The Permanent Temptation of All Governments

Published in the American Institute for Economic Research:

In We Need to Talk About Inflation, his thoughtful, accessible tour of the history, theories, politics and future of inflation, Stephen King warns us that: 

          “Inflation is never dead.”  

He is right about that, and that blunt reminder alone justifies the book. 

The book begins, “In 2021, inflation emerged from a multi-decade hibernation.” Well, inflation had not really been in hibernation, but rather was continuing at a rate which had become considered acceptable. It was worry about inflation that had been hibernating. People found themselves caught up in the runaway inflation of 2021-2023, a wake-up call. As the book explores at length, that explosive inflation had been unexpected by the central banks, including the Federal Reserve, making their forecasts and assurances look particularly bad and proving once again that their knowledge of the future is as poor as everybody else’s. 

Now, in the third quarter of 2024, after historically fast hikes in interest rates, the current rate of inflation is less. But average prices continue going up, so the dollar’s purchasing power, lost to that runaway inflation, is gone forever. Inflation continues and has continued to exceed the Fed’s 2-percent “target” rate. And the Fed’s target itself is odd: it promises to create inflation forever. The math of 2-percent compound shrinkage demonstrates that the Fed wants to depreciate the dollar’s purchasing power by 80 percent in each average lifetime. Somehow the Fed never mentions this. 

King shows us that such long-term disappearance of purchasing power has happened historically. Chapter 2, “A History of Inflation, Money and Ideas,” has a good discussion, starting with the debate between John Locke and Isaac Newton, of the history, variations and continuing relevance of the quantity theory of money. It also contains an instructive table of the value of the British pound by century from 1300 to 2000. The champion century for depreciation of the pound was the twentieth. The pound began as the dominant global currency and ended it as an also-ran, while one pound of 1900 had shriveled in value to two pence by 2000. The century included the Great Inflation of the 1970s, during which British Prime Minister Harold Wilson announced, the book relates, that “he hoped to bring inflation down to 10 percent by the end of 1975 and under 10 percent by the end of 1976.” His hopes were disappointed, as King sardonically reports: “The actual numbers turned out to be, respectively, 24.9 percent and 15.1 percent.”

These inflationary times need to be remembered, as should numerous hyperinflations. Best known is the German hyperinflation of 1921-23, the memory of which gave rise to the famous anti-inflationist regime of the old Bundesbank. (It was once wittily said that “Not all Germans believe in God, but they all believe in the Bundesbank” — however, this does not apply to its successor, the European Central Bank.) King also recounts that the effects of the First World War gave rise to three other big 1920s hyperinflations — in Austria, Hungary and Poland, and that “inflation in the fledging Soviet Union appears to have been stratospheric.” He discusses the 1940s hyperinflation in China, and how in the 1980s “Brazil and other Latin American economies…succumbed to hyperinflation, currency collapse and, eventually, default.” We must add the inflationary disasters of Argentina and Zimbabwe.  

All these destructive events resulted from the actions of governments and their central banks. The book considers the theory of how to put a stop to this problem that Nobel Prize-winning economist Thomas Sargent made in 1982. First and foremost, as described by King, it is “the creation of an independent central bank ‘legally committed to refuse the government’s demand for additional unsecured credit’ — in other words, there was to be no deficit financing via the printing of money.” Good idea, but how likely is this suggested scene in real life? The central bank says to the government, “Sorry about your request, but we’re not buying a penny of your debt with money we create. Of course, we could do it, but we won’t, so cut your expenses. Good luck!” Probably not a winning career move for a politically appointed central banker, and not a very likely response, we’ll all agree. 

Moreover, in time of war or other national emergency, the likelihood of this response is zero. War is the greatest source of money printing and inflation. War and central banking go way back together: the Bank of England was created in 1694 to finance King William’s wars, was a key prop of Great Britain’s subsequent imperial career, and in 1914, fraudulently supported the first bond issue of the war by His Majesty’s Treasury.i The Federal Reserve was the willing servant of the U.S. Treasury in both world wars and would be again, whenever needed. In the massive war-like government deficit financing of the 2020-2021 Covid crisis, the Fed cooperatively bought trillions in Treasury debt to finance the costs of governments’ closing down large segments of the economy. 

Reflecting on the enduring temptation of governments to inflate and depreciate their currencies, King rightly observes: 

• “Inflation is very much a political process.”  

• “Left to their own devices, governments cannot help but be tempted by inflation.” 

• “Governments can and will resort to inflation.” 

• “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” (Here he is quoting J.M. Keynes.) 

Just as economics is always political economics and finance is always political finance, central banking cannot avoid being political central banking. The book considers at length the inevitable interaction between government spending and debt, on one hand, and money creation and inflation, on the other—in economics lingo, between fiscal policy and monetary policy. In theory, there can be a firm barrier between them, the spending and taxing done in the legislative and executive branches; and the money printing, or not, in the control of the central bank. In practice, the two keep meeting and being intertwined. King calls this the “Burton-Taylor” problem. Here is his metaphor: 

“History offers countless examples in which fiscal expediency trumps monetary stability. The two big macroeconomic levers are the economic equivalent of Elizabeth Taylor and Richard Burton, the Hollywood stars who were married twice [and divorced twice] and who were, perhaps still in love when Burton died: occasionally separated but always destined to reconnect.”  

Indeed, governments’ desire for deficit spending and the ready tool of money printing and inflation are always destined to reconnect.  

This reflects the fundamental dilemma of all politicians: they naturally want to spend more money than they’ve got to carry out their schemes, including wars. As the book observes, “Wartime provides the ultimate proof of inflation’s useful role as a hidden tax.” Politicians want to keep their perhaps lavish promises to their constituencies, to reward their friends, to enhance their power, to get re-elected; they like much less making people unhappy by taxing them. The simple answer in every short term, is to borrow to finance the deficit and run up the government’s debt. When borrowing grows expensive or becomes unavailable, the idea of just printing up the money inevitably arises, the central bank is called upon, and yet another Burton-Taylor marriage occurs.  

Just printing up the desired money is a very old idea. As the book discusses, this frequently practiced, often disastrous old idea has been promoted anew—now under the silly name of “Modern” Monetary Theory. 

King writes: 

“The printing press is a temptation [I would say an inevitable temptation] precisely because it is an alternative to tax increases or spending cuts, a stealthy way in the short run of robbing people of their savings…. Ultimately, there is no escaping ‘Burton-Taylor.’” 

When governments and central banks yield to this temptation, can the central banks correctly anticipate the inflationary outcomes? Do they have the required superior knowledge? Clearly the answer is no. 

Chapter 6 of the book, “Four Inflationary Tests,” provides an instructive example of failed Bank of England inflation forecasts, to which I have added the actual outcomes, with the following results[ii]:

To apply an American metaphor to these British results, that is four strikeouts in a row. The inflation forecasting record of the Federal Reserve presents similar failures. 

Central banks try hard, including their large political and public relations efforts, to build up their credibility. They want to preside over a monetary system in which everybody believes in them. 

But suppose that everybody, including the members of Congress, instead of believing, developed a realistic understanding of central banks’ essential and unavoidable limitations. Suppose everybody simply assumed it is impossible for central banks to know the future or the future results of their own actions. Suppose, as King puts it, the whole society had “a new rule of thumb… ‘these central bankers don’t know what they’re doing.’” Rational expectations would then reflect this assumption. 

In that case, central banks would certainly be less prestigious. Would our overall monetary system be improved? I believe it would be. We Need to Talk About Inflation, among many other interesting ideas, encourages us to imagine such a scenario. 

A Monetary Reform Agenda for the GOP, Should It Win the Coming Election

Published in The New York Sun.

It’s been half a century since the collapse of the Bretton Woods gold exchange standard — how do we like the results?

This month will mark the 53rd anniversary of the radical move to a global monetary system of pure paper money.  This system is governed by the changing theories of central banks, especially by the theories of the Federal Reserve, the issuer of paper dollars for the world.

On August 15, 1971, President Nixon felt compelled to renege on the international commitment of the United States to redeem in gold dollars presented to our treasury by foreign governments, and all were forced to set sail on an uncharted sea of fiat currency.

How do we like the results? Since then, average U.S. consumer prices, as measured by the Consumer Price Index, have increased by 670 percent. In other words, the purchasing power of the dollar has fallen by 87 percent.

In terms of its gold value, before 1971 it took $35 to equal an ounce of gold, now it takes about $2,400, a depreciation of the dollar versus gold of more than 98 percent.  In terms of financial stability, there have been financial crises in every decade: the 1970s, 1980s, 1990s, 2000s, 2010s and 2020s.

It’s quite a record for the Nixonian monetary era. Yet the monetary powers granted to our government in the Constitution are granted to Congress, which must bear the ultimate blame for legislating the era of fiat money, meaning paper dollars that must be accepted because of a government fiat.

Suppose that following this year’s election, Republicans control both the administration and the Congress, and suppose they decide to move America to a sounder, Constitutional monetary regime.  Here are eight specific steps they could take.

• Reinforce in legislation the already existing statutory instruction to the Federal Reserve that it is supposed to pursue “stable prices.” This straightforward term has been warped by the Fed’s unilateral announcements that “stable prices” really means perpetual inflation. The Fed’s current theory is that average consumer prices should rise forever, at some rate that the Fed itself would set unilaterally.  Since 2012, the Fed has proclaimed that its “target” for this rate is 2 percent a year, but it believes it could target more inflation, if it decided to — again unilaterally.  

• Formally revoke the 2 percent inflation target proclaimed without congressional debate or approval.  Amend the Federal Reserve Act to make it clear that setting the value of money requires review and approval by Congress — that the Fed may propose, but not decide, the nature of the money the government provides to and imposes on the people.  The central bank is an operational, not an imperial, function.

• Congress should debate and decide what kind of “inflation target,” if any, is consistent with the stipulated goal of “stable prices.”  As a first step, it might set a target at “zero to 2 percent,” so there is no commitment to perpetual inflation.  Or it might specify a long-run average inflation rate of approximately zero, in the context that periods of high productivity growth reduce prices while increasing the standard of living.

• Allow gold-redeemable currencies to compete with the Fed’s paper dollar, consistent with the famous proposal of F. A. Hayek that people should be free to choose the money they prefer.  Hayek’s proposal has been an inspiration for cryptocurrency proponents, but he really hoped it would lead to a remonetization of gold by consumer choice.

• Establish in both the Financial Services Committee of the House and the Banking Committee of the Senate new Subcommittees on the Federal Reserve.  This is to develop the disciplined understanding of central banking issues needed to provide effective oversight of the Fed, its theories, its actions and its risks, which affect every citizen of the United States and every country in the world.  

• Reform the accounting practices of the Federal Reserve, by instructing it to follow GAAP in calculating the Federal Reserve Banks’ retained earnings and capital. The Fed should no longer be able to lose amounts vastly greater than its capital, as it has, and then hide the resulting negative capital. It should honestly report its capital position to the public. Then Congress should consider recapitalization of the Fed.

• Instruct the Fed that its investing in mortgage securities, which is by definition a credit allocation and a market distortion that increases house prices, can only be a temporary, emergency intervention. Specify that the Fed’s more than $2 trillion pile of mortgage securities must be reduced to zero over a reasonable time.

• Finally, Congress should expressly state that it does not suffer from the illusion that the Fed has any special ability to know the future, and that the Fed’s urge to unilateral discretion must be subject to constitutional checks and balances.

Event video: Thirteenth Transatlantic Law Forum

Hosted by Law & Economics Center at GMU Scalia Law in June 2024.

Finance can flow across jurisdictions in multilevel markets much more easily than goods, most services, or labor. Its structure, costs and distribution of gains are more fully organized by law and regulation than perhaps any other part of the economy. The legal and political idiosyncracies of the U.S. and EU have both produced complex mixes—arguably messes—of erratic financial integration. American markets feature omnipresent “too big to fail” kingpins, community lenders and insurance firms under 50 different regulators, and often-struggling regional banks between them. Europe’s mix is messier: cross-border “passporting” rules and partly-integrated supervision without centralized deposit insurance have unleashed cross-border activity for some financial services, but barely touched areas like retail banking. Are rationalizations on either side imaginable, and how would they relate to each other?

• Kathryn Judge, Harvey J. Goldschmid Professor of Law and Vice Dean for Intellectual Life, Columbia Law School

• Niamh Moloney, Professor, London School of Economics and Political Science

• Paolo Saguato, Professor of Law, George Mason University Antonin Scalia Law School

• David Zaring, Elizabeth F. Putzel Professor and Professor of Legal Studies & Business Ethics, University of Pennsylvania Wharton College of Business

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

Without Chevron, the Fed has crucial questions to address

Published with Paul H. Kupiec in The Hill.

On June 28, the Supreme Court overturned the Chevron Doctrine, which previously allowed unelected government bureaucracies to interpret their governing statutes to stretch and expand their agencies’ powers.

Now, unless regulatory powers are explicit in law, federal agencies’ interpretations of their authority will no longer be given deference by the courts when challenged. Congress should remove legislative ambiguities or risk the uncertainty of potential judicial challenges to Federal Reserve powers.

The Federal Reserve is the most powerful unelected body in the country. What could the demise of the Chevron Doctrine mean for the Fed?

When Sen. Jack Reed (D-R.I.) posed this question during the Fed’s recent semiannual congressional testimony, Chairman Jerome Powell said the Fed was “very focused on reading the actual letter and intent of the law and following it very carefully,” calling the practice “a strong intuitional value that we have.”

“Those are brand-new decisions that just came down, and we are in the process of studying them,” Powell said.

Considering the Fed’s history of expanding its powers using creative interpretations of its authorizing legislation, Powell’s answer made us chuckle. The demise of the Chevron Doctrine gives the Fed’s legal eagles lots to ponder.

First, consider the all-important issue of preserving the value of the dollar. In the Federal Reserve Act, Congress instructed the Fed to pursue “stable prices” — a self-evidently clear direction. The Fed, with no congressional debate or approval, reinterpreted its congressional assignment as a duty to promote inflation at the rate of 2 percent per year forever.

Thus, the Fed, without any change in its congressional remit, construed “stable prices” to mean quintupling prices — reducing the dollar’s purchasing power by 80 percent — over an 80-year lifetime.

Stable prices? George Orwell may still be alive, well and working at the Federal Reserve Board.

While obfuscation of the term “stable prices” may be the most consequential example of the Fed’s failure to abide by the letter of the authorizing legislation, it is by no means unique. Consider the Federal Reserve Board’s decision to design its own disingenuous accounting standards to hide the fact that the combined Fed system losses — $183 billion since September 2022 — have consumed all of the system’s capital, and then some.

The Federal Reserve Act also requires the Fed to publish informative financial statements of the Federal Reserve Banks. While the Fed reports losses, it does not subtract losses from its retained earnings, as any bank it regulates must and as standard accounting rules require.

Instead, astonishingly, the Fed classifies its losses as an asset. It books its losses as the opaquely titled “Deferred asset — remittances to the Treasury.” This dubious accounting allows the Fed to report its capital as positive $43 billion when using standard accounting rules, its capital is negative $140 billion. We have been unable to find the law that authorizes the Fed to create a new accounting standard.

Next, consider the Federal Reserve Board’s decision to continue paying the expenses of the Consumer Financial Protection Bureau (CFPB) notwithstanding the fact that the Fed’s payments to the CFPB have been violating the funding provision of the Dodd-Frank Act since September 2022.

The Dodd-Frank Act created the CFPB and provides for its funding. The act does not classify the CFPB’s funding as a Federal Reserve Board expense, but instead, directs that the CFPB be funded out of the Federal Reserve system’s earnings.

The Dodd-Frank Act requires the board of governors to “transfer to the bureau from the combined earnings of the Federal Reserve System, the amount determined by the director to be reasonably necessary.”

Congress could have made CFPB expenses an explicit expense of the Federal Reserve Board and instructed the Fed to pay the CFPB’s expenses using Federal Reserve Act authority whether the Fed had any earnings or not. But it didn’t.

In May, the Supreme Court affirmed the constitutionality of using Fed earnings that otherwise would have been transferred to the Treasury to pay the CFPB’s expenses. This decision did not consider whether it was legal for the Fed to transfer money to fund the CFPB when the Fed has had no combined earnings.

Under a clear reading of the Dodd-Frank Act and the Supreme Court’s recent decision, when the Fed has no earnings, it has no earnings to transfer to the CFPB, just as it has no earnings to send to the Treasury.

The Fed has not offered any legal defense for continuing to pay the CFPB’s expenses. It owes one to Congress and the public.

Other policy questions arise in the post-Chevron world. These include the authority to take on massive balance sheet risk without approval from Congress — a risk that has generated more than a trillion dollars of unrealized market value Fed losses, engineering international agreements governing domestic bank capital and credit regulations that are, in all but name, treaties that should require Senate approval and actively embracing executive branch climate change policies without explicit congressional authority.

The demise of the Chevron Doctrine creates new uncertainty regarding Federal Reserve powers not clearly enumerated in current law. Unless Congress preemptively addresses legislative ambiguities, the economy will face the risks associated with the uncertain outcomes of potential judicial challenges to Federal Reserve powers.

Newsletter: An update from William Isaac

Published in a newsletter by Secura Isaac:

Weekend Reading

Aug 2

….

My friend Alex Pollock published an important column in the New York Sun titled "The Federal Reserve Lacks the ‘Earnings’ With Which Legally To Fund the Consumer Financial Protection Bureau."

Letter: Who do you think had the biggest US bond expos­ure?

Published in the Financial Times.

“Long-dated bonds are still a dan­ger­ous place to be right now,” an investor in hedge funds is quoted as warn­ing in the report by Kate Duguid and Cos­tas Mour­selas “Hedge funds revive ‘Trump trade’ in bet on US bonds” (Report, July 19).

I would say he is right.

So who would you guess has the biggest naked risk pos­i­tion in very long-dated US bonds and mort­gage-­backed secur­it­ies, super-lever­aged, fun­ded short, and unhedged? None other than the lead­ing cent­ral bank in the world — the US Fed­eral Reserve.

As of July 17, the Fed owns — exclud­ing its pos­i­tion in short-term Treas­ury bills — the vast sum of over $6tn in Treas­ury notes and bonds and very long mort­gage-backed secur­it­ies. Of this sum, $3.8tn still has more than 10 years left to matur­ity, accord­ing to the Fed’s own report.

The Fed had a mark-to-mar­ket loss of over $1tn on its invest­ments in its most recent quarterly state­ment (March 31), against its repor­ted total cap­ital of $43bn. Quite a not­able example of asset-liab­il­ity man­age­ment!

Alex J Pol­lock

Senior Fel­low, Mises Insti­tute, Lake Forest, IL, US

The Federal Reserve Lacks the ‘Earnings’ With Which Legally To Fund the Consumer Financial Protection Bureau

The central bank is in circumstances that the authors of Dodd-Frank failed to anticipate — it’s been operating at a loss.

Published in the New York Sun.

The Federal Reserve cannot legally fund the Consumer Financial Protection Bureau now, because the Fed has no earnings and no retained earnings.

The Supreme Court may have recently affirmed the constitutionality of the bureau’s statutory funding provision “allowing the Bureau to draw money from the earnings of the Federal Reserve System,” as the Court wrote. That, though, does not change the fact that since there are no earnings, there is nothing from which to draw.

The Dodd-Frank Act provides: that each year “the Board of Governors shall transfer to the Bureau from the combined earnings of the Federal Reserve System” the amount determined by the bureau’s director “to be reasonably necessary….” The emphasis was added by the Sun.

The fatal fact for the CFPB is that the Dodd-Frank Act funds the bureau only from the Fed’s combined earnings. The problem is that currently there are no such earnings and instead the Fed is suffering spectacular losses. The combined Federal Reserve has reported losses so far this year at the remarkable average rate of about $7.8 billion per month and has not had a penny of earnings since September 2022.

It has instead accumulated the hitherto inconceivable deficit of $179 billion in operating losses. These losses have wiped out the Fed’s retained earnings of a mere $6.8 billion, leaving real retained earnings of a negative $173 billion, not to mention having also wiped out the Fed’s total paid-in capital of only $37 billion.

The Democratic majority that passed Dodd-Frank on a party line vote in 2010, knowing that it was likely to lose the congressional elections of later that year — as it did — longed to evade having its legislative child, the CFPB, disciplined by the power of the purse of a future Congress.

So it decided to find a way to exempt it from needing any future congressional appropriations. The then-majority’s trick to achieve this was to provide in the statute that the CFPB would get a share of the Federal Reserve’s earnings each year, instead of having to get appropriations from the Congress.

At that point, it was easy to assume that the Fed would always have earnings into which the CFPB could dip. The Fed had been profitable for almost a century. Who in 2010 expected that the Fed would ever show a loss of $179 billion? Nobody at all. Yet the losses continue to mount up.

The Federal Reserve properly stopped sending distributions to the American Treasury in September 2022 because it had no earnings to distribute. It should have stopped sending payments to the CFPB at the same time for the same reason. The Fed is not authorized to send nonexistent earnings to the CFPB or the Treasury.

Under standard accounting principles, the Fed has negative retained earnings, negative capital, and is technically insolvent. For going on two years, it has been borrowing, principally in the form of unsecured deposits in the Federal Reserve Banks, to pay the CFPB’s expenses, thereby making its own retained earnings and capital more and more negative. These payments to the CFPB have not been and are not drawn from earnings.

With the arrival of gargantuan Federal Reserve losses instead of earnings, we have conditions that the authors of the Dodd-Frank Act never thought would happen. Yet they wrote what they wrote, and they voted it in, so now Fed payments to the CFPB violate Dodd Frank. As long as the Fed continues to suffer operating losses, there is no legitimate funding for the CFPB from the Fed. Indeed, the CFPB’s funding has not been legitimate since September 2022.

The logical thing is for the CFPB to figure out how to ask Congress for appropriations and for Congress to be demanding that without appropriations there can be no spending by the CFPB. This would bring about a proper separation of government powers, now that the cleverness of the Dodd-Frank authors confronts an unexpected reality.

Examining the New Debate on CFPB Funding

Published in Patomak Global Partners.

To generalize, one side, led by Hal Scott, Alan Kaplinsky, Alex Pollock and Paul Kupiec, offers a relatively narrower construction of the term that means something like “net income” or “profits,” while the other side led by Adam Levitin and Jeff Sovern, offers a relative broader construction that means something like “any income.” The correct construction of the term appears material to CFPB operations, with the narrower construction perhaps prohibiting transfers from the Board of Governors under present circumstances, whereas the broader construction permits them. The debate has now advanced past the theoretical, with Director Chopra fielding questions about the meaning of the term in Congressional hearings last month. This post does not presume to resolve the debate today, but instead seeks to offer additional context that may be relevant to continued scholarship.

Conservatives set the stage for another CFPB funding fight

Published in The Hill.

Alex Pollock, a senior fellow at the right-leaning Mises Institute, suggested that the Dodd-Frank Act blocked a future Congress from “disciplining” the agency with “the power of the purse” by granting it a share of the Fed’s earnings. 

“With inescapable logic, however, that depends on there being some earnings to share in,” Pollock wrote in a post on the blog run by the Federalist Society, a conservative legal group. 

Podcast: Consumer Financial Protection Bureau Wins in Supreme Court But Can the Fed Continue to Fund the CFPB Without Earnings?

Published by Ballard Spahr. Also in JD SUPRA,

Special guest Alex J. Pollock, Senior Fellow with the Mises Institute and former Principal Deputy Director of the Office of Financial Research in the U.S. Treasury Department, joins us to discuss his recent blog post published on The Federalist Society website in which he urges Congress to look into the question of whether the Federal Reserve can lawfully continue to fund the CFPB if (as now) the Fed has no earnings. We begin with a review of the Supreme Court’s recent decision in CFSA v. CFPB which held that the CFPB’s funding mechanism does not violate the Appropriations Clause of the U.S. Constitution. Alex follows with an explanation of the CFPB’s statutory funding mechanism as established by the Dodd-Frank Act, which provides that the CFPB is to be funded from the Federal Reserve System’s earnings. Then Alex discusses the Fed’s recent financial statements and their use of non-standard accounting, the source of the Fed’s losses, whether Congress when writing Dodd-Frank considered the impact of Fed losses on the CFPB’s funding, and how the Fed can return to profitability. We conclude the episode by responding to arguments made by observers as to why the Fed’s current losses do not prevent its continued funding of the CFPB, potential remedies if the CFPB has been unlawfully funded by the Fed, and the bill introduced in Congress to clarify the statutory language regarding the CFPB’s funding.

Alan Kaplinsky, Senior Counsel in Ballard Spahr’s Consumer Financial Services Group, hosts the conversation.

Alex’s blog post, "The Fed Has No Earnings to Send to the CFPB," can be found here.

Who’s got the mortgage credit risk?

Published in Housing Finance International Journal:

The government-centric U.S. system

I have long thought that for any housing finance system which decides to make 30-year fixed rate loans, the Danish mortgage system has created the best division of the main component risks: credit risk and interest rate risk (which includes prepayment risk). The Danish system has a far better division of risk bearing than the government-dominated, taxpayers-at-risk U.S. system.

This was made strikingly clear to me in the year 2000, when thanks to the International Union for Housing Finance (of which I was then the President), I participated in a meeting in Copenhagen in which the Danish mortgage banks presented their covered bond system, and I presented the Fannie Mae and Freddie Mac-based American mortgagebacked securities (MBS) system. I explained how these so-called “GSEs” or “government-sponsored enterprises” worked, how they were the dominant powers in the huge U.S. mortgage market, and how they protected their government-granted financial power with impressive political clout.

At the conclusion of our discussion, the CEO of one of the large Danish mortgage lenders made this unforgettable observation:

“You know, we always say that here in Denmark we are the socialists, and that America is the land of free markets. But now I see that in mortgages, it is exactly the opposite!”

He was so right, especially with respect to American mortgage credit risk, which had become, and still is, heavily concentrated in Fannie and Freddie and thus in Washington DC.

A fundamental characteristic of the American MBS system is that the bank or other lender that makes a mortgage loan quickly sells it to Fannie or Freddie and divests the credit risk generated by its own customer, its own credit judgment, and its own loan. The loan with all its credit risk moves to Fannie or Freddie, totally away from the actual lender which dealt with the borrower. To compensate Fannie and Freddie for taking over the credit risk, the lender must pay them a monthly fee for the life of the loan, which for a prudent and skillful lender, is many times the expected loss rate on the mortgage credit.

Why would the actual lender do this, especially if it believes in its own credit judgment? In America, it does so because it wishes to get the loan financed in the bond market, so it can escape the interest rate risk of a 30-year fixed rate, prepayable, loan.

But the two risks do not necessarily need to be kept together – to divest the interest rate risk you do not in principle need to divest the credit risk, too. The brilliance of the Danish housing finance system is that it gets 100% of the of the interest rate risk of the 30-year fixed rate, prepayable loan financed in the bond market, but the original mortgage lender retains 100% of the credit risk for the life of the loan and gets a fee for doing so. The interest rate risk is divested to bond investors; the credit risk and related income stays with the original private lender. This division of risks, in my judgment, is clearly superior to that of the American system, and results in a far better alignment of incentives to make good loans in the first place

After our most interesting symposium in Denmark, how did the MBS system of the U.S. work out? The risk chickens come home to roost in the US. Treasury. In 2008, both Fannie and Freddie failed from billions in bad loans. They both were bailed out by the Treasury, as being far “too big to fail.” All their creditors, including subordinated debt holders, were fully protected by the bailout, although the stockholders lost 99% from the share price top to the bottom. Fannie and Freddie were both forced into a government conservatorship, which means a government agency is both regulator and exercises all the authority of the board of directors. They became owned principally by the government through the Treasury’s purchase of $190 billion in preferred stock. In addition, the Treasury obtained an option to acquire 79.9% of their common stock for a tiny fraction of one cent per share.

In short, from government-sponsored enterprises, Fannie and Freddie were made into government-owned and government-controlled enterprises (so I call them “GOGCEs”). So they remain in 2024. The government likes having total control of them in political hands, the Treasury likes the profits it currently receives as the majority owner, and no change is anywhere in sight.

While having become part of the government, Fannie and Freddie have maintained their central and dominant role in the U.S. housing finance system. The actual lenders are still divesting the credit risk of their own loans to the GOGCEs. Mortgage credit risk is still concentrated in Washington DC. My mortgage market contacts tell me that Fannie and Freddie’s old arrogance has returned. The two at the end of 2023 represented the remarkable sum of $6.9 trillion of residential mortgage credit risk.

To this huge number, to see the full extent of the U.S. government’s domination of mortgage credit risk, we have to add in Ginnie Mae. Ginnie is a 100% governmentowned corporation, which guarantees MBS formed from the loans of the U.S. government’s official subprime lender, the Federal Housing Administration, and of the Veterans Administration. It guarantees $2.5 trillion in mortgage loans.

Thus, in total, Fannie, Freddie and Ginnie represent about $9.4 trillion or 67% of the $14 trillion total U.S. residential mortgages outstanding. Two-thirds of the mortgage credit risk is ultimately a risk for the taxpayers. In Denmark, in notable contrast, all the credit risk of the mortgage bond market is held by the private mortgage banks.

Can it make any sense to have two-thirds of the entire mortgage credit risk of the country guaranteed by the government and the taxpayers? No, it can’t. The GOGCE-based MBS system can only result in political pressures to weaken credit standards and in excess house price inflation. This is not the system or the risk distribution the U.S. should have, but it is politically hard to get out of it.

The current U.S. MBS system is, I believe, the path-dependent result of the anomalous evolution of American housing finance in the wake of the 1980s collapse of the old savings and loans, combined with the lobbying force of the complex of housingrelated industries. Danish housing finance has superior risk principles, but we in America are unfortunately stuck with our government-centric system.

Event: Mises Supporters Summit 2024

Hosted by the Mises Institute.

Get ready for an extraordinary experience at the 2024 Supporters Summit featuring Lew Rockwell, Tom DiLorenzo, and special guest Tom Luongo. The Summit will take place October 10–12, 2024, at the lovely Omni Hilton Head Oceanfront Resort on the stunning Hilton Head Island.

The theme of this year’s Supporters Summit is “Our Enemy, the State.” Perhaps no institution dominates modern life more than the state, which for centuries has tolerated no competition, whether from families, churches, or local communities. Rather, the state demands total obedience and monopolistic power. Few other institutions have so thoroughly succeeded in achieving this in all of human history.

Mises Institute faculty and scholars will explore the nature, history, and consequences of the state, and how the state has sought to control every aspect of daily life through control of money, education, markets, and more. 

Event Highlights:

• Thursday, October 10: Kick off with a welcoming reception and registration.

• Friday, October 11: Engage in speaker and scholar presentations, enjoy a catered lunch, and wrap up the day with a low country boil dinner and social hour, featuring the debut of our new documentary about the Federal Reserve.

• Saturday, October 12: Gather for more presentations with our speakers and scholars, culminating in a dinner and keynote lecture from Tom Luongo.

Featured Guests:

Lew Rockwell, Tom DiLorenzo, Tom Luongo, Joe Salerno, Guido Hülsmann, Tom Woods, Bob Murphy, Jeff Herbener, Peter Klein, Alex Pollock, Timothy Terrell, Per Bylund, Patrick Newman, Mark Thornton, Shawn Ritenour, Jonathan Newman, Wanjiru Njoya, William Poole, and more.

Register here.

Causes of the Great Depression

Published in Law & Liberty.

About every ten years or so, financial crises spoil economic hopes and many best-laid plans. As scary as they are while happening, like everything else, in time, they tend to fade from memory. For example, can you recall the remarkable number of US depository institutions that failed in the crisis of the 1980s? (The correct answer: More than 2,800!)

The weakness of financial memory is one reason for recurring over-optimism, financial fragility, and new crises. But the Great Depression of the 1930s is an exception. It was such a searing experience that it retains its hold on economic thought almost a century after it began and more than 90 years after its US trough in 1933. That year featured the temporary shutdown of the entire US banking system and an unemployment rate as high as 24.9 percent. More than 9,000 US banks failed from 1929–33. Huge numbers of home and farm mortgages were in default, and 37 cities and three states defaulted on their debt. How could all this happen? That is still an essential question, with competing answers.

This collection of Ben Bernanke’s scholarly articles on the economics of the Depression was originally published in 2000. That was two years before he became a Governor on the Federal Reserve Board, and seven years before, as Federal Reserve Chairman, he played a starring world role in the Great (or Global) Financial Crisis of 2007–09 and its aftermath, always cited as “the worst financial crisis since the Great Depression.”

Bernanke’s Essays on the Great Depression has now been republished, with the addition of his Lecture, “Banking, Credit and Economic Fluctuations,” delivered upon winning the Nobel Prize in Economics in 2022. They make an interesting, if dense and academic, read.

“To understand the Great Depression is the Holy Grail of macroeconomics,” is the first line of the first article of this collection. “Not only did the Depression give birth to macroeconomics as a distinct field of study, but … the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.” Indeed it does.

Bernanke points out that “no account of the Great Depression would be complete without an explanation of the worldwide nature of the event.” As one example of this, we may note that Germany was then the second largest economy in the world, and “the collapse of the biggest German banks in July 1931 represents an essential element in the history,” as a study of that year relates. Germany was at the center of ongoing disputes about the attempted financial settlements of the Great War (or as we say, World War I). Widespread defaults on the intergovernmental debts resulting from the war also marked the early 1930s.

“What produced the world depression of 1929 and why was it so widespread, so deep, so long?” similarly asked the eminent financial historian, Charles Kindleberger. “Was it caused by real or monetary factors?” Was it “a consequence of deliberate and misguided monetary policy on the part of the US Federal Reserve Board, or were its origins complex and international, involving both financial and real factors?”

“Explaining the depth, persistence, and global scope of the Great Depression,” Bernanke reflects in his 2022 Lecture, “continues to challenge macroeconomists.” Although he concludes that “much progress has been made,” still, after nearly a century, things remain debatable. This calls into question how much science there is in economics looking backward, just as the poor record of economic forecasting questions whether there is much science in its attempts to look forward.

In economics, it seems, we can’t know the future, we are confused by the present, and we can’t agree on the past. Those living during the Depression were confused by their situation, just as we are now by ours. As Bernanke writes, “The evidence overall supports the view that the deflation was largely unanticipated, and indeed that forecasters and businesspeople in the early 1930s remained optimistic that recovery and the end of deflation were imminent.”

In Lessons from the Great Depression, a 1989 book that Bernanke often references, Peter Temin provides this wise perspective: “We therefore should be humble in our approach to macroeconomic policy. The economic authorities of the late 1920s had no doubt that their model of the economy was correct”—as they headed into deep disaster. “It is not given to us to know how future generations will understand the economic relations that govern how we live. We should strive to be open to alternative interpretations.”

Bernanke considers at length two alternative causes of the Depression and through his work adds a third.

The first is the famous Monetarist explanation of Federal Reserve culpability, referred to by Kindleberger, derived from the celebrated Monetary History of the United States by Milton Friedman and Anna Schwartz. Friedman and Schwartz, writes Bernanke, “saw the response of the Federal Reserve as perverse, or at least inadequate. In their view, the Fed could have ameliorated the deflationary pressures of the early 1930s through sustained monetary expansion but chose not to.” About this theory, Bernanke says, “I find it persuasive in many respects.” However, “it is difficult to defend the strict monetarist view that declines in the money stock were the only reason for the Depression, although … monetary forces were a contributing factor.” It seems eminently reasonable that multiple causes were at work to cause such a stupendously disastrous outcome.

“The Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

A second approach takes as central to the depth of the Depression the effects of governments’ clinging too long to the Gold Exchange Standard. That was the revised version of the gold standard that was put together in the 1920s as the world tried to return to something like the pre-Great War monetary system, which previously had accompanied such impressive advances in economic growth and prosperity. The Classic Gold Standard was destroyed by the Great War, as governments bankrupted themselves, then printed the money to spend on the war’s vast destruction and set off the rampant inflations and hyper-inflations that followed.

After the inflations, there was no simple going back to the monetary status quo ante bellum. However, “the gold standard [was] laboriously reconstructed after the war,” Bernanke relates, referring to the Gold Exchange Standard. “By 1929 the gold standard was virtually universal among market economies. … The reconstruction of the gold standard was hailed as a major diplomatic achievement, an essential step toward restoring monetary and financial conditions—which were turbulent during the 1920s—to … relative tranquility.”

Financial history is full of ironies. Here we had a “major diplomatic achievement” in global finance by intelligent and well-intentioned experts. But “instead of a new era of tranquility,” Bernanke tells us, “by 1931 financial panics and exchange rate crises were rampant, and a majority of countries left gold in that year. A complete collapse of the system occurred in 1936.” The United States left the gold standard in 1933.

Bernanke highlights the comparative studies of countries during the 1930s which found a notable pattern of “clear divergence”: “the gold standard countries suffered substantially more severe contractions,” and “countries leaving gold recovered substantially more rapidly and vigorously than those who did not,” and “the defense of gold standard parities added to the deflationary pressure.” Thus, he concludes, “the evidence that monetary shocks played a major role in the Great Contraction, and that these shocks were transmitted around the world primarily through the working of the gold standard, is quite compelling.” 

So far, we have an explanatory mix of the behavior of central banks faced with huge shocks in the context of the revised Gold Exchange Standard in the aftermath of the runaway inflations stemming from the Great War.

In addition, Bernanke’s own work emphasizes the role of credit contractions, not just monetary contractions, with a focus on “the disruptive effect of deflation on the financial system”—or in macroeconomic terms, “an important role for financial crises—particularly banking panics—in explaining the link between falling prices and falling output.” Bernanke provides a depressing list of banking crises around the world from 1921 to 1936. This list is nearly four pages long.

Bernanke concludes that “banking panics had an independent macroeconomic effect” and that “stressed credit markets helped drive declines in output and employment during the Depression.” This seems easily believable.

Bernanke’s articles also address employment during the Depression. Although economic conditions significantly improved after 1933, unemployment remained remarkably, perhaps amazingly, high. Continuing through all of the 1930s, it was far worse than in any of the US financial and economic crises since. At the end of 1939, US unemployment was 17.2 percent. At the end of 1940, after two full presidential terms for Franklin Roosevelt and the New Deal, unemployment was still 14.6 percent. Very high unemployment lasted a very long time.

The Depression-era interventions of both the Hoover and the Roosevelt administrations focused on maintaining high real wages. As Bernanke writes, “The New Deal era was a period of general economic growth, set back only by the 1937–38 recession. This economic growth occurred simultaneously with a real wage “push” engineered in part by the government and the unions.” But “how can these two developments be consistent?” Well, economic growth from a low level with a government push for high real wages was accompanied by high and continued unemployment. That doesn’t seem like a surprise.

The New Deal real wage push continued what had begun with President Hoover. The Austrian School economist, Murray Rothbard, says of Hoover in the early Depression years, “No one could accuse him of being slack in inaugurating the vast interventionist program.” He quotes Hoover’s statement in 1932 that wage rates “were maintained until the cost of living had decreased and profits had practically vanished. They are now the highest real wages in the world.” Rothbard rhetorically asks, as we might ask of the 1930s in general, “But was there any causal link between this fact and the highest unemployment rate in American history?” As Temin observes about the 1930s, “the Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

Turning to a more general perspective on the source of the Depression, Rothbard observes that “many writers have seen the roots of the Great Depression in the inflation of World War I and of the postwar years.”

Yet more broadly, it has long seemed to me that in addition to the interconnected monetary and credit problems carefully explored in Bernanke’s book, the most fundamental source of the Depression was the Great War itself, and the immense shocks of all kinds created by the destruction it wreaked—destruction of life, of wealth, in economics, in finance, of the Classic Gold Standard, of currencies, in the creation of immense and unpayable debts, and the destruction of political and social structures, of morale, of pre-1914 European civilization.

As Temin asks and answers, “What was the shock that set the system in motion? The shock, I want to argue, was the First World War.”

And giving Bernanke’s Nobel Prize Lecture the last word, “In the case of the Depression, the ultimate source of the losses was the economic and financial damage caused by World War I.” 

Can the Fed Fund the CFPB?

Published with Paul Kupiec in Law & Liberty also published in AEI.

The Consumer Financial Protection Bureau (CFPB) has been a source of controversy since its creation. Critics of the agency have long argued that its independent status is unconstitutional. In a recent decision, however, the Supreme Court affirmed the constitutionality of the CFPB’s funding scheme, even though it circumvents the normal Congressional appropriation process by “allowing the Bureau to draw money from the earnings of the Federal Reserve System.”

This decision belies the Fed’s current financial condition and conflicts with provisions in the Federal Reserve Act. The fact of the matter is that the Fed no longer has any earnings. It currently has huge cash operating losses and must borrow to fund both the Fed’s and the CFPB’s operations. When it is not literally printing dollars to pay these bills, the Fed is borrowing on behalf of the system’s 12 privately owned Federal Reserve district banks—not the federal government. These borrowings are not federally guaranteed. More problematic still is that nine of the 12 Federal Reserve district banks (FRBs) are technically insolvent, as is the Fed System as a whole.

The CFPB’s unique funding structure comes from provisions in the 2010 Dodd-Frank Act. Essentially, it requires that the Fed transfers funds to the CFPB without oversight from the congressional Appropriations Committees. In its 7-2 decision, the Supreme Court upheld these provisions and found that the funding apparatus “constitutes an ‘Appropriatio[n] made by Law’” because it is “drawn from the Treasury.”

One unfortunate bug in the Court’s opinion is that, since the Federal Reserve is currently making losses, there are no Federal Reserve System earnings for the CFPB to draw upon. The system has lost a staggering sum of $170 billion since September 2022, and continues to accumulate more than $1 billion in operating losses each week. Under standard accounting rules, it has negative capital and is technically insolvent. The Fed stopped sending distributions of its earnings to the US Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments to the CFPB at the same time for the same reason.

The second problem with the Court’s decision is that, unless the CFPB draws all its expenses from the Federal Reserve in the form of Federal Reserve Notes, the transferred monies are neither “public money” nor “drawn from the Treasury.” This is the law of the land as codified in the Federal Reserve Act.

When the Federal Reserve posts an operating loss, it must rebalance its accounts. It can do this by (1) selling assets or using the proceeds from maturing assets to cover the loss; (2) reducing its retained earnings, or if there are no retained earnings, reducing its paid in equity capital; or (3) issuing new liabilities. Regardless of how it chooses to rebalance its books, each new dollar of Fed operating loss or dollar spent funding the CFPB causes the Fed’s liabilities to increase relative to its assets, and, under standard accounting rules, the Fed’s liabilities are already greater than its assets.

Because of interest rate increases, the true market value of the Fed’s assets is far less than their book value—a shortfall of about $1 trillion. The Fed has stated that it will hold these assets to maturity to avoid realizing these mark-value losses. Meanwhile, the Fed’s $170 billion in accumulated cash operating losses have already fully exhausted the Fed’s retained earnings and paid in equity capital, so now the Fed must borrow to balance its accounts.

The Fed has three ways it can borrow to pay for the CFPB or new Fed operating losses. It can: (1) issue new Federal Reserve Notes; (2) borrow by increasing deposits at Federal Reserve district banks; or, (3) borrow from financial markets using reverse repurchase agreements. Of these three ways the Fed borrows, only Federal Reserve Notes are explicitly guaranteed by the full faith and credit of the US government and can be considered “public money drawn from the Treasury.” 

According to the Federal Reserve system’s 2023 audited financial statements:

Federal Reserve notes are the circulating currency of the United States. These notes, which are identified as issued to a specific Reserve Bank, must be fully collateralized. …The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize outstanding Federal Reserve notes. … In the event that this collateral is insufficient, the FRA provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks. Finally, Federal Reserve notes are obligations of the United States government.

The Federal Reserve Act does not grant the Fed unlimited authority to print new paper currency to cover its losses or fund CFPB operations. As of May 22, the Fed’s H.4.1 report shows that it owned less than $7.3 trillion in assets but had more than $7.4 trillion in liabilities issued to external creditors, including $2.3 trillion in Federal Reserve Notes. After collateralizing its outstanding currency, the system has $5 trillion in remaining assets, but more than $5.1 trillion in outstanding liabilities other than Federal Reserve Notes. The system as a whole has more than $127 billion in external liabilities that cannot be legally turned into Federal Reserve Notes.

To the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes, the CFPB is not being funded by “public money drawn from the Treasury.”

Under the Federal Reserve Act, about $5 trillion of Federal Reserve System’s current external liabilities are not backed by the federal government but only by the creditworthiness of the 12 FRBs. But nine, including all of the largest FRBs, have negative capital when measured using generally accepted accounting standards. With about $1 trillion in unrecognized market value losses on their securities, the true financial condition of the 12 FRBs is far weaker than their accounting capital suggests. And to make matters worse, only three of the 12 FRBs have enough collateral to redeem all of their external liabilities by printing new paper currency, which is the only federally guaranteed liability FRBs issue.

In addition, the largest funding source for the Fed, deposits in FRBs, are not explicitly collateralized or guaranteed by the federal government. FRB deposits are only protected by the value of FRB assets that are not otherwise pledged. Although the Fed’s depositors may believe they have an “implicit Treasury guarantee” in the same way that Freddie Mac and Fannie Mae bondholders believed that their bonds were guaranteed by the US Treasury, the Federal Reserve Act does not include a federal government guarantee for FRB deposits.

Fed deposits are meant to be protected by FRB paid-in capital and surplus, but that has been fully consumed by the operating losses in nine of 12 FRBs; and also protected in law (but not in practice) by a callable capital commitment and a “double liability” call on member bank resources that is an explicit FRB shareholder responsibility under the Federal Reserve Act. In other words, member banks as FRB shareholders, are legally responsible for some part of any loss incurred by the FRB’s unsecured liability holders, most importantly FRB depositors.

But notwithstanding large operating losses that have completely consumed the capital of most FRBs, the Federal Reserve Board has never utilized its powers under the Federal Reserve Act to increase the capital contributions of member banks or invoke member bank loss-sharing obligations. Indeed, all FRBs, even the most technically insolvent FRB, New York, continue to pay member banks dividends on their FRB shares, as well as make payments to the CFPB from nonexistent earnings. 

If, in the highly unlikely event that FRB member banks were called upon to inject additional capital into their FRB to cover Fed operating losses and CFPB expenses, these monies would clearly not be public monies drawn from the Treasury. Yet, under the Supreme Court’s ruling, the cash proceeds of the call on FRB member banks would be shipped over to pay the expenses of the CFPB. This fact alone seems to contradict the logic of the Supreme Court’s majority decision.

In sum, the Supreme Court’s recent ruling notwithstanding, the CFPB’s funding mechanism currently conflicts with the clear language of both the Dodd-Frank Act and Federal Reserve Act. As long as the Fed continues to suffer operating losses, the CFPB is not being funded with Federal Reserve earnings, and to the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes—and it is not—the CFPB is not being funded by “public money drawn from the Treasury.”

Fed Losses May Sour CFPB’s Supreme Court Win

Published in Inside Mortgage Finance:

“Because of the losses, the Fed stopped sending its surplus to the Treasury Department, and it should have done the same for the CFPB, Alex Pollock…”

It’s the Fed That’s a Risk to Financial Stability

Published in The New York Sun and The Mises Institute.

Central bankers whistle ‘Dixie’ as mark-to-market losses dramatically shrink the banking system’s economic capital.

Whistling a happy tune, the Federal Reserve vice chairman for supervision, Michael Barr, recently testified to Congress that “overall, the banking system remains sound and resilient.” A more candid view of the risks would be less sanguine.  

Mr. Barr reported that banking “capital ratios increased throughout 2023.” He failed, though, to discuss the mark-to-market losses that have dramatically shrunk the banking system’s economic capital and capital ratios.

A recent study of American banks, including analyses of both their securities and fixed rate loans, estimates that the banking system has at least a $1 trillion mark-to-market loss resulting from the move to normalized interest rates.

Since that loss is equal to half of the banks’ approximately $2 trillion in book value of tangible equity, their aggregate real capital has dropped by about 50 percent. This is just in time for them to be confronted with large potential losses from that classic source of banking busts, commercial real estate, as the prices of many buildings are falling vertiginously.

Given his current position, Mr. Barr could not be expected to mention another particularly large and inescapable threat to financial stability, that from the Federal Reserve itself.  As central bank not only to the United States, but to the dollar-using world, the Fed combines great power with an inevitable lack of knowledge, and its actions are a fundamental source of financial instability.

When the Federal Reserve was created, the secretary of the treasury at the time, William Gibbs McAdoo, proclaimed that the Fed would “give such stability to the banking business that extreme fluctuations in interest rates and available credits… will be destroyed permanently.” A remarkably bad prediction.

Instead, throughout the life of the Fed, the financial system has suffered recurring financial crises and Fed mistakes. Mistakes by the Fed are inevitable because the Fed is always faced with an unknowable economic and financial future.  This explains its poor record at economic forecasting, including inflation and interest rates.

No matter how intelligent its leaders, how many Ph.D.s it hires, how many computers it buys, how complex it make its models, or how many conferences it holds at posh resorts, the Fed cannot reliably predict the future results of its own actions, let alone the unimaginably complex global interactions that create the economy. 

The Fed held both short-term and long-term interest rates abnormally low for more than a decade.  It manipulated long term rates lower by the purchase of $8 trillion of mostly fixed rate Treasury bonds and mortgage securities, mostly funded by floating rate deposits, making its own balance sheet exceptionally risky.  It decided to manage the expectations of the market, and frequently assured one and all that interest rates would be “lower for longer” (until, of course, they were higher for longer).

Observe the result:  Gigantic interest rate risk built up in the banking system. A notable case was Silicon Valley Bank, which made itself into a 21st century version of a 1980s savings and loan, investing heavily in 30-year fixed rate mortgage-backed securities and funding them with short-short term deposits, while its chief executive served on the Board of the Federal Reserve Bank of San Francisco.

SVB was doing basically the same thing with its balance sheet that the Fed was.  In the SVB case, it became the one of the largest bank failures in American history; in the Fed’s case, it has suffered its own mark to market loss of more than $1 trillion, in addition to operating cash losses of $172 billion so far. Adding the mark-to-market losses of the Fed and the banking system together, we have a total loss of $2 trillion. We are talking about real money.

The Fed was the Pied Piper of interest rate risk and consequent losses. 
Jim Bunning was the only man ever to be both a Hall of Fame baseball player and a U.S. Senator. He pitched a perfect game in the major leagues, and he delivered a perfect strike in the Senate when Chairman Ben Bernanke was testifying on how the Fed was going to regulate systemic financial risk. In paraphrase, Senator Bunning asked, “How can you regulate systemic risk when you are the systemic risk?” There is no answer to this superb question.

Challenging the CFPB After CFPB v. CFSA

Published in Ballard Spahr L.L.P.:

On May 20, Professor Emeritus Hal Scott from Harvard Law School, wrote an op-ed in the Wall Street Journal entitled: “The CFPB’s Pyrrhic Victory in the Supreme Court” and on May 21, Alex J Pollock wrote an article which was published on The Federalist Society website entitled: “The Fed has no earnings to send to the CFPB,” Professor Scott and Mr. Pollock stated that Federal Reserve System started incurring losses in September, 2022, that such losses continue to the present day and that the Fed is projected to incur losses until 2027.

The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

The relevant text of the Dodd-Frank Act is clear: “Each year (or quarter of such year) . . . the Board of Governors shall transfer to the [Consumer Financial Protection] Bureau from the combined earnings of the Federal Reserve System, the amount determined by the Director to be reasonably necessary . . . ” (emphasis added).

“Earnings” means net profit:

“EARNINGS: Profits; net income.” (Encyclopedia of Banking and Finance)

“Earnings: Net income for the company during a period.” (Nasdaq financial terms guide)

“A company’s earnings are its after-tax net income.” (Investopedia)

“Earnings are the amount of money a company has left after subtracting business expenses from revenue. Earnings are also known as net income or net profit.” (Google “AI Overview”)

“Earnings: The balance of revenue for a specific period that remains after deducting related costs and expenses.” (Webster’s Third New International Dictionary)

The Democratic majority which passed the Dodd-Frank Act on a party line vote in 2010—knowing that it was likely to lose the next election (as it did)—cleverly blocked a future Congress from disciplining the new creation through the power of the purse by granting the CFPB a share of the Fed’s earnings every quarter. With inescapable logic, however, that depends on there being some earnings to share in.

Naturally the congressional majority assumed (probably without ever thinking about it) that the Fed would always be profitable. It always had been. But that turned out to be a wildly wrong assumption.

The Supreme Court has ruled that the CFPB funding scheme is constitutional. The opinion by Justice Thomas finds that nothing in the text of the Constitution prevents such a scheme, despite, as pointed out in Justice Alito’s dissent, the way it thwarts the framers’ separation of powers design.

However, no one seems to have pointed out to the Court that the Federal Reserve System now has no earnings for the CFPB to share in. Instead, the Fed is running giant losses: it has lost the staggering sum of $169 billion since September 2022, and it continues to lose money at the rate of more than $1 billion a week. Under standard accounting, it would have to report negative capital and technical insolvency.

The Fed stopped sending distributions of its earnings to the U.S. Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments from its earnings to the CFPB at the same time for the same reason. This seems to be required by the statute.

It is sometimes said that the payment to the CFPB is based on the Fed’s expenses, not its earnings, because the statute also provides that “the amount that shall be transferred to the Bureau in each fiscal year shall not exceed a fixed percentage of the total operating expenses of the Federal Reserve.” But this “shall not exceed” provision is merely setting a maximum or cap relative to expenses, not a minimum, to the transfer from earnings. The minimum could be and is now zero—unless you think with negative Fed earnings the CFPB should be sending the Fed money to help offset its losses.

Although the situation seems clear, it is contentious. Congress should firmly settle the matter by rapidly enacting the Federal Reserve Loss Transparency Act (H.R. 5993) introduced by Congressman French Hill. This bill provides, with great common sense and financial logic: “No transfer may be made to the Bureau if the Federal reserve banks, in the aggregate, incurred an operating loss in the most recently completed calendar quarter until the loss is offset with subsequent earnings.”

The Fed’s losses continue. Its accumulated losses will not be offset for a long time. Congress should be thinking about whether it wishes to appropriate funds to the CFPB to tide it over.

Macro or Micro, Blinder Can’t Sell Bidenomics

Published in The Wall Street Journal.

Mr. Blinder wants to compare Mr. Biden to former President Franklin Roosevelt, but the current president doesn’t display the supreme deviousness and talent for manipulation, wrapped in rhetorical brilliance, of Roosevelt. There is, however, an important parallel.

In 1944, the Democratic Party bosses knew that whoever got nominated for vice president had a high probability of becoming the president, as indeed happened when Roosevelt died three months into his new term. They forced sitting Vice President Henry Wallace to be replaced on the new ticket by Harry Truman, luckily for the country and the world. Are the current Democratic bosses as smart and as responsible as the old pols of 1944?

Chairman Powell and The Fed’s Limits

Published in American Institute for Economic Research, RealClear Policy, and the Federalist Society.

Federal Reserve Chairman Jerome Powell has realistically assessed the limits of the Fed’s knowledge, models, and legislative mandate.  Bravo!  His candor is far superior to any “pretense of knowledge” displayed by central banks and is a sound warning of the mission creep to which their regulatory activities are tempted. 

Speaking at the Stanford Business School in early April, Powell observed that “Of course, the outlook is still quite uncertain.”  Indeed, inflation is looking worse than the Fed had hoped, long-term interest rates have backed up, and short-term rates may not fall from here, or may rise. No one knows, including the Fed. The financial and economic future is fundamentally and inherently uncertain. A better statement would have been, “Of course, the outlook is ALWAYS uncertain.”  

The dismal record of central banks’ economic forecasts confirms that they not only do not, but cannot, know the financial future, or what the results of their own actions will be, or what future actions they may take.  Powell, trained in law and on Wall Street instead of academic economics, seems admirably aware of this truth, a truth uncomfortable for those who wish to put their faith in central banks.  

Powell has previously pointed out that the celebrated “r star” (r*) — the “neutral interest rate” — is a theoretical idea which can never be directly observed.  Economic models depending on it must produce uncertain results.  In trying to be guided by such an idea, Powell wittily suggested, “We are navigating by the stars under cloudy skies.”  That is a really good line and deserves to go down with former Fed Chairman William McChesney Martin’s famous “take away the punchbowl” in central banking lore. 

Central banks’ poor forecasting record reflects both the limitations of human minds, no matter how brilliant, educated, and informed, and also the interactive, recursive, complex, expectational, reflexive, non-predictable nature of financial reality itself, so very different from Newtonian physical systems. Economic and financial systems are not composed of mechanisms (although that is a favorite metaphor in economics) but have among their core dynamics competing minds. 

From this recognition, we see why “the macro-economic discipline can be thought more-or-less as an evaluation of a constant stream of surprises,” as an acute financial observer recently wrote.  Economists, he continued, of course including those employed by central banks, tend to build “models of how the world should work, rather than how it does.  It is not surprising that macro-economic forecasts based on these models fail.”  We may conclude, as Powell seems to suggest, that we should not be surprised by the continuing surprises. 

It is essential not to attribute the forecasting failures of central banks to any lack of intelligence, educational credentials, good intentions, or computer power.  These failures of the highly competent arise because of the fundamentally odd kind of reality created by the economic and financial interactions they are trying to forecast and manipulate. 

Especially difficult is that all economics is political economics, all finance is political finance, and all central banking is political central banking.  Politics is always stirring and dumping spices, and sometimes poison, into the economic stew, especially by starting and prolonging wars, which are the single most important financial events.  Just now we have plenty of war to contend with.   

What are the central bankers to do?  A good place to start is intellectual realism about how genuinely cloudy the economic future is.  As an ancient Roman concluded, “Res hominum tanta caligine volvi.” (“Human affairs are surrounded by so much fog!”) 

Sticking to the Assigned Mission 

Also in his Stanford speech, Chairman Powell cited two well-known goals assigned by Congress to the Fed: maximum employment and stable prices. Note that the second, as written in the Federal Reserve Act, is exactly as Powell stated: “stable prices” — not “stable inflation,” “low inflation,” “perpetual inflation at 2 percent,” or any other price target except “stable prices.”  Obviously, the Fed has not achieved stable prices.  Should it nevertheless take on additional issues not assigned by Congress? 

Powell answered soundly: No. “We need to continually earn [our] grant of independence,” he said, “by sticking to our knitting.” 

He continued in a paragraph well worth quoting at length: 

        To maintain the public’s trust, we also need to avoid ‘mission creep.’  Our nation faces many challenges, some of which directly or indirectly involve the economy.  Fed policymakers are often pressed to take a position on issues that are arguably relevant to the economy but not within our mandate, such as particular tax and spending policies, immigration policy, and trade policy.  Climate change is another current example.  Policies to address climate change are the business of elected officials and those agencies they have charged with this responsibility.  The Fed has received no such charge. 

Very true, it hasn’t. 

Thus, he said, “We are not, nor do we seek to be, climate policymakers.”  Nor is the Fed, nor should it seek to be, a policymaker for illegal immigration, law enforcement, failing public schools, the bankrupt student loan fiasco, insolvent Social Security and Medicaid programs, or scores of other issues.   

Powell’s general conclusion is excellent: “In short, doing our job well requires that we respect the limits of our mandate.” This is consistent with his sensible 2024 Senate testimony that the Fed cannot create a US central bank digital currency without Congressional authorization. 

But when it comes to controlling Fed mission creep regarding climate change, Powell did leave himself a significant hedge that Congress should think about.  This was: “We do, however, have a narrow role that relates to our responsibilities as a bank supervisor.  The public will expect that the institutions we regulate and supervise will understand and be able to manage the material risks they face, which, over time, are likely to include climate-related risks.” 

How narrow is “narrow”?  Will Fed actions in this respect be mandate-disciplined?  Or under a different Fed leadership, might they swell and create a gap in limits big enough to drive a (presumably electric) truck through?  We know that out-of-control financial regulators can decide to act as legislatures on their own, such as in the notorious Operation Choke Point scandal.  Political actors who cannot get the Congress to approve their notions have discovered that the banking system is indeed a choke point for anybody needing to make financial transactions — that is, everybody.  The most dangerous thing about a central bank digital currency is that the Fed itself could become a monopoly choke point operator, the dark possibilities of which have already been demonstrated in China and Canada. 

Congress should applaud Chairman Powell’s candor on uncertainty and strongly support his principle of operating the Fed within the limits of its mandate.  But as Fed leadership and presidential administrations come and go, Congress should itself define, not leave up to the Fed, what “narrow” expansions of the Fed’s role are authorized, and what is beyond the limits.