Federal Reserve’s Capital Has Now Plummeted to Negative $121 Billion, and Congress Needs To Act

Published in The New York Sun.

Meantime the central bank seeks to palm off on the public the idea that its staggering negative capital is a ‘deferred asset.’

Hold up your hand if you think that the aggregate losses of an organization are an asset of that organization. No hands at all? Absolutely right. Losses are not an asset. That’s accounting 101. Yet the greatest central bank in the world, the Federal Reserve, insists on claiming that its continuing losses, which have accumulated to the staggering sum of $164 billion, are an accounting asset.

The Fed seeks to palm off this accounting entry as a “Deferred Asset.” Why does the Fed do this, which perhaps makes it look tricky instead of majestic? Because it does not want to report that it has lost all its $43 billion in capital and now has negative capital. The inevitable arithmetic is plain: start with the Fed’s $43 billion in capital, lose $164 billion, and the capital has inescapably become negative $121 billion. 

The Fed is not pleased with this answer. In addition to its “Deferred Asset” gambit, it frequently and publicly asserts that negative capital does not matter if you are a money-printing central bank. The idea seems to be that a central bank can always print up more money. The Fed further declares that it is not in business to maximize profits. Even were all this true, it fails to change the correct capital number: negative $121 billion.

If it really doesn’t matter that the Fed has negative capital, why does it not just publish the true number? If the Fed is right, no one will care at all. The Bank of Canada does it right. Its September 30, 2023 balance sheet clearly reports its capital of negative $4.5 billion in Canadian currency. The Bank of Canada also has an agreement with the Ministry of Finance so that any realized losses it takes on its “QE” bond investments “are indemnified by the Government of Canada.” * 

The Fed has no such contract with America’s Treasury. The Fed presumably has an “implied guaranty” from the Treasury, just like Fannie Mae and Freddie Mac did, but there is nothing formal. It seems certain that Congress never dreamed that the Fed could experience the losses and the negative capital that are now reality.

The Fed ran an exceptionally risky balance sheet with little capital. The key vulnerability was and is interest rate risk, the same risk that caused the failure of the savings and loans in the 1980s. The Fed’s capital was a mere 0.5 percent of its total assets. When the Fed incurred big interest rate risk losses starting in 2022, it rapidly lost all its capital because it had so little capital to begin with.

Whose fault was that? 

The reason the Fed had so little capital was the Congress. Anxious to take the profits of the Fed to spend, the Congress limited by law the retained earnings the Fed could build to a mere $6.8 billion, or less than 0.1 percent of the Fed’s assets. Moreover, as the Fed made itself ever riskier, Congress did nothing to either limit the risk, or to increase the capital to reflect the risk.

Did Congress understand the Fed’s balance sheet? If not, Congress is also at fault for that failure. Congress has provided in the Federal Reserve Act, from the original act to today, that the Federal Reserve Banks have a legal call on their commercial bank stockholders to double their paid-in capital. Thus the Fed has the statutory right to raise $36 billion in additional capital.

That would not bring its capital up to zero. It would, though, be a lot better than nothing. Yet the proud Fed has not chosen to issue the capital call that Congress designed, and Congress has not suggested that the Fed do so. Is Congress paying attention to the Fed’s financial condition? 

The Bank of England, which has a formal support agreement from His Majesty’s Treasury, studied the need for central bank capital in a recent working paper.* * It observed that “Financial strength can support central bank independence and credibility.”

“When capital is low,” the Bank of England concluded, “central banks should be able to retain their profits to help strengthen their capital position.” Congress prohibited the Fed from doing this, even as its capital relative to risk got miniscule. 

Congress needs to fix the Federal Reserve Act to allow capital to be built up corresponding to the risks undertaken. Of course, that means Congress has to understand the risks. As for the Fed’s capital at this point, negative $121 billion certainly qualifies as “low.”

________

*  Bank of Canada, Quarterly Financial Report, Third Quarter 2023.

* * Bank of England, ‘Central bank profit distribution and recapitalization,’ Staff working paper no. 1,069, April 2024.

Why Is the Fed Losing Money When It Does Such a Handsome Business With Irredeemable Paper Money Abroad?

At some point a leader will step forward prepared to call the central bank out on its losses.

Published in The New York Sun.

The Federal Reserve issues the most successful irredeemable, pure fiat circulating paper currency in world history, in other words, dollar bills.  These printed pieces of paper are formally titled “Federal Reserve Notes,” but they are not really notes, because a note is a promise to pay, and Federal Reserve Notes don’t promise to pay anything at all. 

Under the original Federal Reserve Act of 1913, Federal Reserve Notes really were notes. Against them the Federal Reserve promised to pay — and did indeed pay for its first 20 years — gold coin to redeem them.  The Federal Reserve Banks were required to hold gold in reserve to make these promises credible.  No more, of course.  

The Federal Reserve, unlike many other contemporary central banks, now owns zero gold.  The only promise the current Fed makes is that it will depreciate the purchasing power of its dollars forever, trying for a depreciation rate of 2 percent per year. In other words, it aims for an 80 percent depreciation over an average human lifetime. 

There is a lot of the Fed’s paper currency in circulation — in total value about $2.3 trillion.  This compares to $492 billion 25 years ago.  Meaning, in one generation, the Fed’s paper money in circulation has increased to 4.7 times its 1998 amount, far faster than nominal GDP, which has grown to 3.0 times its 1998 level.  

In 1998, Federal Reserve Notes in circulation were equal to 5.4 percent of GDP.  This ratio soared to 8.4 percent in 2023, for an increase of 56 percent relative to GDP. How can this have happened when all those years were marked by constant discussions of how we were moving to a cashless society? 

And how can it have happened when everybody can observe the increasing use of credit cards or electronic payments instead of currency?   I keep being surprised by how my own grown children are content to go around with hardly any cash, and how many people pay with cards for trivially small purchases. 

So why has the Fed’s paper currency outstanding increased so much? An instructive contrast is with Canada, a neighboring economy with a sophisticated financial system. The Bank of Canada had C$118 billion in its fiat paper currency in circulation as of September 30, 2023 — 4.1 percent of the Canadian GDP.  

Thus, relative to GDP, the Fed has more than twice the amount of paper currency circulating as does the Bank of Canada. Why? The reason is that the Bank of Canada is only the central bank of Canada, while the Fed is in important respects the central bank of the world.

That means that America’s paper currency, in spite of the Fed’s constant depreciation of its purchasing power, is widely used in numerous other countries, as superior to whatever money is printed up locally. The Fed has estimated that as of 2021, “foreigners held $950 billion in U.S. banknotes.” 

That comes to “about 45% of all Federal Reserve Notes outstanding, including two-thirds of all $100 bills.”  Updating to 2023, we can guess that foreigners hold approximately $1 trillion in American dollar bills. This constitutes a handsome and profitable international business for the Fed.

Its paper currency, with little cost to produce, provides zero-interest funding, which the Fed invests in interest-bearing securities.  This makes profit as easily as falling off a log.  With market interest rates at 5 percent, those $1 trillion in dollar bills are worth about $50 billion a year in net interest income for the Fed.

Thank you, foreign dollar bill holders.  The remaining $1.3 trillion of domestically held currency is worth a net interest income of $65 billion a year, for a combined total of about $115 billion a year.  This is why the Fed should always be profitable.  And yet — what do you know? — it has become the opposite.

In 2023, the Fed racked up a net loss of the truly remarkable sum of $114 billion.  In other words, it ran through its whole margin on currency issuance plus another $114 billion, and its losses continue in 2024 at about $28 billion for the first quarter. Just to mark the point, these losses are highly newsworthy.

The losses result from the Fed’s $6.3 trillion of investments in long-term Treasury bonds and mortgage securities yielding on average a mere 2 percent or so, while the Fed now must pay more than 5 percent on its own deposits and borrowings, putting it financially upside down.

In short, despite its profitable international business of currency printing, the Fed is suffering giant net losses in the same fashion as typical 1980s savings and loans did. This scandal has yet come into focus for the American public, but it’s a fair bet that it will do so — if the right leader steps forward.

Surprise, the Only Constant

Published in the Federalist Society.

A review of Alex Pollock & Howard Adler, Surprised Again! The COVID Crisis and the New Market Bubble (2022)

I approach phenomena that I don’t understand with good cheer and don’t give in to them. I’m above them. Man should be aware that he is above lions, tigers, stars, above everything in nature, even above what is incomprehensible and seems miraculous, otherwise he’s not a man but a mouse afraid of everything.

The House with the Mezzanine: An Artist’s Story, Anton Chekhov

In the late 1980s, the United States experienced what was called the “Savings and Loan Crisis.” Savings and loan associations (S&Ls), firms much like banks, had committed the financial sin of borrowing short and lending long: they borrowed by taking deposits repayable in the near term to finance their making of longer-term thirty-year residential and other real estate loans at fixed interest rates. As interest rates eventually rose, the S&Ls and investment firms found themselves having to pay higher and higher amounts of interest to cover the low fixed amounts of interest they were receiving from their borrowers. That is a financial practice in which one can engage, albeit not indefinitely. Regulators and investors nonetheless were surprised when many S&Ls failed, costing the federal government billions of dollars.

Even after that, in the late 1990s and early 2000s, the government and financial markets incented banks and investment firms to lend to higher-risk low-income borrowers to purchase homes. Policymakers thought sincerely that relaxed lending standards would enable lower-income persons to more quickly and easily realize the American dream of home ownership, which would in turn enable them to build up equity in their newly purchased homes as home values rose. That equity could be used to start a small business or send children to college. Unfortunately, home prices did not continue to rise relentlessly and eventually dropped, leaving lenders with inadequate collateral. As these borrowers eventually were unable to repay their loans, the lenders found themselves holding loans of dubious and uncertain value, and investors were surprised. This all came to a head in 2008 with what is now called the “Great Financial Crisis.” Regulators charged with protecting our financial system were surprised again.

Read the rest here.

Letter: FDIC Swiss stance — case of pot calling kettle black

Published in the Financial Times:

One may doubt the diplomatic wisdom of the decision of the chair of the US Federal Deposit Insurance Corporation to criticise the Swiss government’s handling of the Credit Suisse failure (Report, April 11), but one cannot fail to be amused by the FDIC pot calling the Swiss kettle black.

Far from using “standard bank closure powers”, the FDIC and other US regulators in 2023 gave assurances all was in good shape, in an attempt to avoid widespread panic in the banking system, and then took the extraordinary action of guaranteeing all the uninsured deposits of collapsing banks. This cost the FDIC $16bn it could not afford; it took these billions from other banks to save wealthy venture capitalists and crypto barons from taking a moderate and well-deserved haircut on the uninsured deposits they so imprudently held in sometimes extravagant amounts. The Swiss are probably too polite to point out to the FDIC chair that this was certainly an unfortunate precedent.

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

House prices are falling in Canada, rising in the U.S. — why the difference?

Published in Housing Finance International.

Canada and the United States both span the North American continent, sharing a 3,900- mile border running between the Atlantic and Pacific Oceans. In GDP, the U.S. is more than twelve times as big, but they are both rich, economically advanced countries, with sophisticated financial systems and active housing finance markets, and similar home ownership ratios of about 66%.

The central banks of both countries practiced extreme “quantitative easing” to suppress interest rates and expand credit; both the Federal Reserve and the Bank of Canada multiplied their total assets to nine times in 2021 what they were in 2008; both central banks reduced short term interest rates to nearly zero in response to the Covid crisis. Both countries experienced a massive house price bubble, which took average house prices by 2022 to far above the former housing bubble peaks of 2006 (U.S.) and 2008 (Canada).

With both countries suffering runaway inflation in 2022, both central banks rapidly pushed short-term interest rates up to about 5% and started “quantitative tightening,” letting their balance sheets shrink. The mortgage interest rates in both countries more than doubled, the standard Canadian five-year mortgage rate jumping from 2.4% to 5.5%, and the standard U.S. 30-year mortgage rate from a low of 2.7% to over 7%. (But note the difference between a very low interest rate fixed for five years and one fixed for 30 years, as discussed further below.)

In both countries, the house buyers’ monthly interest payments for a new mortgage loan of the same size has more than doubled. A normal expectation is that this should be making house prices fall. In Canada, they have indeed fallen, but in the U.S., average house prices have been rising.

As of January 2024, average Canadian house prices have dropped more than 18% from their peak of March 2022, although they of course vary by region. In greater Toronto, Canada’s largest city, for example, house prices are 20% down from their peak; in the Hamilton-Burlington area, down 25%. On the other hand, in the oil and gas capital of Calgary, in western Canada, house prices have reached a new all-time high. On average, across the country, house prices are down significantly from their peak, but the peak was steep, and house prices are still historically high. It would not be surprising for them to continue their decline.

In contrast, U.S. average house prices, after dipping about 5% after their June 2022 peak, are back over it. The S&P Case Shiller national house price index was 308.3 at that peak, in December 2023 it was 310.7, in spite of the greatly increased mortgage interest rates. According to the AEI Housing Center (AEI), year-over-year U.S. average house price appreciation,1 measured monthly, has always been positive from 2022 to early 2024, and in January 2024 the year-over-year house price increase was 6.4%. AEI predicts a 5% average U.S. house price increase for the full year 2024.2

Of course, there is regional variation. Along the Pacific coast, San Francisco prices are down 13% from their 2022 peak, Seattle down over 12%, and Portland down about 8%. On the other side of the country, Miami and New York City have made new highs.

An interesting surprise is that the fastest house price appreciation is now in the mid-sized, Midwestern cities of Indianapolis, Indiana; Grand Rapids, Michigan; and Milwaukee, Wisconsin; all far from the Sun Belt and where they have a real winter. House prices are up over the last year by 13% in Indianapolis, 12% in Grand Rapids and about 11% in Milwaukee.

Overall, the U.S. looks not only different from Canada, but an exception to what the Financial Times described as “the widespread drop in global house prices that hit advanced economies” and “the deepest property downturn in a decade.”3

The U.S. house price behavior is even more notable when combined with its dramatic shrinkage of the volumes of house purchases and of mortgage originations. The volume of mortgages for house purchases in early February 2024 was 35% less than it was in 2019, before the Covid crisis. It was 10% below the already weak same period in 2023. Refinance mortgages with cash taken out were down 60% from 2019, and refinance mortgages with no cash out were down 75%.

With these drops in business volumes, U.S. mortgage banks, which rely on an originate-tosell business model, are in their own recession. United Wholesale Mortgage, the top mortgage originator in 2023 with $108 billion in mortgage loans, was second in 2022 with $127 billion. Its volume was thus down 15% and it posted a loss of $70 million for 2023. Rocket Mortgage, the top originator in 2022 with $133 billion in loans originated, was second in 2023 with $79 billion, or down 41% in volume. It made a 2023 annual loss of $390 million. “One of the worst quarters for mortgage origination in recent history,” said its chief financial officer about the end of 2023.4

How can prices still be rising when volumes are so reduced, and interest rates are so much higher? The most common explanation is that the supply of houses for sale also remains low. Among many others, AEI observes the “historically tight supply.”5

Contributing to the tight supply is that people with 3% or less 30-year mortgages are less inclined to sell and give up the striking financial advantage of the cheap mortgage, which is locked in for a very long time, as long as they stay in the house. There is no way to monetize the large value of that existing mortgage to the borrower except by staying put.

A key difference between the Canadian and U.S. mortgage markets, which presumably affects the house price behavior, is the contrast between a typical five-year mortgage and a typical 30-year mortgage, respectively. With low- rate mortgages from three years ago, for example, the Canadian homeowners have only two years left of value from the cheap financing. The new, higher rates work their way into the household finances much more quickly. After the same three years, the American homeowners have 27 years of a large, valuable liability left—a new, higher rate is very far off indeed, if they keep the house. But if they sell it, the mortgage is due on sale, and they will face the new, more than doubled interest rate right away.

The unique American political and financial commitment to the 30-year fixed rate mortgage is now suppressing the supply of houses for sale and helping hold up house prices, postponing the correction of the 21st century’s second house price bubble, and making American houses less affordable for new buyers. This is certainly an unintended consequence of U.S. national housing finance policy.

The provocative financial writer, Wolf Richter, suggests that the causality runs not only from low supply of houses for sale to higher prices, but also the other way around. “Now the hope for lower mortgage rates is holding back potential buyers and potential sellers alike,” he writes. “The housing market remains frozen because prices are still too high.”6 On a historical basis, it appears that both Canadian and U.S. house prices are still too high. The difference between their principal mortgage instruments is one factor explaining why prices have been falling in one and rising in the other, as we continue to live through the distortions of and adjustments to the Covid crisis.

It might be argued that the U.S. housing finance system would be improved by less subsidy for and less political devotion to the 30-year mortgage. There could be more emphasis on 15-year mortgages instead, which have less interest rate risk and create a faster build-up of housing equity for the borrower. A gradual transition by changing the rules applied to the government mortgage promoters, Fannie Mae, Freddie Mac and the Federal Housing Administration, could be imagined. However, the political probability of such a change is zero.

__________________

1 A better name for this measure would be “house price change,” since there of course can be “depreciation” as well as “appreciation.” But we seem to be stuck with the “HPA” term. “Appreciation,” it is true, has prevailed on average over time, especially in nominal, as opposed to inflation-adjusted terms. Inflation-adjusted U.S. year-over-year house prices were falling from November 2022 to June 2023, but remained positive in nominal terms, as reported by AEI.

2 “Home Price Appreciation (HPA) Index—January 2024,” AEI Housing Center.

3 “Global house price downturn shows signs of reversal as rate-cut hopes rise,” Financial Times, February 26, 2024.

4 “Rocket posts $233 million net loss in 4Q,” National Mortgage News, February 22, 2024.

5 “Housing Finance Watch, 2024 Week 6,” AEI Housing Center.

6 “Mortgage Rates Rise Back to 7%, Housing Market Re-Freezes, Buyers’ Strike Continues. Prices Are Just Too High,” Wolf Street, February 21, 2024.

May 22 AEI Event: The Federal Reserve and Financial Stability Risk

A video livestream will be made available on May 22. Please scroll down to view.

Register here

Contact Information

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

One year after the Silicon Valley Bank failure required a Federal Reserve and Federal Deposit Insurance Corporation bailout, the US banking system is being challenged by large interest rate–related mark-to-market losses on its bond portfolio and a looming commercial property–sector crisis. What was the Fed’s role in these developments, and what should it do now?

Join as AEI scholars and experts discuss the seriousness of these challenges for the banking system and their implications for Federal Reserve policy.

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

Agenda

1:00 p.m.
Introduction:
Desmond Lachman, Senior Fellow, American Enterprise Institute

1:05 p.m.
Panel Discussion

Panelists:
Jan Hatzius, Chief Economist, Goldman Sachs
Desmond Lachman, Senior Fellow, American Enterprise Institute
Bill Nelson, Executive Vice President, Bank Policy Institute
Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics, Hoover Institution

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

2:30 p.m.
Q&A

3:00 p.m.
Adjournment

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Desmond Lachman | AEI event | September 21, 2023

Register here

Fixing A Big Mistake in Risk-Based Capital Rules

Published in AIER:

We are observing a great debate between the US banking regulators who wish to impose new, so-called “Basel III Endgame” rules to significantly increase bank capital, on one side, and the banks who argue they already have more than enough capital, joined by various borrowing groups who fear loans to them may be made more expensive or less available, on the other. It has been described as “the biggest fight between banks and regulators in the US in years.”

Said the president of the Financial Services Forum, “Additional significant capital increases, such as those of the Basel III Endgame proposal, are not justified and would harm American households, businesses and the broader economy.”

The Acting Comptroller of the Currency “pushed back at banks’ claims…saying the lenders could always cut dividends and buybacks instead.”

The debate generated similar disagreements among members of the Senate Banking Committee in a December 2023 hearing and is ongoing.

Leaving aside the fact there never can be an end to the endless and heavily political arguments about bank capital, what is most remarkable in this debate is what is not discussed. Not discussed is that the Basel risk-based capital requirements completely leave out interest rate risk. In its most common form that is the risk created by lending long at fixed interest rates while borrowing short at floating rates, which can be dangerous, even fatal, to the bank.

Excessive interest rate risk was a principal cause of the large bank failures of 2023, three of the largest failures in US history — Silicon Valley Bank, Signature Bank, and First Republic Bank. Widespread vulnerability due to interest rate risk among banks was, at that crisis point, the reason the American financial regulators declared that there was “systemic risk” to financial stability, so they could make exceptions to the normal rules. These involved promising to pay off uninsured depositors in failed banks with money taken from other banks; having the Federal Reserve offer loans to banks without sufficient collateral, so they would not have to sell their underwater investments; and as in every crisis, offering words of assurance from government and central bank officials that really banks were secure — although this does seem inconsistent with declaring a systemic-risk emergency.

Banking expert Paul Kupiec, in an extensive bottom-up analysis of US banks, concludes that the interest rate risk on their fixed rate securities and loans has resulted in an aggregate mark to market, unrealized but economically real, loss of about $1.5 trillion — a staggering number. The tangible capital of the entire banking system is about $1.8 trillion. The market-value losses on interest rate risk would thus have consumed approximately 80 percent of the banking system’s total tangible capital. If that is right, the banks on a mark-to-market basis would have only about 20 percent of the capital they appear to have. A less pessimistic, but still very pessimistic, analysis suggests that the fair value losses on securities and loans of banks with $1 to $100 billion in assets have in effect reduced regulatory capital ratios by about 45 percent. Applying this to the whole system would suggest a mark-to-market loss from interest rate risk of about $1 trillion. The banking system thus displays a dramatically diminished margin for error, just as it faces the looming losses from the imploding sectors of commercial real estate, a common villain in financial busts.

That interest-rate risk is fundamental is obvious, basic Banking 101. But it is a risk nonetheless very tempting when the central bank has artificially suppressed interest rates for long periods, as it did for more than a decade. Lots of banks succumbed as the Fed, playing the Pied Piper, led them into the current problems. Recent press reports tell us: “Rising Rates Hit Regional Lenders”; “US banking sector earnings tumble 45%” as “the swift rise in interest rates…continues to weigh on lenders”; “Truist Financial swung to a loss”; “Citigroup …reported a net loss for the fourth quarter 2023 of $1.8 billion”; “Higher-for-longer interest rates remain the key risk for real estate assets globally”; and “Bank losses worldwide reignite fears over US commercial property sector”.

The Federal Reserve itself is suffering mightily from the interest rate risk it induced. Its operating losses now exceed $150 billion, and its mark to market loss is approximately $1 trillion. If the aggregate market value loss of the banks is $1 trillion to $1.5 trillion, when we consider the greater banking system to include both the banks and the Fed, its total loss due to interest rate risk is about $2 trillion to $2.5 trillion. The Fed is belatedly introducing into its stress test ideas “exploratory scenarios,” to test the effects of rising interest rates. But “the results will not be used to calculate [required] capital.”

Interest-rate risk was at the heart of the notorious collapse of the savings and loan industry in the 1980s, the hopeless insolvency of its government deposit insurer, and the ensuing taxpayer bailout. People thought the lesson had been learned, and probably it had, but it seems it was forgotten. 

Interest-rate risk remains particularly relevant to mortgage finance, mortgages being the largest credit market in the world after government debt, because of the unique devotion of American financial and regulatory politics to 30-year fixed rate mortgages, which are notably dangerous. So are very long-term fixed-rate Treasury bonds, but bank regulation always promotes buying Treasury bonds to help out the government. Both long Treasuries and 30-year mortgages in the form of the mortgage-backed securities guaranteed by government agencies are in current regulation included as “High Quality Liquid Assets.” The agency MBS are given very low risk-based capital requirements. Treasuries are always described as “risk-free assets” and given zero risk-based capital requirements. But of course they both can and have created plenty of interest rate risk.

However the in-process “Basel III Endgame” debate turns out, Basel international risk-based capital requirements will still fail to address interest rate risk. They will still promote investing in 30-year agency MBS and long Treasuries, in spite of their riskiness. This serves the political purpose of favoring and promoting housing and government finance, but not the soundness of the banking system. 

A complete process of including interest rate risk by measuring the dynamic net exposure to interest rate changes of the total on- and off-balance sheet assets, liabilities and derivatives of a bank, and appropriately capitalizing it, would doubtless be a task of daunting complexity for risk-based capital calculations under the Basel agreements, as evidenced by the Basel Committee’s “Standards — Interest rate risk in the banking book.” But an extremely simple fix to address very large amounts of interest rate risk is readily available.

This is simply to correct the woefully low risk-based capital required for 30-year agency MBS and for very long Treasury debt. These miniscule capital requirements get rationalized by very low credit risk, but they utterly fail to reflect very high interest rate risk.

The risk-based capital required for Treasuries, to repeat, is zero. The risk-based capital for 30-year fixed rate mortgages in the form of agency MBS merely 1.6 percent (a risk weighting of 20 percent multiplied by the base of 8 percent). Contrast this zero or minimal capital to the market value losses now being actually experienced. Using as a benchmark the losses the Federal Reserve had on its investments as of September 30, 2023:

          Treasuries    A loss of 15 percent

          Agency MBS  A loss of 20 percent
 

That more capital than provided under the Basel rules is needed to address the interest rate risk of these long term, fixed-rate exposures appears entirely obvious.

I suggest the risk weights of these investments, so potentially dangerous to banks (not to mention to central banks), should be increased to 50 percent for 30-year agency MBS and 20 percent for long Treasuries, thus giving us risk-based capital requirements of 4 percent (instead of 1.6 percent) for long agency MBS and 1.6 percent (instead of zero) for long Treasuries.

These are guesses and approximations, of course. While simple, they come much closer to addressing the real risk than does the current system. It is time to learn and apply the expensive lessons of interest rate risk once again.

Two sets of objections will vociferously be made. The housing complex will complain that this will make mortgages more expensive. The Treasury (and all finance ministries) will complain that this will make ballooning government deficits more expensive to finance. What do we want? To match the capital to the real risks, or to manipulate the capital regulations to subsidize politically favored borrowers?

I am for the former. Lots of people, alas, are for the latter. This is a perpetual problem of political finance.

The Fed Doesn’t Know the Natural Rate of Interest

Published in The Wall Street Journal.

Mr. Levy describes the Fed’s permanent problem: It doesn’t and can’t know what the natural rate of interest is. Everyone should pity the members of the Federal Open Market Committee, who must inwardly confess that they can’t know the answers, yet have to play their parts in the Fed melodrama nonetheless.

Alex J. Pollock

Senior fellow, Mises Institute

Lake Forest, Ill.

Appeared in the March 14, 2024, print edition as 'Fed Doesn’t Know the Natural Rate of Interest'.

The Swiss National Bank vs. the Federal Reserve: The Fed's Capital Losses in Perspective

Published in The Mises Institute’s Mises Wire.

Switzerland’s central bank, the Swiss National Bank (SNB), lost $3.6 billion in 2023,1  after a gigantic loss of $150 billion in 2022. But after booking these losses, and properly subtracting them from its capital, the SNB still had positive capital of over $70 billion. This gives it the quite respectable capital to total assets ratio of 7.9%. All of these numbers are after marking its investments to market, as is required by the SNB’s governing law, so the capital is a real, marked to market equity. The market value of the SNB’s holdings of gold is $65 billion, which includes a large appreciation, including $1.9 billion in 2023. Since the SNB had an overall loss for the year, it paid no dividends to its stockholders.

“The SNB aims for a robust balance sheet with sufficient equity capital to ensure that it can also absorb high losses,” it states.2  This sound financial principle is the opposite of the official position of the Fed. 

The Federal Reserve, central bank not only to the United States but to the dollar-using world, had a gigantic loss of $114 billion for 2023. It had reported a profit for the full year 2022, but had started losing money in September of that year at the remarkable rate of $2 billion a week. The Fed’s huge losses are continuing into 2024—by its February 28, 2024 report the aggregate losses have reached $154 billion. Since the Fed’s governing law does not permit it to maintain “a robust balance sheet with sufficient equity capital to absorb high losses,” indeed forbids it from doing so, the losses have wiped out the Fed’s capital by more than 3.5 times. 

Of course, the Congresses which passed the Federal Reserve Act and its amendments never intended the Fed to run with negative capital—they simply thought it was impossible for the Fed to lose this much money-- a flawed assumption.

The current capital deficit is shown by the undeniable arithmetic of the Fed’s capital as of February 28. The Fed has paid-in capital of $36 billion and miniscule retained earnings of $7 billion, for total of $43 billion. Starting capital of $43 billion minus Losses of $154 billion = current capital of negative $111 billion.

You will not find this negative capital, which is the real capital, reported on the Federal Reserve balance sheet, however. The Fed insists on the accounting charade of booking its massive losses as an asset, a so-called “deferred asset.” Do you believe, Candid Reader, that losses are an asset? You don’t? Neither do I. Do you believe that losses should be subtracted from capital, as responsibly done by the SNB? So do I! In short, the Fed publishes, not to put too fine a point on it, a phony capital number. But that’s its line, and the Fed is sticking to it.

Unlike the SNB, the Fed owns zero gold to help offset the secular depreciation of all paper currencies.

In spite of its huge losses, negative capital and negative retained earnings, the Fed continues to pay dividends to its shareholders. And the Fed does not mark its investments or its capital to market.

Taken all together, this makes quite an interesting contrast with the SNB. 

The Federal Reserve balance sheet combines the balance sheets of the twelve regional Federal Reserve Banks (FRBs). Here is an update on the real capital as of February 28, 2024 of these individual FRBs, as well as the total Federal Reserve. Eight of the twelve FRBs are technically insolvent, with losses of more than 100% of their capital and thus liabilities greater than their assets. Two other FRBs have lost 98% and 85% of their capital and are steadily approaching technical insolvency. Only two have most of their capital left. Of all the FRBs, the biggest and most important by far is the FRB of New York. It also has far and away the biggest losses and the most negative capital. The total system has a huge capital deficit. Recall that the table shows the real capital numbers, not the contrived ones reported by the Fed.

Real Capital of the Federal Reserve Banks as of February 28, 20243 :

Federal Reserve Bank Real Capital Losses as a % of Starting Capital

New York ($82.4 bln) 655%

Richmond ($15.6 “ ) 284%

Chicago ($ 8.8 “ )  515%

San Francisco ($ 2.8 “ ) 151%

Cleveland ($ 1.5 “ ) 134%

Boston ($ 1.2 “ ) 165%

Dallas ($677 mln) 161%

Kansas City ($ 94 “ ) 120%

Philadelphia $ 31 “ 98%

Minneapolis $ 40 “ 85%

St. Louis $891 “ 8%

Atlanta. $ 1.3 bln 13%

Federal Reserve System ($111 bln) 357%

These capital numbers do not include, unlike the SNB, any mark to market results. The Fed does disclose, quarterly, although not put into its financial statements, the mark to market losses on its portfolio. As of September 30, 2023, the net mark to market loss was the pretty amazing amount of $1.3 trillion. A reasonable guess at the end of February 2024 is that market value loss was about $1 trillion. Thus the mark to market capital would be negative $111 billion plus negative $1 trillion = negative $1.1 trillion.

Do you like your central bank capital positive or negative? I believe that the Fed should be recapitalized, but the Fed itself and most economists fervently dispute this. At the very least, Congress should insist, as would be required by the Federal Reserve Loss Transparency Act,4  a bill introduced by Congressman French Hill, that the Fed keep honest books.

Event: Talks With Authors: Better Money: Gold, Fiat, Or Bitcoin?

Hosted by the Federalist Society:

In Better Money: Gold, Fiat, Or Bitcoin?, monetary expert Lawrence H. White delves into the timely debate surrounding alternative currencies amidst the backdrop of constant inflation in the fiat currency world. Better Money explains and analyzes gold, fiat dollars, and Bitcoin standards to evaluate their relative merits and capabilities as currencies. It addresses common misunderstandings of the gold standard and Bitcoin, and scrutinizes the evolution of currency, particularly the interplay between market and government roles. White provides provocative analysis of which standard might ultimately provide better money, and argues that we need a market competition among them.

Please join us as Professor Lawrence White joins discussants Alexandra Gaiser and Bert Ely, and moderator Alex Pollock to discuss Better Money.

Featuring: 

• Prof. Lawrence H. White, George Mason University

• Alexandra Gaiser, General Counsel, Strive

• Bert Ely, Principal, Ely & Company, Inc.

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

Federal Reserve Losses and Monetary Policy

Published by the American Enterprise Institute with Paul H. Kupiec.

Past monetary policy decisions have resulted in the Fed suffering more than $140 billion in accumulated cash losses in addition to $1 trillion in unrealized losses on its securities portfolio. The Fed System and the majority of Reserve Banks are technically insolvent on a GAAP basis. Fed officials claim that the Fed’s losses and negative GAAP capital do not compromise its ability to conduct monetary policy because the Fed can create money to cover its losses, however large the losses may become. The Fed’s narrative leaves out important details including that the Fed’s ability to print paper currency is limited by law and deposits held at insolvent Reserve Banks are unsecured liabilities that are legally at risk because they lack a federal government guarantee. We calculate the GAAP capital of each Reserve Bank and the System, and estimate depositors’ loss exposures under current law. We review the current legal framework in place for addressing insolvent Reserve Banks. We conclude that the framework will be ignored, and the Fed will continue to operate at a loss while deeply technically insolvent as long as depositors maintain their belief that Fed deposits are protected by an implicit federal government guarantee. Congressional action may be needed should this confidence waiver.

Read the full paper here.

Has Anyone Thought About Recapitalizing the Fed, Which Is Underwater by Billions of Dollars?

The answer is ‘yes’ — the authors of the Federal Reserve Act, for starters.

Published in The New York Sun:

The Federal Reserve seems to many people to be a mysterious power, something like the Wizard of Oz in the classic movie version of the story. Yet the Federal Reserve Banks are banks, with assets, liabilities, capital, and profits and losses like other banks. What stands out in the last year and a half are the losses — totaling a staggering sum, $149 billion. The FRBs, in other words, have run through about 3.5 times their total capital.  

The Fed’s real capital as of mid-February 2024 is its stated capital of $43 billion minus the losses of $149 billion, or by ineluctable arithmetic a negative $106 billion. The Fed disguises this in its published financial statements by booking its losses as an asset.  Luckily for it, the Fed is not an SEC filer. It is a striking irony that the greatest central bank in the world feels compelled to fall back on issuing questionable financial statements.

One would like to think that America’s central banking system would be an exemplar of financial probity. Particularly the Federal Reserve Bank of New York. Of the 12 FRBs, the largest and most important is the New York FRB, which is bigger than the other 11 put together. With its losses of $95 billion, it is also far and away the leader in losing money.  

The Fed’s astronomical losses, which continue at the rate of $2 billion a week, have resulted from its taking and imposing on both the Treasury and the taxpayers, as well as on itself, the massive financial risk of investing long and borrowing short to the tune of trillions of dollars. So now it, and the Treasury and the taxpayers, are upside down in a huge, long lasting trade which earns interest at about 2 percent and pays interest at more than 5 percent.

The Federal Reserve’s balance sheet release for February 14 allows an update on the actual capital of each Federal Reserve Bank and of the total Federal Reserve, also showing the accumulated losses of each as a percentage of its stated capital. 

It portrays losses of a magnitude that would previously have been considered impossible by everybody. Note that these numbers do not count the approximately $1 trillion in mark to market losses the Fed has suffered on its investments — only the cash losses from operations are included.

The Fed as a whole and eight of the 12 FRBs are technically insolvent, with liabilities greater than their assets. Two other FRBs have reported losses totaling 83 percent and 94 percent of their capital, with losses continuing.  With combined assets of $7.6 trillion and negative capital, the Fed has infinite leverage. The capital deficit is growing bigger at an annualized rate of more than $100 billion a year.

Did anyone ever think about how to recapitalize a Federal Reserve Bank which is short of capital? The answer is Yes. The authors of the Federal Reserve Act did and provided for it in the Act. The commercial bank members of the Fed are the sole stockholders of the FRBs, and the Act looks to them to contribute new capital.  

The member banks have all purchased only half of their statutory commitment to buy FRB stock. The other half is callable at any time by the Fed. That would be a capital call on the member banks of $36 billion. In addition, the banks are liable to be assessed up to twice their current capital to make good losses of their FRBs. That would not be a purchase of stock, but simply money paid to the Fed to offset losses. The aggregate sum involved could be a $68 billion assessment.

Imagine the outraged comments of banks that were required to make good on their legal commitments as shareholders of FRBs under the Act. Perhaps many of them have never thought about what their exposure is under the law, and will be surprised to learn.

Is the Fed willing to recapitalize itself by following the statutory provisions? Presumably not. It would be humiliating for the Fed, of course, and also it would make the member banks angry. Perhaps the Wizard of Fed will simply stick to the line, “Pay no attention to the man behind the curtain.”

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.