Event video: AEI: Is the Federal Reserve Behind the Curve?

Watch the video here.

Event Summary

On October 8, AEI’s Desmond Lachman hosted Donald Kohn of the Brookings Institution, Nathan Sheets of Citigroup, William White of the C. D. Howe Institute, and Alex J. Pollock of the Mises Institute to discuss whether the Federal Reserve was behind the curve in cutting interest rates to support the economy.

The panelists generally agreed that while the Fed has had considerable success in regaining inflation control without inducing a recession, the Fed should be more forward-looking in making its policy decisions. They agreed that the Fed’s task is complicated by a high degree of uncertainty as to future shocks. These included the risk that the Middle Eastern conflict could cause a spike in oil prices and that the commercial real estate sector’s slump could adversely affect regional banks, as well as an unsustainable public debt situation, an increasing tide of protectionism, and the collapse of China’s real-estate market.

Each panelist commented on whether the Federal Reserve’s recent decision to cut interest rates was consistent with meeting its 2 percent inflation target and avoiding an economic recession. They agreed that while signs were encouraging, it was too early make a final judgment. The event concluded with an audience Q&A.

—Jack Rowing

Event Description

Following years of ultra-easy monetary policy, the Federal Reserve has over the past two years pursued a tight monetary policy to regain control over inflation. As inflation shows signs of easing, the debate about the pace of lowering interest rates has intensified.

This event will discuss whether the Fed has successfully achieved a soft economic landing and how Fed policy has affected financial stability.

Submit questions to Jack.Rowing@aei.org or on Twitter with #AskAEIEcon.

Event Materials

Event Transcript

Agenda

2:00 p.m.
Opening Remarks:
Desmond Lachman, Senior Fellow, American Enterprise Institute

2:05 p.m.
Panel Discussion

Panelists:
Donald Kohn, Robert V. Roosa Chair in International Economics, Brookings Institution
Desmond Lachman, Senior Fellow, American Enterprise Institute
Nathan Sheets, Global Chief Economist, Citigroup
William White, Senior Fellow, C. D. Howe Institute

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

3:30 p.m.
Q&A

4:00 p.m.
Adjournment

A European Fannie/Freddie?

A bad idea

Published in Housing Finance International Journal.

The U.S. national housing finance market is uniquely dominated by two government mortgage companies, Fannie Mae and Freddie Mac. They do exactly the same thing, creating mortgage-backed securities that are de facto government-guaranteed. They are both completely dependent on the credit support of the U.S. Treasury, and thus dependent on American taxpayers. Both went broke in 2008, and both were bailed out by the Treasury, which still owns $193 billion of their senior preferred stock, sixteen years later. Both are in an unending conservatorship of a very political government bureaucracy, the Federal Housing Finance Agency. They are in effect a single huge market intervention and subsidy.

Fannie/Freddie are truly massive, with combined assets of US$ 7.6 trillion.1 They create a systemically risky concentration of national mortgage credit exposure in Washington DC. They are and always have been politicized. They are popular with many politicians because they can be used to create subsidies to favored political constituencies without Congress having to appropriate funds. They are highly popular with Wall Street firms because they create securities easy to sell to domestic and global investors by using the credit of the U.S. Treasury.

Fannie/Freddie were central to causing the U.S. housing bubble of 1999-2006 and its subsequent collapse,2 and supported the explosive house price inflation of 2019-2022, which has made U.S. house prices widely unaffordable.

Should the European Union import this dubious American idea? A distinguished committee chaired by the former Governor of the Bank of France, Christian Noyer, thinks so. Its April 2024 white paper, “Developing European Capital Markets to Finance the Future,” proposes a “European securitization platform,” which would “target a massive asset class,” and “target a homogeneous and low-risk asset class, such as residential loans.”

The paper maintains that “a European platform for securitization could be a powerful tool for deepening capital markets.” So it might, but an essential requirement of the proposal is to move credit risk to the government at a combined European level, analogously to what Fannie/Freddie do. “To achieve the objectives the platform must grant a European guarantee of last resort for securitization of mortgage or SME loans.”3 By providing the guarantee, “a common platform would create a new common safe asset.” The safety for the investors comes from the guarantee: “Any residual heterogeneity would be eliminated, from the investor’s point of view, by a broad government guarantee.” In other words, remove the credit risk from the investors by moving it to the government and the taxpayers.

The U.S. model is clearly in mind: “Platforms for issuing and guaranteeing mortgagebacked securities are long-established in the US,” the proposal observes, and “Guaranteed securitized assets broadly work as safe assets, especially agency MBS,4 which are used as collateral in almost one-third of repo transactions in the United States and trade at close to sovereign rates.”

In short, what is being proposed is a European Fannie/Freddie.

Well aware of the housing finance bailouts previously provided by U.S. taxpayers, the white paper sets an “objective of zero cost for public finances” for a European securitization platform. The zero public cost objective is a nice idea, but the American experience warns of many government guarantee schemes which were similarly supposed to be selffinancing, but failed instead. The Federal Savings and Loan Insurance Corporation, the Farm Credit System, the Pension Benefit Guarantee Corporation, the federal Student Loan program, and of course Fannie/Freddie, all became insolvent and costly to the public finances. Confronted by the combination of political pressures to subsidize current borrowers and the uncertainty of future credit crises, it is very difficult for government guarantee programs to achieve their zero public cost aspirations.

The white paper introduces a further difficulty. The platform is to operate with a European-level guarantee, and “supervision at EU-level should be mandatory.” Nonetheless, “The guarantee provided by the platform should be structured to exclude any transfers between Member States.” This is certainly different from the American model with respect to U.S. states. It is impossible to imagine how Fannie/Freddie could operate without pooling income and losses among states, and it is likewise hard to imagine how European-wide guarantees could involve no transfers among Member States. How this is proposed to work is not clear.

The white paper displays a particular danger of all government guarantee schemes. It develops a securitization proposal obviously designed for mortgage loans, based on the need for “low risk” and “homogeneous” loans with a “standardization objective.” Then it slips in, doubtless as a political thought, that maybe the platform could also be used for commercial loans to small and medium-sized enterprises (“SMEs”). Such loans are of an entirely different kind, with fundamentally different risk characteristics. This is a good example of how a government guarantee is always subject to political pressure to move to riskier loans, just as Fannie/Freddie were pressured into buying low quality, nonprime mortgages, helping inflate the housing bubble.

The European Fannie/Freddie proposal has been accurately criticized by Mark Weinrich, Secretary General of the International Union for Housing Finance.5 I will stress four of Mark’s arguments, then state them less diplomatically. His arguments and my changes follow:

Weinrich: “Government backing of mortgage-backed securities can encourage risky lending practices, as lenders may believe that losses will ultimately be absorbed by the government.”

Pollock: “…as lenders will believe that losses will ultimately be absorbed by the government.”

Weinrich: “Government intervention in the mortgage market can distort pricing and allocation of credit.”

Pollock: “Government intervention…will distort pricing and allocation of credit.”

Weinrich: “A centralized entity would concentrate mortgage risk with a single institution, potentially creating a single point of failure.”

Pollock: “…thereby creating a single point of failure.”

Weinrich: “Creating a centralized European securitization platform could increase systemic risk.”

Pollock: “…will increase systemic risk.”

All of these problems have already characterized Fannie/Freddie in the American experience. Creating a massive government guarantee while claiming that it will be selffinancing tempts people to believe it will be free. It won’t be.

---

[1] Fannie Mae and Freddie Mac, 10-Q filings, June 30, 2024.

[2] See Peter J. Wallison, Hidden in Plain Sight, 2015; and Alex J. Pollock, Boom and Bust, Chapter 7, “A $5 Trillion Government Failure,” 2011.

[3] We address the troublesome addition of “or SME loans” below.

[4] “Agency” MBS are Fannie/Freddie MBS plus those of Ginnie Mae, which has a separate government guarantee.

Can the Federal Reserve Buy Gold? Should It?

Published in Law & Liberty with Paul H. Kupiec.

Since the sixth century BC reign of Croesus of Lydia, refined gold has served as a monetary store of value. Today, many central banks, including the European Central Bank, the Swiss National Bank, the German Bundesbank, the Bank of France, the Bank of Italy, the Dutch National Bank, the Bank of Japan, the Reserve Bank of India, the People’s Bank of China, and the Monetary Authority of Singapore among others, hold gold as an investment and reserve against their monetary liabilities. It may surprise some that, in contrast, the Federal Reserve owns no gold at all.

The original 1913 Federal Reserve Act required the Fed to hold substantial amounts of gold to back its outstanding Federal Reserve Notes and member bank deposits. In 1934, the Roosevelt administration pushed for, and Congress passed, legislation that made it illegal for US persons, including the Federal Reserve, to hold gold for monetary purposes. Fed resistance notwithstanding, it was required by law to hand over all its gold to the US Treasury. The last link between gold and the US dollar was severed in the early 1970s and all legal prohibitions against US persons buying, selling, and holding gold were repealed shortly thereafter. Fifty years later many US citizens and financial organizations hold gold investments, but the Federal Reserve has not owned any gold since 1934.

This raises two interesting questions: Can the Fed today legally buy, sell, and hold gold? And if it can, should it?

The History of Gold and the US Dollar

From 1900 until 1933, a US dollar was legally redeemable for “25.8 grains of gold nine-tenths fine” or $20.67 per fine troy ounce of gold. On April 5, 1933, one month after taking office, as part of his emergency actions in the financial and economic crisis, following the temporary closing of all banks, President Franklin Roosevelt issued an executive order prohibiting American individuals, partnerships, associations, or corporations from owning (so-called “hoarding”) gold. The order required all Americans to turn in their gold to a Federal Reserve Bank, with criminal penalties for violations, receiving in exchange paper dollars at the official price of $20.67 per troy ounce. This radical executive action was subsequently endorsed in a joint Congressional resolution and later in statute.

That year Congress also passed the Emergency Farm Mortgage Act of 1933. Part 8 of this law empowered the President:

By proclamation to fix the weight of the gold dollar in grains of nine tenths fine and also to fix the weight of the silver dollar in grains nine tenths fine at a fixed ratio in relation to the gold dollar as in such amounts as he finds necessary … but in no event shall the weight of the gold dollar be fixed so as to reduce its present weight by more than 50 per centum.

President Roosevelt soon exercised this power.

The Gold Reserve Act of 1934 required Federal Reserve Banks to send all of their gold to the Treasury in exchange for “gold certificates” with a fixed dollar-denominated value of $20.67 per fine troy ounce of gold transferred to the Treasury. These certificates, still on the balance sheet of the Fed today, cannot be redeemed for gold. The 1934 Act reaffirmed the legal prohibition against Americans owning gold for monetary or investment purposes and further required that circulating gold coins be withdrawn and melted into gold bars, ended gold coinage, and suspended the domestic redemption of US currency in gold.

The day after the passage of the Gold Reserve Act in January 1934 and the transfer of all Federal Reserve gold to the Treasury, President Roosevelt increased the official price of gold to $35 per ounce. The dollar became worth only 15.236 grains of gold nine-tenths fine, or just 59 percent of a dollar’s 1933 value in terms of its legal weight of gold. This generated a large dollar-denominated profit for the Treasury, a profit that would otherwise have belonged to the Fed. 

Since 1934, the US legal price of gold has been increased twice, but now bears no resemblance to gold’s market price. In 1972, the US legal price was raised from $35 to $38 per fine troy ounce. In 1973 it was raised again to $42.22. Today, the market price of gold is about $2,500 per ounce.

There are 480 grains of pure gold in a fine troy ounce. With gold at $2,500 per ounce, one US dollar is worth 0.192 grains of pure gold. In terms of grains of gold, a present-day US dollar buys less than 1% of the amount that a 1933 dollar would buy. Said differently, a penny in 1933 was worth more in terms of its weight in gold than a dollar is today.

In 1971, President Nixon severed the last tie between gold and the value of the US dollar by ending the post-World War II Bretton Woods agreement that gave foreign governments the option to redeem dollars for gold at the official price. Subsequently, Congress passed legislation repealing the sections of the Gold Exchange Act that made it illegal for Americans to own gold, and President Gerald Ford revoked Roosevelt’s 1933 executive order.

Central Banks and Gold

Federal Reserve notes, the circulating currency of the United States, by law, must still be fully collateralized by the Fed. But they are not redeemable for anything except for other Federal Reserve notes, an equivalent value in coins that have no intrinsic metallic value, or a deposit liability of the Fed.

The Fed’s founders would be appalled that the collateral backing US currency does not include any gold.

Many central banks have substantial investments in gold. According to the World Gold Council, the above-ground global stock of gold is approximately 212,582,000 kilograms, about 15.4 percent of which is owned by central banks and national treasuries. Many central banks have experienced significant gains from their holding of gold reserves as the market price of gold more than doubled in the past 6 years. In some cases, recent revaluation gains on central bank gold investments have offset losses on central banks’ investments in long-term fixed-rate bonds.

Source: Authors’ calculations. 2024* is the market price of gold on August 28, 2024. All other prices are year-end market closing prices of gold as reported by moneymetals.com.

According to a recent IMF Working Paper, central banks hold gold because it is “seen as a safe haven,” regarded as “respectable and confidence inspiring,” is liquid, provides portfolio diversification, has historically been a reliable store of value, a hedge against inflation, and a hedge against unanticipated systemic shocks to financial stability. In a 2023 interview, Aerdt Houben, Director of the Financial Markets Division of the Dutch National Bank, explained:

The beauty of gold is that … it retains its value. That’s one of the reasons why central banks hold gold. Gold has intrinsic value unlike a dollar or any other currency, let alone Bitcoin. … It’s a fungible product. It’s a liquid product, you can buy and sell it almost anywhere in the world. … Gold is like solidified confidence for the central bank. … If we ever unexpectedly have to create a new currency or a systemic risk arises, the public can have confidence in DNB because whatever money we issue, we can back it with the same value in gold. … If everything collapses, then the value of those gold reserves shoots up.

The IMF paper discusses how, in recent years, the central banks of Russia, China, India, and Turkey have purchased significant amounts of gold in response to US and allied nations’ financial sanctions. Sanctioned countries’ central banks face restrictions on selling reserves held in US dollars, Euro, and Yen securities. Gold held outside an owner’s country can be impounded. Sanctioned national central banks have responded by buying significant amounts of gold and holding it domestically.

Including gold as an instrument of open market operations would provide the Fed a means of increasing or decreasing bank reserves independent of any direct effect on market interest rates.

Can the Fed Own Gold Today?

The Fed owns no gold or other assets to hedge the interest rate risk of its long-maturity fixed-rate securities. The post-COVID 19 inflation required the Fed to substantially increase interest rates which generated more than $1 trillion in unrealized market value losses on its huge fixed-rate securities portfolio. In addition, it has nearly $200 billion in actual accumulated cash operating losses. With 20/20 hindsight, it is clear that the Federal Reserve System could have avoided some of these losses if, instead of investing only in fixed-rate long-term securities, it had diversified and included some gold in its investment portfolio. But could it have done so?

The current Federal Reserve Act as amended still explicitly states that every Federal Reserve Bank, in its open market operations, has the power “to deal in gold coin and bullion at home or abroad.” The provisions of the Gold Reserve Act of 1934 which made it illegal for US persons, including the Federal Reserve, to hold gold for investment or monetary purposes were repealed long ago. Specifically, the Par Value Modification Act of 1973 repealed Sections 3 and 4 of the Gold Reserve Act of 1934—the sections that prohibited US citizens and Federal Reserve banks from buying and holding gold. Public Law 93-373, signed in August 1974, provided that, after December 31, 1974:

No provision of any law in effect on the date of enactment of this Act, and no rule, regulation, or order in effect … may be construed to prohibit any person from purchasing, holding, selling or otherwise dealing in gold in the United States or abroad.

Moreover, President Ford issued Executive Order 11825 on December 31, 1974, formally revoking President Roosevelt’s Executive Order 6102 of 1933 which prohibited Americans from “hoarding” gold. The provisions of the Gold Reserve Act of 1934 that suspend citizens’ right to redeem Federal Reserve notes for gold at the official price, however, remain in place.

Since the legal meaning of “any person” includes a Federal Reserve Bank, a plain language reading of the 1973–74 legislation suggests that Federal Reserve banks can today buy, hold, or sell gold without limitation in the course of their open market operations and have been able to do so since January 1, 1975.

Can the Fed today legally buy and hold gold? We think so, but thus far we have been unable to confirm our opinion in our discussions with former senior Fed officials and financial market experts—no one seems to know. Nor is this question answered in any of the official Federal Reserve materials of which we are aware and our query to the Fed’s official website remains unanswered. The answer to this question should not be a mystery. The Board of Governors of the Federal Reserve should speak authoritatively on the question and explain why the Fed can or cannot buy and sell gold in the course of conducting monetary policy.

If the Fed Can Own Gold, Should It?

The Federal Reserve is a unique central bank as the sole issuer of the world’s dominant fiat, or pure paper, currency. The global holding of fiat dollars is a great advantage to the US Treasury, famously and accurately characterized by the French in the 1960s as an “exorbitant privilege,” in financing the US government.

At the time of the Bretton Woods Conference in 1944, the chief American negotiator, Harry Dexter White, argued, “To us and to the world, the United States dollar and gold are synonymous.” In 2024, the price of gold and the purchasing power of the US dollar are more like opposites. Does the Fed’s reluctance to hold gold reflect ideological resistance within the Fed and the Treasury to reestablish a distant link between gold and the US dollar, even if gold ownership offered advantages for the Fed’s and the country’s finances?

The Fed’s use of debt securities for open market operations has a direct impact on market interest rates, be they short-term Treasury, long-term Treasury, or repo rates, or the rates paid on government-guaranteed mortgage-backed securities. Including gold as an instrument of open market operations would provide the Fed a means of increasing or decreasing bank reserves independent of any direct effect on market interest rates. If conducted at scale, of course Fed gold dealings could impact the market price of gold and the revenues of gold producers.

One possible problem is that the US legal price of gold was set by statute more than 50 years ago. If the Fed bought gold at $2,500 per ounce, would it have to value gold on its financial statements at its legal price of $42.22 per ounce? Or would the Fed’s power to set its own accounting standards allow it to value gold at its current market price or at historical cost? In the future, when the Fed regains profitability, the accounting treatment of unrealized capital gains on gold would in part determine the Fed’s required remittances to the Treasury once the Fed’s surplus exceeds its legal maximum of $6.785 billion. Could the Fed, as do some other central banks, book gold at historical cost and retain unrealized gains as a “hidden reserve”? Conversely, how would the Fed account for unrealized decreases in the market price of gold?

It is curious that few experts seem to know for certain whether it is legal for the Fed to use gold as an instrument of open market operations. It is also puzzling why there is little if any discussion of the potential benefits or costs of using gold as a tool of monetary policy and as a Federal Reserve asset. We think these issues merit serious discussion.

How Can One Understand the Federal Reserve’s Nearly $200 Billion in Losses?

Published in The New York Sun.

Can you understand how it can be that the Federal Reserve, the world’s greatest and by far most important central bank, has now lost the astounding sum of $193 billion?  If not, one is surely not alone. Since September 2022, the Fed has lost money  every month.  These unprecedented losses continue, and this fall they will in the aggregate pass $200 billion.

The Fed has a powerful mystique, which it works hard at cultivating.  It intensely wants to be credible — that is, for you to believe in it (“credo” in Latin means I believe), and perhaps you do.  The people’s belief is an important source of the Fed’s power, and its power is a key source of the government’s power. 

We can accurately say that the Fed prints power by printing money.  The Fed does not want little things like $200 billion in losses to shake your belief — like the Wizard of Oz, it exclaims, “Pay no attention to that man,” or those losses, “behind the curtain.” It puts its losses behind an accounting curtain that pretends that losses are an asset.

These operating losses are not, as is sometimes mistakenly said, mere “paper” losses. They are real, cash losses. The Fed is suffering negative net interest income because its cost of funds is much greater than the income on its investments. The $193 billion in operating losses exceeds the Fed’s $43 billion in total capital by more than four times.

Thus at present, it has no earnings, no retained earnings, and no capital. In addition to that, it had a mark to market loss of over $1 trillion as of its June 30 financial statements. How can this be? How can the bank with the hugely profitable monopoly of issuing the world’s dominant reserve currency, be losing a fortune?

To understand the Fed, or any central bank, you have to divide it analytically into two different parts, and account for the functions and the profits of the two parts separately. The Fed does not do this, although the logic is classic and was already required for the Bank of England by the Bank Charter Act of 1844, also called “Peel’s Bank Act,” after Sir Robert Peel, the Prime Minister who promoted it. 

The Bank of England was divided by Peel’s Act into an Issue Department and a Banking Department. The idea at the time was to tie the paper currency firmly to gold. That has disappeared in both theory and practice, but the Bank of England still keeps its books according to this fundamental division of functions. So should the Fed.  

The Issue Function of the Fed exploits its government-granted monopoly of issuing the American currency. Its liabilities are the $2.3 trillion in currency outstanding, the paper dollars held not only in America, but all over the world. From a profitability point of view, these are wonderful liabilities for the central bank.

The currency is a non-interest bearing, perpetual, non-redeemable source of funds. The Issue Function’s assets are the $2.3 trillion in investments financed by the currency issued. These investments are typically government bonds.

Why is issuing currency so profitable?  If, in 2023, the Issue Function of the Fed had used its $2.3 trillion simply to buy Treasury bills, it would have received about a 5 percent yield. The result would have been interest expense of zero and interest income of $115 billion.

If operating expenses were $1 billion (a guess), the net profit would have been $114 billion. It looks like the Issue Function unwisely, or perhaps foolishly, invested its funds in long-term bonds at 2 percent, at the bottom of interest rates. Even so, it still had a profit of $45 billion in 2023.

The Federal Reserve as a whole lost $114 billion in 2023, the profits of the Issue Function notwithstanding.  That means that the Banking Function — i.e. the rest of the Fed, with its QE investments, mortgage securities, deposits, loans, expenses, and a lot of risk — actually lost the $114 billion plus the entire $45 billion profit from the Issue Function’s currency monopoly. Thus the Fed’s Banking Function for 2023 lost $159 billion — and that’s only for one year.

For the two years ending this September 30, I estimate the Fed’s Banking Function will have lost about $290 billion.  Quite a number, and the losses continue.  If the Fed were to adopt the two-department approach, it would help the Congress and the public understand what it is doing, with a hat tip to Sir Robert Peel.

BankThink The CFPB is funded by the Fed's profits. Trouble is, there are none

Read the article in American Banker here.

A US Bitcoin reserve would do much for Bitcoin and little for taxpayers

Published in The Hill with Paul H. Kupiec. Also Published in Real Clear Markets.

Speaking at the Nashville Bitcoin 2024 conference, Sen. Cynthia Lummis (R-Wyo.) floated a “revolutionary proposal” to make the federal government a Bitcoin investor. It is hard to imagine how this might benefit U.S. taxpayers or support the dollar’s value, but it certainly would raise the dollar price of Bitcoin.

While it is unsurprising that a plan to use taxpayer dollars to benefit foreign and domestic Bitcoin owners would have the Nashville audience cheering, it is impossible to justify. Neither the Federal Reserve nor the U.S. Treasury would want to or should be permitted to support Bitcoin’s price.

According to the accompanying statement issued by Lummis’s office, this proposal would create “a strategic Bitcoin reserve” of 1 million Bitcoins that the government would “would be required to hold … for 20 years.” We couldn’t have the government selling its Bitcoin and driving down the cryptocurrency’s price, now could we? 

This plan is as quintessentially American as a Louis L’Amour novel about mining the Comstock Lode. In 1878, owners of silver mines in places like Virginia City, Nev., succeeded in lobbying Congress to pass the Bland-Allison Act which required the government to support the price of silver by buying and stockpiling large amounts. 

Few ideas are new in politics or finance. Although a plan to force the federal government to buy something to support its price is hardly new, the proposed source of funds for these purchases is especially problematic.

In her Nashville remarks, Lummis said, “We will convert excess reserves at our 12 Federal Reserve banks into Bitcoin over five years. We have the money now!” 

 If by “excess reserves” Lummis means the “paid-in capital and surplus” of Federal Reserve district banks, as we have explained elsewhere, measured by generally accepted accounting standards, the Fed’s total paid-in capital and surplus account balance is negative $145 billion. Since September 2022, the Fed has had to borrow $145 billion just to fund its own expenses.

If the Fed is going to invest in Bitcoin, it would have to borrow even more money. Or it could sell some of its deeply underwater investments and book a big loss. Neither alternative makes sense. 

Even if the Fed did have positive paid-in capital and surplus funds available to invest, there is a more fundamental problem. The Federal Reserve Act, as a bedrock principle, restricts the Fed’s open market investments to U.S. government obligations or instruments guaranteed by the federal government or its agencies. This law would have to be amended to allow the Fed to purchase Bitcoin. 

If Congress did consider changing the act, other crypto coins and special interest assets would assuredly lobby Congress to be included as Fed-eligible investments. Such legislation would create enormous pressure to use the Fed’s monetary powers to purchase these assets, allocate credit and extend implicit subsidies. 

Additionally, holding Bitcoin would create a large operating loss for the Fed. Bitcoin pays no interest, but the Fed has to pay interest on the money it borrows to finance its investments. At current rates, every dollar borrowed to hold Bitcoin would cost the Fed 5.4 percent in annual interest. 

Suppose the Fed bought half a million Bitcoins at today’s price of about $60,000 each. At an interest cost of 5.4 percent, the Fed would incur operating cash losses of $1.6 billion a year on its Bitcoin investment. Over 20 years, the operating losses would total $32 billion, or more than 100 percent of the investment.

According to a report by CoinDesk, Lummis’s proposed Bitcoin Act of 2024 would also require the Treasury to revalue its gold stock and use the resulting capital gains to buy Bitcoin. We explained the mechanics of such a transaction in an article addressing the 2023 federal debt ceiling debate.

The current market price of gold is about $2,500 per ounce. The Treasury owns about 261.5 million ounces of gold. The Gold Reserve Act, amended in 1973, requires the Treasury to value its gold at $42.22 per ounce. At current market prices, the Treasury owns about $640 billion in gold but values it at a little over $11 billion. 

If the law were changed to force the Treasury to revalue its gold, it could issue $629 billion in new gold certificates to the Fed in return for dollars. This accounting transaction would create $629 billion in newly-printed dollars for the Treasury to spend. Using an accounting adjustment to create $629 billion for the Treasury to spend on Bitcoin is inflationary and does nothing to enhance the value of the U.S. dollar.

From a risk exposure perspective, any federal government investment in Bitcoin would be leveraged speculation on the price of a notoriously volatile intangible asset. 

Bitcoin enthusiasts and promoters have long claimed that Bitcoin will be an alternative to replace the dollar, allowing cryptocurrency users to escape the Fed, the Treasury and the U.S. government. Strategically, it’s extremely unlikely that the Fed and the Treasury will embrace this proposal as a cause to subsidize and promote.

The Treasury, in particular, reaps great advantages from the worldwide, massive holdings of U.S. dollar securities and currency — this is the famous “exorbitant privilege” of issuing the global reserve currency. It is central to financing the American government and American geopolitical power.  

It is pretty hard to imagine the Treasury wanting to invest in an alternative asset that seeks to weaken or even end its crucial advantages.

The Bitcoin proposal claims it would “bolster” and “fortify” the U.S. dollar, but truth be told, it is a plan to bolster the value of Bitcoin that provides no benefit for the the dollar. Once the facts are understood, no U.S. taxpayer without Bitcoins would support a proposal to use their tax dollars to bolster its price. 

A government Bitcoin reserve is just a bad idea.

FHLBs—Mission and Possible Improvements

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

Mission

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

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

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

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

FHLBs without doubt have important benefits from their government sponsorship.  These benefits should primarily go to supporting sound and economical home finance provided by member institutions throughout the country.  

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

Suggested Improvements

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

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

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

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

Respectfully submitted to the Federal Housing Finance Agency, August 23, 2024

We Sure Do Need to Talk about Inflation

Published in National Review:

Writing for AIER, Alex Pollock has a superb review of a recent book by Stephen King: We Need to Talk about Inflation. Since that topic is very much on people’s minds these days and with true  believers in omnipotent government like Kamala Harris blaming it on greed and proposing price controls, the book is most welcome.

Pollock writes:

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.)

Absolutely right. Rulers (whether monarchs, elected politicians, military despots, or any other kind) can be counted on to extract wealth from the citizenry to pay for the things they want to do, but prefer to extract it in a hidden fashion by cheapening the currency. And of course, they will try to pin the blame elsewhere.

This new book is must reading.

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.