Hazlitt, Hayek and How the Fed Made Itself into the World’s Biggest Savings & Loan

Source: https://mises.org/wire/hazlitt-hayek-and-how-fed-made-itself-worlds-biggest-savings-loan

by: Alex J. Pollock | Published: April 07, 2022

The Henry Hazlitt Memorial Lecture, March 18, 2022 ¹

Many thanks to the Mises Institute and to sponsor Yousif Almoayyed for this opportunity to be with you all today as we consider one of the truly remarkable developments in the history of American central banking, money printing, and credit inflation.

On a personal note, “the pursuit of clarity” has long been a goal of mine, and it’s a particular pleasure to present a lecture in honor of Henry Hazlitt, whose work is marked by such clarity of style, meaning, and logic.

Taking up our topic, “Hazlitt, Hayek and How the Fed Made Itself into the World’s Biggest Savings and Loan,” we begin with Hazlitt’s Economics in One Lesson. Central to this book is the key problem of government policies which “benefit one group only at the expense of all other groups.”

The Federal Reserve’s huge investment in, and monetization of, residential real estate mortgages is a striking example of this eternal political propensity.

“The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds”—a great phrase, that: “the best buyable minds”—“to devote their whole time to presenting its case,” with, he adds, “endless pleadings of self-interest.”

Such pleadings have characterized the housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the US government in housing finance. Through Fannie Mae, Freddie Mac, and Ginnie Mae, the government guarantees about $8 trillion of mortgage debt. (That’s $8 trillion of credit risk for the account of the taxpayers.) In the latest radical expansion of this involvement, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve. Getting mortgages into the central bank’s balance sheet was a fateful step.

As of March 2022, the Fed owns $2.7 trillion of mortgage securities. This means about 23 percent of all the mortgages in the country are on the central bank’s balance sheet—23 percent of the residential mortgages, which are the biggest loan market in the world. Moreover, mortgages have become 30 percent of the Fed’s own inflated total assets. These are truly remarkable numbers, which would certainly have astonished the founders of the Federal Reserve System. (I am enjoying imagining the architects of the Fed in financial Valhalla, in a lively but puzzled discussion of how their creation came to be a giant mortgage funder.) These developments are not astonishing, however, to students of Hazlitt, Hayek, and Mises, who expect governments and central banks always to try to expand their power.

Since March 2021, one year ago, the Fed has added $557 billion to its mortgage portfolio, increasing the balance by $46 billion a month on average. It had to buy a lot more than that in order first to replace the repayments and prepayments of the underlying mortgages and then increase the outstanding holdings. The Fed has been the reliable and market-distorting big bid in the market, buying mortgages with one hand and printing money to make the purchases with the other.

During this time, there has been an amazing house price inflation. US house prices shot up 17.0 percent in 2021, as measured by the median sales price, and by 18.8 percent, as measured by the Case-Shiller national house price index. In January 2022, average house prices rose at the rate of 17 percent. House prices are far over the 2006 peak, which was reached during the infamous housing bubble. When adjusted for consumer price inflation, they are still over that previous peak, after which house prices fell for six years, from 2006 to 2012.

So the giant US housing sector, representing perhaps $38 trillion in current market value of houses, again has runaway asset price inflation. Faced with this rapid escalation in house prices, the Fed unbelievably kept on stimulating the housing market by buying ever more mortgage securities. It thus further inflated the asset price bubble, subsidizing mortgages and distorting house and land prices. This makes a perfect example of the dangers of central bank behavior and its effects as seen by Austrian economics.

By acquiring $2.7 trillion in mortgages on its balance sheet, the Federal Reserve has made itself far and away the biggest savings and loan institution in the world. Like the savings and loans of old, the Fed owns very long-term fixed-rate assets, and it neither marks its investments to market in its financial statements nor hedges its extremely large interest rate risk.

Like the saving and loans of the 1970s, it has loaded up on fifteen- and thirty-year fixed-rate mortgages, just in time to experience a period of threateningly high inflation, principally of its own making, in which the increases to the cost of living include the effects of the high house prices it has induced. These prices make their way into the Consumer Price Index through the owners’ equivalent rent of primary residence.

Were he with us in 2022, with inflation running at almost 8 percent, Hazlitt would not be surprised that we again face the problem so prominent during his own lifetime. In spite of recurring costly inflationary experiences, as he observed, “the ardor for inflation never dies.”

Here, by the word inflation, the ardor for which never dies, he means inflation in the sense of excessive credit and monetary expansion, the cause of the subsequent inflation in the sense of a rapid rise in prices, which is the effect. Human nature being what it is, central banks and politicians think maybe they can have the cause without the effect. They can’t, but they try, alas.

Writing in 1978, in his book, The Inflation Crisis, and How to Resolve It, republished by the Mises Institute, Hazlitt wrote:

Sounds familiar.

Hazlitt pointed out a central irony which has often struck me:

I think also of Friedrich Hayek, who in his lecture upon accepting the Nobel Prize in economics in 1974, observed:

And now, here we are again.

It is superfluous to say, while speaking at the Mises Institute, that among the economists urging inflationary policies were not those of the Austrian school, then or now.

The people with the hottest ardor for inflationary policies in recent times have been the advocates of so-called modern monetary theory, or MMT. In my view, this needs to be written “modern” monetary theory, or “MMT", because it is far from a new thought—there is no notion older than that if the government is running short of money, it should just print some up. This MMT might equally, of course, be called ZMT, for Zimbabwe monetary theory, or reflecting classic monetary adventures, JLMT—that’s John Law monetary theory.

Hazlitt has a fine term for those of this persuasion, “the paper money statists.” Indeed, the real agenda of “MMT" is a political one: to have no limits on the government’s ability to spend. Needless to say, at the Mises Institute, this is an illusion. The most fundamental of all economic principles is

Nothing is free.

We know it, but it is good to repeat it. “Nothing is free” ought to be put up over the door of every economics department. Printing up vast amounts of money has a heavy cost indeed.

With the galloping inflation we’ve got now, we shouldn’t be hearing too much from the MMT rooters, and I hope that we can write, at least for this political-economic cycle, “MMT, RIP.”

Combine the current 7.9 percent year-over-year inflation with nominal interest rates on savings accounts of 0.1 percent or so, and the real interest rate on savings is –7.8 percent. The Federal Reserve is expropriating 7.8 percent a year of your savings or your money market fund account.

Compared to that, in a true market, what would the real interest rate on savings be? We don’t know, because you need a free money market to find out, and we don’t have one. But it would most assuredly not be – 7 percent. To get that, you must have a central bank.

Of course, the inflation is being made worse by the effects of the war in the Ukraine—the kind of war that many people thought could not happen again in Europe. Unfortunately, in this case “many things which had once been unimaginable, nevertheless came to pass,” in physicist Freeman Dyson’s memorable epigram.

The United States is waging a pervasive economic war to accompany the shooting war, with tumultuous volatility in financial markets and as yet developing, but surely very large, economic effects. We know that increases in the prices of energy, wheat, and other commodities will push essential consumer prices up even further. The spike in the price of nickel has caused a crisis on the London Metal Exchange, and many people expect that defaults on Russian government debt are coming.

Big wars are the single most important financial events in history and the most important source of runaway inflation. Thinking of this history, I found this vivid description the post–World War I economic world when Hayek was in his early twenties and Mises about forty:

Long before the present war began, the Fed was completely surprised by the emergence of the inflation its own actions had created. A far better forecast of what was coming was made by Charles Goodhart and Manoj Pradhan, who, based on the analogy of war finance, wrote in 2020:

Five percent to 10 percent inflation for 2021—an excellent forecast, while the Fed was forecasting 1.8 percent, an egregious miss.

Goodhart and Pradhan went on to say:

This was a perfect prediction of the by now embarrassing “transitory” line taken by the Fed and the administration.

This raises a much larger issue about central banks in general and the Fed in particular—a question very much in the Austrian spirit:

Does the Fed know what it’s really doing?

The answer is of course no. The Fed does not know with any confidence what the results of its own actions will be.

Let us go further:

Can the Fed know what it’s really doing?

Again the answer is no. The Fed will always have the central banking theory currently in fashion, as central banking fashions change; it will have hundreds of economists, and as many computers as it wants, but it cannot ever have the knowledge it would need to be the centralized manager of a complex financial system, let alone of an enterprising market economy. The inevitable lack of knowledge, combined with great power, is why the Federal Reserve is the most dangerous financial institution in the world.

The father of the Fed’s giant mortgage portfolio is Ben Bernanke. In 2012, when he had been chairman of the Fed for six years, Bernanke expressed its knowledge problem with admirable intellectual honesty:

Of course, this was an inside communication, not a candid confession to the outside world.

One need hardly say to this audience that this nicely portrays the inescapable problem of knowledge, the lesson of the impossibility of centralized possession of the requisite knowledge, and therefore the impossibility of successful socialism — or of dirigiste central banking — immortally taught by Mises and Hayek. To maintain otherwise requires, in Hayek’s fine phrase, a “pretense of knowledge.”

Let’s think for a minute about the metaphor of a “mechanism.” Central to the knowledge problem is the fact that an economy with its intertwined financial system is not a mechanism, and cannot be predicted and controlled as a mechanism. It is notable how widespread the misleading metaphor of a machine is in economics—economists talk of the “monetary policy transmission mechanism” or the “European financial stability mechanism,” for example. Yet in fact we are not dealing with mechanisms, but with a different order of reality, a different kind of reality. But what kind of reality is it, then? Well, as many of you know already, it’s a catallaxy.

Naming that which is not a mechanism, Hayek wrote in 1968:

This proposal for a profound and useful new word was made more than fifty years ago. It has obviously not succeeded in becoming popular and would elicit in most company blank stares. We must admit it has a rather unattractive sound and seems obscure. But what is the fundamental reality we are trying to name? An infinitely complex, recursive, expectational interaction of human actions and values shot through with feedback and reflexivity, self-referential, marked by fundamental uncertainty, in which ideas become reality, previously unimaginable innovations appear, and experts are frequently surprised cannot be thought of in any simple way. It is much easier to think of a mechanism or an algebraic formula than to picture or intellectually grasp a catallaxy. Too bad the word hasn’t caught on to express this fascinating type of reality we all work to understand.

Back to our story: into the American catallaxy strode the Federal Reserve, its pockets filled with newly printed dollars and its printer handy to create more, and bought up the biggest pile of mortgage assets that anybody ever owned. It bought even more Treasury securities, too, accumulating $5.8 trillion of them, so that its balance sheet has reached the memorable total of $8.9 trillion. This is another development not imagined by anyone beforehand, including the Fed itself.

$8.9 trillion is twice the Fed’s total assets at the beginning of March 2020, and ten times the $875 billion of December 2006. The Fed’s $2.7 trillion in mortgage securities is double the level of March 2020, but more to the point, infinitely greater than the zero of 2006.

From the organization of the Federal Reserve in 1914 to 2006, the amount of mortgages it owned was always zero. That defined “normal.” What is normal now? Should a Federal Reserve mortgage portfolio be permanent or temporary? Can the mortgage market now even imagine a Fed which owns zero mortgages? Can the Fed itself imagine that?

Should the Federal Reserve’s mortgage portfolio not just shrink some, but go back to zero?

I would say, and I suspect most of you would, too, that it should go back to zero.

In the beginning of its mortgage buying, this was clearly the Fed’s intent. As Chairman Bernanke testified to Congress about his bond- and mortgage-buying program (or “QE”) in 2011:

Obviously, that was bad forecasting, but that does not mean the intentions were not sincere at the time. “I genuinely believed that it was a temporary program and that our balance sheet would go back [to normal],” said Elizabeth Duke, a Fed governor from 2008 to 2013.

The recent book Lords of Easy Money relates that

as far back as 2010, the Fed was debating how to normalize. Credible arguments were made that the process would be completed by 2015, meaning that the Fed would have sold off the assets it purchased through quantitative easing.

A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed’s investments “would expand quickly during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds. After that, the balance sheet would start to shrink, gradually, as the Fed sold off all the assets it bought, falling to under $2 trillion by 2019.”

Any of us, certainly including me, who have tried our hand at financial forecasts will not be too hard on these mistaken projections, having made so many mistakes ourselves. But how clear it is that the Fed has no greater ability than the rest of us to foresee the financial and economic future, including where its own actions are headed.

Early on, the Fed realized that if it did sell assets and interest rates normalized to higher levels, and the prices of bonds and mortgages therefore fell, it could be realizing significant losses on its sales. We will come back to this problem. Of course, the Fed has made no sales as yet.

Over the last few decades, US financial actors have believed in, and experienced, the “Greenspan put,” the “Bernanke put,” the “Yellen put,” and the “Powell put.” This is the belief that the Fed will always manipulate money to save the day for financial markets and leveraged speculators. These “puts” of risk to the Fed have themselves over time induced higher debt and inflated asset prices, including house prices, making the whole system riskier and more in need of the “puts.”

Speaking of needing puts, two years ago today, on March 18, 2020, we were in the midst of the COVID financial panic. As everyone will remember, prices of all kinds of assets were dropping like so many rocks. Fear and uncertainty were rampant. The Federal Reserve and all other major central banks, having adopted Walter Bagehot’s famous theory that central banks need to lend freely to financial actors to stem a panic, applied Bagehot’s theory to the max. The central banks also monetized the huge fiscal deficits run by governments to offset the steep economic contraction which followed their lockdowns. They printed however much money it took.

The panic did end, normal financial functioning was restored, and bull markets resumed in mid-2020, fueled by the monetary expansion. Then came, as it always does, the question: What do you do when the crisis is over? What the Fed did was to keep right on buying mortgage securities and Treasury bonds by the hundreds of billions of dollars.

This demonstrates an abiding problem. How do you reverse central bank emergency programs, originally thought and intended to be temporary, after the crisis has passed? The principle that interventions made to survive in times of crisis should be withdrawn in the renewed normal times which follow I call the Cincinnatian doctrine.

You may recall the ancient Roman hero, Cincinnatus, who was, as it is said, “called from his plow to save the State,” made temporary dictator, did save the state, and then, mission accomplished, left his dictatorship and went back to his farm. Similarly, two millennia later, George Washington, a victorious general and hero who saved the new United States, could perhaps have made himself king but instead, in a deservedly celebrated moment, resigned his commission and went back to his farm, thereby becoming the modern Cincinnatus.

In contrast, emergency central bank interventions, however sincere the original intent that they would be temporary, can build up economic and political constituencies who profit from them and want them to be continued. For central bank monetization of government debt to finance deficits, the biggest such constituent of all is the government itself.

The difficulty of winding emergency actions back down once they have become established and profitable to their constituencies is the Cincinnatian problem. There is no easy answer to this problem. How do you get the Fed to go back to its farm, so to speak, when it has become the dominant bond and mortgage investor in the world?

Will it go back to the farm and withdraw from being a giant savings and loan? Two days ago, on March 16, the Fed announced that it “expects to begin reducing its holdings of Treasury securities and agency debt securities and mortgage-backed securities at a coming meeting.” For now, it will keep buying to replace the runoff of the current portfolio, but shrinkage may be “faster than last time.” The Fed is already very late.

The ten-year Treasury yield touched 2.20 percent this week and long-term mortgage rates are up to about 4.25 percent. These rates now seem high, but they are still very low rates, historically speaking, especially compared to the current inflation. Historically, more typical rates would be at least 4 percent for the ten-year Treasury, or more, and 5 percent to 6 percent for mortgages, or more. The interest rate on thirty-year mortgage loans was never less than 5 percent from the mid-1960s to 2008.

If the Fed stops suppressing mortgage interest rates and stops being the big bid for mortgages, how much higher could those interest rates go from their present, still historically very low level? When the mortgage interest rates rise, how quickly will the runaway house-price inflation end?

This leads to an interesting question about the Fed itself: As interest rates rise, how big will the losses on the Fed’s vast mortgage portfolio, and on its even vaster portfolio of long-term Treasury bonds, be? Could the losses be big enough to make the Fed insolvent on a mark-to-market basis? Yes, they could.

Let’s take a minute to do a little bond math.

The duration of the Fed’s $2.7 trillion mortgage portfolio is estimated at about five years. That means that for each 1 percent that mortgage interest rates rise, the portfolio loses 5 percent of its market value. So a 1 percent rise would be a loss in market value of about $135 billion, and a 2 percent rise in mortgage rates, a loss of value of $270 billion.

With the $5.8 trillion of Treasury securities on the Fed’s balance sheet, the Fed owns about 24 percent of all Treasury debt in the hands of the public. Remarkable. Of these securities, only $326 billion, or 6 percent, are short-term Treasury bills. On the other end of the maturity spectrum, it owns $1 trillion of Treasury bills with maturities of five to ten years and $1.4 trillion with maturities of more than ten years. I tried to estimate the duration of the portfolio and came up with about five years. A Wall Street contact said seven years, but let’s use five. Then, on a 1 percent increase in rates, the market value loss to the Fed will be $285 billion, and on a 2 percent rise, $570 billion.

Add the mortgage results and the Treasury portfolio results together, and you get these market value losses in round numbers: for a 1 percent rise in rates, over $400 billion; for a 2 percent rise, over $800 billion.

Compare that to the net worth of the consolidated Federal Reserve System. Does anybody know what it is? The answer is $41 billion. Compare $41 billion to a potential market value hit of $400 billion or $800 billion. It is easy to imagine that the Fed may become insolvent on a mark-to-market basis.

But does mark-to-market insolvency matter if you are a fiat currency central bank? Most economists say no, and maybe they are right. If the Fed were mark-to-market insolvent, probably nothing would actually happen. You would still keep accepting its notes in payments. The Fed would keep accounting for its securities at par value plus unamortized premium, and the unrealized loss, however massive, would not touch the balance sheet or the capital account.

Now suppose the Fed actually does sell mortgages and bonds into a rising rate market, and takes realized, cash losses. Suppose they bought a mortgage security for the price of $103K and sell it for $98K, for a realized loss of $5K, and that $5K is gone forever. Wouldn’t that loss have to hit the capital account and, if the losses were big enough, force the Fed’s balance sheet to report a negative capital—that is, technical insolvency?

It may surprise you to learn, as it surprised me to learn, that the answer is that this realized, cash loss would not affect the Fed’s reported capital at all. No matter how big the realized losses were, the Fed’s reported capital would be exactly the same as before. That ought to be impossible, so how is it possible?

It is because in 2011, while considering how it might one day sell the mortgages and bonds it was accumulating, the Fed logically realized that if interest rates returned to more normal levels, it would be selling at a loss. What to do? It decided—do you know what?—to change its accounting. The Fed has the advantage of setting its own accounting standards. It decided to account for any realized losses on the sale of securities not as a reduction in retained earnings and capital but as an intangible asset! This was clever, perhaps, but hardly upright accounting. I would certainly hate to be the CFO of a Securities and Exchange Commission–regulated corporation who tried that one.

But here is a great irony: this is precisely what the old savings and loans, facing insolvency, did in the early 1980s. So the new, biggest savings and loan in the world, potentially faced with the same problem as the old ones, came up with the same idea.

Let us shift to how the Federal Reserve fits into the whole American mortgage finance system, a market with about $11 trillion in residential mortgage loans. As mentioned, about $8 trillion, or 70 percent, of these loans are guaranteed by the government in some way, principally by Fannie Mae, Freddie Mac, and Ginnie Mae. Does the government have to guarantee 70 percent of all mortgage credit risk? Does that make sense? Of course it doesn’t. But so it is.

American mortgage finance is dominated by a tightly linked government triangle. The first leg of the triangle is composed of Fannie, Freddie, and Ginnie (with the associated Federal Housing Administration), what we may call the government housing complex.

The second leg in the government mortgage triangle is the United States Treasury, which is fully on the hook for all the obligations of the 100 percent government-owned Ginnie. The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too. Through clever financial lawyering, it is not a legal guarantee, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total US government debt. It does not surprise us that this was and is not politically desired.

The same politically undesired, but honest, accounting result would follow if, in addition to owning 100 percent of Fannie and Freddie’s senior preferred stock, the Treasury owned 80 percent of their common stock. That is why the Treasury controls 79.9 percent, not 80.0 percent, of the common stock through warrants with an exercise price of nearly zero. For historical perspective, to get Fannie’s debt off the government’s books was the main reason for restructuring it into a so-called government-sponsored enterprise in 1968, so that Lyndon Johnson’s federal deficit did not look as big.

The Fed didn’t used to be but it has become the third leg of the government mortgage triangle as the single biggest funder of mortgages. Its mortgage security holdings are limited to those guaranteed by Fannie, Freddie, and Ginnie, but those guarantees are only credible because they are in turn backed by the credit of the Treasury.

However, there is curious circle here. How can the Treasury, which runs constant deficits and runs up its debt year after year, be such a good credit? An essential element in the credit of the Treasury itself is the willingness of the Fed always to buy government debt by printing up the money to do so. This is why having a fiat currency central bank of its own is so useful to any government. These two financial behemoths are intriguingly mutually dependent on the other for their credit, while they both support Fannie, Freddie, and Ginnie.

It is most helpful to think of the Fed and the Treasury as one thing—one combined government-financing operation whose financial statements should be consolidated. Then all the government debt owned by the Fed would be a consolidating elimination. With this approach, we can see the reality more clearly. The Fed buys and monetizes Treasury debt. Consolidate the statements. The Treasury bonds disappear. What do we have? The consolidated government prints up money and spends it. It is still taxing to spend, but taxing by inflation, without the need to vote in taxes. This arrangement must be loved by, to use Hazlitt’s term again, paper money statists.

We need to bring Fannie, Freddie, and Ginnie into the consolidated picture. They issue mortgage securities, and the Fed buys and monetizes them. Consolidate the statements, and the mortgage securities bought by the Fed also disappear as a consolidating elimination. What do we have? The consolidated government prints up money and uses it to make cheap mortgage loans, inflating the price of houses. This arrangement must be loved by paper money housing lobbyists.

In principle, there is no limit to the kinds of assets a fiat currency central bank can buy and monetize, although there are limits of law and policy. The Swiss National Bank has a large portfolio of US stocks, for example. The Fed in the COVID financial crisis, along with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent State of Illinois.

Another good example is that in the 1960s, some members of Congress thought, with the encouragement of the savings and loan industry, that the Fed ought to buy bonds to provide money to—you’ll never guess—housing. Fed chairman William McChesney Martin pointed out that this was a bad idea.

It would, he testified, “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That was the right answer, entirely consistent with Economics in One Lesson. But it did not please the politicians involved. Senator William Proxmire threatened the Fed:

Proxmire died in 2005. He’d be very surprised, I imagine, at how much money the later Fed put into the housing market.

Following the 1960s discussions, a new Fed chairman, Arthur Burns, arrived. In 1971, he decided it would be a good idea for the Fed to “demonstrate a cooperative attitude.” The Fed bought no mortgages in those days, but it did begin to buy the bonds of federal housing and other government agencies. It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks , the Federal Intermediate Credit Banks, the Banks of Cooperatives, and—believe it or not—the debt of the Washington, DC, subway system. There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.

The Fed fortunately managed (under the leadership of Paul Volcker) to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s. Will it really get out of its vastly bigger mortgage program now?

In sum, we have a Federal Reserve which at the amazing size of $8.9 trillion is also the biggest savings and loan in the world, in addition being the most dangerous financial institution in the world, which does not and cannot know what the results of its own actions will be, and which faces the Cincinnatian problem in the midst of runaway inflation and is always, to use a typical quote from Hazlitt as our last word, “swindling its own people by printing a chronically depreciating paper currency.”

Thank you.

Footnotes

Tags: PoliticalEconomy, FederalReserve, CentralBanking

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