Grant’s Current Yield Podcast: Interest Rates, Home Loan Banks, and more

Published on Grant’s Current Yield Podcast:

Juvenal’s Greatest Poser: ‘Who Will Guard the Federal Reserve?’

Published in The New York Sun.

The answer is the body in the government that is famously closest to the people.

“Who will guard these guardians?” That poser of Juvenal, satirist of Rome, is an immortal question — nowhere more pertinent, though, than in deciding who should oversee the Federal Reserve. In the Fed, we have supposed guardians of stable prices who have decided by themselves to create perpetual inflation.

Just to mark the point: Guardians of the currency have  decided by themselves to depreciate it forever. Guardians of financial stability have rendered themselves technically insolvent with negative capital now at more than $100 billion. Guardians who cannot make reliable economic forecasts are tirelessly claiming that they should be “independent.”

What total nonsense.  No part of our Constitutional government should be independent of the checks and balances that are part of the Founding scheme and must apply to all its parts. It is naturally the burning desire of every government bureaucracy to be independent of the elected representatives, but the idea that the Fed is “independent” is stated nowhere in the Federal Reserve Act.  

Displaying the contrary idea, the original Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board. A notable description from Fed history is that the Fed has “independence within the government” — something different from being independent. All — 100 percent — of the monetary powers granted in the Constitution to the government are granted to Congress.

It is well past due for Congress to start getting serious about oversight of the Fed within the government by promptly passing two pending bills:  “The Federal Reserve Transparency Act,” reintroduced by Senator Rand Paul, and the “Federal Reserve Loss Transparency Act,” reintroduced by Congressman French Hill. Enacting these mutually consistent bills would be a big step forward.  

The “Transparency Act,” which was previously passed by the House in 2014 with the overwhelming vote of 333 to 92, is commonly known as “Audit the Fed.”  It is about far more than a financial audit of the books, however, as important such audits are.  It is really about giving Congress the knowledge to carry out serious oversight.  As Senator Paul recently wrote, “transparency and oversight of every government institution is imperative.” 

The “Loss Transparency Act” would put Congress in a better position to understand the Fed’s own finances. It would do so by the obviously sensible requirement that the Fed’s balance sheet must apply Generally Accepted Accounting Principles. The bill would also, with admirable common sense, prohibit the Fed from paying the expenses of an unrelated agency while the Fed itself is losing $114 billion a year.

The profound questions of what kind of money is right for our country, including whether the Fed is empowered to create perpetual inflation rather than stable prices, are not decisions that may be made unilaterally by the Fed. And invite only more questions. If perpetual inflation, at what rate? If stable prices, how to ensure sound money? These are inherently political questions. It is hubristic of the Fed to imagine it has the authority to make such decisions. Let it bring formal recommendations to the Congress.

The Fed has an ever-recurring tendency to create inflations, asset price bubbles, systemic risk, and the ensuing painful corrections, because it combines great power with demonstrated, and inescapable, inability to foretell the financial future.  This combination makes it “the most dangerous financial institution in the world.” It needs serious oversight by and substantive interaction with elected representatives of the people who have made themselves expert in central banking questions.

So who should guard the Fed in the constitutional system of checks and balances?  The answer is Congress, with its unambiguous power over money questions clearly designated in the fifth clause of the Constitution’s Article I, Section 8. Congress needs to revise the laws to ensure effective oversight and to organize itself to be the required guardian of the people’s money and the central bank. 

In my opinion, this should include both the Senate and the House banking committees having a subcommittee devoted exclusively to oversight of the Fed, which is the central bank not only to the United States, but to the entire dollar-using world, and to its dominant credit, money and capital markets, and moreover has huge effects on the daily life of the American people by its debasement of the currency.

How to Recapitalize the Federal Reserve

Published in Law & Liberty with Paul H. Kupiec. Also published in RealClear Markets.

The Federal Reserve starts the new year with capital, properly accounted for, of negative $92 billion. How can that be? How can the world’s greatest central bank, the issuer of the world’s dominant reserve currency, be technically insolvent—and by such a huge number?

The answer is that the Fed has accumulated immense operating losses, which by January 3, 2024, totaled $135 billion. Since September 2022, the Fed has been paying out more in interest expense to finance its more than $7 trillion securities portfolio than it receives in interest income. The losses continue into 2024 at the rate of over $2 billion a week. When you subtract the Fed’s accumulated losses, which are real cash losses, from the Fed’s stated capital of $43 billion, you get the Fed’s true consolidated capital, that is: $43 billion in starting capital minus $135 billion in losses equals the current capital of negative $92 billion. This balance sheet math is straightforward and unassailable under generally accepted accounting principles (GAAP).

The Federal Reserve System includes 12 regional Federal Reserve Banks (FRBs), each one a separate corporation with its own shareholders, customers, and balance sheet. Considered on their own, with proper accounting, 8 of the 12 FRBs start 2024 with negative capital. This means their accumulated cash operating losses exceed 100% of their capital. Two others have lost more than 80% of their capital and will exhaust their capital in 2024. Only two FRBs have their capital intact. Their operating losses have been limited because these banks have an especially high proportion of their funding supplied by the paper currency (Federal Reserve Notes) they issue—currency does not pay interest and thus results in lower overall interest expense. Under commercial bank rules, 10 of the 12 FRBs would be classified as severely undercapitalized, as would the entire consolidated Federal Reserve System. As of January 3, 2024, the FRBs true capital numbers are:

Source: Federal Reserve H.4.1 January 4, 2024, and authors’ calculations.

At the current rate the Fed is losing money, its negative capital will exceed $100 billion by February 2024.

You will not find the Fed’s true capital position reported on the Fed’s official consolidated balance sheet or on the individual FRBs’ balance sheets. This is because the Fed—unbelievably—does not subtract its losses from its retained earnings. Instead, it pretends that its growing losses are an asset. “Ridiculous!” you may exclaim. The kindest way to describe this Fed accounting is that it is non-standard, but Congress has allowed the Federal Reserve to determine its own accounting rules. Since its accumulated operating losses have made the actual liabilities of the Fed larger than its assets, the Fed created a new “asset” because it doesn’t want to show that it has negative capital. We do not suggest you try this accounting sleight-of-hand if you are a private bank, a business, or filling out a home loan application.

The Fed claims that, even if it does have negative capital, it doesn’t matter because it can always print all the money it needs. However, there are, in fact, limits to its ability to print paper currency. But even if there were no limits, the Fed’s large negative capital, growing ever more negative each week, certainly makes the Fed look bad—incompetent even—and calls its credibility into question. While it is not widely understood, the deposits in FRBs are unsecured liabilities of each individual FRB. When an FRB has negative capital, the presumed risk-free status of its deposits hinges on a belief that the deposits are implicitly guaranteed by the US Treasury.

Maintaining market confidence in the Federal Reserve System and FRBs is critical. As the Fed’s losses continue to rapidly accumulate, it would be sensible for Congress to recapitalize the Fed and bring it back to positive capital with assets greater than, instead of less than, its liabilities, and restore it to technical solvency. This could be done with four steps, which would fit well with and expand Pollock’s proposals for Reforming the Federal Reserve:

• Suspend FRB dividends

• Exercise the Fed’s existing capital call on its stockholders

• Assess the stockholders to offset Fed losses, as provided in the Federal Reserve Act (FRA)

• Have the US Treasury buy stock in the Federal Reserve, consistent with the original FRA.

Suspend Dividends

When banks or any other corporations are suffering huge losses, especially if they have negative retained earnings, let alone negative total capital, a typical and sensible reaction is to stop paying dividends. Indeed, the Federal Reserve in its role as a bank regulator would insist on this for the banks and holding companies it regulates. The same logic should apply to the Fed itself. The central bank of Switzerland is an instructive example. Like the Fed, the Swiss National Bank is now facing losses but, unlike the Fed, it still has significant positive capital. Nonetheless, the Swiss National Bank has stopped paying dividends for the last two years. When the Fed is losing over $100 billion per year, there is scant justification for it to be paying $1.5 billion in dividends to its member bank shareholders annually.

However, to stop a technically insolvent Fed from paying dividends, Congress has to get involved and amend the Federal Reserve Act. The FRA currently provides that the Fed’s dividends are cumulative. This provision reflects the former belief that the Fed would always make profits. With today’s reality of massive losses, the Federal Reserve Act should be revised to make dividends noncumulative and to prohibit FRB dividend payments if such payments would result in negative retained earnings (“surplus” in Fed terminology) on a GAAP basis.

Exercise the Fed’s Existing Capital Call on its Stockholders

Section 2.3 of the Federal Reserve Act requires every bank that is a member of a Federal Reserve Bank to subscribe to shares of the FRB in an amount tied to the member bank’s own capital. The member-stockholders, however, are required to pay in and have paid in only half of the amount subscribed. The other half is subject to call by the Federal Reserve Board, and if called, must be paid in by the member bank.

The total paid-in capital of the Fed is $36 billion. An additional $36 billion in FRB capital could be raised if the Federal Reserve Board simply exercised its existing statutory call. This would reduce the Fed’s negative capital as of January 3, 2024, by 39%. If the Federal Reserve Board balks at exercising the capital call, Congress should instruct it to do so.

Under our recommended changes to Fed dividend policy, the newly paid-in shares would not receive dividends until FRBs return to positive GAAP retained earnings (“surplus”).

Assess the Stockholders to Offset Fed Losses, as Provided for in the Federal Reserve Act

In a very little-known but very important provision of the FRA, which goes back to its original 1913 enactment, Federal Reserve Bank shareholders are made liable in addition to their subscription to Fed stock, for another amount equal to that subscription, which they may be assessed to cover all obligations of their FRB; in other words, to offset negative capital. A member bank assessment would be a cash contribution to their FRB, not an investment in more stock. Says the FRA, “The shareholders of every Federal reserve bank shall be held individually responsible … to the extent of the amount of their subscriptions to such stock at the par value thereof in addition to the amount subscribed.” (Italics added.)

The total subscriptions to Fed stock are twice the outstanding paid-in capital of $36 billion, so the subscriptions total $72 billion, and the maximum possible assessment on the Fed member banks is thus $72 billion. Since two FRBs, Atlanta and St. Louis, still have their capital intact, the available assessment would be on the other ten FRBs. The maximum assessments would be these FRBs’ paid-in capital of $34 billion times 2, or $68 billion. By comparison, the Fed paid $177 billion in interest and dividends to its member banks in 2023.

The original Federal Reserve Act, as enacted in 1913, provided for the US Treasury to buy Federal Reserve Bank stock, if necessary.

With the maximum assessment on the members of these ten FRBs in addition to calling the unpaid half of the stock subscriptions for all the FRBs, the total raised would be $104 billion ($36 billion in new stock plus $68 billion in assessments). This amount would offset the Fed’s year-end capital deficit of $92 billion and would cover about six weeks of additional losses at the current rate of $2 billion a week.

Doubtless the Fed’s member banks would be exceedingly unhappy with these actions to shore up the capital of the Federal Reserve. But member banks, as the sole shareholders in the FRBs, have a clear statutory obligation to financially support FRBs that will soon have consolidated true negative capital in excess of $100 billion.

Judging by public financial statements disclosures, few—if any—Fed member banks have seriously considered the large statutory contingent liability that membership in the Fed brings. Taking into account FRBs’ financial condition and their shareholders’ clear legal obligations, it seems that FRB member banks should be disclosing this material contingent liability.

Have the US Treasury Buy Stock in the Federal Reserve, Consistent with the Original Federal Reserve Act

Suspending FRB dividends, calling the rest of the member banks’ stock subscriptions, and assessing FRB stockholders the maximum amount would make the Fed’s capital positive again until mid-February 2024. After that, continuing losses will put it back into negative territory and the Fed back into technical insolvency. Given the fact that the Fed is stuck with long-term fixed-rate investments yielding a mere 2%, and that $3.9 trillion of its investments have more than ten years left to maturity, the Fed’s very large cash losses will most likely continue for quite a while.

Another source of recapitalization is needed.

The original FRA as enacted in 1913 provided for the US Treasury to buy Federal Reserve Bank stock, if necessary. (It also provided for possible sale of FRB stock to the public, which did not happen and could not happen under today’s circumstances.) Section 2.10 of the FRA, which has never been amended, empowers an FRB to issue shares to the Treasury to raise needed capital:

Should the total subscriptions … to the stock of said Federal reserve banks, or any one or more of them, be, in the judgment of the organization committee [the Secretary of Treasury, the Secretary of Agriculture, the Comptroller of the Currency], insufficient to provide the capital required therefor, then and in that event the said organization committee shall allot to the United States such an amount of said stock as said committee shall determine. Said United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated, and shall be held by the Secretary of the Treasury, and be disposed of… as the Secretary of the Treasury shall determine.

In a 1941 opinion, the Federal Reserve Board argued: “As originally enacted, the Federal Reserve Act provided for a Reserve Bank Organization Committee … [and] was authorized to allot Federal Reserve Bank stock to the United States in the event that subscriptions to such stock … were inadequate. However, subscriptions by member banks were adequate. … Accordingly, [this section] is now of no practical effect.”

However, the Fed’s financial condition has dramatically changed since 1941. In 2024, the subscriptions to the capital of the FRBs are grossly inadequate—the FRBs cannot maintain positive capital. Allocation of Fed stock to the United States would now be of very significant practical effect.

In light of the Fed’s technical insolvency, ongoing huge losses, and massively negative capital, Congress could sensibly amend Section 2.10 to read as follows:

Should the total subscriptions to the stock of the Federal reserve banks and the further assessments of the shareholders be insufficient to maintain positive capital as measured by GAAP for any one or more of the Federal reserve banks, then the Board of Governors of the Federal Reserve shall allot to the United States such an amount of said stock as the Board shall determine will bring the capital as measured by GAAP of these Federal reserve banks to not less than $100 million and maintain the consolidated capital of the Federal Reserve System as measured by GAAP at not less than $1.2 billion. The United States stock shall be paid for at par out of any money in the Treasury not otherwise appropriated and shall be held by the Secretary of the Treasury. Said stock may be repurchased at par by a Federal reserve bank or banks at any time, provided that after the repurchase, the capital of each Federal reserve bank as measured by GAAP shall be not less than $100 million and that the consolidated capital of the Federal Reserve System as measured by GAAP shall be not less than $1.2 billion.

The stock purchased by the Treasury would be non-voting, since the FRA provides that “Stock not held by member banks shall not be entitled to voting power.”

If over the next 15 months the Fed loses the same $135 billion as it has in the last 15 months, the Treasury would own about $123 billion in par value of FRB stock by March 31, 2025, and the member banks would own $72 billion after the capital call. The Treasury would thus own about 62% of the consolidated Fed stock but could not vote its shares. Over the long-term future, the FRBs would repurchase the Treasury’s shares as their finances permit.

With these four steps, the recapitalization of the Federal Reserve would be complete. Our proposed consolidated capital of $1.2 billion compared to the Fed’s beginning of 2024 total assets of $7.7 trillion, would give the Fed a leverage capital ratio of 0.016%—small indeed, but always positive. In other words, this revised section of the Federal Reserve Act would mean that the Treasury would, as it does for Fannie Mae and Freddie Mac, ensure that over time, the most important central bank in the world would never again be technically insolvent, no matter how big its losses.

From Inflation to Power Shifts: Alex J. Pollock’s Eye-Opening Dive into Political Finance

Published in Million Dollar Book Agency:

Today’s episode was an absolute game-changer. We had the privilege of diving deep into the world of finance with none other than the incredible Alex J. Pollock. This man has been in the banking game since 1969, and trust me, he’s got some eye-opening insights to share. Buckle up, folks, because we’re about to uncover the hidden truths behind the Federal Reserve, perpetual debt, and the secrets of our monetary system.

SUMMARY

Ever felt like there’s an invisible tax on your hard-earned money? Alex dropped a truth bomb on us – continuous inflation is exactly that. It’s a sneaky tax on anyone holding money, including those with savings accounts. How does this work? When the interest rates on savings are suppressed, wealth is transferred from money holders to the government. The fiat system allows the government to finance deficits indefinitely, making it a subtle yet effective way of expropriating purchasing power.

Hold on tight because this revelation might just blow your mind. Alex simplified the concept of perpetual debt with a powerful analogy. Imagine a banking system that lends you $100 but demands $110 in return. Where does that extra $10 come from? The Federal Reserve. This perpetuates a cycle of constant debt, creating what can only be described as a modern-day slavery system. The Federal Reserve creates a debt-ridden society by injecting money into the system.

Alex emphasized a crucial point – there’s no such thing as pure finance; there’s only political finance. The shift from the gold standard in 1971 marked a pivotal moment in our monetary history. With the introduction of a fiat system, there are no limits on how big a government deficit can be. This translates to an increase in government power. As you monetize and free up money, the government gains the financial resources to expand its reach and control.

Mike Fallat and Alex J. Pollock talk about the book Finance and Philosophy: Why We’re Always Surprised.

Let’s talk about inflation, the silent wealth eroder. While some may cheer at a seemingly low 3% inflation rate, Alex breaks down the reality. Over a lifetime, a 3% inflation rate results in prices going up 10 times! Imagine the impact of a 4% inflation rate – prices skyrocketing 23 times. It’s not just a tax without legislation; it’s a constant expansion of government power through the central bank, all cleverly disguised.

Alex shared two must-reads for anyone looking to unravel the mysteries of finance. First up, Frank Knight’s book is a treasure trove of insights. But that’s not all; he also recommended “The Fourth Branch” by Bernard Shull. This gem provides a historical perspective on the Federal Reserve’s unlikely rise to power. Both books promise to be eye-openers for those eager to understand the intricacies of our financial system.

As we wrapped up the episode, Alex left us with a powerful notion – there’s no such thing as pure economy, only political economy. The fiat currency system, though clever, is also insidious. It not only inflates the currency but also empowers the government at the cost of the people. This conversation with Alex J. Pollock was nothing short of mind-blowing. We’ve scratched the surface today, but there’s more wisdom to uncover.

Insider Perspectives- Alex J. Pollock Unveils the Intricacies of Housing Markets

Published by the Hartman Media Company:

Jason talks about the resilient real estate market as the cost of money decreases and housing affordability improves. With mortgage rates dropping and the promise of increased affordability by the Fed, he anticipates significant price increases in the low-inventory market. Highlighting the 700,000-home deficit compared to normal inventory, Jason emphasizes the simple supply and demand dynamics driving potential price surges. He also urges viewers to consider the upcoming cruise for a unique learning and networking experience. Overall, the episode provides insights into the current real estate landscape, emphasizing the market's strength and predicting positive trends. Then Jason interviews Alex J. Pollock from the Mises Institute. The discussion revolves around the unpredictability of financial markets, particularly in contrast to more deterministic fields like astronomy. Pollock argues that economic and financial forecasts, even by prominent figures like central bankers, often prove inaccurate due to the interactive and recursive nature of human ideas, intents, and strategies within these systems. The conversation delves into the challenges of predicting economic and financial futures and emphasizes the significance of relying on self-corrective market properties rather than central authorities.

"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.

“The setting of interest rates [by central banks] is just one aspect of central planning,” Chancellor observes.

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.

No ‘Pat on the Back’ for the Federal Reserve

Published in The Wall Street Journal.

Mr. Cochrane writes that “the Fed can costlessly buy bonds and issue interest-paying money.” To the contrary, by following exactly this formula, the Fed has so far accumulated net losses of about $130 billion for itself, the Treasury and the taxpayers, and there are unavoidably tens of billions in losses still to come.

This “costless” formula meant the Fed took massive interest-rate risk, investing very long and borrowing very short, thereby also imposing that risk on the Treasury and the taxpayers. For the Fed as for anybody else, taking interest-rate risk isn’t costless. It has proved far more costly than the Fed ever expected.

Alex J. Pollock

Senior fellow, Mises Institute

Hearkening to Hayek: How About a Free Competition Between Bitcoin, Paper Money, and Gold?

Published in the New York Sun:

That object of volatile speculation, the Bitcoin, is not a physical coin or any physical object at all. It is certainly not a gold coin and is not redeemable or backed by anything, let alone gold coins. Yet it is endlessly pictured in press illustrations as a gold coin with a “B” stamped on it.

Go ahead, kid me. These illustrations are a notable marketing success for Bitcoin, but why is there such an urge among publishers to show Bitcoins as gold coins? Not one of them would dream of illustrating United States dollars as gold coins — though our own government has tried the trick.

Gold coins are physical reality, while Bitcoins, being electronic accounting entries in a complex computer algorithm, never are. Gold coins with their durability, beauty, and scarcity will still be there even if all electric systems are knocked out and your computers don’t work at all.

The ubiquitous visual suggestion that Bitcoins are gold coins is, though, a misrepresentation. How could one more accurately suggest in an illustration the electronic accounting entry which Bitcoin is, given that one can’t actually draw a Bitcoin? Could one  show a drawing of a computer screen with Bitcoin prices on it?

For those who reasonably maintain that the unbacked Bitcoin is simply a form of gambling, a computer screen with an electronic roulette wheel on it might be used. Dollars are often depicted in publications as paper currency. Paper currency is physical reality which also will still be there if the electricity and the computers don’t work.

Then again, too, it’s only cheap paper which can be endlessly depreciated by its issuing central bank. Paper currency is normally convertible into bank deposits and vice versa. Yet if the bank fails, paper currency looks a lot better than deposits. It would be there, still at par, when the bank has folded, and one would not need to worry about what government bailouts may be in process.

Even so, in holding the paper currency, one would still be a target of the inflationist drive of the Federal Reserve and other central bankers. One would be holding a unit of money, in respect of the Fed has formally set a goal of depreciating at an average of two percent — forever. 

Historically, it would have been accurate to depict dollars as gold coins. Gold coins denominated in dollars freely circulated for parts of our history. Dollar paper currency was redeemable in and backed by gold. Bank deposits were withdrawable in gold coins. The Federal Reserve was required by law to hold gold collateral against its paper currency.

This gold standard world is hardly even imaginable by most people today. It ended in 1933 when the government made owning gold illegal for American citizens, with criminal penalties. This prohibition, which lasted more than 40 years, was remarkably oppressive. It enabled a vast expansion of government power.

The Nobel laureate Friedrich Hayek, in his 1974 essay “Choice in Currency,” argued that “With the exception… of the gold standard, practically all governments in history have used their exclusive power to issue money in order to defraud and plunder the people.” 

Therefore, Hayek asked, “why should we not let people choose freely what money they want to use?” Bitcoin enthusiasts love this idea, and propose Bitcoin as the alternative money to escape the monetary control of inflationist central banks.

Despite its remarkable record as an object of speculation, Bitcoin has a scant record as a currency in general use. What a contrast to the long history of gold-backed currency.

That a revived gold-backed currency would become a renewed alternative to pure paper currencies was Hayek’s actual hope. “It seems not unlikely that gold would ultimately reassert its place…if people were given complete freedom to decide,” he wrote. This would require paper and accounting money defined as a weight of gold and freely redeemable in gold coins.

Would such a money based on gold coins be chosen by the people over paper dollars and Bitcoins in a free competition? How instructive it would be, although directly against the self-interest of every deficit-monetizing government, to run this comparison.

A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

Central Banks and Housing Finance

Published in Housing Finance International Journal:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse.

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy. Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages. This caused severe rationing of mortgage loans. The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems.

In the 1970s, the Fed unleashed the “Great Inflation.” Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%.

This meant the mortgage-specialist savings and loans were crushed in the 1980s. With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-tomarket basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios. So did Fannie Mae. More than 1,300 thrift institutions failed. The government’s deposit insurance fund for savings and loans also went broke. The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen. Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991. Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom. This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro” – until he wasn’t. For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century. It began deflating in 2007 and turned into a mighty crash – setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years. The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022. It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgagebacked securities. As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds. This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans. The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century.

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher – to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world. It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%. That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates. The Fed also began letting its long-term bond and mortgage portfolio roll off. U.S. 30-year mortgage interest rates increased to over 7%. That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers. A lot of people, including me, thought this would cause house prices to fall significantly.

We were surprised again. Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023. Then they started back up, and have so far risen about 6%, up to a new all-time peak. Over the last year, Case Shiller reports an average 3.9% increase. Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7% – slightly ahead of inflation. How is that possible when higher mortgage rates have made houses so much less affordable?

Of course, not all prices have gone up. San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks. The median U.S. house price index of the National Association of Realtors is down 5% from June 2022. The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% yearover-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses. (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010. They are “on track for their worst performance since 1992,” Reuters reported.1 The lack of mortgage volume has put the mortgage banking industry into its own sharp recession. So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell – highly interesting bifurcated effects. The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply. A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses. It has the simple problem of an old-fashioned savings and loan: its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments. As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity. The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money – so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion. Since September 2022, it has racked up more than $122 billion in losses. It is certain that the losses will continue. These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency. Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio. On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.2

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities. A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.3

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion. This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

_______________

1 “Home sales fell to a 13-year low in October as prices rose,” Reuters, November 21 2023.

2 Federal Reserve financial data is taken from the weekly Federal Reserve H.4.1 Release, and from the Federal Reserve Banks Combined Quarterly Financial Report as of September 30 2023.

3 Paul Kupiec, “Forget Climate Change and NBFIs, the Biggest Systemic Risk are the Unrealized Losses in the Banking System,” American Enterprise Institute, November 2023, and personal correspondence with the author.

Time for colleges to pay, Dem ‘swells’ ‘blinded by privilege’ and other commentary

Published in the New York Post:

Ed desk: Time for Colleges to Pay

“It’s time that the cost of nonpayment of student loans be shared” by “colleges and universities themselves,” argue Arthur Herman and Alex J. Pollock at The Hill. Schools now “get and spend billions in borrowed money and put all the loan risk on somebody else,” which “incentivizes them to push” costs “ever higher — by an average of 169 percent since 1980.” We need a “model that realigns incentives and rewards,” and “the first principle should be that the more affluent the college is, the higher its participation in the losses should be.” Joe Biden has shifted $132 billion “of student debt from borrowers to taxpayers.” “It’s high time to give the rest of us a Christmas present of a new model for government student loans.”

It’s time for universities to share the burden of student loan defaults

Published with Arthur Herman in The Hill.

While the nation is rightly worried about the proliferation of antisemitism on its college campuses, another higher education abuse also needs prompt attention.

On Dec. 6 – St. Nicholas Day – President Biden handed student loan defaulters another $5 billion gift in debt forgiveness. The administration’s eagerness to win the votes of student loan borrowers by shifting the cost of student debt from borrowers to taxpayers now adds up to $132 billion of student loans those borrowers will not have to pay — even though the Supreme Court ruled a related scheme unconstitutional last June.

But if borrowers don’t pay the debts they incurred and default on their debts, someone else has to pay. Right now, that someone else is American taxpayers. Now it’s time that the cost of nonpayment of student loans be shared by those who have benefitted the most directly from federal student loans: namely, the colleges and universities themselves.

By inducing their students to borrow from the government, higher education institutions collect vastly inflated tuition and fees, which they then spend without worrying about whether the loans will ever be repaid. This in turn incentivizes them to push the tuition and fees, and room and board, ever higher — by an average of 169 percent since 1980, according to a Georgetown University study.

In short, in the current system the colleges get and spend billions in borrowed money and put all the loan risk on somebody else — including those student borrowers who responsibly pay off their own debt and those who never borrowed in the first place, not to mention taxpayers, whether they attended a college or not.

This perverse pattern of incentives and rewards must stop. A more equitable model would insist that colleges have serious “skin in the game.” It would insist that they participate to some degree in the losses from defaulted and forgiven loans to their own students.

This idea has been thoughtfully discussed and proposed in Congress before, but now is the time to implement a model that realigns incentives and rewards in our national student loan system and distributes the burden of risk more equitably.

The first principle should be that the more affluent the college is, the higher its participation in the losses should be. The wealthiest colleges with massive endowments should be covering 100 percent of any losses on federal loans to their students, which they can easily afford. Others can cover a lower, but still significant, percentage, but every college that finances itself with federal student loans should assume some real cost when its students default on their loans. Four million student loans enter default each year, not counting the Biden scheme for student loan “forgiveness,” which creates even more losses.

Specifically, we propose the following “skin in the game” requirements for colleges on losses from federal student loans to their students, based on their endowment size:

Endowment Size     Cumulative Rank in Endowments   Coverage of Losses

Over $10 billion                           Top 0.6%                                          100%

$5 billion to $10 billion                Top 1.1%                                            80%

$3 billion to $5 billion                  Top 1.7%                                            60%     

$2 billion to $3 billion                  Top 2.6%                                            40%

All others                                         100%                                            20%

Any fair observer would have to conclude that this represents a rational and efficient matching of benefits and costs.

Moreover, we propose that the most affluent colleges that participate in federal student loans, such as Harvard, Yale and Stanford, should contribute to a “Trust to Offset Losses from Federal Student Loans” through an excise tax on their endowments — some of which are larger than the GDP of sovereign countries. 

This tax would apply to only about the top 1 percent or 2 percent of college endowments. The trust would then be used to offset some of the remaining losses the less affluent colleges cannot pay, thus sharing the wealth of the top 1 percent or 2 percent to help others in need.

For the excise tax to fund the Trust to Offset Losses, we propose:

Endowment Size           Cumulative Rank In Endowments          Tax Rate                     

Over $5 billion                             Top 1.1%                               1% per annum

$2.5 to $5 billion                          Top 2%                                   0.5% per annum

It seems only fair that the wealthiest colleges be asked to contribute to cover the student loan losses the Biden administration is sticking taxpayers with. After all, they benefited the most from the Great Tuition Bubble since the 1980s, just as subprime mortgage brokers benefited in the Great Housing Bubble in the early 2000s.

Since Biden’s St Nicholas Day gift to student borrowers simultaneously gave a large lump of coal to the taxpaying public, not to mention to those borrowers who made every sacrifice to meet their loan obligations, it’s high time to give the rest of us a Christmas present of a new model for government student loans. The proper model should be one that will keep on giving as colleges and universities take on the responsibility and accountability they have shirked until now.

Letter: Bitcoin loses its lustre next to gold bullion

Published in the Financial Times.

Your editorial, “Bitcoin’s bounceback déjà vu” (FT View, December 6), is oh so right that bitcoin “has no intrinsic value, nor is it backed by anything” and is different from gold. Indeed, a mere electronic accounting entry like a bitcoin is utterly unlike a gold coin — the gold coin being a notable piece of physical reality, not dependent on anybody’s accounting system to exist. Yet at the top of your page one of December 5, illustrating your story, “Bets on cuts boost bitcoin”, you misleadingly depict bitcoin precisely as a large gold coin stamped with a “B.” This silly illustration promotes the fallacy that bitcoin is like a gold coin and flatly contradicts the sound and sensible statements of your editorial.

I suggest that FT policy should eliminate depicting bitcoin as a gold coin. Of course, it is difficult to illustrate bitcoin as the mere electronic accounting entry it is, but you should try to reflect the reality.

Alex J Pollock Senior Fellow, Mises Institute,

Lake Forest, IL, US

The Federal Reserve Is Running Losses. Does This Cost Anyone Anything?

Published in Zero Hedge.

The debate has raged in the banking and finance communities. Two investigators, Paul Kupiec at the American Enterprise Institute and Alex Pollock at the Mises Institute, have analyzed Fed financial statements and presented their findings about these Fed losses in publications such as the Wall Street Journal and on the websites of the American Enterprise Institute, the Mises Institute, the Federalist Society, and Law and Liberty. The Wall Street Journal has produced a nontechnical video explaining how the Fed makes (and loses) money.

…

Kupiec and Pollock responded with a letter to the editor of the Wall Street Journal to reiterate their earlier conclusions that American taxpayers will ultimately bear the cost of the Fed’s losses. When asked by email how he can justify his claim that no one, including taxpayers, actually bears the cost of the Fed’s losses, Professor Furman responded as follows:

The Fed’s losses do lead to higher debt. And its gains to lower debt. On net it has reduced the debt. But it is a public entity and we didn’t assign it the job of maximizing profits—and for good reason—we should leave that to the private sector. Instead we assigned it macroeconomic goals which it has done well at times and done badly at other times—like in not responding fast enough to inflation in 2021.

Common Fallacies in the 2023 Debt-Ceiling Debates

Published in the Mises Institute’s Quarterly Journal of Austrian Economics.

Abstract: This article investigates the veracity of three claims made by current and former government officials in the context of the 2023 debt-ceiling debates: it would be unconstitutional to enforce the debt ceiling; the U.S. government has never defaulted; and there are no measures that could be taken to avoid a government default except raising the debt limit. None of these claims is true.

As Congress and the Biden administration carried out the combative negotiations that led to the passage of the Fiscal Responsibility Act of 2023 (H.R. 3746), the news media was replete with stories and opinion pieces about the debt-ceiling debates. Many of these repeated claims made by administration officials and surrogates were designed to promote a political narrative. Such claims included the following: it is unconstitutional for the United States to default on its debt (Blinder 2023); the U.S. has never defaulted on its debt (Biden 2023); there are no additional measures that can be taken to prevent default (Janet Yellen, quoted in Condon and Hordern 2023); and finally, the sole solution to averting a debt crisis is to raise the debt ceiling (Powell 2023). This article will analyze these claims and explain why they are exaggerations, if not demonstrably untrue.

Read the full paper here.

Video: How to Reform the Fed

Speech from the Mises Institute 2023 Supporters Summit. Watch the video here:

How Can It Be That a ‘Thief in the Night’ Is Loosed by the Federal Reserve Under the Nose of a Passive Congress?

And what would it mean if Congress were active in the decisions?

Published in The New York Sun and also the Federalist Society.

The Federal Reserve is a problem for the constitutional order of our republic. How can it be that the central bank considers itself able to unilaterally impose permanent inflation on the country, without legislative debate or approval?

The shifting theories believed by central banks are among the most important of macro-economic factors. The chairman of the Federal Reserve Board between 1951 and 1970, William McChesney Martin, characterized inflation as “a thief in the night.” 

In remarkable contrast, the Fed under Ben Bernanke, chairman between 2006 and 2014, explicitly committed itself and the country to inflation forever at the rate of 2 percent a year, thus assuming that constant inflation should not only be taken for granted, but pursued. 

If the purchasing power of the currency continuously depreciates at the rate of two percent per year, as the Fed now promises, in the course of a single lifetime, average prices would quintuple. At three percent, as is sometimes suggested, prices in a lifetime would multiply by ten times. At four percent, they would multiply by 23 times.

Is this the kind of money the American people want? I don’t think so. Congress did acquiesce in the 1970s to the executive move to fiat money, untied to gold, as previously required by the Bretton Woods agreement, and later removed legislative ties of the dollar to gold. 

That’s the kind of money wanted by those who long to expand government power and finance it by an unlegislated inflation tax. The Congress didn’t, though, call for, enact, or approve a policy of pursuing inflation per se.  It wrote into the Federal Reserve Reform Act of 1977 a requirement that a principal goal of the Fed is “stable prices.”

The nature of money and the stability of its value is an essential political and social question. William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” On the other hand, we may proclaim, “You shall not drown mankind in a flood of paper money.” Who gets to choose between inflationist money and sound money?

Not the Fed by itself. Coining money, and regulating the value thereof,  are questions profoundly requiring the Congress. They are specifically enumerated in the Constitution as among the powers granted, in Article One, Section Eight, to Congress.

The press is full of references to “the Fed’s” two percent inflation target. But if there is to be such a target, it should be “the country’s” target, not “the Fed’s” target. The Fed’s proposal to constantly depreciate the people’s money should have been presented to the elected representatives of the people for approval or rejection. It wasn’t.

How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and depreciation of the currency at some rate of its own choosing? The only explanation I can think of is pure arrogance. 

Being the most powerful financial institution in the world and the purveyor of the dominant fiat currency might lead the Fed to an excessively high opinion of its own authority. At the same time, the Fed has crucial and dangerous inherent weaknesses.

It has demonstrated beyond question its inability to predict the financial and economic future. It can inflate disastrous asset price bubbles as well as consumer prices. It is unable to know what the results of its own actions will be.

This inability is notably shown by its own financial performance: a net loss of $111 billion since September 2022, as reported on October 19, tens of billions in net losses still to come, and a mark to market loss on its investments of more than $1 trillion.

Congress should, first and foremost, amend the Federal Reserve Act to make it clear that setting any “inflation target” requires review and approval by Congress, as a public choice between kinds of money. And make it clear that the Fed lacks  unilateral power to decide the nature of the money the Congress provides.

Congress should also cancel the two percent inflation target announced by the Fed, until the Congress has approved such an action or provided some other guidance — say, “stable prices” — a goal that is already stated in the Federal Reserve Act, but is being evaded.

Stable prices imply a long-run average inflation rate of approximately zero — in other words, a goal of sound money. All in all, we need to control the powerful and dangerous Federal Reserve by using the checks and balances of our constitutional republic.

Letter: Fed rates slogan should read: ‘Normal for longer’

Published in the Financial Times.

From Alex J Pollock, Senior Fellow, Mises Institute, Lake Forest, IL,

With your page one headline “Fed’s ‘higher for longer’ interest rate message weighs on stocks and bonds” (Report, September 28), the Financial Times joins the chorus of commentators singing a similar tune.

But interest rates are not particularly high — they are normal, historically speaking.

For example, in the half-century from 1960 to 2010, before a decade of suppression of interest rates to abnormal lows by the Federal Reserve and other central banks, the 10-year US Treasury note yielded more than 4 per cent, for 90 per cent of the time.

Interest rates only seem high because we got used to the abnormal lows.

So the right slogan now is not “higher for longer,” but “normal for longer”.

The Federal Reserve loses billions on mortgages

Published in Housing Finance International.

Can house prices achieve a soft landing?

The largest holder by far of residential mortgages in the United States, a country often supposed to favor private markets, is none other than the central bank, the Federal Reserve. The Fed owns the remarkable sum of $2.5 trillion (that’s “trillion” with a T) in mortgage-backed securities (MBS).[1] That is more than one-quarter of the entire federal agency residential MBS market, the dominant U.S. source of housing finance. The Fed has mainly invested this enormous amount in the typical American 30-year fixed rate, freely prepayable, mortgage, an instrument of notorious interest rate risk. This risk infamously sank the savings and loan industry in the 1980s, and in 2023 was a principal factor in sinking Silicon Valley Bank, the second largest bank failure in U.S. history at the time of its collapse.

In this Fed MBS investment program, the entire risk of the mortgage is absorbed by the government: the credit risk of the Fed’s MBS investments is taken by other government organizations (Fannie Mae, Freddie Mac, Ginnie Mae), but the Fed itself bears 100% of the interest rate risk. How has the Fed managed this risk as interest rates have dramatically risen since 2022? Not well.

Faced with the runaway inflation of 2021- 22, the Fed pushed short-term interest rates rapidly up from close to zero to 5 ½% after it belatedly stopped buying MBS. Interest rates on 30-year mortgage loans have more than doubled from less than 3% to more than 7%. The resulting mark-to market on the Fed’s MBS portfolio is a loss of $394 billion as of June 2023, or more than 9 times the Fed’s total capital of $42 billion. Striking numbers![2]

The Fed’s huge purchases of mortgage securities began as an emergency, “temporary” action in the crisis of 2008, accelerated again in the Covid financial crisis of 2020, and lasted longer than needed—until March 2022. These central bank purchases drove the interest rates on 30-year fixed rate mortgage loans down to under 3% in late 2020 and 2021-- as low as 2.7% in late 2020—not much return for a 30-year risk! —and the yields on MBS can run 1% or so lower than the mortgage loan rates. The Fed bought a lot of MBS at the bottom in MBS yields—that is, it bought a lot at the market top in MBS prices which its own buying created.

In a leveraged balance sheet like the Fed’s, mark to market losses move into operating results through negative interest spreads. The Fed now has a $2.5 trillion MBS portfolio yielding a little over 2%, which to finance, it pays its depositors and repurchase agreement lenders over 5%. So this massive investment is now running at an interest rate spread of about negative 3%.

One hardly needs to say that lending at 2% and borrowing at 5% is a losing proposition. The $2.5 trillion MBS investment at a negative 3% spread is costing the Fed (and the Treasury and the taxpayers) about $75 billion a year. When added together with the rest of the Fed’s operations, principally the profits from issuing currency and losses from investing in long-term Treasury securities, the Fed accumulated from September 2022 through the end of August 2023 net losses of the notable sum of $95 billion.[3]

The losses will clearly continue for the rest of 2023, by which time the Fed will have lost on operations about three times its capital, and on into the future if interest rates stay at their current historically normal levels. Since the Fed’s profits mostly go to the Treasury, its losses mean that the U.S. Treasury and the taxpayers also lose. The many banks which also bought MBS and hold fixed-rate mortgage loans acquired at 3%, also have very large mark-to-market losses and negative spreads on them. These banks, like the failed Silicon Valley Bank, could correctly claim that they were only doing the same thing the Federal Reserve was.

From the point of view of mortgage borrowers, those who borrowed at 3% or less for 30 years obviously got a great and very attractive deal. A current borrower at 7.2% has to pay 2.5 times as much in monthly interest to buy the same house at the same price as a lucky 2.7% borrower did. On a house in the median price range costing $400,000, that is $1,500 more a month. Naturally, this much more expensive mortgage financing puts a downward pressure on house prices, but it also gives former borrowers a strong motivation to stay in their current houses and keep them off the market, in order to preserve the large financial advantage of the great 30-year mortgage rate the Fed created.

The astronomical house price increases of the second great American house price bubble of the 21st century are over. National average house prices, according to the S&P CoreLogic Case-Shiller Index, fell 1.2% yearover-year in June 2023. Over the same period, U.S. consumer price inflation was 3%, so in inflation-adjusted (real) terms, house prices fell 4.2%. That is a far cry from the bubble’s annualized increases in nominal terms which reached 18% and more in 2021 and early 2022. However, U.S. house prices have not fallen as much as many, including me, expected.

Serious reductions in house prices have indeed occurred in overpriced cities in the U.S. West. These year-over-year decreases reported by Case-Shiller as of June 2023 include the following. In real terms, the drops are in double digits.

House Price Changes Year-Over-Year June 2023

| Nominal | Real

San Francisco | -9.7% | -12.7%

Seattle | -8.8% | -11.8%

Las Vegas | -8.2% | -11.2%

Phoenix | -7.5% | -10.5%

These drops are, however, from very high peaks, and prices in these areas remain historically high.

The two metropolitan areas with the largest price increases in the June Case-Shiller report are the Midwestern cities of Chicago, at +4.2%, and Cleveland, at +4.1%, being in real terms, 1.2% and 1.1%, respectively, which are similar to the long-term growth rate in real house prices.

The AEI Housing Center finds that in July 2023, national average house prices increased year-over year by 3.5%, or by +0.3% real, after falling year-over-year in real terms for eight months in a row. Can falling real prices becoming more or less flat make for a “soft landing” of U.S. average house prices? Maybe--considering that 7% is in a historically normal range of mortgage interest rates. It only seems so high to us because of the previous suppression of mortgage rates to abnormally low levels by the Fed.

Still, many observers wonder why U.S. house prices have not fallen more, given the large reduction in buying power for most people from the sharply increased cost of mortgage loans.

Two measures which have dropped like a rock are the volume of home sales and of mortgage originations. Sales of existing houses were down 40% in July 2023 compared to the pre-pandemic July 2019[4] . The volume of interest rate commitments for new mortgage loans is down about 30%- 40% from 2019, and the volume of mortgage refinancings (“refis” in U.S. parlance) simply to lower the interest rate, is correspondingly down 95%.[5] The mortgage banking and brokerage businesses are experiencing heavy stress and their own painful recession with the disappearance of business volumes. Their total staffs have been cut by 43,000 employees or about 11% over the last year.[6]

How can house prices stay high while sales volume shrivels?

One factor is that while sales of existing houses are way down, so is the inventory of houses being put up for sale. The July 2023 inventory of houses for sale was down 36% from July 2019, which helps support house prices.[7]

A popular and plausible theory is that this low inventory at least in part reflects the desire of the lucky mortgage borrowers at 3% or less to hang on to their great mortgages by simply staying in their current houses. As a typical article explains, “Borrowing costs have not had the expected effect of cooling house prices [because] most US homeowners…have in effect been trapped in their properties by [the] low rates.” So the Fed’s manipulation of mortgage interest rates to exceptionally low levels created an unexpected factor to later restrict the supply of houses for sale and help hold house prices up. In addition, when working from home, the borrowers don’t have to change houses to change jobs, which supports the ability to hang on to the old mortgage.

These factors help slow prepayments of 30-year mortgage loans, extend the duration of the Fed’s MBS portfolio, and increase the Fed’s mark-to-market and operating losses.

It doesn’t help right now, but as a long-term strategy the Federal Reserve needs to return the amount of MBS in its balance sheet to what it always was from its founding in 1913 to 2008--namely zero.

_________

1 Federal Reserve H.4.1 Release, August 31, 2023, Section 5.

2 Federal Reserve Banks Combined Quarterly Financial Report, June 30, 2023.

3 Federal Reserve H.4.1 Release, August 31, 2023, Section 6.

4 AEI Housing Center, Home Price Appreciation Index report, July 2023.

5 AEI Housing Center, Housing Market Indicators report, August 1, 2023.

6 “Nonbank mortgage jobs undergo a seasonal dip,” National Mortgage News, September 1, 2023.

7 AEI Housing Center, Home Price Appreciation Index report, July 2023.

8 “Investors keep close eye on US mortgage rates,” Financial Times, September 3, 2023.

Why the Fed’s Unprecedented Losses Matter

Published in The Wall Street Journal.

The Federal Reserve’s risky policy has backfired.

Mr. Furman excuses the Fed’s unprecedented losses, which have surpassed $100 billion on their way to $200 billion or more, suggesting taxpayers shouldn’t care. To the contrary, taxpayers should care that the Fed will spend, without authorization, $200 billion or more that will be added to their future taxes.

These Fed losses are the result of a radical and exceptionally risky Fed choice to build a balance sheet resembling a giant 1980s savings and loan. In the process, it stoked bubbles in bonds, stocks, houses and cryptocurrencies, in addition to inducing enormous interest-rate risk in the banking system. Those risks have now come home to roost.

Mr. Furman argues that the Fed’s negative capital position doesn’t matter. If so, why cook the books to avoid reporting it? The Fed books its cash losses as a “deferred asset” so that it can obscure its true negative capital position. The Fed changed its own previous accounting rules precisely so it could do so. We know what would happen if Citibank tried that.

Who authorized the Fed to take an enormous interest-rate bet, risking taxpayer money? Nobody but the Fed itself. Does “independence” give the Fed the right to spend hundreds of billions of taxpayer dollars without congressional approval? That question needs to be debated.

Alex J. Pollock and Paul H. Kupiec

Mises Institute and AEI

Lake Forest, Ill., and Washington