constitutionally featuring presidential usurpation and congressional abdication. The price has been staggering—not only in the squandering of trillions of dollars and lives lost but in the annihilation of liberty and the rule law. Committee salons also explore the funding necessary to finance the wars that earmark an imperial presidency. The Federal Reserve is the rich uncle of war finance.

Central banking is a cornerstone of government power under any monetary standard. But it is a lead actor in our pure fiat currency system. The first step was taken in 1933 when President Franklin Roosevelt by executive order prohibited Americans from owning gold. The culminating step was taken in 1971 by President Nixon's severing of the last tie of the dollar to gold -- putting the world on an "elastic" paper money standard.

Alex Pollock and Howard Adler will address their new book, Surprised Again!--The Covid Crisis and the New Market Bubble. It dissects the 2020 financial panic, the massive government interventions to finance it, and the ensuing Everything Bubble and high inflation. With fiat currency in unlimited supply, the Fed was essential to financing these expansions of government. Its balance sheet ballooned by over $4 trillion in printing the dollars needed to "lend freely" into the financial crisis and to cover the staggering government deficits which ensued. The Fed performed the real first mission of every central bank: financing the government of which it is a part.

The salon will also explore the wider implications of the role of the Fed as paymaster of the American empire and enabler of our multi-trillion-dollar military-industrial-security complex. Since the Bank of England was formed in 1694 to finance King William's wars, the link of central banking to war finance has continued. The Constitution entrusts to Congress financing government operations, but Congress has surrendered responsibility to the executive branch and the central bank. The dollar as a reserve currency enables the Fed to fund the empire with foreign dollar holdings.

Opening remarks:

Have we lost an independent central bank?

In post-WW1 Germany, who caused inflation?

Explain if we are really surprised by massive financial events or not.

What are the implications long-term of manipulating interest rates?

How expensive would wars be if we weren't the reserve currency?

Broad question about the role of the Fed.

Question about the broad role of the Fed and its political involvement as well as the value of currency boards.

The Fed’s Operating Losses Become Taxpayer Losses

Published in the Federalist Society with Paul H. Kupiec.

The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?The year 2023 is shaping up to be a financially challenging one for the Federal Reserve System. The Fed is on track to post its first annual operating loss since 1915. The annual loss will be large, perhaps $80 billion or more, and this cash loss does not count the massive unrealized mark-to-market losses on the Fed’s fixed-rate securities portfolio. An operating loss of $80 billion would, if properly accounted for, leave the Fed with negative capital of $38 billion at year-end 2023. If interest rates stay at their current level or higher, the Fed’s operating losses will impact the federal budget for several years, requiring new tax revenues to offset the continuing loss of billions of dollars in Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth quarter operating loss of over $18 billion. The losses continued in January 2023, bringing the total loss since September to $27 billion, as shown in the Fed’s February 2 H.4.1 Report. Since it raised the cost of its deposits again by raising rates on February 1, the Fed is losing at an even faster rate. If short-term interest rates increase further going forward, the operating loss will correspondingly increase. Again, these are cash losses, and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion as of September 30, 2022.

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed rate, low-yielding mortgage and Treasury securities with floating rate liabilities. These quantitative easing (QE) purchases were a Fed gamble. In the past, with interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose—as they now have.

The return of high inflation required increases in short-term interest rates, but they are only back to normal historical levels. This pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s Savings & Loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits in the future, when its massive interest rate mismatch will finally have rolled off. This may take a while, since the Fed reports $4 trillion in assets with more than 10 years to maturity (see H.4.1 Report, Section 2). During this time, the future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for federal tax revenues, will not be remitted. It turns out the Fed’s gamble carried the risk that QE might generate taxpayer costs, costs that are being realized today. The Fed’s QE gamble has turned into a buy-now pay later policy—costing taxpayers billions in 2023, 2024, and additional years to pay for its QE purchases.

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did the Fed explain to Congress the risk of the gamble? The Fed now tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses by a different name: a “deferred asset.” They are assuredly not an asset of any kind, but properly considered are a reduction in capital. The political effects of the losses are complicated by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest—if anything at all—on bank excess reserve balances. Besides, until 2008, excess reserve balances were very small, so the Fed’s interest expense on them was expected to be negligible.

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds, and other financial institutions, while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits with a positive fiscal impact. In 2023 and going forward, the Fed will negatively impact fiscal policy—something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the ongoing billions in Fed losses are no big deal?

Letter: A piece that displayed that iron law of finance

Published in the Financial Times:

Martin Wolf’s timely opinion piece “We must tackle crisis of global debt” (January 18) displays once again an iron law of finance that “loans which cannot be paid will not be paid” — which applies to sovereign debtors as well as all others who have borrowed beyond their means.

Once we realise that this is the situation we have got ourselves into, the only question is how to divide up the losses among the parties. “Who gets to eat how much loss?” is the simple statement of what all the discussions of “debt restructuring” are about.

Mises Institute's Alex Pollock explains how to pay all of Treasury’s bills easily

From Chicago’s Morning Answer:

How to pay all of the Treasury’s bills without raising the debt limit

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The news is filled with dire warnings of what will happen if Congress does not lift the debt ceiling and the U.S. Treasury defaults on its debt. 

Conservative House Republicans in the new Congress have promised to block any increase in the debt ceiling without an agreement to make cuts in the government’s massive deficit spending. President Biden has vowed not to negotiate and says Congress must pass a clean bill that only increases the debt ceiling. 

Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”

Voila! The Treasury has $494 billion more in cash with no additional debt. The president’s budget proposed a deficit of $1.2 trillion for fiscal 2023, so the additional funds should carry the Treasury from the current June deadline to easily past the end of fiscal 2023, giving the new Republican House majority, and the Democratic Senate majority, time to negotiate, in regular order, and pass a 2024 fiscal year budget with spending cuts as well as pass a new appropriately-sized debt ceiling to facilitate government funding in fiscal 2024 and beyond.

By merely recognizing the true market value of the Treasury’s gold holdings, the intense embarrassment to the administration and Congress of a looming default by the Treasury can be completely avoided. It is indeed ironic that in a world of inflated fiat currency and massive deficit finance, simply recognizing the true value of the government’s gold holdings can keep the government solvent. There are no budgetary tricks involved. It’s been done before and can work again.

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

The Fed’s quantitative easing gamble costs taxpayers billions

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The year 2023 is shaping up to be a challenging one for the Federal Reserve System. 

The Fed is on track to post its first annual operating loss since 1915. Per our estimates, the loss will be large, perhaps $100 billion or more, and this cash loss does not count the unrealized mark-to-market losses on the Fed’s massive securities portfolio. An operating loss of $100 billion would, if properly accounted for, leave the Fed with negative capital of $58 billion at year-end 2023. 

At current interest rates, the Fed’s operating losses will impact the federal budget for years, requiring new tax revenues to offset the continuing loss of billions of dollars in the Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth-quarter operating loss of over $18 billion. The weekly Fed H.4.1 reports suggest that after December’s 50 basis point rate hike, the Fed is losing at a rate of about $2 billion a week. This weekly loss rate when annualized totals a $100 billion or more loss in 2023. If short-term interest rates increase further, operating losses will increase. Again, these are cash losses and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion on Sept. 30. 

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed-rate, low-yielding mortgage and Treasury securities with floating-rate liabilities. These are the net investments of non-interest-bearing liabilities — currency in circulation and Treasury deposits — thus investments financed by floating rate liabilities.

These quantitative easing purchases were a Fed gamble. With interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose — as they now have.

The return of high inflation required the Fed to increase short-term interest rates, which pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s savings and loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits (the dollars the Fed earns managing the money supply) in the future once its massive interest rate mismatch has rolled off. This may take a while since the Fed reports $4 trillion in assets with more than 10 years to maturity. During this time, future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for Federal tax revenues, will not be remitted. 

While not widely discussed at the time, the Fed’s quantitative easing gamble put taxpayers at risk should interest rates rise from historic lows. The gamble has now turned into a buy-now-pay-later policy — costing taxpayers billions in 2023, 2024 and perhaps additional years as new tax revenues will be required to replace the revenue losses generated by quantitative easing purchases. 

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did Congress understand the risk of the gamble? The Fed tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses something else: a “deferred asset.” The accumulated losses are assuredly not an asset but properly considered are a reduction in capital. The political fallout from these losses will be magnified by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest — if anything at all — on bank excess reserve balances. Besides, at the time, excess reserve balances were very small, so if Fed did pay interest on excess reserves, the expense would have been negligible.  

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds and other financial institutions while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits and contribute to Federal revenues. In 2023 and going forward, the Fed will negatively impact fiscal policy — something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the looming Fed losses are no big deal? 

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

A “default on our debt” would be unprecedented in American history?

Published in Politifact:

Possible precedents for defaults

In a 2021 op-ed in The Hill, a political news outlet, Alex J. Pollock, a former Treasury Department official, argued that there are four precedents for U.S. defaults.

Pollock cited cases of the U.S. Treasury:

• Resorting to paper money largely not supported by gold during the Civil War in 1862;

• Redeeming gold bonds with paper money rather than gold coins during the Great Depression in 1933; 

• Not honoring silver certificates with an exchange of silver dollars in 1968; and

• Abandoning the Bretton Woods Agreement in 1971, which included a commitment to redeem dollars held by foreign governments for gold. 

…

Our Sources

Hakeem Jeffries, interview with NBC’s "Meet the Press," Jan. 8, 2023

Congressional Research Service, "Has the U.S. Government Ever ‘Defaulted’?" Dec. 8, 2016

Alex J. Pollock, "The US has never defaulted on its debt — except the four times it did," Oct. 7, 2021

How FedGov Destroyed the Housing Market

This podcast is published by the Mises Institute.

There is no real housing market in the US. Instead, an unholy trinity of Fannie/Freddie, the US Treasury, and the Federal Reserve Bank operate to distort the market at every turn and drive home prices up dramatically. Mises Institute Senior Fellow Alex Pollock, an economist and former mortgage banker, joins Jeff to describe the reality few Americans know.

Alex Pollock's new book Surprised Again: The Covid Crisis and the New Market Bubble : Mises.org/HAP377a

Alex Pollock on how the Fed became the world's biggest S&L: Mises.org/HAP377b

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"The Most Important Price of All"

Published in Law & Liberty:

In The Price of Time, Edward Chancellor has given us a colorful and provocative review of the history, theory, and profound effects of interest rates, the price that links the present and the future, which he argues is “the most important price of all.” 

The history runs from Hammurabi’s Code, which in 1750 BC was “largely concerned with the regulation of interest,” and from the first debt cancellation (which was proclaimed by a ruler in ancient Mesopotamia) all the way to our world of pure fiat currencies, the recent Everything Bubble (now deflating), cryptocurrencies (now crashing), and the effective cancellation of government debt by inflation and negative interest rates.

The intellectual and political debates run from the Old Testament to Aristotle to John Locke and John Law, to Friedrich Hayek and John Maynard Keynes, to Xi Jinping and Ben Bernanke, and many others.  

As for the vast effects of interest rates, a central theme of the book is that in recent years interest rates were held too low for too long, being kept “negative in real terms for years on end,” with resulting massive financial distortions for which central banks are culpable. 

The Effects of Low Interest Rates

Chancellor chronicles how over the centuries, many writers and politicians have favored low interest rates. They have in mind an image of the Scrooge-like lender, always a usurer lending at excessive interest, grinding down the impoverished and desperate borrower—not unlike contemporary discussions of payday lending. For example, Chancellor quotes A Discourse Upon Usury, written by an Elizabethan judge in 1572, which describes the usurer as “hel unsaciable, the sea raging, a cur dog, a blind moul, a venomus spider, and a bottomless sacke…most abominable in the sight of God and man.” Presumably, the members of the American Bankers Association and of the Independent Community Bankers of America would object to this description.

In fact, the roles of lender and borrower have often been and are in large measure today the opposite of the traditional image. This was already clear to John Locke, as Chancellor shows us. The great philosopher turned his mind in 1691 to “Some Considerations of the Lowering of Interest Rates” and “saw many disadvantages arising from a forced reduction in borrowing costs” and lower interest rates paid to lenders. For who are these lenders? Wrote Locke: “It will be a loss to Widows, Orphans, and all those who have their Estates in Money”—just as it was a loss in 2022 to the British pension funds when these funds got themselves in trouble by trying to cope with excessively low interest rates. Moreover, who would benefit from lower interest rates? Locke considered that low interest rates “will mightily increase the advantages of bankers and scriveners, and other such expert brokers … It will be a gain to the borrowing merchant.” Lower interest rates, Chancellor adds, would also benefit “an indebted aristocracy.”

In Chancellor’s summary, “Locke was the first writer to consider at length the potential damage produced by taking interest rates below their natural level.” Locke’s position in modern language includes these points:

• Financiers would benefit at the expense of ”widows and orphans”

• Wealth would be redistributed from savers to borrowers

• Too much borrowing would take place

• Asset price inflation would make the rich richer

Just so, over our recent years of too-low interest rates, ordinary people have had the purchasing power of their savings expropriated by central bank policy and leveraged speculators of various stripes made large profits from overly cheap borrowing, while debt boomed and asset prices inflated into the Everything Bubble.

The central bankers knew what they were doing with respect to asset prices. Chancellor quotes a remarkably candid statement in a Federal Open Market Committee meeting in 2004, in which, as a Federal Reserve Governor clearly put it:

[Our] policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of the distortion is deliberate and a desirable effect if the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand.

That boosting asset prices was “deliberate” is correct; that it was “desirable” seems mistaken to Chancellor and to me. “The records show that the Fed had used its considerable powers to boost the housing market,” he writes (I prefer the phrase, “stoke the housing bubble”). What is worse, the Fed did it twice, and we had two housing bubbles in the brief 23 years of this century. In 2021, the Fed was inexcusably buying mortgage securities and suppressing mortgage rates while the country was experiencing a runaway house price inflation (now deflating).

In general, “Wealth bubbles occur when the interest rate is held below its natural level,” Chancellor concludes.

Bad Press

On a different note, he mentions that suppression of interest rates could lead to “Keynes’ long-held ambition for the euthanasia of the rentier,” using Keynes’ own memorable, if unpleasant, phrase. The recent long period of nearly zero interest rates, however, led to huge market gains on the investments of the rentiers, and caused instead the euthanasia of the savers—or at least the robbing of the savers.

Our recent experience has shown again how borrowers may be made richer by low interest rates, as were speculators, private equity firms, and corporations that levered up with cheap debt. “It is clear that unconventional monetary policies…had a profound impact on inequality,” Chancellor writes, “the greatest beneficiaries from the Fed’s policies [of low interest rates] were the financial elite, who got to enhance their fortunes with cheap leverage at a time when asset values were driven higher by easy money.”

Historically there was a question of whether there should be interest charged at all. “Moneylenders have always received a bad press,” Chancellor reflects, “Over the centuries… the greatest minds have been aligned against them”—Aristotle, for example, thought charging interest was “of all modes of making money…the most unnatural.” The Old Testament restricted charging interest, but as Chancellor points out, the Book of Deuteronomy makes this important distinction: “You shall not lend upon interest to your brother, interest on money, interest on victuals, interest on anything,” but “To a foreigner you may lend upon interest.” This raises the question of who is my brother and who is a foreigner, but does seem to be an early acceptance of international banking. It also makes me think that anyone who has made loans from the Bank of Dad and Mom at the family interest rate of zero, will recognize the intuitive distinction expressed in Deuteronomy.

Needless to say, loans and investments bearing interest prevail around the globe in the tens of trillions of dollars, the moneylenders’ bad press notwithstanding. This is, at the most fundamental level, because interest rates reflect the reality of time, as Chancellor nicely explains. One thousand dollars ten years from now and one thousand dollars today are naturally and inescapably different, and the interest rate is the price of that difference, which gives us a precise measure of how different they are.

A perpetually intriguing part of that price is how interest compounds over long periods of time. “The problem of debt compounding at a geometrical rate has never lost its fascination,” Chancellor observes, and that is certainly true. “A penny put out to 5 percent compound interest at our Savior’s birth,” he quotes an 18th-century philosopher as calculating, “would by this time [in 1773]… have increased to more money than would be contained in 150 millions of globes, each equal to the earth in magnitude, all solid gold.”

The quip that compound interest is “the eighth wonder of the world” is often attributed to Albert Einstein, but Chancellor traces it to a more humble origin: “an advertisement for The Equity Savings and Loan Company published in the Cleveland Plain Dealer” in 1925. “Compound interest… does things to money,” the advertisement continued, “At the Equity it doubles your money every 14 years.” This meant the savings and loan’s deposits were paying 5% interest—the same interest rate used in the preceding 1773-year calculation, but that case represented 123 doublings.

The mirror image of sums remarkably increasing with compound interest is the present value calculation, which reduces the value of future sums by compound interest running backward to the present, a classic tool of finance. Just as we are fascinated, as the Equity Savings and Loan knew, by how much future sums can increase, depending on the interest rate that is compounding, so we are also fascinated by how much today’s market value of future sums can shrink, depending on the interest rate. 

If the interest rate goes from 1% to 4%, about what the yield on the 10-year Treasury note did in 2021-2022, the value of $1,000 ten years from now drops from $905 to $676, or by 25%. You still expect exactly the same $1,000 at exactly the same time, but you find yourself 25% poorer in market value.

Central Bank Distortions

In old British novels, wealth is measured by annual income, as in “He has two thousand pounds a year.” One role of changing interest rates is to make the exact same investment income represent very different amounts of wealth. If interest rates are suppressed by the central banks, it makes you wealthier with the same investment income; if they are pushed up, it makes you poorer. If they change a lot in either direction, the change in wealth is a lot. The math is elementary, but it helps demonstrates why interest rates are, as Chancellor says, the most important price. 

In the 21st century, “The Federal Reserve lowered interest rates to zero and sprayed money around Wall Street.” But if the interest rate is zero, $1,000 ten years in the future is worth the same as $1,000 today, a ridiculous conclusion, and why zero interest rates are only possible in a financial world ruled by central banks.

More egregious yet is the notion of negative interest rates, which were actually experienced on trillions of dollars of debt during the last decade. “The shift to negative interest rates comprised the central bankers’ most audacious move,” Chancellor writes. “What is a negative interest rate but a tax on capital—taxation without representation.” With negative interest rates, $1,000 ten years in the future is worth more than $1,000 today, an absurd conclusion, likewise proof that negative interest rates can only exist under the rule of central banks.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes. In his ideal world, expressed on the book’s last page, “central banks would no longer be able to pursue an active monetary policy,” and “guided by the market’s invisible hand, the rate of interest would find its natural level.” Given all the mistakes central banks have made, with the accompanying distortions, this is an attractive vision, but unlikely, needless to say.

Will The FTX Crash Kill Crypto?

Cited in Forbes:

That includes digital currencies. This the irony which Mises Institute scholar Alex Pollock points out in his new book, Surprised Again!, coauthored with Howard Adler: that crypto’s problems may well speed the digitization of national currencies and increase the power and influence of central banks—the crypto enthusiast’s No. 1 nemesis.

Jan 17 AEI Event: Should the Federal Reserve Raise Its Inflation Rate Target?

Click here to watch live.

Near-zero interest rates prevailed for more than a decade, raising concerns that the Federal Reserve lacked policy tools should stimulus be needed to counteract a recession. While some central banks experimented with negative rates, the Fed adopted quantitative easing (QE) to stimulate the economy without lower rates.

Some economists argue that the Fed should raise its inflation target so that normalized interest rates are high enough to allow interest rate cuts to stimulate the economy without resorting to QE. A recent Wall Street Journal article argues that an optimal inflation target could be as high as 4 percent—or even 6 percent.

Join AEI as a panel of experts discuss arguments for and against changing the Fed’s inflation target.

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

Agenda

10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI

10:15 a.m.
Panel Discussion

Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia Business School
Gerald P. Dwyer, Professor and BB&T Scholar, Clemson University
Thomas Hoenig, Distinguished Senior Fellow, Mercatus Center
Alex J. Pollock, Senior Fellow, Mises Institute

Moderator:
Paul H. Kupiec, Senior Fellow, AEI

11:45 a.m.
Q&A

12:00 p.m.
Adjournment

Click here to watch live.