Sept 21: AEI Event: Has the Fed Produced a Soft Economic Landing?

Hosted by the American Enterprise Institute (AEI).

A video livestream will be available on this page starting at 2:00 PM on Thursday, September 21st. Please scroll down to view.

Contact Information

Event: Beatrice Lee | Beatrice.Lee@aei.org
Media: MediaServices@aei.org | 202.862.5829

RSVP to Watch Online

Over the past year, US headline inflation has declined from a peak of over 9 percent to 3 percent. At around 3.5 percent, unemployment has remained close to a postwar low, while the Federal Reserve has moved away from its earlier zero interest rate policy to the most aggressive tightening cycle in the past 40 years.

Our expert panel will discuss whether the Fed has succeeded in producing a soft economic landing and will examine the remaining risks to the economy and the financial system.

Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon.

Agenda

2:00 p.m.
Introduction:
Desmond Lachman, Senior Fellow, AEI

2:05 p.m.
Panel Discussion:

Panelists:
Donald Kohn, Robert V. Roosa Chair in International Economics, Brookings Institution
Desmond Lachman, Senior Fellow, AEI
Kevin Warsh, Shepard Family Distinguished Visiting Fellow, Hoover Institute
William White, Senior Fellow, C.D. Howe Institute

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

3:30 p.m.
Q&A

4:00 p.m.
Adjournment

Rsvp here.

Will the Fed take the medicine one of its presidents prescribes for other banks?

Published in The Hill.

The president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, like an old doctor for ailing banks, recently prescribed a stern regimen for those in weakened conditions from big mark-to-market losses on their long-term investments and loans. Speaking at a National Bureau of Economic Research panel this month, Kashkari pointedly asked: 

“What can a bank do that is already facing large mark-to-market losses?” 

An excellent and hard question, for the losses have already happened, economically speaking. Of course, these banks can passively hold on and hope that interest rates will go back down to their historic lows, and hope that depositors will stop demanding higher yields or departing elsewhere. 

Besides hoping, what can they do?

Doctor Kashkari unsympathetically reviewed the possible medicines, all bitter. These, he said, were three: 

1. Try to raise more equity. 

2. Sell the underwater assets. 

3. Cut dividends. 

Considering these options, Kashkari observed that raising equity may not be so easy or attractive, since investors may not be inclined to invest in funding losses. Divesting the underwater assets by definition means selling at a loss, so the unrealized losses become realized losses on the accounting books.  This perhaps would render the bank formally undercapitalized or worse and may frighten large depositors — will they run?

The third option of cutting dividends then appears as the most practical way to conserve some capital, but as Kashkari asked rhetorically, how many bank CEOs are likely to want to cut their dividends? So he proposed new stress tests with high-interest rates, which would lead to restricting the dividends by regulatory order.

Physician, Heal Thyself! 

Kashkari did not mention that the biggest bank in the country, the one he works for, is facing particularly large mark-to-market losses. The $8 trillion Federal Reserve has net mark-to-market loss of $911 billion as of its last report on March 31. This mark-to-market loss is a remarkable 21 times its total capital of $42 billion. Moreover, according to my calculations, the Fed appears to be heading for an operating loss of about $110 billion for the year 2023. 

So it is timely and appropriate to apply “Doctor” Kashkari’s three possible medicines to the Federal Reserve itself.  

1. The Fed is clearly in a position to raise more equity in the face of its losses if it chooses to. All the commercial bank members of the Federal Reserve are required to subscribe to stock in the Federal Reserve according to a formula based on their own capital, but they all have bought only half of their required subscriptions. The Fed has the right to call for the purchase of the other half at its discretion. It could issue that call right now, and double its paid-in capital. But will it?   

1. The Fed could obviously sell some of its underwater investments. But just as for other banks, that would turn unrealized losses into realized losses and make the Fed’s existing accounting losses even bigger. As the leading investor in mortgage-backed and long-term Treasury securities, large sales by the Fed could move market prices downward, increasing its mark-to-market losses on the remaining investments. Although it has produced projections of realizing losses by sales of underwater investments, the Fed, like the banks Kashkari discussed, chooses not to sell. 

1. How about dividends then? The Fed is paying rich dividends of 6 percent to small banks and the 10-year Treasury yield to large banks while it is running an estimated annual loss of about $110 billion, has a $911 billion mark to market loss, and properly accounted for per my calculations, has negative capital of $38 billion, which is getting more negative each week. It is borrowing money to pay its dividends. And what would a high interest rate stress test applied to the Fed’s massive interest rate risk show? Should the Fed take Kashkari’s dividend medicine and restrict or skip its dividends in light of its huge losses? Revising Kashkari’s rhetorical question, how many Federal Reserve presidents and governors want to do that, including the president of the Federal Reserve Bank of Minneapolis? 

As that president explained, when you already have large economic losses, none of the options are appetizing. 

Letter: Fed at the forefront of inflation-driven losses

Published in the Financial Times.

Martin Wolf (“Inflation’s return changes the world”, Opinion, July 5) rightly points out the “further problems . . . as losses build up in institutions most exposed to property, interest rate and maturity risks.”

He does not mention that the institution with the biggest losses of all from interest rate risk, the one most changed by inflation’s return, is none other than the world’s leading central bank. In the past nine months, the Federal Reserve has suffered previously unimaginable operating losses of $74bn from its deeply underwater interest rate risk position, a loss which far exceeds its total capital of $42bn. In misleading and arguably fraudulent accounting, the Fed refuses to reduce its reported capital by these losses; with proper bookkeeping, it would now be reporting capital of negative $32bn, growing more negative every month. It insists that no one should care about its negative capital, but carefully cooks the books to avoid reporting it.

The Fed is on the way to operating losses of an estimated $110bn this year. Its mark to market loss as of March 31 2023 was $911bn. The Fed has no possibility of generating offsetting gains from revaluing gold, since it owns exactly zero gold. Wolf reasonably asks if “economies must be kept permanently feeble in order to stop the financial sector from blowing them up”. We can likewise ask, “Must central banks make themselves so feeble in order to prop up economies and the financial sector?”

Will the Fed Ever Relinquish Its New Powers?: The Fed's "Cincinnatian Problem"

Published by the Mises Institute. See the PDF here.

In times of banking and financial crises, central banks always intervene. This is not a law of nature, but it is an empirical law of central bank behavior. The Federal Reserve was created 110 years ago specifically to address banking panics by expanding money and credit when needed, by providing what was called in the Federal Reserve Act of 1913 an “elastic currency,” so it could make loans in otherwise illiquid markets, when private institutions can’t or won’t.

The great Victorian banking thinker (as well as private banker) Walter Bagehot proposed that the Bank of England “lend freely” to quell a panic, and the central banks of the world today are all his disciples in this respect. With the post–Bretton Woods, pure-fiat-currency Federal Reserve, the US currency is elastic with a vengeance. That’s how we got a Fed with assets of $3 trillion during the great real estate bust of 2007–12 and then the truly remarkable $8.9 trillion Fed balance sheet in the wake of the covid financial crisis of 2020.

Austrian economists are generally against any central bank intervention at all, but suppose with me arguendo that the case for intervention in a crisis prevails: that the periodic financial crises that do and doubtless will continue to occur should be addressed by the temporary expansion of the compact power and money-printing ability of the government and its central bank—especially the money-printing power, which shifts assets and risks to the government’s balance sheet. The central bank’s balance sheet thus expands to offset the pressured private balance sheets. Even if the crisis was caused by the actions of the central bank itself, as Austrians would point out, and even though the expansion creates moral hazard for the future, the central bank’s elastic currency and balance sheet are handy in midst of the crisis. This is the credo of all modern central banks.

But what happens when the crisis is over?

Note well the essential word temporary in the preceding argument for crisis intervention. The crisis interventions should be temporary. If prolonged, they will tend more toward monopoly and bureaucracy and less toward innovation, growth, and economic well-being than will competitive, enterprising markets. In the extreme, long-term intervention will produce markets characterized by socialist stagnation. How do you get interventions withdrawn when the crisis is over?

Consider a huge and radical intervention of the last fifteen years. The Federal Reserve started buying mortgage securities at the beginning of 2009. The amount of mortgage securities which had been owned by the Federal Reserve until then, from 1913 to 2008, was exactly zero. Then, faced with the shriveling of the vast housing bubble and the panic of 2008, the Fed was led by Chairman Ben Bernanke into a new intervention and started buying mortgage securities to prop up house prices and the housing finance market. This was the opposite of the former Fed orthodoxy, which held that the monetary power of the central bank should not be used to favor any particular economic sector.

Bernanke’s theory was that this radical intervention would be temporary. As he testified before Congress in February 2011: “What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in money outstanding, in the Fed’s balance sheet, or in inflation” (Italics added).

Needless to say, the promised normalization didn’t happen. As of the end of April 2023, the Fed owns $2.6 trillion of mortgage securities. That is larger than what the total assets of the Fed were at the end of 2008. That number and the interest rate risk it represents would have astonished previous generations of Federal Reserve governors. The Fed also experienced a massive mark to market loss on these mortgage securities: a loss of $408 billion as of the end of 2022, or almost ten times the Fed’s total capital of $42 billion.

In the intervening years, the Fed’s mortgage purchases, driving down mortgage interest rates to an unprecedented less than 3 percent, stoked a major house price inflation. By 2021, US national house prices were in a new bubble, their increase rising to an annual rate of over 16 percent. Faced with runaway inflation of house prices, the Fed has unbelievably continued to buy hundreds of billions of dollars of mortgage securities, and never sells any. I know of no one who now defends this far overextended intervention.

In my view, the Federal Reserve should get out of the business of pushing up house prices, and the Fed’s mortgage portfolio should go back to the normal amount of exactly zero.

Emergency interventions, however sincere the original intent that they be temporary, inevitably build up political and economic constituencies who profit from them and want their continuation. When the central bank monetizes government debt, the biggest such constituent is the government itself.

So here is our essential and unsolved problem: How do you reverse the central bank emergency programs, originally thought and meant to be temporary, after the crisis has passed? No one has successfully addressed the issue of how to do this—not even central banking’s most ardent supporters propose an answer.

That the emergency interventions of the crisis should be withdrawn in the normal times which follow I call the Cincinnatian doctrine. The name comes from the ancient Roman hero Cincinnatus, who was called from his plow to save the state and made temporary dictator of Rome. He did save the state, and then, mission accomplished, eft his dictatorship and went back to his farm. Similarly, two millennia later, George Washington, the victorious general and hero who had saved the United States and might perhaps have made himself king, voluntarily resigned his commission and went back to his farm, becoming to the eighteenth century “the modern Cincinnatus.”

But the Federal Reserve does not have the republican virtue of Cincinnatus or Washington, so how do we get the Fed to go back to its farm? The difficulty of ending vast emergency interventions whose day has passed but which have become established and advantageous to their constituencies and have increased the power enjoyed by the central bankers is the Cincinnatian problem. There is no easy answer to the Cincinnatian problem. It deserves our intense focus.

July 3--Sympathy for Thomas Jefferson Day

Everybody knows about July 4, but what was happening on July 3, 1776?  On that day, the draft of the Declaration of Independence submitted by Thomas Jefferson was edited by the Continental Congress, meeting as a committee.  Jefferson had to sit there, “the writhing author,” says my well-worn history of the Declaration, while his words were criticized, deleted and altered.  Jefferson “was far less happy when his handiwork was subjected to what he called the ‘depredations’ of Congress.” He “kept silent for propriety’s sake,” but “in his opinion, they did a good deal of damage [as] the delegates took a hand in the drafting.”  

All those who have worked assiduously on their writing, then had it edited by a committee, will have lively sympathy for Jefferson every July 3!

The Congress “effected economy in words,”  “deleted unnecessary phrases,”  “eliminated the most extravagantly worded of all the charges [against King George],” “deleted a passage in which Scottish mercenaries were coupled with foreign [ones],” changed Jefferson’s final paragraph so as to include in it the precise language of the resolution of independence just adopted [on July 2]”, and “left out several moving phrases of his toward the end.”

I have reviewed the edits made by the Congress, and find that they definitely improved the final, world historical document.  Nonetheless, to sit there while your work suffers “depredations” by a committee of your colleagues, even if they are in fact improvements, is surely difficult.  Our sympathy for the author should be undiminished.

1. Dumas Malone, The Story of the Declaration of Independence, Oxford University Press, 1954.

U.S. banking problems: Mortgage interest rate risk strikes again

Published in Housing Finance International.

Notable U.S. bank runs and failures in spring 2023 followed speeches from the Treasury Department and the Federal Reserve in 2022 and early 2023 about what a good shape the U.S. banking system was in. Of course, they wanted the non-bank financial companies (so-called “shadow banks”) to be regulated more, but they claimed the commercial banks were in great condition. This was thanks to the Dodd Frank Act and its greatly expanded regulation, it was suggested, and we could congratulate ourselves for this banking stability.

Surprise! Shortly thereafter came the second, third and fourth largest bank failures in U.S. history (First Republic, Silicon Valley, and Signature banks, respectively). These were accompanied by emergency government declarations that the failing banks were “systemically important”—in other words, that the banking system in general was at risk. Such declarations allowed bailouts of wealthy depositors who had accounts with the failing banks of far over the normal statutory maximum of $250,000 for government deposit insurance coverage. Those depositors should have taken a loss on the risky investments they had made and from their folly in maintaining hundreds of millions, in some cases, or even billions of dollars, in single small-enough-to-fail banks. That was quite unwise risk taking on their part, but big money venture capitalists, tech entrepreneurs and cryptocurrency barons, among others, got all their deposits back by being given other people’s money. The insurance fund of the Federal Deposit Insurance Corporation was reduced below its minimum statutory level by the cost of these failures.

Central to the failures were billions of dollars in losses resulting from investing in long-term, fixed rate mortgage securities and financing them with short-term, floating-rate liabilities. The interest rate risk of the American 30-year fixed-rate mortgage strikes again! Although these mortgages were often held in securitized form, making them theoretically liquid, once their market value was far below their cost, selling them would trigger the realization of the huge losses, which could and did set off a run on the bank. So just as in the case of the U.S. savings & loans in the 1980s, the shortfunded 30-year mortgages contributed to first massive interest rate risk and then fatal liquidity risk for the failed banks.

However, not only the failed banks, but hundreds of banks across the country have made this mistake. In doing so, they were following the Pied Piper of the Federal Reserve and its long lasting, but now ended, suppression of both short-term and long-term interest rates, its predictions of “lower interest rates for longer,” and quite remarkably, its own practice of investing trillions of dollars in long term fixed rate assets funded by borrowing short in its own balance sheet. Investing in long-term mortgages and also long-term Treasury securities, the banks and the Federal Reserve together created huge amounts of interest rate risk for the total banking system.

This is a classic banking risk, a classic banking mistake. Along with it comes a classic problem: although it is often said that bank runs reflect irrational fears, in fact runs are highly rational from the viewpoint of the depositor.

Keeping your money in a questionable bank instead of getting it out, when you can’t really know what the bank’s assets are worth or what is really going on inside it or who is lying, has no upside potential and large downside potential of serious losses on money you didn’t intend to be at risk at all. So, it is rational to run.

Every bank should be structured with the thought that runs are rational from the viewpoint of the depositors. This is an old and essential banking truth. As the great Walter Bagehot wrote in Lombard Street in 1873, “A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for.” Bagehot adds, “Adventure is the life of commerce, but caution is the life of banking.”

One recent academic analysis has estimated the mark to market loss of all U.S. banks, including both their fixed-rate securities and fixed-rate loans, and concluded that the banking system has a mark to market loss of about $2 trillion on these assets. That’s $2 trillion.

In comparison, the book capital of the U.S. banking system is about $2.2 trillion, and of that $2.2 trillion, $400 billion are intangible assets. So, the tangible capital is approximately $1.8 trillion, while the mark to market loss may be something like $2 trillion. That would suggest that we have an entire banking system with something like zero real capital. While there is large variation among the 4,700 banks and savings associations, the overall situation is certainly sobering on a mark-to-market basis.

The way unrealized losses turn into real losses in financial institutions that have fixed rate, long term assets funded with short term floating rate liabilities, is that the cost of their liabilities goes dramatically up and the yield on their assets doesn’t.

The big question in the banking system has thus become: how resistant are the banks to the cost of their deposits rising to full market levels of 5% or so, in order to fund the deeply underwater fixed rate loans and securities on which there is a $2 trillion market value loss? How much is their interest cost going to rise? In other words, as the unrealized losses turn into greater interest expense, how much can you continue to cheat the savers in order to prop up the banks? What we will observe going forward is the contest between the inexorable rise in the funding cost, and the hope that banks can continue to cheat the savers and keep the deposit cost below market. This puts the banking regulators, who are in favor of bank safety, on the side of cheating the savers. All this is just like the U.S. savings & loans and their regulators in the 1970s and 1980s.

On top of its interest rate risk, we find out the U.S. banking system has, once again, a large risk exposure to troubled commercial real estate. Consider this observation: “The unfavorable conditions in banking were greatly aggravated by the collapse of unwise speculation in real estate.” That is from the report of the U.S. Comptroller of the Currency in 1891. Little about this connection has changed since then.

The famous Fed Chairman Paul Volcker observed that “There are no new problems in banking, only new people.”

But why do crises keep recurring if we have comprehensive regulation, like the Dodd Frank Act and its thousands of pages of implementing regulations? The banking scholar, Bernard Shull, insightfully wrote, “Comprehensive banking reform, traditionally including augmented and improved supervision, has typically evoked a transcendent, and in retrospect, unwarranted optimism.”Writing in the 1990s, Shull continued, “Confronting the S&L disaster with yet another comprehensive reform, the Secretary of the Treasury proclaimed ‘Two watchwords guided us as we undertook to solve this problem. Never again.’”

That was the savings & loan reform of 1989, and then came the banking reforms of 1991, and the housing finance reforms of 1992. But in the following decade, instead of “never again,” another massive crisis happened again anyway. Then after that 2007-09 crisis, comprehensive reform was once again debated with the political result of the Dodd Frank Act. But another decade or so later, once again we have bank runs and failures.

We are up against the reality of the politics of banking and finance. All finance is political, especially housing finance. No matter how we politically organize any bank regulation, it will over time have to be reorganized, because the perfect answer does not exist. Whenever we try to engineer and control human behavior, the attempts at control themselves induce unexpected adaptations and reactions in the behavior of financial markets, and also in the behavior of the regulators and politicians themselves. Hence, as we observe historically, every reform requires another reform to address the unexpected results and failures of the prior reform, and so on, ad infinitum. The current troubles are part of the ongoing crisis of 2020. Starting in 2020, we experienced the Covid crisis, the financial panic, the sharp economic contraction, the vast expansion of money printing and government expenses in response, the following bubble markets, the everything bubble, the runaway inflation, the correction with rising interest rates, the deflation of the everything bubble in 2022, and now the banking problems of 2023. I think of that as all one big crisis-- we’re still in the aftermath of 2020.

In that aftermath, with assets inflated to $8.4 trillion, the Federal Reserve is by far the biggest bank in the country. It is also the biggest savings & loan, because inside the Fed is a mortgage portfolio of $2.6 trillion of long-term fixed rate mortgages, funded short with floating rate liabilities. This makes it far and away not only the biggest savings & loan in the country, but in all of history. The Fed is now earning more or less 2% on its mortgages, and more or less 2% on its long-term Treasuries. The duration of its mortgages has become longer than expected with their negative convexity and increasing interest rates. Its Treasuries are also very long, over $1.4 trillion with remaining maturities of more than 10 years. While earning 2%, the Fed is now paying over 5% to carry those investments. If your income is 2% and your cost is 5%, it’s hard to make money that way! From September 2022 to early June 2023, the Fed has had a net loss of $68 billion, and is on its way to an annual loss of about $100 billion, more than twice its capital.

The Fed’s own balance sheet was and is jammed with gigantic interest rate risk. One might not unreasonably ask, how could the Fed criticize banks like the failed Silicon Valley Bank for doing exactly the same thing that the Fed itself was and is doing? A fair question!

Of course, if the failed banks or the technically insolvent Fed had been right in the forecast that short-term interest rates would stay abnormally low, that kind of balance sheet would have been a profitable bet. They could have had 2% income and say, 0.25% interest expense. So let us ask: what was the Fed’s own interest rate forecast as it was accumulating its massive portfolio and interest rate risk?

Consider the Fed’s interest rate forecast done in June 2021 for the end of the year 2022. The median forecast for fed funds target was 0.25%. Of Federal Open Market Committee members submitting estimates, the highest rate was 0.75%. Compared to the 4.25%-4.5% reality, a big miss indeed!

What about the projection for 2023 at that same meeting? What did they think the fed funds target interest rate would be by the end of 2023? The median forecast was 0.75%. The highest submitted estimate was 1.75%. Another big miss, to say the least, with the rate now at 5%-5.25% five months into 2023.

The Fed’s poor forecasts bring to mind that famous American baseball poem, Casey at the Bat. In trying to forecast interest rates, and inflation, and banking problems, just like “Mighty Casey,” the mighty Fed has struck out.

In the meantime, the spring of 2023 provided some extreme drama in U.S. banking, tied significantly to the risk of the American 30-year fixed rate mortgage-- and this cycle is not over. Whatever may the coming in the way of further increases in interest rates, or interest rates continuing at current levels, or an often-predicted recession with lower interest rates but increased loan defaults, all will cause risks to the banking system. In any case, financial markets should remember not to put their trust in the forecasts of the Federal Reserve.

Time To Rein in a Runaway Federal Reserve That Took Congress for Granted

Published in the New York Sun and the Federalist Society.

Juvenal put it best when he asked, who will guard the guardians.

The ancient Roman poet, Juvenal, posed the incisive question that must be applied to all structures of power and authority, “Sed quis custodiet ipsos custodes?” Who will guard the guardians? Let us apply Juvenal’s question to the Federal Reserve.

The Federal Reserve endlessly repeats that it ought to be “independent.” If it is independent, though, who will guard our central bank? The Constitution grants that power — to “coin Money, and regulate the Value thereof, and of foreign coin” — to the Congress.

Every economist with whom I have ever discussed this question immediately replies, “You certainly don’t want a bunch of politicians managing monetary policy.” They all assume that elected politicians will always impose an inflationary bias which the expert central bank will resist.

Yet it was the Fed, without congressional approval, that unilaterally announced in 2012 that it was committing the nation to inflation and perpetual depreciation of its currency at the rate of 2 percent a year. That means average prices quintuple in a lifetime — an odd interpretation of the Fed’s statutory mandate of “stable prices.”

Would Congress have approved a commitment to 2 percent inflation forever? The Fed didn’t seek or wait for an approval from Congress. “The Congress let us put in an inflation target without being part of the process,” Mr. Bernanke, I was reminded by the Sun, boasted to a recent panel.

In internal Fed discussions when Alan Greenspan was chairman, he suggested that the right inflation target was “zero, properly measured” and that the setting of an inflation target should involve the Congress. The Bernanke Federal Reserve adopted neither suggestion.

Moreover, the Fed unilaterally increased its inflationary tilt in 2020 by announcing, again without the approval of Congress, that the 2 percent target meant on average over some unspecified time, so that it might run higher when the Fed desired.

In contrast, other countries — notably the first country with a formal inflation target, New Zealand — set that target of zero to 2 percent as an agreement between the parliamentary government and the central bank.

Why does the Fed need a guardian? Its formidable power combined with the inherent unknowability of the economic future makes it a most dangerous source of systemic risk, and it experiences the constant temptation to be the captive finance company of the Treasury.

A way to improve the substantive oversight of the Congress would be for the Senate Banking Committee and the House Financial Services Committee to each form a new subcommittee devoted solely to engaging the key issues of the Federal Reserve.

The central bank is important enough to the country and the world, and powerful enough for good or bad, to merit this accountability. How much the mandarins of the Fed would hate this idea is a good measure of how important it is.

Such subcommittees would not be impressed by the “pretense of knowledge,” in F.A. Hayek’s particularly perceptive and piercing phrase. Nowhere is this pretense so common as in the Federal Reserve and central banks in general.

These subcommittees would be studying and quizzing the Fed about its recently released first quarter financial statements. They would be probing its knowledge and skill, and examining its booking massive net losses. They would examine how the Fed has itself become technically insolvent.

These are the results of its truly remarkable $5 trillion mismatch of long term, fixed rate assets, including $2.6 trillion of mortgage securities, funded by floating rate liabilities. This has become an expensive mismatch indeed.

In the first quarter alone, the Fed suffered a net loss of $27.7 billion. That annualizes to a net loss for the year of about $110 billion — a number big enough to get anyone’s attention. When the Fed is making money, its profits go to reduce the federal deficit; when it loses money, the government’s deficit is increased.

Did the Fed discuss with the Congress how the interest rate risk it took was going to cost the government $110 billion this year? And how much in the coming years? What could be done? Should the Fed’s dividends to its shareholders be cut? Should its paying the expenses of the unrelated Consumer Financial Protection Bureau be scrapped?

The Federal Reserve has lost billions every month since October 2022, up to an aggregate net loss of $70 billion so far. This far exceeds its total capital of $42 billion, so the Fed’s actual capital is now negative $28 billion and constantly getting more negative. The Fed insists that its negative capital doesn’t matter, but would Congress agree? Might Congress prefer the greatest central bank in the world to have positive capital?

Finally, it is certainly time to reconsider the question of committing the nation to inflation forever at 2 percent, with the engagement and required approval of the Congress. The Money Question — in Latin or plain English — is far too important to be left to unguarded central bank guardians.

June 16 event: The 2023 Bank Runs and Failures: What Do They Mean Going Forward?

Hosted by the Federalist Society.

William M. Isaac - Chairman - Secura/Isaac Group

Keith Noreika - Executive VP & Chairman, Banking Supervision & Regulation Group - Patomak Global Partners

Lawrence J. White - Robert Kavesh Professorship in Economics - Leonard N. Stern School of Business, New York University

MODERATOR

Alex J. Pollock - Senior Fellow - Mises Institute

This year’s sudden collapse of First Republic, Silicon Valley, and Signature banks were the second, third, and fourth largest bank failures in US history, bringing perceived systemic risk and bailouts of wealthy depositors. In addition, the global Credit Suisse bank collapsed and commercial real estate losses threatened. Politicians, regulators, and bankers are debating why the massive regulatory expansion following the last crisis didn’t prevent the renewed failures. Some emphasize repetition of the classic financial blunder of buying long and borrowing short. Others question the 2018 reforms to the Dodd-Frank Act, or cite the monetary actions of the Federal Reserve. Various proposals include more deposit insurance, mark-to-market accounting, higher capital requirements, more stress tests, or bigger regulatory budgets.

Our expert panel discusses the issues and risks going forward, the outlook for new legislation and regulation, and what, if anything, should be done.

Letter: Bagehot had much to say on the caution of bankers

Published in the Financial Times.

The run on Credit Suisse “has got every thoughtful banker and regulator in the world looking over their shoulder”, writes Robin Harding (Opinion, May 31).

Congratulations to them! They have understood the fundamental nature of the business they’re in. Walter Bagehot, the great 19th-century economist and journalist, had already explained this in Lombard Street in 1873: “A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for.” Bagehot adds: “Adventure is the life of commerce, but caution is the life of banking.”

Alex J Pollock

Senior Fellow, Mises Institute, Auburn, AL, US

Fed Watch Podcast: The Fed Is Insolvent, and That's a Bad Thing

From the Mises Institute:

On this first episode of the Fed Watch Podcast, Ryan McMaken and Senior Fellow Alex Pollock talk about how the Federal Reserve has negative cash flow. The Fed will print money to "solve" the problem.

Be sure to follow the Fed Watch Podcast at Mises.org/FedPod.

Recommended Reading

"The Fed’s Capital Goes Negative" by Alex J. Pollock: Mises.org/FW_01_A

"Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?" by Alex J. Pollock and Paul H. Kupiec: Mises.org/FW_01_B

"Why the Fed Is Bankrupt and Why That Means More Inflation" by Ryan McMaken: Mises.org/FW_01_C

How much would debt default damage US? History offers clues.

Published in CS Monitor.

The U.S. has repudiated its financial obligations at other times too, says Alex J. Pollock, a senior fellow at the Mises Institute and author of “Finance and Philosophy – Why We’re Always Surprised.” In 1968, it refused to redeem silver certificate paper dollars for actual silver dollars, despite a written guarantee. Three years later, the U.S. went off the gold standard completely, despite its commitment in an international agreement to convert dollars to gold. The agreement, known as the Bretton Woods system, collapsed.The U.S. has repudiated its financial obligations at other times too, says Alex J. Pollock, a senior fellow at the Mises Institute and author of “Finance and Philosophy – Why We’re Always Surprised.” In 1968, it refused to redeem silver certificate paper dollars for actual silver dollars, despite a written guarantee. Three years later, the U.S. went off the gold standard completely, despite its commitment in an international agreement to convert dollars to gold. The agreement, known as the Bretton Woods system, collapsed.

…

“Eight thousand tonnes of gold is not a gimmick,” says Mr. Pollock of the Mises Institute. “Eight thousand tonnes of gold is reality.”

The debt ceiling debates are tainted by these common fallacies

Published in The Hill with Paul H. Kupiec.

After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

The media is full of stories and opinion pieces about the debt ceiling, many of them repeating administration officials’ and their surrogates’ claims that: It is unconstitutional for the U.S. to default on its debt, the U.S. has never defaulted on its debt and there are no other measures to prevent default, so the only solution to averting an imminent debt crisis is to raise the debt ceiling without reducing deficits. 

These claims are misleading, if not demonstrably false.

The 14th Amendment to the Constitution, ratified in 1868, included language that asserted the validity of war debt incurred by the Union while forbidding repayment of any debts incurred by the states of the Confederacy. The amendment states in part:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned” and “Neither the United States nor any state shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States.”

The Civil War context is clear.

In the midst of the 1995-1996 debt ceiling negotiations, President Bill Clinton said, if need be, he would use the 14th Amendment as justification for ignoring the debt ceiling “and force the courts to stop me.” In contrast, during the 2011 debt ceiling negotiations, the Treasury general counsel wrote that “the Constitution explicitly places the borrowing authority with Congress, not the President.” The latter is correct legal thought, the former mere political bravado. 

The 14th Amendment argument especially fails because it is obvious that the U.S. could easily pay all its debt by not making other expenditures, and moreover, because the United States has in fact defaulted on its debt multiple times since the amendment’s adoption, once explicitly upheld by the Supreme Court.

The U.S. government refused to redeem Treasury gold bonds for gold in 1933 as the bonds had unambiguously promised. In 1968, it refused to redeem its silver certificates for silver notwithstanding its explicit promise to pay “one silver dollar, payable to the bearer on demand.” In 1971, the U.S. government refused to redeem the dollar claims of foreign governments for gold, as promised in the Bretton Woods Agreement, approved by Congress in 1945. Reneging on its Bretton Woods commitments by the U.S. government in 1971 fundamentally changed the global monetary system, putting the whole world onto a pure fiat currency system — a significant default event by any measure.

The 1933 gold bond default is instructive since the government’s refusal to make the gold payments it had unquestionably promised was upheld by the Supreme Court in a 5-4 decision in 1935. The majority opinion found, “Contracts, however express, cannot fetter the constitutional authority of the Congress.” A concurring opinion wrote, “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion announced for the Court.”

Also, contrary to assertions by the secretary of the Treasury and the chairman of the Federal Reserve, there is a proven legal measure that could be used to materially postpone the day the U.S. Treasury runs out of cash without increasing the debt limit.

The Treasury owns 261.5 million ounces, or 8,000 tons, of gold that have a current market value of over $500 billion at the market price of just under $2,000 per ounce. However, for government accounting purposes, the value of the Treasury’s gold is set by the Par Value Modification Act of 1973, which “directed the Secretary of the Treasury … to establish a new par value of the dollar … of forty-two and two-ninths dollars per fine troy ounce of gold.“

Congress could allow the Treasury to raise cash and avoid a default by amending this law to value gold at or near its current market price. Such a revaluation would be consistent with the guidance in the Federal Accounting Standards Advisory Board’s Technical Bulletin 2011-1. This change would allow the Treasury to monetize more than $500 billion in new gold certificates with no additional Treasury debt issuance.

Updating the value of gold certificates to avoid default is not a hypothetical idea — it has been done before. In 1953, when the Eisenhower administration faced a debt ceiling standoff and needed more time to negotiate, it issued $500 million in new gold certificates to the Fed to raise cash and avoid a government default. The transaction worked as intended, as it would again.   

In contrast to what is often claimed in the current debt ceiling debate: The 14th Amendment does not allow an administration to ignore a congressional debt ceiling, the U.S. government has defaulted on its obligations multiple times and Congress and Treasury have a proven option they could use to produce large amounts of additional cash without raising the debt ceiling.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute. Alex J. Pollock is a senior fellow at the Mises Institute and co-author of “Surprised Again!—The Covid Crisis and the New Market Bubble” (2022). After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

Quantum attack would trigger Great Depression, think tank warns

Published in SC Media:

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?,” said Alex Pollock, a former deputy director of the Treasury Department’s Office of Financial Research in response to the report.

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?”

Event video: Hudson Institute: Prosperity at Risk: The Quantum Computer Threat to the US Financial System

Hosted by the Hudson Institute.

May 22, 2023.12:00 p.m. - 1:00 p.m.

Listen to Event Audio

Cybersecurity experts and technology policy officials, including those in the White House, are realizing that quantum computers will pose a significant threat to existing public encryption systems and that they need to act now to make America’s key infrastructure quantum ready and secure.

Join Hudson Senior Fellow and Director of the Quantum Alliance Initiative (QAI) Arthur Herman and QAI Associate Director Alex Butler as they discuss their most recent report. This publication details the potential consequences of a future quantum computer attack on the Federal Reserve, specifically the Fedwire Funds Service, which facilitates large-scale interbank transactions. 

Mises Institute Senior Fellow and former Deputy Director of the Treasury Department’s Office of Financial Research Alex Pollock, and John Prisco, CEO and founder of Quantum Safe Inc., will discuss the implications of the report for the future of our financial system.

Speakers:

• Arthur Herman, Senior Fellow

• Alexander Butler, Associate Director, Quantum Alliance Initiative

• Alex J. Pollock, Senior Fellow, Mises Institute

• John Prisco, CEO and Founder, Quantum Safe, Inc.

Mandating Mortgage Taxes

Published in Law & Liberty.

The Federal Housing Finance Agency (FHFA) is the regulator of Fannie Mae and Freddie Mac. On top of that, it has controlled them as their Conservator since 2008, amazingly for nearly 15 years, since reform of Fannie and Freddie has proved politically impossible. As Conservator, FHFA can exercise the power of their boards of directors. It is therefore not only the regulator, but also the boss of both of these giant providers of mortgage finance. Fannie and Freddie together represent more than $7 trillion in mortgage credit and dominate the mortgage market. FHFA also regulates the $1.6 trillion Federal Home Loan Bank System. Thus, the FHFA has impressive centralized power over the huge US mortgage market, although most people have probably never heard of it.

Housing finance is always political, and a housing finance regulator is always sailing in strong political winds, in addition to the cyclical storms of housing finance crises. The American housing finance system has collapsed twice in the last 40 years, in the decades of the 1980s and the 2000s, with corresponding regulatory reorganizations. The FHFA is a second-generation successor to the unlamented Federal Home Loan Bank Board (FHLBB), the cheerleader-regulator of the savings and loan industry. It presided over the 1980s savings and loan industry collapse, a collapse which also caused the government’s Federal Savings and Loan Insurance Corporation to go broke. The FHLBB was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision (OTS) to regulate savings and loans and the Federal Housing Finance Board (FHLB) to regulate the Federal Home Loan Banks.

Beginning in the 1990s, the federal government made the disastrous mistake of promoting and increasing the amount of risky mortgage loans in the pursuit of increasing home ownership, notably requiring Fannie and Freddie to buy more and more such loans. The riskier loans were promoted as “innovative” mortgages by the Clinton administration. That push was a major contributor first to the housing bubble and then to the housing finance collapse of 2007–09. The homeownership percentage temporarily went up and then fell back to where it had been before. After the crisis, Congress abolished OTS. FHFB was also abolished, with its operations merged into the newly created FHFA. Less than two months after its creation in 2008, FHFA became the Conservator of Fannie and Freddie, which it remarkably remains to this day.

The housing politics and the enjoyment of its power seem to have gone to the FHFA’s head. Now, carrying out instructions from the White House, one imagines, or at a minimum with White House approval, it is trying once again to encourage riskier mortgage loans in Fannie and Freddie. Moreover, it proposes to act as if it were the Congress, trying by its own rule to mandate what are effectively taxes on mortgage borrowers with good credit, in order to provide subsidies to riskier borrowers with poor credit. The FHFA is thus de facto legislating to create in the nationwide mortgage market a welfare and income transfer operation through mortgage pricing. However misguided an idea this is, it could be done by the power of Congress, but the last time we checked, the FHFA wasn’t the Congress. Its project here is remarkable bureaucratic overreach.

In this case, the FHFA wants to politically manipulate Fannie and Freddie’s Loan-Level Price Adjustments (LLPAs). The LLPAs are meant to be credit risk-based adjustments, which reflect fundamental factors in the credit risk of a mortgage loan, to the price of getting Fannie or Freddie to bear the credit risk of the loan. They are an adjustment to the cost of the loan to the borrower, supposed to be based on objective measures of risk. As one mortgage guide says:

A loan-level price adjustment is a risk-based fee assessed to mortgage borrowers … [and] adjustments vary by borrower, based on loan traits such as loan-to-value (LTV), credit score, loan purpose, occupancy, and number of units in a home. Borrowers often pay LLPAs in the form of higher mortgage rates. … Similar to an auto insurance policy, a person loaded with risk will typically pay a higher premium.

Considering the key risks of smaller down payments (higher LTVs) and lower credit scores, there is no doubt that these factors statistically result over time in higher delinquencies, more defaults, and greater credit losses. Simply put, they are riskier loans. The AEI Housing Center has shown that default rates in times of stress differ dramatically based on these factors. For mortgage loans acquired by Fannie and Freddie in 2006–07, for example, the subsequent credit experience was “among borrowers with 20% down payments and credit scores between 720 and 769, the default rate was between 4.2% and 8.8%. Among borrowers with less than 4% down payments and credit scores between 620 and 639, the default rate was between 39.3% and 56.2%.”

Many commentators have pointed out that the FHFA project to manipulate the LLPAs for a political purpose is a distinctly bad idea. It is an “Upside Down Mortgage Policy … against every rational economic model, while encouraging housing market dysfunction and putting taxpayers at risk”; it signals to well-qualified borrowers, “Your credit score is excellent, so prepare to be penalized”; it is income redistribution by bureaucratic fiat; it will encourage the growth of riskier loans in Fannie and Freddie, just as the government disastrously did leading up to the great housing bust of 2007–09; it reduces the incentives to make significant down payments and for establishing a good credit rating—a notably dumb housing credit policy. This is the kind of thing Ed Pinto and I predicted in 2021 that a Biden administration FHFA would do, anticipating “the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.”

The rule is also ethically challenged. As Jeff Jacoby wrote in the Boston Globe, the policy is not only backwards credit logic: “First and foremost, it is egregiously unfair to creditworthy borrowers. … The new mortgage fees amount to a tax on responsible behavior.” In short, “You shouldn’t be punished for having done the right thing.” This seems incontrovertible.

The Congress long ago set up by law a very large, specialized government agency to enable subprime mortgage loans, the Federal Housing Administration (FHA). FHA mortgage loans outstanding total about $1.4 trillion. The FHA provides subsidized mortgage credit, allowing mortgage loans with down payments of as little as 3.5%. The FHA and its sister organization, Ginnie Mae, which guarantees securitized FHA loans, both operate with explicit government support and with direct risk to the taxpayers. The FHFA should not be trying to compete with the FHA for subprime mortgage financing.

The FHFA’s political initiative on loan-level adjustments is a bad idea on the merits, but there is an even more fundamental issue: the creation of a tax and mortgage subsidy program which increases risk to the taxpayers is a question for the Congress to decide—it is not the purview of the FHFA.

Very belatedly, FHFA announced it would issue a “Request for Input” from the public, which would include consideration of LLPAs. This announcement, however, did not alter FHFA’s egregious LLPA changes, which are being imposed long before the “input” will be received.

If the FHFA wanted to pursue its initiative in a constitutional way, it would withdraw its new rule and bring its proposal to Congress, requesting that a bill be introduced to authorize charging those with good credit more on their mortgage loans in order to subsidize those with riskier credit. I imagine that such a bill would not make much progress among the elected representatives of the People.

What to Know About the History of the Debt Ceiling

Published in TIME:

But Alex Pollock, a former Treasury Department official, argued in a 2021 op-ed in The Hill that there are four precedents for U.S. defaults: 1) During the Civil War in 1862, when the U.S. printed paper money after the Union’s reserves of gold and silver coin were depleted; 2) during the Great Depression in 1933, when the government refused to repay bondholders with gold, as agreed to when the securities were sold; 3) in 1968, when the U.S. did not honor silver certificates with an exchange of silver dollars; and 4) in 1971, when the government abandoned the Bretton Woods Agreement, which included a commitment to redeem dollars held by foreign governments for gold.

Joe Biden Could Use Gold to Solve the Debt Ceiling Crisis

Published in Newsweek:

Economists Paul H. Kupiec and Alex J. Pollock recently published an article advocating for Congress to "simply direct the U.S. Treasury to value its gold holdings, which are real, at real market prices."

…

"If Congress were to make a simple, financially sound amendment to the Gold Reserve Act, it would free up nearly $480 billion in new Treasury cash without raising the debt limit," wrote Kupiec and Pollock in their piece.

"These funds would allow the Treasury to pay all its bills past the end of fiscal 2023, thereby giving Congress an entire session to debate, negotiate budgets, reduce deficits, and set the debt ceiling accordingly, all in bills passed under regular order—something that has not happened in years."

For this to work, write Kupiec and Pollock, Congress would need to change just five words of the Gold Reserve Act.

…

For Pollock, 50 years is too long for the statutory price of gold and the Gold Reserve Act to have remained unchanged.

"The government can fund itself past the end of the fiscal year if Congress merely recognizes that the Treasury's gold is a real massively undervalued monetary asset," Kupiec and Pollock wrote.

"Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin [a solution that was first floated in 2011], the Treasury already has the legal authority to monetize its gold holdings without creating new government debt. It is only because Congress has failed to amend a woefully outdated law that the Treasury values its gold at an absurdly low price."

They add: "To monetize the market value of the Treasury's gold holding, the Congress need only replace five words in the Gold Reserve Act. Replacing '42 and two-ninths dollars' with 'the current market value (as determined by the Secretary at the time of issuance),' would allow the Treasury to use nearly $480 billion in spendable dollars without raising the current debt limit."

How Would Amending It Help Solve The Debt Ceiling Crisis?

"It's already been done in history, it was done under President Eisenhower in the 1950s," Pollock told Newsweek. "It can be done. It does take an act of Congress to do it," he added.

Neither Kupiec nor Pollock see amending the Gold Reserve Act as a definite solution to the debt ceiling crisis—but as an available alternative.

…

"Of course, that's not a permanent solution," said Pollock. "It's a way for them to create space, to have a serious negotiation of expenses and deficits without raising the debt limit. That's what's so intriguing about it, since there's no debt involved in this transaction. You don't have to raise the debt limit."

…

While the solution suggested by Kupiec and Pollock is legal and could technically work, others are skeptical that it would actually help the current situation.

AEI May 9: Addressing the Underlying Causes of the Banking Crisis of 2023

Click here for more details.

View Alex’s address:

AEI, Auditorium
1789 Massachusetts Avenue NW
Washington, DC 20036

In June 2017, then–Federal Reserve Chairwomen Janet Yellen said that because of enhanced Dodd-Frank Act regulations, she did not believe there would be a new financial crisis in her lifetime. Unfortunately, like many Federal Reserve forecasts, this turned out too optimistic as regulators were forced to invoke emergency systemic risk powers to contain contagious bank runs. What went wrong? Was it a failure of monetary policy? Supervision? Regulation? What changes, if any, are needed?

Join AEI as a panel of experts discusses the causes of the recent banking crisis and the federal agencies’ forensic reports and policy prescriptions and shares their own views on what policies, regulations, and supervision practices need to be reformed.

Submit questions to Catriona.Fee@AEI.org.

If you are unable to attend, we welcome you to watch the event live on this page. After the event concludes, a full video will be posted within 24 hours.

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 University
Andrew Levin, Professor, Dartmouth College
Bill Nelson, Executive Vice President, Bank Policy Institute
Alex J. Pollock, Senior Fellow, Mises Institute

Moderator:
Paul H. Kupiec, Senior Fellow, AEI

12:00 p.m.
Q&A

12:30 p.m.
Adjournment

Chicago’s Morning Answer: Mises Institute's Alex Pollock talks latest finance news

Published by Chicago’s Morning Answer:

JPMorgan Chase, FDIC put an end to First Republic's slow bleed

Published in the American Banker:

"There's a lesson in that for all finance that what seems like a darling and a wonderful winner at one moment seems like the opposite only a little while later," said Alex Pollock, a former Treasury Department official.

…

"Obviously there's a very generalized problem of people making the most classic financial mistake, which is investing in long-term fixed-rate assets and funding them with floating-rate money," Pollock said. "They were lulled into it by the actions of the central banks — by keeping interest rates both long and short-term very low for very long periods of time, and convincing people that it was going to continue."