The Federal Reserve’s Ballooning—and Risky—Balance Sheet

The Federal Reserve’s Ballooning—and Risky—Balance Sheet

05/28/2021Bill Bergman

The Fed has embarked on a massive expansionary quest in recent years. In 2020, total Reserve Bank assets rose from $4.2 trillion to $7.4 trillion amidst the pandemic and related government lockdown and fiscal “stimulus” policies. That was roughly three times the extraordinary growth in the consolidated balance sheet for the Reserve Banks in the 2008-2009 financial crisis. And in the latest weekly “H.4.1” release, total assets were up to $7.8 trillion – rising about a hundred billions dollars a month so far this year. 

In banking, rapid growth isn’t hard to achieve, if you are willing to assume risk. In fact, rapid growth should always be questioned as a sign of possible undue risk taking. How about the Federal Reserve Banks? How much risk are they taking, and on whose dime? 

To answer these questions, we first have to identify the accounting principles on which the Fed’s balance sheet is based. 

In the United States, there are “Generally Accepted Accounting Principles” (GAAP) – but there are different strokes for different folks. Private sector companies follow accounting standards set by the FASB – the Financial Accounting Standards Board. State and local governments follow a different set of “generally accepted” rules that are set by the GASB – the Governmental Accounting Standards Board. The federal government of the United States follows yet another set of “generally accepted” principles, set by the FASAB – the Federal Accounting Standards Advisory Board.

Put aside for now the question whether “generally accepted accounting principles” can even exist in a world where there are more than three sets of them, including international accounting standards. Who sets the accounting standards for the Federal Reserve?

There are two main parts of the “Federal Reserve.” The Federal Reserve Board of Governors is an independent regulatory commission, a government agency, and it follows the standards for the federal government set by the FASAB. But the Federal Reserve Banks are another story: they follow accounting standards set by the Federal Reserve Board of Governors! Those standards are not GAAP.  

One way the Fed’s principles for the Reserve Banks differ from GAAP matters for understanding material risks facing the Reserve Banks, and in turn, the U.S. Treasury.

The Reserve Banks’ assets include trillions of dollars of bonds, most of them government or government-backed bonds. Like any bond portfolio, those investments are subject to interest rate risk. When interest rates go up, bond prices go down (and vice versa).

Under the Board of Governors’ accounting standards for the Reserve Banks, “unrealized” losses in bond investment value do not immediately find their way into the financial statements. Only when losses are “realized” (for example, when the bonds are sold) does loss enter the financial statements.

Today, short and long-term interest rates on government bonds rest near historic lows, important in part because the Fed massively expanded its purchases of government bonds. But low interest rates can’t be taken for granted, particularly if we get significantly higher inflationary expectations -- which appear to have begun to sprout in recent weeks.  

If we get significantly higher interest rates for that reason, the Reserve Bank balance sheet impact from losses on securities assets would arrive if the losses become “realized” – a realistic prospect if the Federal Reserve  reverses course and starts selling off securities as a means of conducting monetary policy amidst higher inflationary expectations.

This impact, and risk, is higher for entities with significant financial leverage. And the Reserve Banks are some of the highest-leveraged banks on the planet. On the 2020 balance sheet, which reported $7.4 trillion in assets, Reserve Banks reported “only” $40 billion in total capital – a capital/asset ratio of one-half of one-percent.

For a given percentage change in the value of assets, highly leveraged entities will see a greater percentage decline in the value of capital. In this case, Reserve Banks would begin reporting negative capital after losses amounting to just one-half of one percent of their total assets.

That is, if they were required to post the losses. Under current standards set by the Board of Governors, they won’t begin to do that until the losses are realized in sales on the open market. And even then, the Reserve Banks won’t show a negative capital amount because the Fed sets its own accounting standards, a least for the Reserve Banks, and changes them as it sees fit.

Back in 2011, after the first spike upward in Reserve Banks’ balance sheet with the financial crisis, the Federal Reserve Board of Governors changed the accounting standards for the Federal Reserve Banks. These changes limited  the possibility that the Reserve Banks’ capital account could ever turn negative. And more recently, some have argued that the Fed’s control over its own accounting principles could allow for even more creative ways of cushioning the blow from any investment losses.

But a free lunch for the Fed isn’t necessarily a free lunch for the rest of us.

The problem (and risk) facing the Treasury (and the rest of us) is compounded by the Fed’s legally dubious new practice of paying interest on reserves that banks maintain with the Reserve Banks. If short-term interest rates rise amidst heightened concern about inflation, under current policy, the Fed would pay higher interest on the massive multi-trillion dollars worth of reserve balances currently at the Reserve Banks.

Introducing its own balance sheet, a balance sheet with about $6 trillion in assets against nearly $33 trillion in (understated) liabilities, the federal government gives us the following comforting words:

There are, however, other significant resources available to the government that extend beyond the assets presented in these Balance Sheets. Those resources include stewardship PP&E in addition to the government’s sovereign powers to tax and set monetary policy.

In other words, we should be comforted that our government will be able to take our money away, or inflate the value of the dollar away, to pay off its debts. 

Maybe we shouldn’t be comforted by these assertions, especially because they arrive in a document theoretically providing  accountability of the government to the real sovereign in the United States – the people.

The Federal Reserve has returned earnings regularly to the Treasury for decades. And the government appears to see the Fed and monetary policy as its ace in the hole. But this is not  necessarily an ace in the hole for the people.

When justifying the fact that the Fed sets its own accounting standards, Fed leaders regularly assert that the value of central bank independence warrants this state of affairs. But how independent is the Fed, really, under current law and policy?

Back in 2010, the opinion of the Government Accountability Office (GAO) on the financial statements of the U.S. Government began including a cautionary note about the risks of the Fed’s ballooning balance sheet to the Treasury. The GAO opinion letters stopped including these notes in 2015. Now that the Fed’s balance sheet is ballooning again, these issues deserve greater scrutiny.

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The Roots of Concord and Discord

6 hours agoGary Galles

In Abraham Lincoln’s June 16, 1858, speech upon being chosen as Illinois’ Republican nominee for U.S. Senate against Stephen Douglas, he cited Jesus’ words in the Bible that “a house divided against itself cannot stand.”

Today, that principle is once again an ominous portent for America. We have piles of politicians who claim they will unify us, protecting us from division (e.g., President Biden’s promise to be a leader who “seeks not to divide, but to unify”), but the only unity they really offer is the creation of slight and unstable majorities who wish to benefit themselves at others’ expense. Such unity is really tyranny.

That is why we also could benefit from remembering Lincoln’s reason for his house divided language: “I want to use some universally known figure, expressed in simple language as universally known, that it may strike home to the minds of men in order to rouse them to the peril of the times.”

Leonard Read, creator of the Foundation for Economic Education, also echoed that house divided language and the seriousness of the problem it highlighted for America, in his “The Roots of Concord and Discord,” Chapter 8 in his 1975 The Love of Liberty. The reason? It was abundantly clear to him that our house was seriously divided.

The house we call America is divided against itself, as is evident to anyone who has eyes to see and ears to hear. Discord is rampant…If our house is to stand, concord must replace discord and, if this is to be accomplished, we must practice the way of life that leads to harmony.

What is the essence of the contrasting roads to discord and concord that Read recognized? Dictocratic determination versus free markets.

What road are we now treading? It’s the road to serfdom. Day by day and in nearly every way, we move nearer to omnipotent government, the totalitarian state--dictocrats by the millions telling us how to live our lives.

When discord is rampant, we’re on the wrong road; when concord prevails, we’re on the right one.

What is the road in the opposite direction? It is the free market, private ownership, limited government way of life. Not a single dictocrat [with] those in government confined to invoking a common justice and keeping the peace…no man-concocted restraints standing against the release of creative human energy.

Read then evaluates dictocratic determination and the discord--disunity in more modern terms--that results. That discord is created by attempts to coerce people into conformity with dictocrat wishes against their will.

Why does the road featured by dictocrats lead to discord? And why does the road in the opposite direction, featured by a free and self-responsible people, lead to concord?

The road to serfdom--socialism, the planned economy, the welfare state, call it what you will--is featured by millions of dictocrats…each trying to make over society in his image.

In view of their dissimilarities, it is instructive to reflect on what dictocrats have in common…no doubt that were he to direct the whole economy it would be improved…politically applied know-it-all-ness.

Note the mess we’re in--the failures more apparent each day. And the discord! With millions of dictocrats advancing as many or more panaceas--all at odds--how could it be otherwise!

All that the dictocrats can possibly do to modify their mistakes…is to attempt something less bad. But not so bad is error still!

The seed is socialism; the fruit has to be discord!

Each individual of the…dictocrats…assesses himself as the focal point of wisdom….[But] every assumed focal point of wisdom [is] at odds one with the other. Discord!

The ability of individuals to freely choose for themselves with their own resources is what converts the discord created by dictocrats into concord. All parties whose rights are involved must agree to the arrangements made, rather than some uniting with one another to violate others’ rights.

What then is the way of life that leads to harmony? It is every man pursuing his legitimate--intelligent--self-interest, that is, acting any way he pleases so long as his way does not impair the rights of others to be their creative selves.

This reflects the importance of understanding that in a world where agreement on who should get how much of what is beyond our potential--because in a world of scarcity, more for me at your expense, which is the vast majority of political determination, will seldom achieve your voluntary agreement. There is no real unity in that direction.

However, despite our disagreement on myriad aspects of who should get what, we share far greater unity about what we do not want to happen to us. None of us wants what John Locke called our “lives, liberties and estates” violated. Each of us wants our rights and property defended against invasion. That protection expands our joint freedom to peacefully pursue our goals.

As Lord Acton put it, “liberty is the only object which benefits all alike, and provokes no sincere opposition,” because freedom to choose for ourselves is always the primary means to our ultimate ends. That is why the traditional functions of government are to protect us from abuse, which Acton recognized as requiring “the limitation of the public authority,” because creating added rights and privileges for some at the expense of others’ rights--the mainstay of dictocrats--makes government itself the most dangerous predator.

Well-established property rights and the voluntary market arrangements they enable let individuals decide for themselves, limiting each of us to persuasion rather than coercion. And since we all want persuasion rather than coercion used when it comes to ourselves, the kind of unity that is impossible in allocating “who gets what” becomes possible when it comes to “rules of the game” we all prefer for ourselves.

Reflect on…how we may switch from the kind of actions that produce discord to the way of life that leads to concord…[where] liberty is a blessing to everyone.

Coercion in every instance [is] the root of discord…Is it any wonder that discord rather than concord is dominant!

These people who exercise coercion see only the “advantages” of their special privilege, of their coercion.

The remedy is nothing less than an eye-opening performance…the seeing at once of a delusion and of a truth.

The delusion?...that the dictocrats’ coercive tactics are responsible for life being as good as it still is. That which is seen! The truth? That the free flowing of creative energy--liberty--is the source of human welfare. That which is not seen!

Leonard Read thus saw that the transition from the discord we know to the concord we could have involved expanding people’s ability to choose for themselves, under private property rights, rather than dictocrat coercion into different choices. That requires better protection for our rights than we receive today. And while that would not eliminate our disagreements on many things, it would stop them from threatening our society.

Concord can replace discord. It is only a matter of seeing. When seen, our house will no longer be divided against itself.

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Fear the Repo, Man

08/04/2021Robert Aro

Effective July 29, 2021, the Federal Reserve directed the New York Federal Reserve’s Trading Desk (the Desk), to:

Conduct overnight repurchase agreement operations with a minimum bid rate of 0.25 percent and with an aggregate operation limit of $500 billion; the aggregate operation limit can be temporarily increased at the discretion of the Chair.

What does this mean?

Per the Desk:

In a repo transaction, the Desk purchases securities from a counterparty subject to an agreement to resell the securities at a later date.

As the Fed announced, through the domestic Standing Repo Facility (SRF), they are willing to create up to $500 billion in order to buy securities such as US Treasurys or mortgage-backed securities (MBS) from primary dealers like JP Morgan Securities. The following day, the primary dealers will buy the security back, but at a higher price, which equates to an interest rate of 0.25 percent.

Whether it's for emergency purposes or so the institution can think of a creative way to use the loan has yet to be seen. “Over time,” the facility is expected to be available to depository institutions.

It doesn’t end there! A second facility was announced under similar terms, but offered to “Foreign and International Monetary Authorities” (FIMA), which encompasses “foreign central bank and international accounts maintained at a Federal Reserve Bank.” The limit for each counterparty who takes the Fed’s offer is $60 billion, whereas no cap per counterparty was specified for the SRF.

The newly announced SRF and FIMA repo facilities are not to be confused with reverse repos, which are similar but follow the opposite arrangement, as the Desk explains:

the Desk sells securities to a counterparty subject to an agreement to repurchase the securities at a later date.

In a reverse repo (RRP), firms are in effect lending money to the Fed and currently making 0.05 percent for their service. The volume of RRPs that primary dealers are currently utilizing has now surpassed $1 trillion.

There are various explanations for why the Fed might want to engage in repo transactions, but the explanation offered in the press release was:

These facilities will serve as backstops in money markets to support the effective implementation of monetary policy and smooth market functioning.

Chair Jerome Powell echoed the statement when asked about the new facilities in his latest address:

So it really is a backstop … it's there to help address pressures in money markets—money markets that could impede the effective implementation of monetary policy. So, really, it's to support the function of—functioning of monetary policy and its effectiveness.

The repetitive nature of Powell’s speech as he echoed the press release doesn’t offer much comfort. Given the recession has long passed, and anything cataclysmic like a bank failure doesn’t seem to be on the Fed’s radar, it’s unfortunate they’ve given the public little more than the “smooth market function” rationale. Hollow phrases have the ability to permit every action by the Fed, but in no way do they constitute an explanation based on economic theory.

As for the reverse repo facilities of $1 trillion a day, these overnight, nearly risk-free and lucrative trades deserve some reflection. But can anyone blame an institution for making what practically amounts to “free money” by lending to the Fed? Of course, they’ll never explain it as such. Rather, Powell says:

[S]o we think it's doing what it's supposed to do, what we expect of it to do, which is to help provide a floor for money market rates and help ensure that the federal funds rate stays within the target range.

Therefore, it’s important the wealthiest institutions in the world lend $1 trillion to the central bank for overnight lending, quite possibly with money they created out of thin air itself, in order to keep rates in the appropriate range, says the Fed.

Domestic repos, international repos, and reverse repos; once the financial schemes are invented, they have a habit of never going away. On top of that, they continually reinvent themselves in new and interesting ways, while the dollar amounts continue to increase ever so steadily … As of this writing, no plan of winding down these facilities has been noted.

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The Fed’s Failure to Launch

07/31/2021Robert Aro

The July Federal Open Market Committee (FOMC) meeting this week had many interesting sound bites and a lot of Fedspeak, as is typical from one of the nation’s most powerful central planners, talk of the Fed’s “liftoff” being among them. Don’t bother looking in any textbook in search of an economic model or the theory behind liftoff; there is none.

It began when a reporter pressed Fed Chair Jerome Powell on his inflation target, asking:

In your opening statements in March and April, you noted that a transitory rise in inflation above 2 percent this year would not meet the threshold of moderately exceeding 2 percent for some time, and I noticed you didn't repeat that qualification last month or today. And so, in your view, has the rise in inflation this year met the threshold of moderately exceeding 2 percent for some time?

Exceeding the inflation target, or average inflation targeting, where the Fed purposely overshoots inflation to make up for previous years of low inflation, is an idea whose origins started with central bankers. It is not an economic theory.

It’s curious the Fed spent over a decade aiming for its (arbitrary) 2% target, yet earlier in the year warned us that if the target were met, they still wouldn’t consider the goal achieved...

Powell responds to the reporter:

That would, again, be a question for the Committee. But I would really say the guidance that you're talking about is really the guidance to do with liftoff, right? That's -- what the guidance is for liftoff…

Liftoff occurs when we have:

… labor market conditions consistent with full employment, inflation at 2 percent and on track to run moderately above 2 percent for some time.

However (per the Chair of the Federal Reserve):

It really isn't relevant now.

Concluding with:

It -- because we're really -- we're looking at tapering asset purchases. We're clearly a ways away from considering raising interest rates. It's not something that is on our radar screen right now. You know, so when we get to that question, when we start to get to the question of liftoff, which we are not at all at now or near now, that's when we'll ask that question. That is when that will become a real question for us.

Said plainly, the Fed is in no rush to taper asset purchases. When Powell speaks of tapering, he’s referring to the decrease of $120 billion a month in bond purchases. This is very different from actually shrinking the balance sheet which seems entirely off the table. As for raising rates, that will also be at an indeterminate time in the future. When these goals are to be met remains both immeasurable and unknown to everyone outside the Fed’s committee.

Consider humoring all the Fed plans. It may take months or years, but the Fed’s accommodative stance is expected to continue until its goals are achieved. Once sufficiently met, liftoff (tightening) will commence. It’s a big if but assuming this happens exactly as the Fed hopes, how long until the Fed capitulates its liftoff, citing a new crisis, a recession, or other external factor attributed to anything else except the Fed?

The cycle comes full circle. Once the tightening starts, it’s only a matter of time until the Fed will have to reverse course, engage in expansionary monetary policies yet again, citing another new economic crisis. Due to the accumulation of past interventions and its compounding effects, regardless of whether the Fed is on an expansionary or tightening stage, the current trajectory is a path ensuring everything increases, as the idea of any sort of a deflation clearly is not on the agenda. If there is a liftoff, it will come in the form of higher prices for all we hold dear, as over time, the money supply, national debt, asset prices, and the prices of goods and services will continue to “liftoff” in unimaginable ways.

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Was It Always This Way?

07/29/2021Robert Aro

How well can anyone remember past Federal Reserve Chairs? There was Volcker, who allegedly solved the inflation crisis by raising rates and bringing about a recession. After Volker there was Greenspan who is still referred to as “the Maestro.” Followed by “Helicopter” Ben Bernanke... a name he probably doesn’t appreciate much. After Ben came Yellen and now Powell. With each new Chair came a bigger and bigger balance sheet and expansion of central bank powers. We now live in an era where the Fed garners a significant amount of attention; but was it always this way?

Roughly every 6 weeks the world waits to see what the Fed will say, closely listening for clues as to what they might do next. A significant amount of our time and decision making is heavily wrapped around this elusive club of central planners who create money at will and determine the benchmark interest rate for an entire nation.

As per usual, leading up to the main event, the economic news headlines are abuzz with mounting speculation as to the decisions to come out of this Wednesday’s Fed meeting. CNBC notes that:

While no action is expected, there could be some mention of the central bank’s possible wind down of its bond program. That could move the markets since the tapering of the central bank’s bond purchases is seen as the first step on the way to interest rate hikes.

The article goes on to say that the Fed may take a year to eventually scale back its $120 billion a month bond purchase to zero, which should then open the door to rate hikes.

Reuters notes a new dilemma on the horizon: a Fed that is now facing higher than expected price increases, accompanied by “slow annual economic growth” (which it blames on supply chain problems) and the rise of the delta variant. No definitive answer was given, but it’s believed that:

Things could play out in a way they didn't expect.

The Fed could always shrink its balance sheet quicker than expected, but the opposite can easily come true and it could find reasons to increase its asset purchases. If an expansion of the balance sheet were to happen this year, it would definitely be something “they didn’t expect,” but still a move that cannot be put past the Fed given how nimble they are to act when circumstances change (according to them).

As the world waits, various stock market indices flirt around all time highs, house prices continue to increase and inflation calculations continue to read red hot, while it was announced just last week that the recession officially ended in April 2020… over a year ago.

But was it always like this?

Did the world always wait to see what the Fed would say or do, speculating the effects on asset and general prices? Given the monumental growth of the balance sheet, the percentage of debt to national debt held, and its robust set of assets like mortgages debt and corporate bonds, it’s safe to say the role the Fed has played in our lives has increased with each passing Fed Chair. Combining its power with the digital age, it's no wonder not a day passes on any business news channel where “the Fed” is not mentioned in some capacity.

It’s difficult to say how sentiment towards the Fed was several generations ago. But if the former Fed Chairs and their escalating level of intervention under each tenure is used as a measure, then our future becomes certain. Any talk of tapering the balance sheet, raising rates, or getting back to some sense of normal will be nothing more than a “transient” phase at best.

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Mark Spitznagel: At What Price Safety?

07/27/2021Mark Spitznagel

Editor's note: Mark Spitznagel is President and Chief Investment Officer for Universa Investments. He has written about risk mitigation and "tail hedging" in his books The Dao of Capital and Safe HavenHe is a well-read student of Austrian economics, and has applied the insights of Mises and others to his professional work. This editorial, originally published July 20 in the Financial Times here, provides compelling insights into Mr. Spiztnagel's view of "risk mitigation irony": as politicians and investors attempt to mitigate risk, they miss the "unseen," which Frédéric Bastiat admonished us to consider. For Spitznagel, both politicians and investors fail to understand the true (i.e., full) costs of their risk mitigation strategies—the former overcorrect for covid dangers, the latter overcorrect for crashes. For those interested in the distinction between uncertainty and risk in economics, see Frank Knight's Risk, Uncertainty, and Profit and Mises's Human Action, chap. 6.

From public policy to private investing, it is the central question of our time: how high a price should we pay to keep ourselves safe from harm?

And this begs even more fundamental questions: should risk mitigation come at a cost at all, or should it rather come with rewards? That is, shouldn’t risk mitigation be “cost-effective”? And if not, what is it good for? 

Think of your life like an archer releasing just one single arrow at a target. Naturally, you want to make your one shot at life a good one—to hit your bullseye—and this is why you mitigate your risks: to improve your precision (or the tightness of the grouping of your potential arrows) as well as your accuracy (or the closeness of that potential grouping to your bullseye). We often lose sight of this: safety is instead perceived as improving precision (removing our bad potential arrows) at the expense of accuracy.

The fact is, safety from risk can be exceedingly costly. As a cure, it is often worse than the disease. And what’s worse, the costs are often hidden; they are errors of omission (the great shots that could have been), even as they mitigate errors of commission (the bad shots). The latter are the errors we easily notice; ignoring the former for the latter is a costly fallacy.

Of course, we expect politicians to commit this risk mitigation irony. Ours is the great age of government interventionism—from corporate bailouts to extraordinary levels of debt-fueled fiscal spending and central bank market manipulations. Fallaciously ignoring errors of omission to avoid errors of commission essentially is the job of politics, as every government programme involves hidden opportunity costs, with winners and losers on each side.

More surprising, even investors engage in risk mitigation irony as well. They strive to do something—anything—to mitigate risk, even if it impairs their portfolios and defeats the purpose. The vast majority of presumed risk mitigation strategies leave errors of omission in their wake (i.e. underperformance), all in the name of avoiding losses from falling markets.

Modern finance’s dogma of diversification is built around this very idea. Consider diversifying “haven” investments such as bonds or, God forbid, hedge funds. Over time, they exact a net cost on portfolios’ real wealth by lowering compound growth rates in the name of lower risk. They have thus done more harm than good.

The problem is, such safe havens simply do not provide very much (if any) portfolio protection when it matters; therefore, the only way for them to ever provide meaningful protection is by representing a very large allocation within a portfolio. This very large allocation will naturally create a cost burden, or drag, when times are good—or most of the time—and ultimately on average. Over time, your wealth would have been safer with no haven at all.

An overallocation to bonds and other risk mitigation strategies is the principal reason why public pensions remain underfunded today—an average funding ratio in the US of around 75 per cent—despite the greatest stock market bull run in history.

For instance, a simple 60/40 stocks/bonds portfolio underperformed the S&P 500 alone by over 250 per cent cumulatively over the past 25 years. What was the point of those bonds again? Cassandras typically and ironically lose more in their safety interventions than they would have lost to that which they seek safety from.

Most investor interventionism against looming market crashes ultimately leads to lower compound returns than those crashes would have cost them. Markets have scared us far more than they have harmed us.

While Cassandras may make great career politicians and market commentators, they have proven very costly in public policy and in investing. We know that times are fraught with uncertainty, and the financial markets have perhaps never been more vulnerable to a crash. But should we seek safety such that we are worse off regardless of what happens?

We should aim our arrows such that we mitigate our bad potential shots and, as a direct result, raise our chance of hitting our bullseye. Our risk mitigation must be cost-effective. This is far easier said than done. But by the simple act of recognizing the problem of the deceptive, long-term costs of risk mitigation, we can make headway. If history is any guide, this might just be the most valuable and profitable thing that any investor can focus on.

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The Federal Reserve Cannot Help America

07/21/2021Robert Aro

Over the weekend, Yahoo Finance Editor-in-Chief Andy Serwer wrote an article titled: How the Federal Reserve can really help America. His error is as old as the word “Socialism” itself. The author seems genuine in wanting a better society, but his misguided belief is that the way there is through better planning from the government and the Fed. Unfortunately, this is asking for something unachievable, as history has shown.

He opens with a nod to central banking, saying the:

Federal Reserve has greatly aided our economic well-being (by cushioning us from and even helping us avoid economic catastrophe)…

It’s understood the Fed tells us that without their interference in the free market, society would be a worse place; but multiple generations of Austrian authors have written to the contrary. Specifically, about the boom/bust cycle central banks cause through the interference of the money supply and interest rates, which most impacts vulnerable members of society. Yet the warnings go unheeded.

He says things like:

The Fed’s boosting of the economy by keeping interest rates low disproportionately helps rich people and thereby actually disadvantages those in need.

The revelation can be applauded. But Mises, Rothbard, Hayek, Hazlitt, to name a few of a long list of authors, have been saying this and much more for a very long time. Why aren’t their ideas further explored?

A difficult passage comes from an associate professor at University of Chicago, Michael Weber, who, according to the author, says:

It’s important to note here that low rates and goosing the economy does help people of color, lower educated women and other less wealthy groups… It’s just that it benefits the already advantaged more. 

In an era where statues are being torn down and maple syrup has become offensive, it’s shameful to think comments from an academic like Mr. Weber go unnoticed. That a handful of experts are paid to support a system which plans the economic landscape for “people of color” and “lower educated women” is highly disrespectful.

Despite mentioning “inequality” nearly 20 times, the author never defines specifics that can be resolved. The article continues with various opinions on how intervention can be used to address inequality, with no clear message other than the Fed should do something, which always boils down to money creation or interest rate manipulation.

The hope of using money creation to create a more just society is actually a very old tactic known as “inflationism.” Mises discussed this over 100 years ago, the various problems with tinkering with the money supply and how it ultimately hurts society. That the Fed’s metaphorical money printer be halted is not even considered by the author.

By the end, one question illustrates the problem the author missed completely, asking:

What if the Fed, Treasury Secretary (and former Fed chair) Janet Yellen and congressional leaders from both parties, convened a summit on how the federal government should address inequality? 

The appeal to a higher power is tempting. But it neglects over a century of Fed intervention, the boom/bust cycle, perpetual loss of the dollar’s purchasing power, asset bubbles, and abysmal track record governments have with creating solutions to our problems.

A desire to ameliorate economic disparity is commendable. But because it’s the government and the Fed who creates the disparity, the request is little more than appeal to popular hope and emotion. The author even cites some of the Fed’s missteps, but instead of asking to stop central planning, he asks for a better central plan.

He is asking that a mix of elected and unelected officials, by way of taxation or money creation, confiscate or create money to disburse to certain members of society, as well as manipulate interest rates to help those deemed most in need. The hope is that this new allocation of funds and changes to rates will make for a better society.

Congress mandated the Fed the tasks of full employment and price stability; but we must delve deeper to understand this. The goals can only be reached when the Fed says they are reached, as judged by measurements known only by the Fed. Although there is no such thing as an optimal money supply or an ideal interest rate, the Fed insists on controlling these on behalf of the nation; both being tasks that hundreds of millions of market participants can do better than any central bank.

If free market solutions to America’s economic problem are not considered, the alternative will always be a call for more socialism, except this time, it’s definitely going to be done right.

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Bitcoin Hodling and Gresham’s Law

07/16/2021Connor Mortell

In 2013, a bitcoiner posted “I AM HODLING” on a bitcoin forum, intending to write that he was holding during a large price drop. He was explaining that most people are not successful traders and as a result they will inevitably just lose out in the process of trying to time the bear market, so instead he encouraged that bitcoiners should hold and trust bitcoin. Since that day, this typo, “hodl,” has worked its way into the everyday vernacular of bitcoiners. It now represents the stance that not only should one not attempt to trade bitcoin through bull and bear runs, but also should not sell bitcoin under any circumstances because whatever asset it is one may purchase with it will one day be outperformed by bitcoin. For some purposes, this may be helpful, but for the adoption of a private money, this is exceedingly dangerous.

Gresham’s law is what makes this such a threat to bitcoin adoption. Gresham’s law is colloquially stated as “the tendency for bad money to drive out good money.” This happens because the consumer will find it preferable get rid of their “bad money” and as a result when they have to spend something, they will spend the “bad money” and it will end up being the money that is most widely accepted. It is used regularly to argue against private currencies with individuals like W.S. Jevons even citing it as the reason that “there is nothing less fit to be left to the action of competition than money.” Friedrich A. Hayek, however, dismantles this claim in his essay Denationalisation of Money: The Argument Refined:

What Jevons, as so many others, seems to have overlooked, or regarded as irrelevant, is that Gresham’s law will apply only to different kinds of money between which a fixed rate of exchange is enforced by law. If the law makes two kinds of money perfect substitutes for the payment of debts and forces creditors to accept a coin of a smaller content of gold in the place of one with a larger content, debtors will, of course, pay only in the former and find a more profitable use for the substance of the latter.

With variable exchange rates, however, the inferior quality money would be valued at a lower rate and, particularly if it threatened to fall further in value, people would try to get rid of it as quickly as possible. The selection process would go on towards whatever they regarded as the best sort of money among those issued by the various agencies, and it would rapidly drive out money found inconvenient or worthless. Indeed, whenever inflation got really rapid, all sorts of objects of a more stable value, from potatoes to cigarettes and bottles of brandy to eggs and foreign currencies like dollar bills, have come to be increasingly used as money, so that at the end of the great German inflation it was contended that Gresham’s law was false and the opposition and the opposite true. It is not false, but it applies only if a fixed rate of exchange between the different forms of money is enforced.

Sure, the consumer would have the desire to spend their “bad money” in order to get rid of it in exchange for preferable products, but the producer would have a desire to not accept this “bad money” and thus would require more of it in exchange for any given good. That’s why, as Hayek explained, Gresham’s law is not true with variable exchange rates, as bitcoin has with the dollar.

Under the natural system that Hayek lays out, if bitcoin really is the so called “good money” then because the exchange rate between these two currencies is variable, bitcoin should be able to drive out the “bad money.” However, if there is a widespread cultural discouragement of giving up bitcoin in exchange for other assets—put more simply, using bitcoin—there is an inverse effect to that of the variable exchange rate as it relates to Gresham’s law. Instead the average bitcoiner returns to the image originally painted in Gresham’s law where the owners of “good money” hold it away in a safe while the actually circulating money is the “bad money.” For all intents and purposes, the bad money ends up driving out the good again when bitcoiners over commit to hodling.

This all comes with one final disclaimer: there is nothing wrong with holding/saving. In fact, as Austrians we know that saving is vital to the economy. I am by no means saying that bitcoin has reached some objective value that makes it worth selling and using now. Obviously, bitcoin’s value is subjective and thus one should not spend it on things which they hold lower in ordinal value than that amount of bitcoin. I’m simply saying that as long as the bitcoin community pushes a narrative of hodling no matter what and spending that bitcoin under no circumstances, it will push more and more a scenario in which the “bad money drives out good.”

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The Fed’s “Special Topics”

07/15/2021Robert Aro

This week, Federal Reserve Chair Jerome Powell gave two days worth of testimony before Congress. As part of his testimony, he presented the Monetary Policy Report July 2021. With this week’s major economic news flow undoubtedly being that (price) inflation, as measured by the Labor Department, is on the dramatic rise, it’s easy to lose sight of the Fed’s “special topics” outlined in Powell’s report.

The report mentions:

The labor force participation rate (LFPR) has improved very little since early in the recovery and remains well below pre-pandemic levels.

But this seems strange. Just last month various news outlets, including CNBC, had headlines to the effect of:

Job openings set record of 9.3 million as labor market booms.

The Chair doesn’t mention job openings but provides various reasons why the LFPR is down, including the explanation that the:

level of unemployment insurance benefits may also have supported individuals who withdrew from the labor force.

Imagine an America where individuals must choose between working to receive a salary or not working and still receiving a salary….

Powell moves on to price increases, noting:

Consumer price inflation has increased notably this spring as a surge in demand has run up against production bottlenecks and hiring difficulties.

The concept of “bottlenecks” continues to take a large part of the blame for the increase in prices lately. However, what level of bottlenecks should be across all industries, whether they should exist at all, and what the Fed can do to manage said bottlenecks hasn’t been specified by Powell.

“Inflation expectations” are another area the Fed tries best to manage, as the notes to the report specifies:

Inflation expectations are often seen as a driver of actual inflation, which is why a fundamental aspect of the FOMC's monetary policy framework…

Inflation expectations have been on the rise. Yet various surveys, expert opinions, forecasters and market-based measures allow the Fed to understand inflation expectations, which in turn drive “actual inflation” doesn’t add up. If it were that easy, there shouldn’t be any inflation problems in the USA, or anywhere else in the world. If inflation expectation only influences a portion of the actual inflation numbers without knowing whether that influence is 1% or 99%, the Fed will have no concept as to how effective its efforts to influence opinions really are.

Lastly, there remains “the balance sheet.” Per Powell’s report:

The Federal Reserve's balance sheet has grown to $8.1 trillion from $7.4 trillion at the end of January, reflecting continued asset purchases to help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.

Of all the Fed’s special topics, this remains the most stunning: that we live in a society where $8 trillion has been lent out by a central bank on the basis of fostering a smooth and accommodative market. What can hardly be explained in great detail has become the Fed’s guiding principle, responsible for the increase in the money supply and suppression of interest rates for a very long time. The response from mainstream economists, members of government and the public remains deafening. Either they don’t understand or don’t care enough to demand that the Fed’s hand be halted. And if they do understand the problem, at the present time they remain in a position to do little about it.

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As Inflation Rises, the Fed Is Losing the Narrative

07/13/2021Tho Bishop

Another week, another economic report far worse than expectations.

As Vladimir Zernov notes:

U.S. has just released Inflation Rate and Core Inflation Rate reports for June. Inflation Rate grew by 0.9% month-over-month in June compared to analyst consensus which called for growth of just 0.5%. On a year-over-year basis, Inflation Rate increased by 5.4% compared to analyst consensus of 4.9%.

Core Inflation also exceeded analyst expectations, increasing by 4.5% year-over-year compared to analyst estimate of 4%.

Just as important as the official numbers is the growing drumbeat of Fed skepticism outside of its usual critics. This week prior to the new Consumer Price Index (CPI) report, the Wall Street Journal published the results of a survey of economists forecasting inflation higher than the Fed’s projections.

Economists surveyed this month by The Wall Street Journal raised their forecasts of how high inflation would go and for how long, compared with their previous expectations in April.

The respondents on average now expect a widely followed measure of inflation, which excludes volatile food and energy components, to be up 3.2% in the fourth quarter of 2021 from a year before. They forecast the annual rise to recede to slightly less than 2.3% a year in 2022 and 2023.

That would mean an average annual increase of 2.58% from 2021 through 2023, putting inflation at levels last seen in 1993.

Last week, the International Monetary Fund’s (IMF) Kristalina Georgieva also warned that the Fed may be underplaying inflation risks.

The world is also keeping a close eye on the recent pickup in inflation, particularly in the U.S. We know that accelerated recovery in the US will benefit many countries through increased trade; and inflation expectations have been stable so far. Yet there is a risk of a more sustained rise in inflation or inflation expectations, which could potentially require an earlier-than-expected tightening of US monetary policy.

For an institution like the Fed, the growing recognition that its future projections are entirely unreliable is as important as troubling inflation reports. Central banks recognize that the ability to shape the narrative is a vital policy tool. A Fed whose forecasts lack credibility is a Fed in trouble and one that may be panicked to act in ways that contradict previous statements.

This explains why today’s inflation report raised market expectations that the Fed will end up increasing rates by the end of 2022, quicker than what most Fed members projected last month.

Source: Bloomberg via Tyler Durden, "Stocks, Bonds, and Bitcoin Slammed after Surgin CPI; Dollar, Rate-Hike Expectations Spike," July 13, 2021, ZeroHedge.

It should go without saying that the Fed’s issues go well beyond bad forecasting. The monetary hedonism of America’s central bank is one of the great policy disasters of the current century. Eroding mainstream confidence in the Fed’s forecasting is a factor that could help shape the timing of the next financial crisis.

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How "Cultural Distance" Acts as a Barrier to Trade

07/09/2021Lipton Matthews

Economists frequently tout trade as a mechanism to boost growth and living standards. Yet some continue to extol the virtues of protectionism. However, the internecine debate between free traders and protectionists is less interesting than interrogating why countries erect barriers to international trade. A basic explanation is that opposition to trade is a consequence of nationalism and this assumption is partially true.

During the early twentieth century, trade policies in several European countries were cultivated by national sentiments, and more recently Donald Trump advocated imposing tariffs on China, so undoubtedly nationalism can stimulate demand for protectionist policies. Likewise, protectionism also gains traction when leaders perceive trade as a zero-sum game by not recognizing that the savings derived from trade are incomparable to the deficit.

Like most transactions, we engage in international trade because it increases utility. For example, when we purchase consumer goods, clearly, we lose money, but in exchange, we are provided with commodities that enrich the quality of life. Hence, in this regard, international trade is no different, since it is essentially about maximizing utility. A fundamental misunderstanding in the perception of international trade is that it should privilege the national good, when, in reality, trade serves to elevate the preferences of individuals.

States have political agendas that are usually incompatible with the interests of individuals. As such, advocating the national good is a rhetorical trick employed by politicians to guilt citizens into embracing their policies. Ideally, the state and the individual are separate entities, and the former should refrain from encroaching on the rights of the latter. When the state limits the choices of consumers by instituting protectionist measures, this violates one’s right to choose and by extension property rights.

Although we have exposed the fallacies inherent in political and economic critiques, the puzzle remains unsolved. Such arguments articulate why countries renounce international trade under certain circumstances, but they do not demonstrate why trade is more likely to be parochial than global. In brief, direct opposition to trade is not the only barrier to international distance, cultural distance also explains obstacles to international trade.

Though libertarians would prefer a stateless society, the truth is that governments are primarily responsible for economic policy, and like people, they select trading partners based on commonalities. Although trading occurs to ensure that both parties obtain products that cannot be sourced locally, states must respect each, before trading is initiated. Of course, culturally similar states do compete, but due to commonalities, they are more likely to be appreciative of individual differences.

On an anecdotal level, it is evident that regional trade blocs are more popular than global ones. A perfect example is that despite the glorification of global trade, bureaucrats in Europe and Asia are passionately promoting regional trade, supranational trade blocs encompassing several regions are failing to gain steam. Unsurprisingly, research has captured the impact of cultural distance on trade. Tadessa and White in a 2007 paper tracking the effect of cultural distance on US state-level exports during the year 2000, submit that greater cultural distance reduces aggregate exports, alongside the exports of cultural and noncultural products.

Furthermore, after employing bilateral trade data that cover the period 1996–2001 for nine Organisation for Economic Co-operation and Development (OECD) countries and fifty-eight other countries for which cultural distances can be calculated, researchers conclude that cultural dissimilarity has a statistically positive and negative influence on the volume of trade flows. According to the results, a 1 percent increase in the cultural distance between OECD countries and their trading associates would reduce aggregate imports of the typical OECD country by 0.7758 percent.

In addition, according to a 2017 meta-analysis exploring the nexus between cultural distance and firm internationalization, companies are unlikely to establish operations in culturally distant locations. The researchers further report that cultural distance has a negative effect on subsidiary performance, but no effect on the performance of the whole multinational corporation (MNC). A possible reason for this is that MNCs can use the experiences of the subsidiary as a guide to improving performance in other markets, thus compensating for the negative performance of the subsidiary.

Undeniably, cultural distance inhibits trade, but luckily economic analysis suggests that immigration might play a role in countering the trade inhibiting effects of cultural distance. Immigrants through their diverse preferences can generate demand for foreign products thereby accentuating partnerships with non-traditional trading neighbors. Moreover, by possessing intimate details relating to their country of origin, immigrants can enhance the quality of information available to local businesses; therefore, lowering information costs for producers.

For example, in a groundbreaking paper, Burchardi et al. (2018) assert a relationship between the number of residents with ancestry from a foreign country and the propensity of firms to engage economically with that country. Further, they also contend that immigration achieves these results by reducing the cost of information transmission.

In sum, cultural distance is not a prominent topic in economic debates, but it deprives people of major opportunities, by acting as a barrier to trade. Therefore, policymakers must consider this hurdle when crafting trade policy. We cannot afford to lose the benefits of trade due to an inability to transcend cultural differences.

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