Risk, Uncertainty and Profit 100 Years Later

Published in Law & Liberty. Also appears in AIER.

The year 2021 marks the 100th anniversary of Frank Knight’s great book, Risk, Uncertainty and Profit (RU&P), which established uncertainty as a fundamental idea in economics and finance, and as a key to understanding enterprise, entrepreneurship, cycles of booms and busts, and economic growth. Viewed from the present, it also explains why faith in economic management by central banks will be disappointed, and why any idea that economies or financial markets are governed by “mechanisms” is deluded. Its ideas open the way to seeing that economies and financial markets are a different kind of reality than are machines, and thus why the econometric equations that seem so plausible in some times, at other times fail.

Knight lived from 1885 to 1972; RU&P was published in 1921 when he was 35. Although he subsequently had a long and distinguished career at the University of Chicago, where he influenced numerous future economists including Milton Friedman, RU&P is far and away his magnum opus, a book that “ended up changing the course of economic theory” and established Knight “in the pantheon of economic thinkers.” It might also be called “the most cited economics book you have never read.” Indeed, it is long, complex, and often difficult, but contains brilliant insights which do not go out of date. We may enjoy the irony that it arose from a contest by the publishers in 1917 in which its original text won second, not first, prize.

RU&P is most and justifiably famous for its critical distinction between Uncertainty and Risk, with the term “Knightian Uncertainty” immortalizing the author, at least among those of us who have thought about it. Although in common language, then and now, “It’s uncertain” or “It’s risky” might be taken to mean more or less the same thing, in Knight’s clarified concepts, they are not only not the same, but are utterly different, with vast consequences.

Knight set out to address, as he wrote in RU&P, “a confusion of ideas which goes down deep into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein.” So “the answer is to be found in a thorough examination and criticism of the concept of uncertainty, and its bearings upon economic processes.”

“But,” Knight continued, “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated”—until RU&P in 1921, of course. They are “two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different.”

Specifically, risk means “a quantity susceptible of measurement,” but uncertainty is “unmeasurable,” and “a measurable uncertainty is so far different from an unmeasurable one that it is not in effect an uncertainty at all.” It is only a risk.

Another way of saying this is that for a measurable risk, you can know the odds of outcomes, although you don’t know exactly what will happen in any given case. With uncertainty, you do not even know the odds, and more importantly, you cannot know the odds.

When facing risk, since you can know the odds, you can know in a large number of repeated events what the distribution of the outcomes will be. You can know the mean of the distribution of outcomes, its variation, and the probability of extreme outcomes. With fair pair of dice, you know that rolling snake eyes (one spot on each die) has a reliable probability of 1/36. We know that the extreme outcome of rolling snake eyes three times in a row has a probability of about 0.00002—roughly the same probability of flipping a fair coin and getting tails 16 times in a row. Of course, even that remote probability is not zero.

With risk, by knowing the odds in this fashion, and knowing how much money is being risked, you can rationally write insurance for bearing the risk when it is spread over a large number of participants. It may take specialized skill and a lot of data, but you can always in principle calculate a fair price for insuring the risk over time, and the ones taking the risk can accordingly buy insurance from you at a fair price, solving their risk problem.

Faced with uncertainty, however, you cannot rationally write the insurance, and the uncertainty bearers cannot buy sound insurance from you, because nobody knows or can know the odds. Therefore, they do not and cannot know the fair price for bearing the uncertainty.

In short, an essential result of Knight’s logic is that risk is in principle insurable, but uncertainty is not.

Of course, you might convince yourself that the uncertainty is really risk and then estimate the odds from the past and make calculations, including complicated and sophisticated calculations, manipulating your guesses about the odds. There is often a strong temptation to do this. It helps a lot in selling securities, for example, or in making subprime loans. You can build models using the estimated odds, creating complicated series of linked probabilities for surviving various stress tests and for calculating the required prices.

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it.

Your analysts will certainly solve the mathematical equations in the models properly; however, under uncertainty, the question is not doing the math correctly, but the relationship of the math to the unknown and unknowable future reality. In the uncertainty case, your models will one day fail, because in fact you cannot know the odds, no matter how many models you run. The same is true of a central bank, say the Federal Reserve, running a complex model of the whole economy and employing scores of economists. Under uncertainty, it may, for example, in spite of all its sophisticated efforts, forecast low inflation when what really is about to happen is very high inflation—just as in 2021.

There is no one to ensure against the mistake of thinking Uncertainty is Risk.

Let us come to the P in RU&P: Profit. Every time Knight writes “profit,” as in the following quotations, and also as used in the following discussion, it does not mean accounting profit, as we are accustomed to seeing in a profit and loss statement, but “economic profit.” Economic profit is profit in excess of the economy’s cost of capital. When economic profit is zero, then the firm’s revenues equal its costs, including the cost of capital and the cost of Risk, so the firm has earned exactly its cost of capital.

In a theoretical world of perfect competition, prices, including the price for insuring Risk, would adjust so that revenues always would equal cost. That means in a competitive world in which the future risks are insurable, there should be no profit. We obviously observe large profits in many cases, especially those earned by successful entrepreneurs. Knight concludes that in a competitive economy, Uncertainty, but not Risk, can give rise to Profit.

It is “vital to contrast profit with payment for risk-taking,” he wrote. “The ‘risk’ which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis,” and “the only ‘risk’ which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured.” Thus, “profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated…a probability calculation in regard to them is impossible and meaningless.” Loss also arises from the same brute fact, of course. We are again reminded that human activity is a different kind of reality than that of predictable physical systems.

Economic progress, or a rising standard of living for ordinary people, depends on creating and bearing Uncertainty, but this obviously also makes possible many mistakes. These include, we may add, the group mistakes which result in financial cycles. We don’t get the progress without the uncertainty or without mistakes. “The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress.” The paradox of economic progress is that there is no progress without Uncertainty, and no Uncertainty without mistakes.

To have Uncertainty, there must be change, for “in an absolutely unchanging world the future would be accurately foreknown.” But change per se does not create an unknowable future and Uncertainty. Change which follows a known law would be insurable; so “if the law of change is known…no profits can arise.” Profits in a competitive system can arise “only in so far as the changes and their consequences are unpredictable.”

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it. He takes the “ultimate responsibility” of bearing uncertainty in business.

Knight clearly enjoyed summing up “the main facts in the psychology of the case” of the entrepreneurs, when the uncertainties “do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance.” The entrepreneurs may have “an irrational confidence in their own good fortune, and that is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves.” They are “the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.” This suggests that a kind of irrational faith is required for progress.

A former student of philosophy, Knight always was a very philosophical economist. On the last page of RU&P comes this true perspective on it all: “The fundamental fact about society as a going concern is that it is made of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. . . . Life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out.” We need to be reminded of this as we in our turn strive to increase the great funds of inheritance for those who will carry on into the ever-uncertain future.

For it is as true now and going forward as when RU&P was published one hundred years ago that, as Knight wrote, “Uncertainty is one of the fundamental facts of life.”

Biden's radical Treasury nominee in her own words

Published in The Hill.

In an incomprehensible act, President Biden has nominated as comptroller of the currency Saule Omarova — a law school professor who thinks that banks should have their deposit business taken away and transferred to the government, the Federal Reserve should be the monopoly provider of retail and commercial deposits, the Fed should perform national credit allocation, the Federal Reserve Bank of New York should intervene in investment markets whenever it thinks prices are too high or too low (shorting or buying a wide range of investments accordingly), the government should sit on boards of directors of private banks with special powers and disproportionate voting power, new federal bureaucracies should be set up to regulate financial regulators and carry out national investment policy and in general, it seems, has never thought of a vast government bureaucracy or a statist power that she doesn’t like.

What follows is a collection of such particularly unwise proposals in Professor Omarova’s own words, which might be appropriately called “Omarova’s Little Book.” 

“On the liability side” of the banking system, Professor Omarova “envisions the ultimate ‘end-state’ whereby central bank accounts fully replace — rather than compete with — private bank accounts,” according to her 2020 paper, “The People’s Ledger: How to Democratize Money and Finance the Economy.”

“On the asset side,” she “lays out a proposal for restructuring the Fed’s investment portfolio and redirecting its credit-allocation power…leaving the asset side free to serve as the tool of the economy-wide credit allocation.”

In short, “the key is…eliminating private banks’ deposit-taking function and giving the Fed new asset-side tools of shaping economy-wide credit flows,” the proposed regulator of national banks writes.

At this point, it is already unnecessary to proceed any further, but we will.

In the paper, “The ‘Too Big To Fail’ Problem,” Omarova suggests “an expansion of the Federal Reserve’s so-called ‘open market operations’…to encompass trading in a wide range of financial assets. … If, for example,  a particular asset class — such as mortgage-backed securities or technology stocks — rises in market value at rates suggestive of a bubble trend, the FRBNY trading desk would short these securities.” 

“The FRBNY trading desk would go long on particular asset classes when they appear to be artificially undervalued.” 

Also, a “National Investment Authority” would be “charged with developing and implementing a comprehensive strategy of national economic development.” 

In “The Climate Case for a National Investment Authority,“ she said "The NIA will act directly within markets as a lender, guarantor, market-maker, venture capital investor and asset manager. … It will use these modalities of finance in a far more assertive and creative manner.”

These ideas will perhaps strike you, as they do me, as exceptionally naïve.

Meanwhile, in “Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation,” Omarova proposes creating a “Public Interest Council,” which “would have a special status … outside of the legislative and executive branches." The Council "would comprise…primarily academic experts [!]" and "it would have broad statutory authority to collect any information it deems necessary from any government agency or private market participant and to conduct targeted investigations.”

On top of that, in “Bank, Governance and Systemic Stability: The ‘Golden Share’ Approach,” she recommends a “new golden share mechanism” which would give “the government special, exclusive and nontransferable corporate-governance rights in privately owned enterprises.”

“As a holder of the golden share, the government could have disproportionate voting power with respect to the election of the company’s directors and various strategic decisions,” reads the paper.

“This ability to affect directly a private firm’s substantive business decisions — without holding a controlling economic equity stake — is a particularly promising feature of the golden share,” Omarova thinks. Do you?

While considering this quite remarkable nomination, any member of the Senate Banking Committee who personally supports these proposals of Omarova should boldly hold up their hand and then speak in their defense. It seems hard to believe there would be many hands.

The US has never defaulted on its debt — except the four times it did

Published in The Hill.

Every time the U.S. government’s debt gets close to the debt ceiling, and people start worrying about a possible default, the Treasury Department, under either party, says the same thing: “The U.S. government has never defaulted on its debt!” Every time, this claim is false.

Now Treasury Secretary Yellen has joined the unfailing chorus, writing that “The U.S. has always paid its bills on time” and “The U.S. has never defaulted. Not once,” and telling the Senate Banking Committee that if Congress does not raise the debt ceiling, “America would default for the first time in history.”  

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This is all simply wrong. If the United States government did default now, it would be the fifth time, not the first. There have been four explicit defaults on its debt before. These were:

1. The default on the U.S. government’s demand notes in early 1862, caused by the Treasury’s financial difficulties trying to pay for the Civil War. In response, the U. S. government took to printing pure paper money, or “greenbacks,” which during the war fell to significant discounts against gold, depending particularly on the military fortunes of the Union armies.

2. The overt default by the U.S. government on its gold bonds in 1933. The United States had in clear and entirely unambiguous terms promised the bondholders to redeem these bonds in gold coin. Then it refused to do so, offering depreciated paper currency instead. The case went ultimately to the Supreme Court, which on a 5-4 vote, upheld the sovereign power of the government to default if it chose to. “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States,” wrote Justice Harlan Stone, a member of the majority, “the government, through exercise of its sovereign power…has rendered itself immune from liability,” demonstrating the classic risk of lending to a sovereign. In “American Default,” his highly interesting political history of this event, Sebastian Edwards concludes that it was an “excusable default,” but clearly a default.

3. Then the U.S. government defaulted in 1968 by refusing to honor its explicit promise to redeem its silver certificate paper dollars for silver dollars. The silver certificates stated and still state on their face in language no one could misunderstand, “This certifies that there has been deposited in the Treasury of the United States of America one silver dollar, payable to the bearer on demand.” It would be hard to have a clearer promise than that. But when an embarrassingly large number of bearers of these certificates demanded the promised silver dollars, the U.S. government simply decided not to pay. For those who believed the certification which was and is printed on the face of the silver certificates: Tough luck.

4. The fourth default was the 1971 breaking of the U.S. government’s commitment to redeem dollars held by foreign governments for gold under the Bretton Woods Agreement. Since that commitment was the lynchpin of the entire Bretton Woods system, reneging on it was the end of the system. President Nixon announced this act as temporary: “I have directed [Treasury] Secretary Connally to suspend temporarily the convertibility of the dollar into gold.” The suspension of course became permanent, allowing the unlimited printing of dollars by the Federal Reserve today. Connally notoriously told his upset international counterparts, “The dollar is our currency but it’s your problem.”

To paraphrase Daniel Patrick Moynihan, you are entitled to your own opinion about the debt ceiling, but not to your own facts about the history of U.S. government defaults.

Seven Possible Causes of the Next Financial Crisis

Published in Law & Liberty.

The great financial historian, Charles Kindleberger, pointed out in the 1970s that over several centuries, history showed there was a financial crisis about once every ten years. His observation still holds. In every decade since his classic Manias, Panics and Crashes of 1978, such crises have indeed continued to erupt in their turn, in the 1980s, 1990s, 2000s, 2010s, and again in 2020. What could cause the next crisis in this long, recurring series? I suggest seven possibilities:

1. What Nobody Sees Coming

A notable headline from 2017 was “Yellen: I Don’t See a Financial Crisis Coming in Our Lifetimes.” The then-head of the Federal Reserve was right that she didn’t see it coming; nonetheless, well within her and our lifetimes, a new financial crisis arrived in 2020, from unexpected causes.

It has been well said that “The riskiest stuff is what you don’t see coming.” Especially risky is what you don’t think is possible, but happens anyway.

About the Global Financial Crisis of 2007-09, a former Vice Chairman of the Federal Reserve candidly observed: “Not only didn’t we see it coming,” but in the midst of it, “had trouble understanding what was happening.” Similarly, “Central banks and regulators failed to see the bust coming, just as they failed to anticipate its potential magnitude,” as another top central banking expert wrote.

The next financial crisis could be the same—we may take another blindside hit for a big financial sack.

In his memoir of the 2007-09 crisis, former Secretary of the Treasury Henry Paulson wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.” If the next financial crisis is again triggered by what we don’t see coming, the government reactions will once again be flying by the seat of their pants, making it up as they go along.

2. A Purely Malicious Macro-Hack of the Financial System

We keep learning about how vulnerable to hacking, especially by state-sponsored hackers, even the most “secure” systems are. Here I am not considering a hack to make money or collect blackmail, or a hack for spying, but a purely malicious hack with the sole goal of creating destruction and panic, to cripple the United States by bringing down our amazingly complex and totally computer-dependent financial information systems.

Imagine macro-hackers attacking with the same destructive motivation as the 9/11 terrorists. Suppose when they strike, trading and payments systems can’t clear, there are no market prices, no one can find out the balances in their accounts or the value of their risk positions, and no one knows who is broke or solvent. That is my second next crisis scenario.

3. All the Central Banks Get It Wrong Together

We know that the major central banks operate as a tight international club. Their decisions are subject to vast uncertainty, and as a result, they display significant cognitive and behavioral herding.

I read somewhere the colorful line, “Central banks have become slaves of the bubbles they blow.” Whether or not we think that, there is no question that the principal central banks have all together managed to create a gigantic global asset price inflation.

Suppose they have also managed to set off a disastrous, runaway general price inflation. Then ultimately interest rates must rise, and asset prices fall. This will be in a setting of stretched asset prices and high debt. As asset prices fall, speculative leverage will be punished. “Every great crisis reveals the excessive speculations of many houses which no one before suspected,” as Walter Bagehot said. The Everything Bubble of our time would then implode and the crisis would be upon us. Huge government bailouts would ensue.

We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

4. A Housing Collapse Again

A particularly notable asset price inflation is, once again, that in the price of houses, which are the biggest investment most households have and are the mortgage collateral for the biggest loan market in the world. House prices are now rising in the U.S. at the unsustainable rate of more than 18% a year, but this is also global problem. Many countries, about 20 by one reckoning, face extreme house price inflation. Said one financial commentator, “This is now a global property bubble of epic proportions, never before seen by man or beast, and it has entrapped more central banks than just the Fed.”

House prices depend on high leverage and are, as is well known, very interest rate sensitive. What would an actual market-determined mortgage rate look like, instead of the Federal Reserve-manipulated 3% mortgage rate the U.S. has now? A reasonable estimate would begin with a 3% general inflation, and therefore a 4.5% 10-year Treasury note. The long-term mortgage rate would be 1.5% over that, or 6%. That would more or less double the monthly payment for the same-sized mortgage, house prices would fall steeply, and our world record house price bubble implode. Faced with that possibility, so far the Federal Reserve’s choice has been to keep pumping up the bubble.

Overpriced, leveraged real estate is a frequent culprit in financial crises. Maybe once again.

5. An Electricity System Failure

Imagine a failure, similar to our financial system macro-hack scenario, resulting from an attack maliciously carried out to bring down the national electricity system, or from a huge solar flare, bigger than the one that took down the electric system of Quebec in 1989.

Physically speaking, the financial system, including of course all forms of electronic payments, is an electronic system, utterly dependent upon the supply of electricity. Should that fail, it would certainly be good to have some paper currency in your wallet, or actual gold coins. Bank accounts and cryptocurrencies will not be working so well.

6. The Next Pandemic

It feels like we have survived the Covid pandemic and the crisis is passing. Even with the ongoing problem of the Delta variant, we are certainly more relaxed than at the peak of the intense fear and the lockdowns of 2020. Instead of financial markets being in free fall as they were, they are booming.

But what about the next pandemic? We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

How soon could a new pandemic happen? We don’t know.

Might that new pandemic be much more deadly than Covid? Consider Professor Adam Tooze: “One thing 2020 forces us to come to terms with is that this wasn’t a black swan [an unknown possibility]. This kind of pandemic was widely and insistently and repeatedly predicted.” What wasn’t predicted was the political response and the financial panic. “In fact,” Tooze continues, “what people had predicted was worse than the coronavirus.”

If the prediction of an even worse and more deadly new pandemic becomes right, perhaps sooner than we might think, that might trigger our next financial crisis.

7. A Major War

By far the most important financial events of all are big wars.

A sobering talk I heard a few years ago described China as “Germany in 1913.”

This of course brings our mind to 1914. The incredible destruction then unleashed included a financial panic, and the war created huge, intractable financial problems which lasted up to the numerous sovereign defaults of the 1930s.

What if a big war happened again in the 21st century? If you think that is not possible, recall the once-famous book, Norman Angel’s The Great Illusion, which argued that a 20th-century war among European powers would be so economically costly that it would not happen. In the event, it was unimaginably costly, but nonetheless happened.

One distinguished scholar, Graham Allison of Harvard, has written: “A disastrous war between the United States and China in the decades ahead is not just possible, but much more likely than most of us are willing to allow.” A particular point of tension is the Chinese claim to sovereignty over Taiwan.  Might a Chinese decision to end Taiwan’s freedom by force be the equivalent of the German invasion of Belgium in 1914?

Would anyone be crazy enough to start a war between China and the United States? We all certainly hope not, but we should remember that such a war did already occur: most of the Korean War consisted of battles between the Chinese and American armies. In his history of the Korean War, David Halberstam wrote, “The Chinese viewed Korea as a great success,” and that Mao “had shrewdly understood the domestic benefits of having his county at war with the Americans.”

If it happened again it would be a terrific crisis, needless to say, with perhaps a global financial panic thrown in.

Overall, we can say there is plenty of risk and uncertainty to provide the possibility of the next financial crisis.

Based on remarks at an American Enterprise Institute teleconference, “What might cause the next financial crisis?” on June 29, 2021.

The Next Housing Bust

Published in Law & Liberty.

The Supreme Court has determined that the Federal Housing Finance Agency (FHFA)—the regulator and conservator of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—was unconstitutionally structured because its director could only be removed from office for cause. The Court held in its June 23, 2021 decision that the constitutional issue could be resolved by striking the “for cause” language—leaving the FHFA in place, but headed by a director who could be removed from office at any time by the President.

Immediately upon the Court’s decision, the White House fired the FHFA director, Mark Calabria, and replaced him with a temporary appointment. Calabria had been following a policy of increasing the capital of the GSEs in preparation for privatizing them and reducing their risk to the taxpayers; his temporary replacement forthwith reversed course. Said Sandra Thompson, Calabria’s acting replacement, “It is FHFA’s duty through our regulated entities to ensure that all Americans have equal access to safe, decent, and affordable housing.”

This means a sharp change in marching orders for Fannie and Freddie—from a future as privatized companies to a future of being used to accumulate the risk of the government’s housing policies and increase the risk to taxpayers. 

This sets up the conditions for the next housing bust. We have seen this movie twice before and know the ending.

The first time began in 1968 when HUD developed a “10-year housing program to eliminate all substandard housing.” Since there were then, like now, very large budget deficits, this program was implemented off-budget. The answer was the 1968 Housing and Urban Development Act, which had FHA insuring the 10-year plans’ subsidized single- and multifamily loans and Fannie funding them. Fannie was up to then a government agency with its debt on-budget. The 1968 Act converted it to an off-budget GSE. Now it was in a position to fund the largest expansion of newly built and rehabilitated subsidized housing in the nation’s history with up to 40-year fixed-rate loans. There have been only two years where privately owned single- and multifamily housing completions exceeded 2 million: 1972 (2.00 million) and 1973 (2.10 million)—when the population was 210 million and the number of households was 67 million, 36% and 48% respectively and smaller than today. As a reference, in 2006, at the peak of the Housing Bubble, there were 1.98 million completions.

In just a few years, HUD’s program turned into a disaster for cities and their residents, as described in the book Cities Destroyed for Cash: The FHA Scandal at HUD written in 1973.  Detroit, Chicago, Cleveland, and many other cities never fully recovered from the effects of HUD’s scheme. By the early 1980s, Fannie’s investment in these loans had suffered huge interest rate risk losses that left it effectively insolvent. It was only able to continue in business given its GSE status and backing by the Treasury.   

The second time began in 1992. Over the following years, the government forced Fannie and Freddie to reduce their credit standards so as to acquire trillions in risky loans under the rubric of affordable housing. The first of many trillion-dollar commitments was announced by Jim Johnson, Fannie’s very politically connected CEO, in March 1994. He vowed to “transform the housing finance system.” He did, but not in the way he intended. In 1994, HUD followed with its National Homeownership Strategy, about which President Clinton claimed: “Our home ownership strategy will not cost the taxpayers one extra cent.” A poor prediction indeed!

This government policy was pursued until 2008 through HUD’s authority to impose what were called “Affordable Housing Goals” on the GSEs. To meet ever more aggressive HUD goals, Fannie and Freddie had to continually reduce their mortgage credit standards, especially with respect to loan-to value and debt-to-income ratios. Instead of HUD’s strategy promoting homeownership, it resulted in some 10 million foreclosures and once again devastated our cities.

The full extent of the catastrophic credit risk expansion that took place has now been documented in a detailed analysis that researchers at FHFA and AEI released in May 2021. This is the first “comprehensive account of the changes in mortgage risk that produced the worst foreclosure wave since the Great Depression.” By analyzing over 200 million mortgage originations from 1990 onward, they showed “that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis well before the actual event.” Average leverage and average DTI (the debt-payment to income ratio) on both home purchase and refinance loans increased significantly over the decade. Since Fannie and Freddie accounted for about 50% of the total mortgage market over the period 1994-2007, their complicity in the ensuing disaster is clear. The bubble’s inevitable collapse brought down many banks and other financial institutions, creating the 2008 financial crisis. In 2008 Fannie and Freddie were bailed out by the taxpayers and put into conservatorship, where they remain today, 13 years later.

The Democratic Congress elected in the wake of the crisis adopted the Dodd-Frank Act of 2010. It reflected the Democrats’ view that insufficient regulation caused the crisis. But the most important culprits—Fannie and Freddie—were left untouched, insolvent, and still functioning. Because it has become entirely clear that the US government is effectively the 100 percent guarantor of the GSEs, with the taxpayers fully on the hook, the financial markets provide unlimited funds for their operations. Thus the GSEs are allowed to operate profitably in their government conservatorship by using the U.S. Treasury’s global credit card. Today their off-budget, taxpayer-backed debt totals nearly $6 trillion, with the Federal Reserve funding more than $2 trillion of their mortgage-backed securities. 

As the saying goes, those who cannot remember the past are condemned to repeat it, and the U.S. has a history of catastrophic housing blunders to remember, also including the spectacular failure and bailout at taxpayer expense of the savings and loan industry in 1989. Three dramatic failures in four decades—not an enviable track record. 

Any president, thanks to the Supreme Court decision, now has direct control over most of the mortgage finance system. This includes Fannie and Freddie through FHFA; and the FHA and Ginnie Mae through HUD.

Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

While the Supreme Court’s decision about the governance of FHFA is correct on its merits, the main problem is that we have a nationalized and socialized housing finance system. The American Jobs Plan proposes spending $318 billion to construct, restore, and modernize more than two million affordable homes. It is almost certain that the government will use its new control over the GSEs to once again make them the central elements of its plan with another weakening of credit standards. Thus we face the prospect of combining some of the worst features of HUD’s 1968 subsidized housing debacle with the GSEs’ disastrous foray into high-risk lending. Given this, can another mortgage debt crisis be far behind? 

However, the government does not have to follow the fatally flawed policies of the Johnson, Clinton, and Bush administrations. If instead the following four principles were implemented, the United States would have a robust, successful housing finance system it needs and its citizens deserve.

I. The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should function principally as a private market, not a government-dominated one.

The foreclosures and financial losses associated with the 1968 Housing Act, the savings and loan (S&L) debacle of the 1980s, and the actions of Fannie, Freddie, and HUD did not come about in spite of government support for housing finance but because of that government backing. Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

Although many schemes for government guarantees of housing finance in various forms have been circulating in Washington ever since the GSEs entered receivership, they are fundamentally the same as the policies that caused failures in the past. The flaw in all these ideas is the notion that the government can successfully guarantee increasing risk and will establish an accurate risk-based price for its guarantees. Many examples show that this is politically beyond the capacity of government.

First, the government’s guarantee eliminates an essential element of financial discipline—it removes credit risk from the investors. Second, the seemingly free-lunch nature of the off-budget guarantees creates the lure of the “affordable housing cookie jar”—cross-subsidies, “free money,” FHA and the GSEs competing for high-risk borrowers, and the perennial weakening of underwriting standards—all of which are backed by a government guarantee. So the outcome will be the same: underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.

II. Ensuring mortgage credit quality, and fostering the accumulation of adequate capital behind housing risk, can create a robust housing investment market without a government guarantee.

This principle is based on the fact that high-quality mortgages are good investments and have a long history of low losses. Instead of expanding government guarantees to reassure investors in MBS, we should simply ensure that the mortgages originated and distributed are predominantly of good quality. The characteristics of a good mortgage do not have to be invented; they are well known from many decades of experience. These are loan characteristics that, taken together, are highly predictive of loan performance. They include the borrower’s credit score, the debt-payment to income ratio (DTI), the combined loan-to-value ratio (CLTV), loan type (fixed or adjustable mortgage rate), loan term, loan purpose, whether the borrower’s income is fully documented, and whether the mortgage has a feature that modifies the amortization of loan principal. We know that mortgage lending must limit risk layering. We know how to apply a summary measure of default risk. The Stressed Mortgage Default Rate (MDR) is a simple, straightforward way to do this.

Regulation of credit quality could help prevent the deterioration in underwriting standards, although in previous cycles regulation promoted lower credit standards. The natural human tendency to believe that good times will continue—and that “this time is different”—will continue to create price booms in housing. Housing bubbles spawn risky lending; investors see high yields and few defaults, while other market participants come to believe that housing prices will continue to rise. Future bubbles and the losses suffered when they deflate can be minimized by focusing regulation on the maintenance of credit quality.

Stressed MDRs have demonstrated their efficacy. Calculated solely on the basis of loan characteristics present at origination, Stressed MDRs are highly predictive of default rates both in a non-stress delinquency environment (R-squared is 96%) and in a stress delinquency environment (R-squared is 99.9%) for all types of mortgage loans. By using MDR to risk rate loans at origination and regulate loan risk, we can control the accumulation of future losses which result from deteriorating underwriting standards.

III. All programs for assisting low-income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.

The third principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must explicitly balance the interest in low-income lending against the risks to the borrowers and to the taxpayers. In the past, implicit “affordable housing” subsidies through weak credit standards turned out to escalate the risks for both borrowers and taxpayers. The quality and budgetary trade-offs of riskier lending should be clear and on-budget.

The boom-bust cycle that low-income homebuyers have been subjected to for decades under the guise of making homes more affordable by escalating risk with weak lending standards should be broken. This result could be accomplished with the 20-Year Wealth Building Home Loan combined with an interest rate buy down provided by the federal government to an income-targeted group of first-time buyers. This would materially reduce defaults in low-income neighborhoods and sustainably foster generational wealth building. 

If the federal government wants to subsidize low and moderate income homebuyers effectively, it should use this and other on-budget, transparent and sustainable ways to do it. Fannie and Freddie have no role here, as the only way they can participate is through reducing their credit standards with the real cost hidden in the form of expanding risk.

IV. Fannie Mae and Freddie Mac should be truly privatized, with their hidden subsidies and government-sponsored privileges eliminated over time.

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so the private sector takes on more of the secondary market as the GSEs withdraw. The progressive withdrawal of GSE distortions from the housing finance market should lead to the sunset of the GSE charters at the end of the transition. This should include successive reductions in the GSEs’ conforming loan limits by 20 percent of the previous year’s limits each year, according to a published schedule, so the private sector can plan for the investment of the necessary capital and create the necessary operational capacity. The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance (MI) companies, and private securitization. Congress should make sure that it facilitates opportunities for additional financing alternatives.

We know that none of this will happen in the near term, and the opposite of these principles will probably be followed by the current administration. Nonetheless, the principles define the housing finance direction that a future, market-oriented Congress and administration should take. In the meantime, all mortgage actors should try to protect themselves against the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.

The Rise (and Fall) of the Modern Bank of England

Published in Law & Liberty.

The notion of “an essentially contestable concept” means an issue which by its very nature can never be definitively settled, no matter how much brilliance is expended on it, and about which no logic or evidence can ever force disputing parties to agree. Thus, they are, in the words of Stuart Hampshire, “permanently and essentially subject to revision and question.” In short, the debate never ends. How many such essentially contestable propositions have we seen! Macroeconomics, like politics and philosophy, is full of them.

In macroeconomics, one essentially contestable issue is what the ideal nature and functions of a central bank should be. Given the immense financial and political importance of central banks in a world that runs entirely on the fiat currencies they create and inflate, these are critical questions. But no answer, though it may be in fashion for a time, turns out to be permanent. Crises occur, theories run up against surprising reality, the debates resume, and central bank evolution has no end, no ideal final state.

Harold James’ Making a Modern Central Bank is a very instructive book in this respect. It relates in great and often exhausting detail the lengthy debates concerning the functions and organization of that iconic central bank, the Bank of England, in the midst of the financial events of the years 1979-2003, with a brief but essential update at the end on what has happened since then. “The Bank of England seemed to be engaged in a constant quest to determine what its real function might be,” James observes. The quest involved lots of brilliant minds and colorful personalities, and they remind us that it is easier to be brilliant than right when dealing with the economic and financial future.

In the longer historical background of these debates, and important to their psychology, is that “the Bank,” as the book usually refers to it, had had a great run as the dominant central bank in the world under the gold standard. It had impressive traditions going back to its founding in 1694. Then, in the wake of the financial destruction (as well as all the other destruction) of the First World War, the role of the world’s leading central bank was taken over by the Federal Reserve representing the newly dominant U.S. dollar.

Still, the Bank of England “punches internationally above its weight,” James writes, “not because of the strength of the British economy, but because [quoting Paul Krugman] of its ‘intellectual adventurousness.’” This intellectual flair is well displayed in the book. Moreover, in its institutional history, the Bank calls on long experience in the grand sweep of economic and financial evolution. In 1979, it was approaching its 300th anniversary, while the Fed was less than 70 years old.

At that point, the Bank of England was facing severe stress. “The 1970s were years of crisis everywhere, but especially in the U.K.” There was “in particular the collapse of the fixed exchange rate world of Bretton Woods,” which was the final disappearance of the gold standard over which the Bank had once presided. There were the two oil price shocks, generating “substantial instability.” The global Great Inflation was roaring. The British pound sterling kept getting weaker

According to James, “The policy discussions of the U.K. in 1976 were dramatic and humiliating. They turned into an indictment of a Britain that had failed. Because of the foreign exchange crisis, the Governor of the Bank of England and the Chancellor of the Exchequer could not make their scheduled journeys to the IMF [International Monetary Fund] Annual Meetings.” The prime humiliation was that Britain, once a vast imperial and financial power, had been forced to ask the IMF for a loan which imposed heavy cuts in the government budget. “’Goodbye Great Britain” said a 1975 Wall Street Journal headline.

Of course, there were different ideas about what to do: “There was a struggle between differing parts of the British economic establishment, a clash [between] Treasury and Bank.” The discussions, debates, and political dialectic between the Treasury and the Bank are a central theme of the entire book. Can a central bank be truly independent, or is it instead just a subsidiary and a servant of the Treasury, or is it something in between—perhaps “independent within the government,” as the Federal Reserve used to incoherently but diplomatically say? For James, “The relationship between Treasury and Bank remained permanently haunted by potential or actual controversy.”

Always in the background in the Bank of England case, James points out, is this provision of the Bank of England Act of 1946:

The Treasury may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest.

That’s pretty clear. There is certainly nothing in the Federal Reserve Act about giving directions in that fashion, although the U.S. Treasury Department and the White House always do want to give directions to the Fed and sometimes succeed. As Donald Kettl observed in Leadership at the Fed, “The Fed’s power continues to rest on its political support,” and James shows how true this is of the Bank of England.

The Bank of England Act of 1998 is more nuanced, but does not change who the senior partner is:

The objectives of the Bank of England shall be—(a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government.

It is the Treasury (Her Majesty’s Government) that gets to determine what “price stability”—that is, the inflation target— will be, not the Bank. The Bank thus has “operational” independence, but not target independence. In contrast, the Federal Reserve has had the remarkable hubris to assert it can set an inflation target (define “price stability”) by itself. In most other countries it is given by or negotiated with the government.

Throughout these challenging events, the roles of the Bank of England as promoter of systemic financial stability, provider of financing to combat the panics and financial instability, coordinator and regulator of the banking firms, and creator of moral hazard by bailouts, are prominent—all in addition to its key monetary, inflation-controlling role.

As the book proceeds, the Bank moves from 1970s humiliation to what appears to be a successful “modern central bank” by 2003, although that afterwards turns out to be ephemeral. Along the way were many crises, all interestingly related for those with a taste for financial history.

There was another foreign exchange crisis, involving more humiliation. On “Black Wednesday”—September 16, 1992—the pound sank in spite of very costly “and ultimately futile” support by the Bank of England, breaking the European Exchange Rate Mechanism of fixed parities and famously making giant profits for George Soros and other speculators. “The experiment in European cooperation had ended in failure,” bringing “a progressive distancing of the U.K. from Europe,” and was “an earlier version of Brexit,” James suggests.

There were multiple credit and banking crises and bailouts. These included a deep real estate bust, when house prices fell from 1989 to 1993 and many banks fell along with them. A larger one, National Home Loans, had “two-fifths of its loan book over two months in arrears.” There was the scandalous collapse of BCCI, the Bank of Credit and Commerce International, “popularly dubbed the Bank of Crooks and Cocaine International.” In 1991, “it looked as if there might be a panic and a run on the Midland Bank,” one of the largest banks. The Bank of England considered Midland “indeed too big to fail.”

The famous firm of Barings, “London’s oldest merchant bank,” collapsed in 1995 from the notorious losses of a rogue trader in Asia. Barings had also failed in 1890 from Argentine entanglements, when it was rescued by the Bank of England; this time it got sold to a Dutch bank for one pound. The 1995 Barings crisis involved a particularly British problem: “the worry that the Queen had very nearly lost some of her funds.”

Throughout these challenging events, the roles of the Bank of England as promoter of systemic financial stability, provider of financing to combat the panics and financial instability, coordinator and regulator of the banking firms, and creator of moral hazard by bailouts, are prominent—all in addition to its key monetary, inflation-controlling role. How many functions should the Bank of England have? This kept being debated.

“In the 1990s, the Bank began to specify essential or core purposes, in particular initially three: currency or price stability, financial stability, and the promotion of the U.K. financial service sector,” James points out. However, the Bank still had “fourteen high-level strategic objectives, twenty-seven area strategic aims, forty-nine business objectives and fifty-five management objectives.”

And then came the big redesign. Complex, intensely political, intellectually provocative negotiations among strong personalities in the government and the Bank, related in enjoyable journalistic detail, led to the 1998 Bank of England Act. This act sharply focused the Bank on the core function of maintaining price stability, which as defined turned out to be an inflation target. The Bank would get to choose the methods to achieve this, though it would be given the target. The act also took financial supervision away from the Bank and moved it all to a new, consolidated regulator, the Financial Services Authority (FSA).

The result was an “independent,” “modern” central bank in line with the international central banking theories and fashion of the new 21st century. As James explains: “A modern central bank has a much narrower and more limited set of tasks or functions than the often historic institution from which it developed. The objective is the provision of monetary stability, nothing more and nothing less.” For the Bank of England, “By the early 2000s . . . that task looked like it had been achieved with stunning success.”

It takes the book 450 scholarly pages to reach this outcome. The remaining 11 pages relate how it didn’t work. The “modern” central bank turned out to be far from the end of central banking history or the end of the related debates:

“The monetary and financial governance . . . which appeared to have been functioning so smoothly and satisfactorily, was severely tested after 2007-2008.”

“The crisis . . . required central banks to multi-task feverishly.”

“A new wave of institutional upheaval set in.”

“The 2012 Financial Services Act abolished the FSA.”

“By 2017 . . . Something that looked rather more like the old Bank . . . was being recreated.”

“The old theme of the Bank as provider or guarantor of financial stability came back.”

And so in central banking, the great evolution and cycling of ideas and of fashions continues. The essentially contestable concepts keep being contested.

Fifty Years Without Gold

Published in Law & Liberty.

Fifty years ago, on Sunday evening, August 15, 1971, after crisis meetings with close advisers at Camp David, President Richard Nixon announced an historic decision in his “Address to the Nation Outlining a New Economic Policy.” It was by then clear that the United States might not have enough gold to meet its international commitment to redeem dollars. It was experiencing “the start of a run on the dollar.” Paul Volcker, then with the Treasury Department, reported to the President on gold losses. “Dollar dumping accelerated. France sent a battleship to take home French gold from the New York Fed’s vaults.” The French not unreasonably believed that the special status of the dollar gave it an “exorbitant privilege,” making it “monumentally over-privileged.” Already in the 1960s, French President Charles de Gaulle had ordered the Bank of France to increase the amount of payments in gold from the United States.

Said Nixon to the nation, “The speculators have been waging an all-out war on the American dollar,” and that to “protect the dollar from the attacks of the international money speculators” would take “bold action.” “Accordingly,” he announced, “I have directed [Treasury] Secretary Connolly to suspend temporarily the convertibility of the dollar into gold.” The suspension of course turned out to be permanent. Today everybody considers it normal and almost nobody even imagines the slightest possibility of reversing it.

Nixon had thereby put the economic and financial world into a new era. By his decision to “close the gold window” and have the American government renege on its Bretton Woods commitment to redeem dollars for gold for foreign governments, he fundamentally changed the international monetary system. In this new system, still the system of today, the whole world always runs on pure fiat currencies, none of which is redeemable in gold or anything else, except more paper currency or more accounting entries. Instead of having fixed exchange rates, or “parities,” with respect to each other, the exchange rates among currencies can constantly change according to the international market and the interventions and manipulations of central banks. The central banks are free to print as much of their own money as they and the government of which they are a part like.

This was a very big change and highly controversial at the time. The Bretton Woods agreement was a jewel of the post-World War II economic order, negotiated in 1944 and overwhelmingly voted in by the Congress and signed into law by President Truman in 1945. Its central idea was that all currencies were linked by fixed exchange rates to the dollar and the dollar was permanently linked to gold. Now that was over. Sic transit gloria.

Economist Benn Steil nicely summed up the global transition:  “The Bretton Woods monetary system was finished. Though the bond between money and gold had been fraying for nearly sixty years, it had throughout most of the world and two and a half millennia of history been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was, in essence, the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good.” It was sailing, we might say, from a Newtonian into an Einsteinian monetary world, from a fixed frame of reference into many frames of reference moving with respect to each other. Nobody knew how it would turn out.

Fifty years later, we are completely used to this post-Bretton Woods monetary world. We take a pure fiat money system entirely for granted as the normal state of things. In this sense, in this country and around the world, we are all Nixonians now.

How very different our prevailing monetary system is from the ideas of Bretton Woods. The principal U.S. designer of the Bretton Woods system, Harry Dexter White insisted, strange to our ears, that “the United States dollar and gold are synonymous.” Moreover, he opined that “there is no likelihood that . . . the United States will, at any time, be faced with the difficulty of buying and selling gold at a fixed price.”

This was a truly bad forecast. It may have been arguable in 1944, but by the 1960s, let alone 1971, it was obviously false. (White’s misjudgment here was exceeded by his bad judgment in being, in addition to an officer of the U.S. Treasury, a spy for the Soviet Union.)

A better forecast was made by Nixon’s Treasury Secretary, John Connally. Meeting with the President two weeks before the August 15, 1971 announcement, he said, “We may never go back to it [convertibility]. I suspect we never will.”  He’s been right so far for fifty years.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard. . . . But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.”

Running low on gold and facing the inability to meet its Bretton Woods obligations, the American government had to do something. Instead of cutting off gold redemption, it could have devalued the dollar in terms of gold. A decade before, British Prime Minister Harold Macmillan had suggested to President John Kennedy that the already-apparent problems could be addressed if the dollar were devalued to $70 per ounce of gold, from the official $35. Whether you have enough gold or not depends on the price. But announcing a formal devaluation was politically very unattractive and no one could really know what the right number was going forward. Today, after fifty years of inflation, it takes about $1,800 to buy an ounce of gold, which is a 98% devaluation of the dollar relative to the old $35 an ounce.

How shall we judge the momentous Nixon decision? Was it good to break the fetters of the “barbarous relic” of gold and voyage into uncharted seas of central bank discretion? Most economists say definitely yes. At the time, the public response to Nixon’s speech was very positive. The stock market went up strongly.

But wasn’t it dangerous to remove the discipline Bretton Woods provided against wanton money creation and inflationary credit expansion? The end of Bretton Woods was followed by the international Great Inflation of the 1970s, and later by our times in which central banks, including the Federal Reserve, with a clear conscience, commit themselves to perpetual inflation instead of stable prices, and promise to depreciate the value of the currency they issue. They speak of “price stability,” but mean by that a stable rate of everlasting inflation. As we observe the renewed unstable and very high rate of inflation of 2021, we may reasonably ask whether discretionary central banks can ever know what they are really doing. Personally, I doubt it.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard….But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.” Central banks, including the Federal Reserve, are indeed subject to political pressure and depend on political support. Politicians, Hayek added, are governed by the “modified Keynesian maxim that in the long run we are all out of office.” If Hayek is watching today from economic Valhalla as the Federal Reserve buys hundreds of billions of dollars of mortgages, and thus stokes the housing market’s runaway price inflation, he will be murmuring, “As I said.”

The distinguished economist and scholar of financial crises, Robert Aliber, pointedly observed that the Nixonian system of pure fiat money and floating exchange rates has been marked by a recurring series of financial crises around the world. Such crises erupted in the 1970s, 1980s, 1990s, 2000s, and 2010s. The fiat currency system was born to solve the 1971 crisis, but it certainly cannot be given a gold medal for financial stability since then. Aliber wrote to me recently: “I used to think that the failure to ‘save Lehman’ was the biggest mistake that the U.S. Treasury ever made, now I realize 1971 was the bigger mistake.”

Professor Guido Hülsmann, speaking in 2021, described the results of the end of Bretton Woods in these colorful terms: “All central banks were suddenly free to print and lend as many dollars and pounds and francs and marks as they wished. . . . Nixon’s decision led to an explosion of debt public and private; to an unprecedented boom of real estate and financial markets;…to a mind-boggling redistribution of incomes and wealth in favor of governments and the financial sector;…and to a pathetic dependence of the so-called financial industry on every whim of the central banks.”

As always in economics, you cannot run the history twice. What would have happened had there been a different decision in 1971, and whether it would have been better or worse than it has been under the Nixonian system, is a matter for pure speculation. Another speculation, good for our humility, is to wonder what we ourselves would usefully have said or done, had we been at Camp David among the counselors of the President, or even been the President, in that crucial August of fifty years ago.

The Bretton Woods system had developed by then a severe, and as it turned out, fatal problem. Our Nixonian system is seriously imperfect. But given the deep, fundamental uncertainty of the economic and financial future at all times; the inescapable limitations of human minds, even the best of them; and the inevitable politics that shape government behavior, including central bank behavior, we are not likely ever to achieve an ideal international monetary system. We are well-advised not to entertain either foolish hopes or foolish faith in central banks.

In any case, there is no denying that August 15, 1971 was a fateful date.

‘Biden Inflation’ made simple: Borrow from the Fed, take away from the rest of us

Published in The Hill and MSN.

“What is the difference between banking and politics?” a pointed old witticism goes. “Banking is borrowing money from the public and lending it to your friends. Politics is taking money from the public and giving it to your friends.”

The current American government has a new twist on this, however: Politics is borrowing money from the Federal Reserve and giving it to your friends. Clever, eh? The Fed can print up all the money it wants and the government can borrow it and pass it out. Except that, eventually, you find out that this depreciates the nation’s currency and brings high inflation.

So now we have the ‘Biden Inflation’, which I calculated as running at an annualized rate of more than 7 percent from the end of 2020 through June.

Let us state the obvious facts which everybody knows about a 7 percent rate of inflation. It means that if you are a worker who got a pay raise of 3 percent, the government has made your actual pay go down by 4 percent — that is, plus 3 percent minus 7 percent = minus 4 percent.  If you got a raise of 2 percent, the government cut your real pay by 5 percent.

If you are a saver earning, thanks to the Federal Reserve’s policies, the average interest rate on savings accounts of 0.1 percent, then with a 7 percent rate of inflation, the government has taken away 6.9 percent of your savings account.

If you are a pensioner on a fixed pension or annuity, the government has cut your pension by 7 percent.

In a sound money regime, in order to spend a lot, the politicians have to tax a lot. They then have to worry about whether workers, savers and pensioners will vote for those who escalated their taxes.

With the borrowing from the Federal Reserve ploy, the politicians avoid the pain of having to vote for increased taxes but they still savor the pleasure of voting for their favorite spending. Nonetheless, all the money for the politicians to give their friends has, in fact, been taken from the workers, the savers and the pensioners. It has just been taken in a tricky way by using the Fed.

In a previous generation, when the Federal Reserve was led by William McChesney Martin, for example, the public discourse was clear about this. Martin, who was Fed chairman from 1951 to 1970, called inflation “a thief in the night.” He also said, “We can never recapture the purchasing power of the dollar that has been lost.”  This was long before the Fed newspeak of today, which pretends that inflation at 2 percent forever is “price stability.”

But not even today’s Fed can languidly face a 7 percent rate of inflation. So while still planning to create perpetual inflation, it keeps repeating, and hoping against hope, that the very high inflation is “transitory.”

However transitory the current high inflation may be, the money of the workers, the savers and the pensioners has still been taken and won’t be given back. If the rate of inflation falls, their money will still be being taken, just at a lower rate. If inflation speeds up further, as it may, their money will be taken faster.

Why a Fed Digital Dollar is a Bad Idea

Published in Real Clear Markets with co-author Howard Adler.

On July 19, the top-level President’s Working Group on Financial Markets met to address “the need to act quickly to ensure there is an appropriate U.S. regulatory framework in place” for stablecoins,  a form of cryptocurrency backed by assets, often denominated in dollars. The meeting cited “the risks to end-users, the financial system and national security.”  This is a pretty clear message from a group composed of the Secretary of the Treasury, the Chairs of the Federal Reserve, SEC, CFTC, and FDIC and the Comptroller of the Currency.

Another element of federal policy on this issue was telegraphed by Fed Chair Jerome Powell when he recently discussed the Federal Reserve’s research on issuing its own digital dollar stablecoin.  “You wouldn’t need stablecoins, you wouldn’t need cryptocurrencies if you had a digital U.S. currency– I think that’s one of the stronger arguments in its favor,” he said.  The impetus towards such central bank digital currencies (CBDCs) in many other countries, coupled with the thought that this might weaken the dollar’s global role, added to regulatory concerns about private stablecoins, appear to be pushing the Fed towards the issuance of its own CBDC.  The motivation is understandable, but we still think it would be a bad idea.

There are now a number of private stablecoins circulating that are backed in some fashion by U.S. dollar-denominated assets, such as Tether and USD coin.  Facebook has announced its intention to launch its own U.S. dollar-backed stablecoin, the “diem,” later this year.  If used by a meaningful proportion of Facebook’s several billion subscribers, this could enormously increase the stablecoin universe.  Government officials, unsurprisingly, are focusing on the lack of any regime for their regulation and the need for one.

At the same time, central banks worldwide are considering their own CBDCs.  As of April 2021, more than 60 countries were in some stage of exploring an official digital currency, including many highly developed countries. But it is China’s digital yuan, now being tested in a dozen Chinese cities, that causes the most concern.

China seems to have two goals in establishing a CBDC. The first is more control over its citizens. If the digital yuan became ubiquitous, the Chinese government would have instant knowledge and control over its citizens’ money, potentially allowing it, for example, to confiscate the funds of political dissidents or block their payments and receipts.

The second goal is to challenge the dominance of the U.S. dollar in international transactions. The dollar is the currency used in 88 percent of foreign exchange transactions, while the renminbi was used in only four percent, according to the Bank for International Settlements. Who, located outside of China, would choose to give the Chinese Communist Party control over their money? The answer is those potentially subject to U.S. sanctions. As the issuer of dollars that the world’s banks need to transact business, the United States government has long demanded and received access from banks to information related to international transactions, which it has used to impose sanctions on hostile states and those it considers terrorists and criminals. Some countries (perhaps Iran, Cuba and Venezuela) may choose to use the digital yuan to avoid U.S. sanctions, as may countries participating in China’s Belt and Road program whose large debts to China may provide the Chinese with leverage over their choices.

If the digital yuan and other CBDCs are widely implemented, as seems almost inevitable, proponents of the Fed digital dollar may argue that there would be erosion in the dominance of the U.S. dollar in international trade and less demand for U.S. dollar-denominated assets including U.S. Treasury securities, pushing interest rates on Treasuries up, making it more costly for the United States to fund its historic deficits. The Federal Reserve might also believe it is in the public interest to issue its own stablecoin because it would be safer and less prone to fraud than private cryptocurrencies.  In order to preserve the dollar’s dominance and to constrain the use of private cryptocurrencies, it appears likely that the Federal Reserve will decide this fall, when it is scheduled to report on its consideration of a digital dollar, to move forward with its own CBDC.  Is this desirable?

Regulation of private stablecoins is on the way in any case, regardless of whether the Fed issues a stablecoin.  More importantly, a digital dollar would further centralize and provide vastly more authority to the already powerful Federal Reserve.  The negative impact of a Fed CBDC, both on citizens’ privacy rights and by shifting the power to allocate credit from the private sector to the government, would be enormous.

A Fed CBDC would make it hard for private citizens to avoid financial snooping by the government in every aspect of their financial lives. Moreover, suppose, as one would expect, that that the Fed’s CBDC siphoned large deposit volumes from private banks. The Fed would have to invest in financial assets to match these deposit liabilities, which would centralize credit allocation in the Federal Reserve, politicizing credit decisions and turning the Fed into a government lending bank. The global record of government banks with politicized lending has been dismal. A digital dollar could therefore undo more than a century of central bank evolution, which has usefully divided the issuer of money from private credit decisions. In the process, a digital dollar would subject private banks to vastly unequal and inevitably losing competition with the government’s central bank.  Finally, a CBDC would make it easier for the central bank to expropriate the people’s savings through negative interest rates.  For these reasons, a CBDC may fit an authoritarian country like China, but not the United States.

The delicious irony in the CBDC saga is that cryptocurrency was created because people were afraid of government control and wished to insulate their financial lives from monetary manipulation by central banks. With CBDCs, their ideas would be used to increase exactly the type of government interference and control that the crypto-creators sought to escape.

Pity FOMC Members Trying to Divine a Future They Can’t Know

Published in Real Clear Markets.

Pity the poor members of the Federal Open Market Committee! These Federal Reserve Board Governors and Federal Reserve Bank Presidents all know in their hearts, for sure, each one, that they do not and cannot know the financial and economic future—that they do not and cannot know, among other things, how bad the current hot inflation is going to get, or how long it will last.

Yet they are forced to make forecasts and statements published all over the world about things they cannot know.  Their statements move markets and influence behavior, so they have to guess and worry about not only about what will happen, but about what others will do based on what they say.  They cannot know for sure what the results of their own actions will be, or what actions others will take, no matter how sincerely they try to make their best guesses.  And of course, they have to worry about what the politicians will say or demand.

How seriously should we take the Fed’s forecasts?  Last December, they projected inflation for 2021 at 1.8%.  Half way through the year, this looks to have been wildly wrong.  The rapid inflation of 2021, with the Consumer Price Index increasing year to date at well over 6% annualized, clearly surprised them. I am speaking of the inflation as experienced only in 2021, with no comparison to the crisis time of 2020 or “base effect.”  You might say this was a blind side hit on the FOMC quarterbacks.

On June 16, FOMC members upped their guess for this year’s inflation to 3.4%–an 89% increase in their expected inflation rate, best thought of as the rate of depreciation in the dollar’s purchasing power, of your wages and of your savings.  This revised expectation came with an essential hedge: “Inflation could turn out to be higher and more persistent than we expect”– a sensible and true statement by Fed Chairman Powell.

Powell also made this sound observation: “We have to be humble about our ability to understand the data.”  Just like the rest of us!  But the rest of us are not assigned a part in the public drama of the FMOC.  “All the world’s a stage,” but the FMOC is an especially challenging stage.  The Fed is no better at economic and financial forecasting than anybody else, but the show must go on.

The FMOC continues to characterize the current high inflation as mostly “transitory.”  Well, paraphrasing J.M. Keynes, we may observe that in the long run, everything is transitory.  In the process of transitioning, a lot can happen.  FMOC members are now hoping and making estimates for inflation to fall back to around 2% by the end of 2022—a long forecasting way away.  There is a self-referential problem here: what inflation does depends on what the FOMC does. So the poor FOMC members must forecast their own behavior under future, unknown circumstances.

In particular, future inflation depends on whether the Fed keeps up its historic, giant monetization of government debt and mortgages, and on how big it bloats its own balance sheet, already over $8 trillion as of this week.  At its June meeting, the FMOC gave instructions to keep up the big buying, including buying more mortgages at the rate of $480 billion a year.

Consider that the housing market is in the midst of a runaway price inflation.  By March, using the Case-Shiller Index, house prices were up by 13% year over year.  The most current data indicates, according to the AEI Housing Center, house price inflation now running at over 15%.  Yet the Fed continues to stimulate and subsidize a market which is already red hot.  One is hard pressed to imagine any remotely plausible excuse for that.

We have to wonder what the poor FOMC members must feel in their own hearts about this issue.  Do they really believe in some rationale?  Is it a case of “We easily believe that which we wish to believe,” as Julius Caesar said?  Or in their private hearts, are the FOMC members only voting “yes” for monetizing more billions of mortgages with serious mental reservations and doubts?  I have to believe the latter is the case, but suppose we won’t know until their memoirs are published.

Meanwhile, the members of the FOMC are like the airmen in the old World War II song, “Comin’ in on a wing and a prayer!”  They have no alternative to that, so we must all wish them good luck.

A New Inflationary Era

Published in Law & Liberty.

In this provocative but calmly argued book, The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan predict a new era of widespread and lasting inflation. Goodhart, who has been a respected expert in financial, monetary, and central banking issues for decades, and Pradhan, a macroeconomist who studies global financial markets, express as their “highest conviction view” that “the world will increasingly shift from a deflationary bias to one in which there is a major inflationary bias.”

This conviction reflects their “main thesis” that “demographic and globalization factors were largely responsible for the deflationary pressures of the last three decades, but that such forces are now reversing, so the world’s main economies will, once again, face inflationary pressures over the next three or so, decades.”

The demographic factors include the end of the “positive supply shock” to the global supply of labor provided by China over the previous decades. That is because “China’s working age population has been shrinking, a reflection of its rapidly aging population,” and “the surplus rural labor supply no longer provides a net economic benefit through [internal] migration.” Thus, “China will no longer be a global disinflationary force” and it “no longer stands in the way of global inflation.”

A second key factor is that birth rates around the world continue to decline and longevity to increase, furthering the aging of society and increasing dependency ratios. In this context, the authors point out that the average fertility rate in advanced economies has fallen to well below replacement. This includes the U.S. For the foreseeable future, there will be an ever-lower ratio of active workers to the dependent elderly, with the huge expense of support and health care for the elderly stressing government budgets. They add this striking thought: “Our societies today are still relatively young compared to what is to come.”

These are longer-term, not short-term movements. The implication is that we may envision a slow, great cycling over decades of inflationary and disinflationary or deflationary periods. The 2020s swing to inflation would mark a great cycle reversal, with perhaps a book like The Death of Inflation of 1996 symbolizing the previous reversal.

In a different estimate of the duration of the coming inflationary era, Goodhart and Pradhan make it somewhat shorter: “The coronavirus pandemic… will mark the dividing line between the deflationary forces of the last 30-40 years, and the resurgent inflation of the next two decades.” But whether it’s two or three decades, the authors expect two or three decades, not two or three years, of significantly higher inflation.

The effects of such an inflation would be, they write, “pervasive across finance, health care, pension systems and both monetary and fiscal policies,” and they surely would be. For example, they suggest, “It will no longer be possible to protect the real value of pensions from the ravages of inflation.” Nominal interest rates will be higher, but “Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate,” so “negative real interest rates… will happen.” Here they should have written, “will continue,” since we already have negative real interest rates, the yield on the 10-year U.S. Treasury note now falling short of the year-over-year inflation rate.

Further, “The excessive debt amongst non-financial corporates and governments will get inflated away.” In other words, governments will implicitly default on their bloated debt through inflation, a classic strategy. Of the three alternatives the book cites for reducing excess debt, “inflation, renegotiation and default,” inflation is the easiest for a government with debt in its own currency.

As the authors say, “neither financial markets nor policymakers are prepared” for such an inflationary future world.

In a final chapter written in 2020, Goodhart and Pradhan conclude that the government deficits and debt created in response to the coronavirus pandemic have reinforced and accelerated the coming inflationary era. Government-mandated quarantines and lock-downs were “a self-imposed [negative] supply shock of immense magnitude.” To finance it, “the authorities quite rightly opened the floodgates of direct fiscal expenditures,” in turn financed by escalating debt and monetization.

“But,” they logically ask, “what then will happen as the lock-down gets lifted and recovery ensues”—as is now well under way—“following a period of massive fiscal and monetary expansion?” To this question, “The answer, as in the aftermaths of many wars, will be a surge in inflation.”

Directionally, I think this is a very good forecast. We are already seeing it play out in the first months of 2021.

How much inflation might there be? They suggest the inflation numbers will be high: “quite likely more than 5%, or even on the order of 10% in 2021.”

Is 5% inflation possible? Well, the U.S. Consumer Price Index rose from December 2020 to April 2021 at the annualized rate of 6.2% when seasonally adjusted, and 7.8% when not seasonally adjusted. Signs of increasing inflation are widespread.

It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

How about that 10%? Could we really go to a 10% inflation? It has happened before. The U.S. has been at 10% inflation or more in 1917-20, 1947, 1974, and 1979-81. Most of these followed inflationary financing of wars, but the fiscal deficits and money printing of late are as great as during a war.

The authors proceed to the question of “What will the response of the authorities then be?” and offer this prediction—made in 2020: “First and foremost, they will claim that this a temporary and one-for-all blip.” We already know that this prediction was correct.

Overall, is this theory of a new inflationary era plausible? It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

Speaking of the central bankers, Goodhart and Pradhan observe something important: “In recent decades Central Banks have been the best friends of Ministers of Finance [and Secretaries of the Treasury], lowering interest rates to ease fiscal pressures and to stabilize debt service ratios.” But what will happen “when inflationary pressures resume, as we expect”? Will the relationship become more tense or even hostile? To put it another way, might the disputes of 1951 between the U.S. Treasury and the Federal Reserve be re-played and the celebrated “Accord” between them come out in the opposite way: with the central banks more subservient? “Inevitably,” the authors rightly say, “central banks have to be politically agile.”

The book interestingly comments on an implied cycle in the standing of macroeconomics and macroeconomists. How credible are their pronouncements and forecasts? “From the Korean War until about 1973 was a transient golden age for macroeconomics.” The 1960s featured the misplaced confidence of macroeconomists that they could “fine tune the economy,” and control inflation and employment using the “Phillips Curve” they believed in. Sic transit gloria: “It all then went horribly wrong in the 1970s,” when they got runaway inflation and high unemployment combined. And “the second golden period for macroeconomics (1992-2008) [also] went horribly wrong.” That time the announcements of the “Great Moderation,” which central bankers gave themselves credit for, turned into a Great Bubble and collapse. The golden macroeconomic ideas of one era may seem follies to the next.

If the new inflationary era predicted by Goodhart and Pradhan becomes reality, the follies of the present will seem blatant. Should we adopt their “highest conviction” that this inflationary era is on the way? In my view, the economic and financial future is always wrapped in fog, but their argument is well worth pondering and entering into our considerations of the biggest economic risks ahead.

The Many Faces of Government Default

Published in Law & Liberty.

Although government debt is a favored investment class all over the world, it has a colorful history of over 200 defaults in the last two centuries, which continue right up to the present time.

This record reflects a perpetual political temptation, memorably described by the sardonic observer of sovereign defaults, Max Winkler in 1933. Of “the politicians in the borrowing countries,” he wrote, “from Abyssinia to Zanzibar”—which we may update to Argentina to Zambia, both governments having defaulted again in 2020—“Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures . . . and exchange favors by the misuse of the public treasury. In order to enjoy the present, they cheerfully mortgage the future.” Of course, we can’t read this without thinking of the Biden $1.9 trillion project to spend, borrow, and print.

Often enough, historically speaking, booming government debt has resulted in “national bankruptcy and default” around the world. Winkler chronicled the long list of government defaults up to the 1930s. He predicted that future investors would again be “gazing sadly” on unpaid government promises to pay. He was so right. Since then, the list of sovereign defaults has grown much longer.

A Short Quiz: Here are six sets of years. What do they represent?

1. 1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014, 2020

2. 1828, 1898, 1902, 1914, 1931, 1937, 1961, 1964, 1983, 1986, 1990

3. 1826, 1843, 1860, 1894, 1932, 2012

4. 1876, 1915, 1931, 1940, 1959, 1965, 1978, 1982

5. 1826, 1848, 1860, 1865, 1892, 1898, 1982, 1990, 1995, 1998, 2004, 2017

6. 1862, 1933, 1968, 1971

All these are years of defaults by a sample of governments. They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

6. The United States.

In the case of the United States, the defaults consisted of the refusal to redeem demand notes for gold or silver, as promised, in 1862; the refusal to redeem gold bonds for gold, as promised, in 1933; the refusal to redeem silver certificates for silver, as promised, in 1968; and the refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.

With the onset of the Civil War in 1861, the war effort proved vastly more costly than previously imagined. To pay expenses, Congress authorized a circulating currency in the form of “demand notes,” which were redeemable in precious metal coins on the bearer’s demand and promised so on their face. Secretary of the Treasury Salmon Chase declared that “being at all times convertible into coin at the option of the holder . . . they must always be equivalent to gold.” But soon after, by the beginning of 1862, the U.S. government was no longer able to honor such redemptions, so stopped doing so. To support the use of the notes anyway, Congress declared them to be legal tender which had to be accepted in payment of debts. About issuing pure paper money, President Lincoln quoted the Bible: “Silver and gold have I none.”

In 1933, outstanding U.S. Treasury bonds included “gold bonds,” which unambiguously promised that the investor could choose to be paid in gold coin. However, President Roosevelt and Congress decided that paying as promised was “against public policy” and refused. Bondholders sued and got to the Supreme Court, which held 5-4 that the government can exercise its sovereign power in this fashion. Shortly before, when running for office in 1932, Roosevelt had said, “no responsible government would have sold to the country securities payable in gold if it knew that the promise—yes, the covenant—embodied in these securities was . . . dubious.” A recent history of this failure to pay as agreed concludes it was an “excusable default.”

In the 1960s, the U.S. still had coins made out of real silver and dollar bills which were “silver certificates.” These dollars promised on their face that they could be redeemed from the U.S. Treasury for one silver dollar on demand. But when inflation and the increasing value of silver induced people to ask for redemptions as promised, the government decided to stop honoring them. If today you have a silver certificate still bearing the government’s unambiguous promise, this promise will not be kept—no silver dollar for you. The silver in that unpaid silver dollar is currently worth about $20 in paper money.

An underlying idea in the 1944 Bretton Woods international monetary agreement was that “the United States dollar and gold are synonymous,” but in 1971 the U.S. reneged on its Bretton Woods agreement to redeem dollars held by foreign governments for gold. This historic default moved the world to the pure fiat money regime which continues today, although it has experienced numerous financial and currency crises, as well as endemic inflation. Since 1971, the U.S. government has stopped promising to redeem its money for anything else, and the U.S. Treasury has stopped promising to pay its debt with anything except the government’s own fiat currency. This prevents explicit defaults in nominal terms, but does not prevent creating high inflation and depreciation of both the currency and the government debt, which are implicit defaults.

Winkler related a pointed story to give us an archetype of government debt from ancient Greek times. Dionysius, the tyrant of Syracuse, was hard up and couldn’t pay his debts to his subjects, the tale goes. So he issued a decree requiring that all silver coins had to be turned in to the government, on pain of death. When he had the coins, reminted them, “Stamping at two drachmae each one-drachma coin.” Brilliant! With these, he paid off his nominal debt, becoming, Winkler said, “the Father of Currency Devaluation” and thereby expropriating real wealth from his subjects.

Observe that Dionysius’s stratagem was, in essence, the same as that of the United States in its defaults of 1862, 1933, 1968, and 1971. In all cases, like Dionysius, the U.S. government broke a promise, depreciated its currency, and reduced its obligations at the expense of its creditors. Default can have many faces.

So convenient it is to be a sovereign when you can’t pay as promised.

The Oversight Board Keeps Working On Puerto Rico’s Record Insolvency

Published in Real Clear Markets.

The government of Puerto Rico continues to hold the all-time record for a municipal insolvency, having gone broke with over $120 billion in total debt, six times as much as the second-place holder, the City of Detroit.

Faced with this huge, complex, and highly politicized financial mess, and with normal Chapter 9 municipal bankruptcy legally not available, the Congress wisely enacted a special law to govern the reorganization of Puerto Rico’s debts. “PROMESA,” or the Puerto Rico Oversight, Management, and Economic Stability Act, provided for a formal process supervised by the federal courts, in effect a bankruptcy proceeding.  It also created an Oversight Board (formally, the Financial Oversight and Management Board for Puerto Rico) to coordinate, propose and develop debt settlements and financial reform.  These two legislative actions were correct and essential. However, the Oversight Board was given less power than had been given to other such organizations.  The relevant models are notably the financial control boards of Washington DC and New York City and the Emergency Manager of Detroit, all successfully called in to address historic municipal insolvencies and deep financial management problems.

It was clear from the outset that the work of the Puerto Rico Oversight Board was bound to be highly contentious, full of complicated negotiations, long debates about who should suffer how much loss, political and personal attacks on the Board and its members, and heated, politicized rhetoric.  And so it proved to be.  Since the members of the Oversight Board are uncompensated, carrying out this demanding responsibility requires of them a lot of public spirit.

An inevitable complaint about all such organizations, and for the Puerto Rico Oversight Board once again, is that they are undemocratic.  Well, of course they are, of necessity, for a time. The democratically elected politicians who borrowed beyond their government’s means, spent the money, broke their promises, and steered the financial ship of state on the rocks should not remain in financial control.  After the required period of straightening out the mess and re-launching a financial ship that will float, normal democracy returns.

It is now almost five years since PROMESA became law in June, 2016.   It has been, as it was clear it would be, a difficult slog, but substantial progress has been made.  On February 23, the Oversight Board announced a tentative agreement to settle Puerto Rico’s general obligation bonds, in principle the highest ranking unsecured debt, for on average 73 cents on the dollar.  This is interestingly close to the 74 cents on the dollar which Detroit’s general obligation bonds paid in its bankruptcy settlement.   If unpaid interest on these bonds is taken into account, this settlement results in an average of 63 cents on the dollar.  In addition, the bondholders would get a “contingent value” claim, dependent on Puerto Rico’s future economic success—this can be considered equivalent to bondholders getting equity in a corporate reorganization–very logical.

The Oversight Board has just filed (March 8) its formal plan of adjustment.  It is thought that an overall debt reorganization plan might be approved by the end of this year and that the government of Puerto Rico could emerge from its bankrupt state.  Let us hope this happens.  If it does, or whenever it ultimately does, Puerto Rico will owe a debt of gratitude to the Oversight Board.

We can draw two key lessons.  First, the Oversight Board was a really good and a necessary idea.  Second, it should have been made stronger, on the model of previous successes.  In particular, and for all future such occasions, the legislation should have provided for an Office of the Chief Financial Officer independent of the debtor government, as was the case with the Washington DC reform.  This was highly controversial, but effective. Any such board needs the numbers on a thorough and precise basis.  Puerto Rico still is unable to get its audited annual reports done on time.

A very large and unresolved element of the insolvency of the Puerto Rican government remains subject to a debate which is important to the entire municipal bond market.  This is whether the final debt adjustments should include some reduction in the almost completely unfunded government pension plans.  Puerto Rico has government pension plans with about $50 billion in debt and a mere $1 billion or so in assets.

There is a natural conflict between bondholders and unfunded pension claims in all municipal finance, since not funding pensions is a back door deficit financing scheme.  General obligation bonds are theoretically the highest ranking unsecured credit claims, and senior to unfunded pensions.  But the reality is different.  De facto, reflecting powerful political forces, pensions are the senior claim.  Pensions did take a haircut in the Detroit bankruptcy, but a significantly smaller one than did the most senior bonds.  In other municipal bankruptcies, unfunded pensions have come through intact.

What should happen in Puerto Rico?  The Oversight Board has recommended modest reductions in larger pensions, reflecting the utter insolvency of the pension plans.  Puerto Rican politicians have opposed any adjustment at all.  Bondholders of Illinois: take note of this debate.

I suggest a final lesson:  the triple-tax exemption of interest on Puerto Rican bonds importantly contributed to its ability to run up excess and unpayable debts.  Maybe there was a rationale for this exemption a hundred years ago.  Now Puerto Rico’s bonds should be put on the same tax basis as all other municipal bonds.

Inflation Comes for the Profligate

Published in Law & Liberty.

Printing money to finance wars with resulting inflation is the most time-honored monetary policy. It can also be used for other crises thought of as analogies to wars, like to finance the massive expense of bridging the Covid 19-triggered bust of 2020.

In these situations, the central bank necessarily becomes the Treasury’s partner and servant, stuffing its balance sheet with government debt and correspondingly inflating the supply of money. This captures an essential mandate of every central bank, though it is not one you will find in the Federal Reserve’s public relations materials, namely lending money to the government of which it is a part.

Now, as the economic recovery from the Covid bust strengthens, soaring government debt is still being heavily monetized in the Federal Reserve’s balance sheet, which has now expanded to a previously unimagined $7.6 trillion, in a classic Treasury-Fed cooperation. The printing (literal and metaphorical) continues and the new administration wants to expand it even more. Isn’t accelerating inflation on the way?

The distinguished former Secretary of the Treasury, economist Larry Summers, recently suggested that it may be. “There is a chance,” he wrote, that government actions “on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.” I believe this is correct.

If we agree that there is such “a chance,” how big a chance is it? With political delicacy, Summers’ essay does not address this question. Instead, he carefully points out the “enormous uncertainties” involved. While the fog of uncertainty always obscures the economic future, it looks to me like the answer is that the chance is substantial. It would not be at all surprising to see inflation move significantly higher.

“There is the risk,” Summers writes, “of inflation expectations rising sharply.” Well, inflation expectations are already rising among bond investors and analysts, giving rise to such commentaries as these:

“According to the Bank of America’s January fund manager survey, some 92% of respondents expect rising inflation.” (Almost Daily Grant’s Newsletter, February 10, 2021)

“Bonds Send Message that Inflation is Coming” (Barron’s, February 5, 2021)

“For those of us not inclined to believe in free lunches, the funding of large deficits with printed money is another source of inflation and financial stability concerns” (Barron’s, February 12, 2021)

“A new worry now is whether the tremendous spending plans…can really be done without prompting a historic inflation.” (Don Shackelford, Proceedings newsletter)

“With growth in unit labor costs surging and a range of survey indicators also pointing to rising price pressures, we think inflation will be much stronger over the rest of this year.” (Andrew Hunter in Capital Economics)

“Inflation Worries Drive Platinum Up” (Wall Street Journal)

“The rat the Treasury market is smelling is consumer price inflation.” (Wolf Street, February 13, 2021).

Reflecting these concerns, the yield on the 10-year Treasury note, while still low, has risen meaningfully of late, to about 1.4 percent from 0.7 percent six months ago. This move has imposed serious losses on anybody who bought long-term Treasuries last summer and held them. The price of the iShares Treasury Bond ETF, for example, is down about 18 percent since the beginning of August.

In contrast to the views just quoted, Summers observes “administration officials’ dismissal of even the possibility of inflation.” Who is right, the investors or the politicians? Whose assessments of inflation risk do you believe? Politicians may be expected to deny an economic result that would get in the way of their intense desire to spend newly printed money.

As has frequently been discussed, a notable inflation has already been running for some time—the inflation in asset prices. Monetary expansion, needing to go somewhere, has gone into the prices of equities, bonds, houses, gold, and Bitcoin. The “Everything Bubble” stoked by the Federal Reserve and the other principal central banks has taken asset prices to historically extreme, and in the case of Bitcoin, amazing, valuations. Financial history presents an essential recurring question: How much can the price of an asset change? It also provides the answer: More than you think.

U.S. house prices have been and are inflating rapidly. They are substantially over their Housing Bubble peak of 2006. According to December’s Case-Shiller index, they are rising at an annualized rate of 10 percent, and AEI’s December Home Price Appreciation Index shows a year-over-year increase of 11 percent. This is abetted by the Fed’s monetization of long-term mortgages, of which it owns, including unamortized premiums, a striking $2.3 trillion—a sum 2.6 times its total assets in 2007—and which it continues to buy in size. This huge monetization of mortgages by the institution they created would greatly surprise the founders of the Federal Reserve, could they see it, and displease them. Instead of taking away the punch bowl as the party warms up, the Fed is now pouring monetary vodka into the housing finance punch. Reflecting on this inversion of the famous metaphor, Ed Pinto of the American Enterprise Institute has reasonably asked if they couldn’t at least stop buying mortgages. But it appears this will not happen anytime soon.

Of course, as a base line, we have endemic inflation of goods and services prices. The Federal Reserve has moreover formally committed itself to perpetual inflation. The Covid bust notwithstanding, the Consumer Price Index increased 1.4 percent year-over-year in January, 2021, and over the two months of December-January at an annualized rate of 3.1 percent. We are told frequently by the Fed about its “2% target” and hear it endlessly repeated by a sycophantic chorus of journalists. Since the Constitution unambiguously gives the power of regulating the value of money to the Congress, I believe the Federal Reserve acted unconstitutionally in announcing on its own, and carrying out without the approval of the Congress, a commitment to perpetual depreciation of the purchasing power of the U.S. currency.

Last year it formally added a new willingness to let inflation go higher than 2 percent for a while. How much higher and for how long nobody knows, including the Fed itself, but this willingness is consistent with a greater chance of accelerating inflation.

How much inflation is a sustained 2 percent? At that rate, average prices quintuple in a lifetime. The global movement among central banks, including the Fed, to trying for 2 percent inflation is a notable example of the changing intellectual fashions of central bankers. When serving as Federal Reserve Chairman, Alan Greenspan suggested the right inflation target was zero, correctly measured, and an inflation rate of zero was the long-term goal of the Humphrey-Hawkins Act of 1978. The distinguished economist, Arthur Burns wrote in 1957 that “our economy is faced with a threat of gradual or creeping inflation over the coming years.” He was right about that, except that gradual unexpectedly became galloping in the 1970s (ironically, when he was Fed Chairman).

“It is highly important that we try to…stop the upward drift of the price level,” Burns argued. Over time, “even a price trend that rises no more than 1 percent a year will cut the purchasing power of the dollar”—so much the more would 2 percent, he added. How ideas have changed. . Since the 1970s, we never are told about “creeping inflation” anymore. While Burns in the 1950s attacked 1 or 2 percent inflation, our current monetary mandarins strive for 2 percent forever and more than 2 percent for now. This increases the risk, consistent with Summers’ observations, that they will get more than they are bargaining for.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

At 3 percent inflation, prices would multiply by 11 times in the course of a lifetime. We are always a little surprised at the result over time of relatively small changes in a compound growth rate like the average rate of inflation.

One of the key Keynesian arguments for inflation was that wages are sticky downwards, so that if real wages economically need to fall, you can make then go down by inflation instead. Over the decade prior to the Covid crisis, average U.S. hourly earnings for all employees were rising first at about 2 percent and later 3 or 3.5% percent a year. So a 2 or 3 percent inflation would sharply cut or wipe out real wage gains, at the same time as it imposes negative real returns on savers. Other items you will never see in the Federal Reserve’s public relations materials are its potent abilities to reduce real wages and punish savers.

“Throughout history, there’s absolutely no currency in the world that has maintained its value,” international fund manager Mark Mobius pronounced. The U.S. dollar certainly has not, losing 96 percent of its purchasing power since the creation of the Federal Reserve and losing 98 percent of its value in terms of gold since 1971. (That was when the U.S reneged on its Bretton Woods commitments and led the world into a pure fiat currency regime.) Increasing inflation going forward from here would be consistent with history.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

With the opinion farthest from mine, we have the cheerleaders for monetizing a lot more debt and practicing “What, me worry?”—these are the proponents of “MMT” or Modern Monetary Theory. Of course, it should be written “M”MT, or “Modern” Monetary Theory, since solving your problems by printing up money and forcing the people to accept the depreciating currency is a very old financial idea. The City of Venice used it in 1630, for example, to spend with inflationary result during an attack of bubonic plague. Alternately, we could consider calling it “WMT” or “ZMT” for Weimar Monetary Theory or Zimbabwe Monetary Theory. Even better would be “JLMT” for John Law Monetary Theory.

John Law was the creative, persuasive theorist of risk and paper money, “secretary to the King of France and controller general of His Majesty’s finances,” who presided over first the inflation and then the panicked collapse of the Mississippi Bubble of 1720. A main theme, then as now, was how to produce paper assets to cover the government’s debts, but his history also provides a precedent for our house price discussion: “Thanks to Law’s money-printing, land and houses were expensive.”

Like the close ties of John Law to the French monarchy, the question of debt monetization and its inflationary risks is closely tied to the question of what kind of government we want. Should the federal government’s power be limited or expansive and dominant? What the proponents of “M”MT really long for is a vastly expanded and more powerful government, with themselves in charge. If debt can be indefinitely expanded by bloating the central bank, then you don’t have to tax much in order to spend forever. Thus one of the most important limits on the power of Leviathan to dominate the society can be removed. We see that much more is involved than a monetary theory.

Are those desiring to wield the expanded power willing to cause much higher inflation to get it? This is the political meaning of the monetary question.

Congress Must Take Control of Money Back From the Fed

Published in Real Clear Markets.

The question of Money is always political.  What is the definition of “money,” what is its nature, how is it created, and how are debts settled—these are questions that have been much debated over time, sometimes very hotly.  Recall, for example, William Jennings Bryan’s famous, burning rhetoric of 1896:

“You shall not press down upon the brow of labor this crown of thorns—you shall not crucify mankind upon a cross of gold”!

He was addressing the definition of money.

What the U.S. Constitution says about the definition of money is succinct.  Article I, Section 8 gives Congress the express power:

“To coin money [and] to regulate the value thereof.”

As writers on the subject have pointed out innumerable times, to “coin” is obviously not the same as to “print.”

How then does it come about that the American government issues irredeemable, fiat, paper money, and this is the only kind of money we have today?

The Constitution expressly prohibits the states from issuing such paper money, but is silent about the national government on this point.

Considering original intent through the Constitutional debates, the founding fathers were nearly unanimous in their strong opposition to paper money, as the Notes of the Debates in the Federal Convention make completely clear.  In general, they shared the view later expressed by James Madison about:

“The rage for paper money…or any other improper or wicked project.”

Although this was the dominant opinion of the members of the convention, and although they debated an express prohibition of national paper money, they decided not to include it.  Of course, neither was there an authorization.

In the discussion, George Mason explained:

“Though he had a mortal hatred to paper money, yet…he could not foresee all the emergencies” of the future and was “unwilling to tie the hands of the legislature.”

Paper money in this view is a matter only for emergencies.

The Constitutional result was the express power “to coin” and silence on “to print.”  Should one conclude that there is an implied power for the government to print pure paper money?  Further, is there an implied power to make it a legal tender in payment of debts, even if those debts had been previously contracted for and explicitly required payment in gold coin?

A lot of supreme judicial ink would later be devoted to debating and ultimately deciding this question.
In the Constitutional Convention debates, Gouverneur Morris:

“Recited the history of paper emissions and the perseverance of the legislative assemblies in repeating them, with all the distressing effects.”

He further predicted:

“If a war was now to break out, this ruinous expedient would again be resorted to.”

This prediction was proved right when the Civil War did break out, and the Lincoln administration soon turned to paper money to pay the costs of the Union Army.

In 1861, faced with the staggering expenses of the war, Congress authorized the issuance of paper money, or “greenbacks,” as they were called.  In 1862, it made them a legal tender.  Predictably, the greenbacks went to a large discount against gold—their value fluctuated with the military fortunes of the ultimately victorious Union.

As another war measure, national bank notes were created by the National Currency Acts of 1863 and 1864, which we now know as the National Bank Act.  The main point was to use the new national banks to monetize the Treasury’s debt.  Governments always like the power to monetize their deficits.

After the Civil War, the expedient of paper money as legal tender resulted in a series of Supreme Court cases in which:

First, making paper money a legal tender for debts previously contracted in gold was found unconstitutional in a 4-3 decision.

Then, soon afterwards, the Court reversed itself 5-4, after the addition of two new justices, finding that it was constitutional, after all.  The new majority stressed the sovereign right of a government to do what was necessary to preserve itself.

About the legal tender cases it has been said:

“Measured by the intensity of the public debate at the time, it was one of the leading constitutional controversies in American history.”

Yet they are now largely forgotten.

In one of the series of legal tender decisions, one later overruled, the Court wrote:

“Express contracts to pay in coined dollars can only be satisfied by the payment of coined dollars…not by tender of United States notes.”

That this decision did not stand was handy for the United States government later—in 1933, when it defaulted on its express promise to pay Treasury gold bonds in gold.  Instead it paid in paper money.

This action the Supreme Court upheld in 1935 by 5-4, although no one doubted the clarity of the promise to pay that was broken.  Among the majority’s arguments were the sovereign right of the government to default if it wanted to and the sovereign right of the national government to regulate money.

Coming to today: We have a pure fiat money system of the paper Federal Reserve notes in your wallet and bookkeeping entries on the books of the Fed.

This paper currency, the Federal Reserve on its own has committed to depreciate by 2% per year forever, in spite of the fact that the Federal Reserve Act instructs it to pursue “stable prices.”

By promising perpetual 2% inflation, the Fed keeps promising to make average prices quintuple in a normal lifetime.  (That is simply the math of compound interest.)

The Fed made this momentous, inherently political, decision on its own, without the approval of the Congress.  It did not ask Congress for legislative approval and no hearings on this debatable proposal about the nature of money were held.

Where, under the Constitution, did the Fed get this right to proceed without Congress?  That the Fed presumed to do this on its own authority was a highly questionable action of the administrative state.

I believe one could correctly argue that this was an unconstitutional violation of Article I, Section 8. Unfortunately, we have no lawsuit about it, so we can only observe it.

One scholar of the legal tender cases concluded:

“There remains the intriguing question of the Constitutional basis for today’s legal tender paper… today’s fiat money.”

Indeed there does.  But the political basis rules and life goes on.

Will the Federal Reserve have a monopoly in digital currencies?

Published in The Hill.

Cryptocurrencies started out with a libertarian desire to give people an alternative to national money, thereby escaping government power to depreciate their fiat currencies through inflation. Many governments, including the United States, have gone so far as to promise perpetual inflation, a key function of which is to help governments depreciate their own debt. Governments can also completely destroy the value of their currency through hyperinflation, as has happened throughout history.

To create a meaningful alternative to this government money monopoly was a noble intent, consistent with the classic proposal by Friederich Hayek in “Choice in Currency.” He asked, “Why should we not let people choose freely what money they want to use?” He argued, “Practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.” Cryptocurrency enthusiasts agreed. They were, however, too optimistic about how forcefully governments could react, first by imposing regulation and then by realizing that governments themselves could issue digital currency to the public.

The great irony here is that the idea of a digital alternative to national money can morph into an idea to expand and solidify the government money monopoly. According to a survey by the Committee on Payments and Market Infrastructure of the Bank for International Settlements, more than 60 central banks, representing 80 percent of the world population, are researching central bank digital currencies. More than half of them have moved on to actual experiments or more “hands on” activities.

The broadest form of government digital currency would be the central bank offering deposit accounts to the public at large, so individuals, businesses, corporations, nonprofit organizations, and municipal entities could have deposit accounts at the Federal Reserve instead of with a private bank. Then their financial transactions in the digital currency with each other would be settled directly by the accounting entries on the electronic books of the Federal Reserve. Efficient and risk reducing!

Such a centralization has happened before. Paper currency became monopolized by the Federal Reserve in the form of government notes in the early 20th century. Until then, private banks issued their own paper currency. I have a copy of a $3 bill issued in the 1840s by a previous banking employer. Needless to say, no such currency is used today.

Could money in the form of deposits, such as money in the form of paper currency, be monopolized by the central bank, given current technology? In principle that could be the case. Direct deposits at the Federal Reserve would be close to being default and liquidity risk free. No need to worry about whether your bank might fail, whether it might become illiquid or insolvent, or whether your deposit was over the insurance limit. You would have no need to withdraw cash if you were worried about banks in a crisis because you would be holding a direct Federal Reserve obligation. That would no doubt appeal to many holders of money and, in our electronic world, it is quite easy to imagine such a central bank digital currency.

Do we like the idea, however, that deposits would be concentrated in the government instead of spread among 5,000 private banks? How much of the deposit market the central bank could take over depends on whether it would pay interest on the deposits. If it paid zero interest, its market share would be much less. But the Federal Reserve can and does pay interest on deposits. There are $14 trillion in total deposits in the banking system. Suppose 50 percent of them moved to digital deposits with the Federal Reserve compared to the 100 percent market share the Federal Reserve has in paper currency. That would be a towering $7 trillion. The government money monopoly would become bigger and more powerful.

What would the Federal Reserve do with its new $7 trillion? It would have to invest it. It would become an even bigger allocator of credit. It might allocate a lot more credit to the government itself and its favored housing sector. Or it might get into corporate credit, displacing private investors and becoming a state commercial bank. The history of such banks has been generally pathetic because their credit decisions inevitably become politicized. The Federal Reserve could also more readily impose negative interest rates directly on the people, thereby expropriating their savings.

On top of all that, the government would also have financial Big Data extraordinaire. It would know almost everything about our financial lives. Digital currency would then have traveled from libertarian choice to Big Brother. If not strictly limited and controlled, central bank digital currency could turn out to be one of the worst financial ideas of the 21st century.

Should the Fed Be Run by Economists?

Published in Law & Liberty.

Tomorrow, November 2, marks two years since the nomination of Jerome Powell to be Chairman of the Federal Reserve. Leaving aside President Trump’s subsequent expressions of regret at his choice, the nomination represented an important institutional change for the Fed: the first Chairman in 30 years lacking a Ph.D. in economics.

The anniversary of Powell’s appointment offers us an opportunity to reflect: Was this a good thing, or should the Fed always be an “econocracy,” run by economists? Does other expertise matter?

In a 1977 conference at the American Enterprise Institute, Irving Kristol observed: “Most professors of economics genuinely believe they know how to run the economy and would very much like to have the chance to prove it.”

It does seem that inside every macroeconomist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king—or at least an assistant deputy philosopher king.

On the other hand, the will to power is hardly limited to economists. What kind of education and experience, we may wonder, helps us best moderate our natural ambitions, apply wisdom to our actions, and control, in Friedrich Hayek’s terms, the “fatal conceit” of “the pretense of knowledge”?

On the 100th anniversary of the creation of the Federal Reserve, I made a dozen predictions about the Fed’s next 100 years.[1] Among them was this:

An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of Chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro-economics is or can be a science.

I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.

This prediction was fulfilled much more quickly than I thought with the appointment of Chairman Powell, and I think it is a good thing for the Fed to move away from econocracy. Whatever the illusions in the past may have been, we not only no longer believe, but we all ought to know by now that macroeconomics is not a science. Moreover, in my view, it cannot ever be one. Therefore, it is healthy to move the chairmanship of the Fed around among various professional domains.

Chairman Powell was trained as a lawyer and has significant Wall Street experience in investment banking and private equity investing. This is a completely appropriate background, as it seems to me.

Speaking of lawyers, the first Chairman of the Federal Reserve Board was William G. McAdoo, who was at that time the Secretary of the Treasury. Under the original Federal Reserve Act, the Treasury Secretary was automatically the chairman. McAdoo was a lawyer and a businessman, who among other things built two tunnels under the Hudson River between Manhattan and New Jersey. As Treasury Secretary during the cataclysm of the First World War, he set out to and succeeded in helping New York displace London as the world financial center.

But the real power inside the Fed in its early days was Benjamin Strong, the president (they called it “Governor” at the time) of the Federal Reserve Bank of New York from 1914 to 1928. Strong was definitely one of Kristol’s “men of experience.” He went to work in banking right out of public high school—no college, let alone a graduate degree for him. He nonetheless became president of Bankers Trust Company and then took charge of the New York Fed.

If you were President of the United States, whom would you want to pick as chairman of the central bank to the dollar-based world? Here, by principal vocation, are the ones who did get picked in chronological order: Lawyer, banker, lawyer, banker, investment banker, banker, banker, corporate executive, financier, Ph.D. economist (we have reached Arthur Burns), corporate executive, economist without Ph.D. (that is, Paul Volcker), Ph.D. economist, Ph.D. economist, Ph.D. economist, financier (bringing us up to the present).

We may further consider that there are two major Federal Reserve buildings in Washington, DC. The first is the main Fed headquarters. This familiar, impressive temple to the importance of money is the Eccles Building, named for Marriner Eccles, who was chairman of the Fed from 1934 to 1948, and after that stayed on the Federal Reserve Board without being chairman until 1951. About Eccles, we read:

Although he neither attended college nor received any formal training in economics, Marriner S. Eccles became the intellectual force who led the Fed through financial crises during the Depression and World War II.

Eccles was a Salt Lake City banker who controlled two dozen banks, in addition to a number of other companies, and set up one of the first multiple bank holding companies. It is fair to say that this powerful Fed chairman bore little resemblance to an economics Ph.D.

The second main Federal Reserve building in Washington is the Martin Building. It is named for William McChesney Martin, who was chairman of the Fed from 1951 to 1970, which included serving under five U.S. presidents, and represents the record tenure in the job.

Martin’s highest academic degree was a B.A. in English from Yale, where he also studied Classics. Perhaps this prepared him to be, as Peter Conti-Brown has written, the Fed’s greatest creator of language. His most famous metaphor, of course, was “the punchbowl,” which the Fed must take away “just when the party was really warming up.”

Martin did take classes in economics in college, in which “he was astonished,” we are told, that the academic economists believed that his father, who was the president of the St. Louis Federal Reserve Bank, and other Fed bankers were “hopelessly out of date because of their misguided warnings about excessive speculation in the stock market” of the 1920s. Of course, his father and friends turned out to be right.

Among other things, Martin served as the president of the New York Stock Exchange. He did take some graduate classes in economics, too, but through his long tenure at the Fed, he remained highly skeptical of economic models and forecasts.

History does make clear that while having professional education in economics can be a relevant qualification for leading the Federal Reserve, it certainly isn’t the only one or a necessary one.

A very instructive book on whom you might want as Federal Reserve chairman is Donald Kettle’s Leadership at the Fed. Its final chapter, “The Chairman as Political Leader,” draws these insightful conclusions:

The Fed’s policymaking is inevitably political, and no institutional (or even constitutional) fix can change that. History demonstrated the folly of thinking that monetary management can be reduced to a process of technical adjustment, for any monetary policy has political implications and creates political conflicts. The very attempt to shield such inherently political decisions behind “technical” standards and legal “independence” is itself a political strategy.… In framing monetary policy, the chairman operates as a political leader. He seeks to craft a policy for which he can build political support (and deflect attack)… [while enmeshed in] the intricate and complex balance of political forces in the Fed’s constituencies.

These points seem to me correct and to reflect reality. They must make us think of Alan Greenspan, Chairman of the Fed from 1986 to 2006, who earned an economics Ph.D., but was not an academic, and repeatedly demonstrated his skills as a master politician and political leader. This took him all the way to being “The Maestro”—though even he could not sustain that exalted but unrealistic perception.

In sum, are we better off for having had at the Fed an econocracy of Ph.D.s for most of the last three decades? Forty years ago, Kristol mused: “I am not so sure the world has improved much since we began being governed by economic theories rather than by men of experience using some common sense.” As with other counter-factual speculations, we can never know what would otherwise have been.

Turning to the future, it is safe to predict that the Federal Reserve staff will continue to be full of economics Ph.D.s, whose advice and analysis any Fed chairman will want to consider.

But at the top of the Fed, will Chairman Powell be the start of a new phase, which returns to a model of financial experience and practical knowledge—like Eccles, Martin, McAdoo, and Strong? In my view, this would be a good addition to the Fed leadership mix over time. We should certainly not exclude economics Ph.D.s from the office, but they should most definitely not have an exclusive claim on this hugely powerful, globally impactful, systemically important job. The Fed should not be an econocracy.

Eliminating Fannie & Freddie’s Competitive Advantages by Administrative Action

Published in Real Clear Markets.

Among the strategic goals for reform of Fannie Mae and Freddie Mac specified by Treasury Secretary Steven Mnuchin in Congressional testimony on October 22 was: “Legislation could achieve lasting structural reform that…eliminates the GSEs’ competitive advantages over private-sector entities.” A good idea, except legislation won’t happen.

As the Secretary suggests, replacing the current government-dominated, duopolistic secondary housing finance sector with a truly competitive one is an excellent goal. But fortunately, it does not take legislation. It can be achieved with purely administrative actions—three of them, to be exact. These administrative actions are:

1. Set Fannie and Freddie’s capital requirements equal to those of private financial institutions for the same risks.

2. Have Fannie and Freddie pay the same fee to the government for its credit support that other Too Big To Fail financial institutions have to pay.

3. Set Fannie and Freddie’s g-fees at the level that includes the cost of capital required for private financial institutions to take the same risk.

The Same Capital Requirement

The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator, has full authority to set their capital requirements. FHFA simply has to set them in a systemically rational way: namely, so that the same risk requires the same capital across the system: the same for Fannie and Freddie as for private financial institutions.

Running at hyper-leverage was a principal cause of Fannie and Freddie’s failure and bailout. It naturally induced market actors to perform capital arbitrage and send credit exposure to where the capital was least—that is, into Fannie and Freddie—thereby sticking the taxpayers with the risk.

The capital for mortgage credit risk is still the least at Fannie and Freddie and the risk is still sent every day to the taxpayers by way of them. Even with the revised agreement between the FHFA and the Treasury announced on September 30, Fannie and Freddie will be able to in time increase their capital only to $45 billion combined. This is exceptionally small compared to their risk of $5.5 trillion: it would represent a capital ratio of less than 1%, still hyper-leverage.

Something like a 4% capital requirement would be more like the equilibrium standard required to eliminate the capital arbitrage, which would imply a total capital for the two government-backed entities of about $220 billion. I do not insist on the exact numbers, only that the FHFA should implement the right principle: same risk, same capital.

The Same Fee for Government Support

Fannie and Freddie are Too Big To Fail (TBTF). No one doubts or can doubt this. Their business and indeed their existence utterly rely on the certainty of government support. This means their creditors have immense moral hazard: they don’t have to worry about the credit risk of the trillions of Fannie and Freddie fixed income securities they hold. History has proved that the creditors are right to rely on government support—when Fannie and Freddie were deeply insolvent, the bailout assured that the creditors nonetheless received every penny of interest and principal on time.

What is this government support worth? A huge amount. There is widespread agreement that Fannie and Freddie should pay an explicit fee for it, but how much? The right answer is to remove their unfair competitive advantage by having them pay at the same rate as any other Too Big To Fail institution with the same leverage and the same risk to the government.

In other words, have the FDIC determine what the deposit insurance rate for a TBTF bank with Fannie and Freddie’s leverage and risk would be, and require them to pay that to the Treasury. Then they would be on the same competitive basis as private financial institutions.

Setting the right fee in exchange for the ongoing government support is within the power of the FHFA as Conservator and the Treasury, by the two of them amending their Fannie and Freddie Senior Preferred Stock Purchase Agreements accordingly.

The Same Guaranty-Fee Logic

The key action here, which the FHFA is already not only empowered but directed by Congress to take, is already in law—to be specific, in the Temporary Tax Cut Continuation Act of 2011. This statute requires the setting of Fannie and Freddie’s g-fees to include not only the risk of credit losses, but also “the cost of capital allocated to similar assets by other fully private regulated financial institutions.” The FHFA Director is instructed to make this calculation and increase the g-fees accordingly. The FHFA has egregiously not carried out this unambiguous instruction. It should do so now, thereby removing the third distorting competitive advantage which historically allowed Fannie and Freddie to drive out private capital.

Each of these administrative actions by itself would create a serious advance toward the stated goal. To take all three of them would settle the matter: game, set, match. No legislation needed.

Actually, Sovereigns Do Go Broke

Published in Law & Liberty.

The ballooning debt of the United States government is an especially large and interesting case of sovereign debt. One chronicler of sovereign debt’s long, global, colorful history, Max Winkler, concluded that “The history of government loans is really a history of government defaults.” More moderately, we may say that at least defaults figure prominently in that history.

In a vivid recent example, the government of Greece, in its 2012 debt restructuring, paid private holders of its defaulted debt 25 cents on the dollar, so these creditors suffered a 75 percent loss from par value. Greek government debt was at the vortex of Europe’s 21st century sovereign debt crisis. Various governments of Greece have defaulted seven times on their debt, which has been in default approximately half the time since the 1820s.

With such a record, how soon would the lenders be back this time?

Pretty soon, as usual. Defaults were the past; new loans proclaim a belief in the future. Thus in July, the print edition of the Financial Times informed us, “Greek debt snapped up as investors seek higher yields”! That’s a headline that would not have been predicted a few years ago—except by students of financial history who have observed the repeating cycles of sovereign borrowing, default, and new borrowing.

“Greece has seen vigorous demand for its latest bond sale,” read the Financial Times article. “The Mediterranean country received orders of more than €13 billion for the seven-year bonds, well above the €2.5 billion on offer.” And the “higher yield”? A not very impressive 1.9 percent. The recently again-defaulting Greek government has succeeded in borrowing at the same interest rate as the United States government was at the same time for the same tenor. Of course the currencies are different, but this is nonetheless remarkable.

Note the common but inaccurate figure of speech used in the article. It talks about the country borrowing, when it is in fact the government of the country that borrows. That these two are not the same is an important credit consideration. Governments can be overthrown and disappear, while the country goes on. Governments can and do default on their debt with historical regularity.

Breaking the Faith

Notorious in this respect is the government of Argentina, which has “broken good faith with its creditors on eight occasions since it declared independence from Spain in 1816,” as James Grant reminds us. That is a default on average about once every 25 years. Obviously the lenders reappeared each time—in 2017, they bought Argentine government bonds with a maturity of 100 years. That is long enough on average to cover four defaults. In August 2019, the Argentine government announced it would seek to restructure its debt once again, and its 100-year bonds at the end of the month were quoted at 41 cents on the dollar.

In contrast to this, an optimistic columnist for Barron’s pronounced in that same August that sovereign bonds “have minimal to no credit risk because they are backstopped by their governments.” This financially uneducated statement is reminiscent of the notorious Walter Wriston line that “countries don’t go bankrupt.” Wriston, then prominent in banking as the innovative chairman of Citicorp, was defending the credit expansion that would shortly lead to the disastrous sovereign debt collapse of the 1980s. While sovereign governments indeed do not go into bankruptcy proceedings, they nevertheless do often default on their debt.

The great philosopher, economist and historian, David Hume, famously argued two and a half centuries ago, “Contracting debt will almost infallibly be abused, in every government.”

Max Winkler shared a realistic appreciation of the risk involved, as he was writing during the sovereign debt collapse of the 1930s. His instructive and entertaining book, Foreign Bonds: An Autopsy (1933), provides a simple but convincing explanation for the recurring defaults. Considering “politicians in the borrowing countries, from Abyssinia to Zanzibar,” Winkler memorably observed:

The position they occupy or the office they hold is ephemeral. Their philosophy of life is carpe diem. . . . Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures, proposed by themselves and their temporary adherents. . . . In order to enjoy the present they cheerfully mortgage the future, and in order to win the favor of the voter they . . . exceed the taxable possibilities of the country.

This sounds familiar indeed. We only need to update Winkler’s A to Z country names—we could make it “from Argentina to Zimbabwe.” Otherwise, the logic of the politicians’ behavior he describes is perpetual. It applies not only to national governments but to the governments of their component states, cities, and territories, like over-indebted Illinois and Chicago; New York City, which went broke in 1975; and Puerto Rico, now in the midst of a giant debt restructuring, among many others.

The observation fits the governments of advanced, as well as emerging, economies. This political pattern includes the expanding debt of the United States government, although it has not defaulted since 1971. In that year, it reneged on its Bretton Woods agreement to pay in gold. The U.S. government also defaulted on its gold bonds in 1933. Then Congress declared that paying these bonds as their terms explicitly provided had become “against public policy.”

The always insightful Chris DeMuth, writing in The American Interest and pondering the long-term trend of rising U.S. government debt, proposes that we have seen “the emergence of a new budget norm.” This is “the borrowed benefits norm.” “Voters and public officials,” he writes, have forged “a new political compact: for the government to pay out benefits considerably in excess of what it collects in taxes, and to borrow the difference.” He points out that the benefits “are mainly present consumption and are not going to generate returns to pay off the borrowed funds. Borrowing for consumption leads to immoderation now, immiseration down the road.”

This scholarly language captures the same behavior Winkler described in more popular terms in 1933.

A Habit of Default that Few Seem to Have Noticed

How frequent are defaults on sovereign debt? In their modern financial classic, This Time Is Different (2009), Carmen Reinhart and Kenneth Rogoff counted 250 government defaults on their external debt between 1800 and 2006, or 12 sovereign defaults per decade on average (of course, there have been more since 2006). In addition, they found 70 defaults on domestic public debt over that period.

A study by the Bank of Canada finds that, since 1960, 145 governments “have defaulted on their obligations—well over half the current universe of 214 sovereigns.” That is on average 24 defaulting governments per decade.

The study considers “a long-held view among some market participants . . . that governments rarely default on local currency sovereign debt [since] governments can service such obligations by printing money.” It points out that “high inflation can be a form of de facto default on local currency debt.” Holders of U.S. Treasury bonds found that out in the Great Inflation of the 1970s, when the bonds became called “certificates of confiscation.” But not counting the inflation argument, the Bank of Canada still finds 31 sovereigns with local currency defaults between 1960 and 2017. “Sovereign defaults on local currency debt are more common than is sometimes supposed,” it concludes.

The Wikipedia “List of sovereign debt crises,” relying heavily on Reinhart and Rogoff, shows 298 sovereign defaults by the governments of 88 countries between 1557 and 2015.

“The regularity of default by countries on their sovereign debt” is how Richard Brown and Timothy Bulman begin their study of the Paris Club and the London Club. These are organizations of governmental and private creditors, respectively, to negotiate with over-indebted governments. The first Paris Club debt rescheduling was in 1956 for Argentina; the London Club’s first was in 1976 for Zaire. (A to Z again.) The clubs have been busy since then. “Reschedulings increased dramatically from 1978 onwards,” Brown and Bulman observed in 2006. The current webpage of the Paris Club reports that in total it has made 433 debt agreements with the governments of 90 debtor countries.

The cycle of sovereign borrowing, default, and new borrowing has a long and continuing history. “Defaults will not be eliminated,” Winkler wrote in 1933. He further predicted that “debts will be scaled down and nations will start anew,” and that “all will at last be forgotten. New loans will once again be offered, and bought as eagerly as ever.” He was entirely right about that, and now we observe once again “Greek debt snapped up.”

How far back in time do government defaults go? Over 2,300 years in Greece. As Sidney Homer, in A History of Interest Rates, tells us: “In 377-373 B.C., thirteen [Greek] states borrowed from the temple at Delos, and only two proved completely faithful; in all, four-fifths of the money was never repaid.”

Shall we expect the fundamental behavior of politicians and governments to change?

Unfunded Pensions: Watch out, bondholders!

Published in Real Clear Markets.

A reorganization plan for the debt of the government of Puerto Rico was submitted to the court Sept. 27 by the Puerto Rico Oversight Board. It covers $35 billion of general obligation and other bonds, which it would reduce to $12 billion.

On average, that is about a 66 percent haircut for the creditors, who thus get 34 cents on the dollar, compared to par. Pretty steep losses for the bondholders, but steep losses were inevitable given the over-borrowing of the Puerto Rican government and the previous over-optimism of the lenders. Proposed haircuts vary by class of bonds, but run up to 87 percent, or a payment of 13 cents on the dollar, for the hapless bondholders of the Puerto Rican Employee Retirement System.

In addition to its defaulted bonds, the Puerto Rican government has about $50 billion in unfunded pension obligations, which are equivalent to unsecured debt. But the pensioners do much better than the bondholders. Larger pensions are subject to a maximum reduction of 8.5 percent, while 74 percent of current and future retirees will have no reduction. Those with a reduction have the chance, if the Puerto Rican government does better than its plan over any of the next 15 years, to have the cuts restored.

The Oversight Board’s statement does not make apparent what the overall haircut to pensions is, but it is obviously far less than for the bondholders. “The result is that retirees get a better deal than almost any other creditor group,” as The New York Times accurately put it. This may be considered good and equitable, or unfair and political, depending on who you are, but it is certainly notable. The Times adds: “Legal challenges await the plan from bondholders who believe the board was far too generous to Puerto Rico’s retired government workers.”

The Puerto Rican debt reorganization plan demonstrates once again, in municipal insolvencies and bankruptcies, unfunded pension obligations are de facto a senior claim compared to any other unsecured debt, including general obligation bonds that pledge the full resources and taxing power of the issuing government. This is not because they are legally senior, but because they are politically senior.

By running up their unfunded pensions, municipalities have not only stressed their own finances, but have effectively subordinated the bondholders. When it comes to unfunded pensions, the Puerto Rico outcome, like that of Detroit and others, announces: Bondholders, Watch Out!