Hat Tip: Malcolm Greenhill
Update: Time reports that the Boston Globe story has jumped the gun. The planned shift in the PBGF holdings toward more equities had only begun to be implemented. But of course the fund is in trouble anyway.
Hat Tip: Jack Dean
I knew my rating of Washington would raise some eyebrows. To start with, I believe that the replacement of the Articles of Confederation with the Constitution was a terrible mistake in American history. The major problem with the Articles is that it created a central government that was too strong, not one that was too weak. So to the extent that Washington contributed to the Constitution's success, he earns a minus from me rather than a plus, as most historians would give him.
But even ignoring that, we still confront Washington's appointment of Alexander Hamilton as Secretary of the Treasury, with Hamilton's State-aggrandizing and mercantilist financial program: including an array of internal taxes (all later repealed under Jefferson), the assumption of state government debts (when the states should have assumed the federal debt, if not repudiated it outright), the establishment of the First U.S. Bank, and the creation of a government mint. For more detailed discussion of these issues, see an article I published back in 1988 in the British libertarian publication, Free Life, v. 5, n. 4, entitled"The Constitution as Counter-Revolution: A Tribute to the Anti-Federalists."
The Washington Administration furthermore used trouble with the Indians in the Northwest territory to justify a greatly expanded army of four thousand regulars. Not only did this military establishment swallow more than two-thirds of the remaining half of national expenditures not devoted to paying interest on Hamilton's huge debt, but it also makes Washington the president who initiated at the national level expropriation and extermination of Native Americans. Although Congress refused to go along with the Secretary of War Knox's plan for a federally trained and supervised militia, the Uniform Militia Act of 1792 etched the principle of universal military obligation into national statute. A second congressional act specified the conditions under which the militia could be called into national service and instituted heavy militia fines for failure to report when drafted.
Through the use of patronage within the new federal judiciary and the executive bureaucracy, supplemented by the pervasive influence of the debt, the public lands, the central bank, and the militarist Society of the Cincinnati, the Washington Administration created an effective "court party" of rent seeking Federalists. Any doubts about the national government's new grandeur were dramatically dispelled in 1794, when it smashed the Whiskey Tax Rebellion in western Pennsylvania. For this demonstration, Washington called up from four state militias no less than 12,950 men--more than he had usually commanded throughout the entire American Revolution. The widespread reliance upon militia conscription to raise this overwhelming force sparked further disturbances in eastern Pennsylvania, Virginia and Maryland.
Even Washington's foreign policy led to infringements on American liberty. His Neutrality Proclamation of 1793 applied to the actions of private citizens as well as to those of the government. Congress backed Washington's proclamation with the country's first neutrality act the following year, forbidding U.S. citizens from enlisting in a foreign military or fitting out a foreign armed vessel in U.S. ports. Congress also imposed a temporary embargo, closing all U.S. ports to foreign commerce. Finally, Congress ordered construction of six frigates, the first U.S. naval vessels since 1784, when the remnant of the Continental Navy had been sold off. After contracting for a navy to fight Algiers and restricting the liberty of those Americans enthusiastic about the French Revolution, the Washington Administration turned around and signed Jay's Treaty, with terms indecently favorable to the British State.
As for John Adams, one commenter suggested that the only blemish on his presidential record is the Alien and Sedition Acts. In reality, the only positive thing about his administration was Adams's break with Hamilton's High Federalists and his willingness to negotiate an end to the undeclared naval war with France (as vividly portrayed in the TV mini-series). But those who admire this as a courageous about face seem to overlook that it was the Adams Administration that got the country into that war in the first place.
The Quasi-War, as it was called, occasioned a government embargo of all trade with France. Congress authorized a forty-ship navy (which Jefferson later curtailed and partly sold off), established a separate Navy Department, and reactivated the Marine Corps. After George Logan, an ex-Quaker from Philadelphia, traveled on his own to France and returned to report that the French were now interested in conciliation, Congress passed the infamous Logan Act, which prohibited future private diplomacy.
Although British naval superiority made the threat of French invasion non-existent, Congress provided for a quadrupling of the standing army's size, to 14,500 soldiers, and laid plans for a Provisional Army of trained reserves numbering tens of thousands more. Paying for the new navy and enlarged army required more revenue, as expenditures nearly doubled. Anticipating the crisis, Adams had already signed into law a stamp tax in 1797. Among the legal transactions requiring stamp duties were legacies and probates, making this the U.S. government's first inheritance tax.
Once war began, Congress added a direct tax on real estate. John Fries, a disaffected Federalist, led a rebellion against the new tax in eastern Pennsylvania. This time, rather than using the militia to suppress a tax revolt (as had the Washington Administration), the Adams Administration set the ominous precedent of using the army. The rebels were quickly overawed, and Fries and two of his cohorts were tried for treason and sentenced to be hanged (although Adams, to his credit, pardoned them once peace was restored). Adams's undeclared naval war was also responsible for the first federal relief: hospitals for sick and disabled seamen, a measure from which the U.S. Public Health Service ultimately descended. Finally, the war saw the first national quarantine act.
When you add the the outrageous violations of civil liberties under the Alien and Sedition Acts, it is hard to find much admirable during the Adams presidency. (As a footnote, of the four Alien and Sedition Acts, the only one that subsequently did not expire or was not repealed, the Alien Enemy Act, became the basis for Woodrow Wilson's internment of enemy aliens during World War I.)
This put AIG under the regulatory umbrella of the Office of Thrift Supervision (OTS). The Federal Reserve has regulated all multi-bank holding companies since passage of the Bank Holding Company Act of 1956 and all single-bank holding companies after the act was amended in 1970, whereas the Office of the Comptroller of the Currency (OCC) regulates all nationally chartered banks. After the S&L crisis, when OTS was set up in the Treasury Department alongside OCC to give thrifts a parallel regulatory structure, OTS became the regulator of all nationally chartered thrifts. But in one of the many byzantine inconsistencies in U.S. regulations, thrift holding companies also fall under OTS rather than the Fed. And many of the other early failures in the current financial crisis were of OTS regulated institutions, providing an intriguing historical link to the S&L crisis.
But more important, the fact that AIG was a thrift holding company meant that several of its subsidiaries were, of course, receiving the deposit-insurance subsidy. I have frequently suggested (here and here) that deposit insurance has played a bigger role in causing the current crisis than is generally acknowledged, and this just reinforces my suspicion. Not only might the moral hazard from leaking deposit insurance have encouraged excessive risk taking on the part of AIG itself. But this is probably one reason that AIG's counterparties put so much confidence in its credit default swaps.
Although neither bank nor thrift holding companies qualifies for deposit insurance directly, the FDIC or Fed had often bailed them out along with their depository subsidiaries prior to the current crisis. Thus, when Continental Illinois National Bank and Trust Company was essentially nationalized after its failure in 1984, the regulators covered the holding company's debt as well. (On the other hand, when Charles Keating's Lincoln Savings and Loan finally went under in 1989, the government chose not to reimburse the bondholders of Lincoln's holding company, American Continental Corporation, but that was before the creation of OTS.) Then in 1998, when Alan Greenspan came to the rescue of Long Term Capital Management, which was neither a depository nor a depository holding company, but merely a private, unregulated hedge fund, he inevitably reinforced the impression that more regulated bank and thrift holding companies were protected.
Bear in mind that the swap contracts AIG wrote were over-the-counter derivatives in which AIG agreed to provide additional collateral both if the insured securities looked more likely to default or if the financial condition of AIG itself weakened. Thus, after AIG's credit rating was downgraded in September of 2008, the necessity to post further collateral provoked a liquidity squeeze that led to the first Fed intervention. As James Hamilton recently put it at Econbrowser:"Could AIG's counterparties have been thinking that their payments would come not from AIG but from the Federal Reserve and taxpayers? . . . To the extent that the buyer and seller of the CDS were making a bet for which the taxpayers were implicitly picking up the downside, the CDS market, rather than helping institutions effectively manage risk, would have been a factor directly aggravating systemic risk." For useful details about AIG, check out this report from the Congressional Research Service.
1. There are up to five different ways of defining bank insolvency, and most discussions equivocate among them. While many of the banks may face"regulatory insolvency" because of failure to maintain mandated capital, they are not necessarily insolvent under GAAP (generally accepted accounting principles). The government imposition of the former is worsening the situation.
2. The capricious nature of government policy is making it more difficult for the banks to weather the crisis and is piling on losses much larger than they otherwise would suffer.
Hat Tip: Tyler Cowen
The authors essentially argue that the reason the crisis spread beyond housing is because of all the explicit and implicit government guarantees for large financial institutions. Thus, they emphasize that the problem was most definitely not the spreading of risk through securitization and fancy credit derivatives. Rather, the problem was the financial system’s failure to spread risk. The large institutions used these innovations to engage in regulatory arbitrage in order to take on and concentrate excessive risk.
Let me quote a central paragraph: “In a world without regulation, creditors of financial institutions (depositors, uninsured bondholders, etc.) would put a stop to excesses of risk and leverage by charging higher costs of funding, but lack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation—capital requirement in particular—has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators. ”
I’ve been claiming for some time that deposit insurance was central to the crisis. It is striking to have that analysis confirmed by mainstream economists who in no way share my opposition to government guarantees and indeed explore ways (ultimately futile, in my opinion) to “fix” them. This should make their book, when it comes out, one of the more important on this enormous government failure.
Hat Tip: Tyler Cowen.
As for the swaps, the Fed is now breaking them out from under the category “Other assets” in sections 1 and 8 of the H.4.1 Release into a category of their own, “Central bank liquidity swaps.” One thing that was previously unclear was whether the swaps involved any exchange-rate risk, and if so, how it was booked on the balance sheet. But the Fed now explains that the swaps are unwound at exactly the same exchange rate at which they first take place. If the Fed creates $200 and exchanges it with the Bank of England for 150 pounds, then when the Bank of England is done with the $200, it gets exactly 150 pounds back, irrespective of what has happened to exchange rates during the interval, which can be three months or more. This is one way swaps differ from normal central-bank interventions into foreign exchange markets.
What made this confusing is that the Fed marked to market all its holdings of foreign currency on a daily basis anyway, even those from the swaps. This created no problem for reading the balance sheet if the value of foreign currencies fell, because the Fed put a positive exchange rate adjustment factor into “Other assets,” the total of which would therefore be unaffected on net. But when foreign currencies rose in value, the rise in the value of “Other assets” would be matched by a positive exchange rate adjustment factor on the other side of the balance sheet, in “Other liabilities and accrued dividends.” This meant that any appreciation of foreign currencies would overstate the size of the Fed’s balance sheet until the offending swaps were unwound. Fortunately, the Fed has discontinued this balance-sheet oddity. It will now book “Central bank liquidity swaps” at the originating exchange rate throughout their duration.
Not that this has removed all of the balance-sheet mysteries surrounding the Fed’s currency swaps. They continue to mainly show up on the liability side not as foreign deposits at the Fed but as Treasury deposits, and I’m still not entirely sure how this works in detail.
Yet the monetary base has fallen hardly at all. As of January 14, according to the Fed’s H.3 Release, it had climbed to $1.75 trillion, 2.9 percent higher than two weeks before, which translates into an annual growth rate of over 100 percent. The Fed reports changes in the base only every other week, but you can estimate the base weekly from the Fed’s balance sheet (I will explain how below, in the last paragraph), and as of January 21, the base was still at $1.70 trillion.
So how is this possible? Hamilton observes that the decline in Fed assets is mostly concentrated in lending to banks through the new Term Auction Facility. But Fed borrowing from the Treasury has declined even further: from around half a trillion to only around $245 billion. Most of this borrowing is through a special Supplementary Financing Account, which involves issuing Treasury securities specifically for this purpose, but this account is now being worked down. So only $200 billion remains in these special Treasury deposits at the Fed, while an additional $45 billion is in regular Treasury deposits at the Fed (up from only $4.5 billion a year and a half ago).
When you couple that with an additional $150 billion plus decline in the Fed’s holding of foreign currencies in its reciprocal swaps with foreign central banks, it explains why the base can continue to grow. Part of the fall in Fed assets represents a decline in dollars that the Fed has loaned abroad and that are not counted in the base. And while domestic assets have also declined somewhat, that decline was more than offset by the Treasury releasing into the economy part of its base-money holdings (that took the form of deposits at the Fed).
The Mysterious Currency Swaps
I explained in a post back in October how the Fed’s enormous Treasury borrowings could cause its balance sheet to grow larger than the monetary base. By borrowing this money in order to relend it, the Fed, in addition to creating fiat money, has in essence become a large, government intermediary—just like Fannie and Freddie. This completely new aspect of the Fed will only expand if it gets the power to issue its own bonds, borrowing on the domestic market in its own name, as Ben Bernanke wishes.
What I didn’t realize at the time is that this Treasury borrowing is closely tied to the Fed’s currency swaps. The Fed coordinates its swaps with the Treasury’s Exchange Stabilization Fund, which bears any resulting exchange-rate risk. Thus, it was no coincidence that, just as the amount of foreign currency holdings mushroomed on the asset side of the Fed’s balance sheet, the Treasury initiated its Supplementary Financing Account on the liability side.
Although holdings of foreign currency are incorporated into the weekly totals of the Fed’s “Other assets,” the breakdown by country is only available monthly from the Fed in a statistical supplement to the online Federal Reserve Bulletin, and then for the currency swaps only in a footnote. Although you can find some good discussions of currency swaps online here, here, and here, they remain one of the least transparent of all the Fed’s recent machinations. But the bottom line: as the currency swaps unwind, reducing “Other assets” on the Fed’s balance sheet, the Treasury’s Supplementary Financing Account declines on the liability side.
Impact on M1, M2, and MZM
The unprecedented increase of the monetary base over the last several months is finally showing up in the broader monetary measures. The Fed’s latest H.6 Release reports that M1 grew at the seasonally adjusted annual rate of 40 percent over the last three months of 2008, whereas M2 grew at nearly 20 percent over the same period. Thus, M1 at the end of December was 17 percent higher than a year prior, and M2 was 9.5 percent higher. The St. Louis Fed puts MZM growth at 25 percent over the three months up to the beginning of December, with its level 13 percent higher than a year prior. These match the highest growth rates seen over the last quarter century. In other words, bank lending is responding to the base increase. Whether you think this is good or bad news in the long run, it certainly contradicts the ultra-Keynesians, such as Paul Krugman, who have been touting a liquidity trap that makes monetary policy impotent and portends severe deflation. As I have emphasized before, neither a short-run lag in the growth of the broader monetary aggregates nor a one-shot increase in base money demand constitute a genuine liquidity trap.
On the other hand, the Fed’s paying interest on reserves has severely compromised the effectiveness of monetary policy. Consider the extreme case. Suppose the interest rate on Treasuries and bank reserves is exactly the same. Not only does this entirely eliminate any seigniorage. But then open market operations are merely exchanging one form of government debt for another. The two differ slightly in minor details: Treasuries can be held by the general public whereas deposits at the Fed cannot; deposits at the Fed can be redeemed directly for currency whereas Treasuries cannot. Nonetheless, if both pay the same interest, open market operations should be approximately neutral in their economic impact. Any increase in bank reserves should be offset by a decline in bank Treasury portfolios, with little change in overall bank lending or the broader monetary aggregates.
So the power of open market operations now hinges on the interest differential between reserves and Treasuries. In short, the Fed has undermined monetary policy at a moment it may have been most needed, creating a self-fulfilling Keynesian prophecy. This is just another aspect of the problems arising from this incredible Fed blunder that I have blogged about before here and here.
Recent Changes in the Fed’s Balance Sheet
Looking at the Fed’s balance sheet, you will discover that its holdings of securities (Treasury and Federal agency, which includes GSE’s) through traditional open market operations has actually declined from nearly $800 billion a year and a half ago, before the current crisis, to around $500 billion today. And the current total includes the $140 billion of securities temporarily lent to dealers through the new overnight and term securities lending facilities, as well as the $6 billion worth of mortgage-backed securities that the Fed has just started buying.
Traditional discounts are up from about a quarter of a billion dollars a year and a half ago to around $60 billion. But the big growth is in the Term Auction Facility, which didn’t exist a year and a half ago, and currently has loaned out over $400 billion. This facility is basically a modified discount window. Discounts set the interest rate and allow banks to determine the amount the Fed loans, whereas the Term Auction Facility sets the amount to be loaned and allows banks to determine the interest rate (through auction). The Fed has also extended “discounts” to securities dealers ($30 billion), money market funds ($15 billion), and AIG ($40 billion).
The other big item on the Fed’s balance sheet is assets denominated in foreign currencies (discussed above), which peaked at $650 billion, and is now down to around half a trillion. Remaining items that bring the Fed’s assets up to a total of $2.0 trillion include commercial paper ($350 billion), assets relating to the Bear Stearns bailout ($27 billion—given the exotic name Maiden Lane in the accounts), more assets relating to AIG and its subsidiaries ($47 billion under the names of Maiden Lane II and Maiden Lane III), and all the other miscellaneous items that have conventionally shown up on the Fed’s balance sheet.
The three Maiden Lanes along with the Commercial Paper Funding Facility and the Money Market Investor Funding Facility (the last of which has acquired no assets so far) are LLCs (limited liability corporations) set up under the New York Fed. Created for complex legal reasons to conduct these particular bailouts, think of them as the Fed’s very own Structured Investment Vehicles (SIVs). In addition to using Fed created money to acquire assets, they can also raise funds (i.e, have outstanding liabilities) in their own names, although so far they have done very little of that.
Interpreting the Fed’s H.4.1 Release
The H.4.1 Release seems to present the Fed’s balance sheet twice. The first time is in section 1, under the heading “Factors Affecting Reserve Balances of Depository Institutions.” Then after a lot of detail about specific Fed facilities, including the LLCs already discussed, you find section 8, “Consolidated Statement of Condition of All Federal Reserve Banks.” But only section 8 is the actual Fed balance sheet.
The reason section 1 looks like the Fed balance sheet is because it consolidates the Fed accounts with the monetary accounts of the Treasury. Bear in mind, that in the U.S., for historical reasons, the central bank is not the only institution issuing fiat money. The Treasury issues coins, which are also part of the monetary base. So to get a full picture of the factors affecting the monetary base, you have to combine the two accounts. If you want to see this done in a straightforward, logical way, consult Appendix B (pp. 797-98) of Milton Friedman and Anna Jacobson Schwartz’s classic, The Monetary History of the United States, 1867-1960 (1963).
Unfortunately the Fed, again as a historical holdover, presents the weekly consolidation in a very confusing fashion, the details of which are not worth going through even if you wouldn’t be totally bored by them. But I will note a few terminological anomalies. In section1, “Treasury currency outstanding” represents the value of coins, and “Currency in circulation” represents the total of Federal Reserve notes and coins outside both the Fed and the Treasury. But it includes all vault cash held by private banks as reserves. Thus, it differs from the Currency reported in the H.6 Release as a component of M1 (which excludes vault cash) as well as the Federal Reserve notes reported in the Fed’s actual balance sheet (which excludes Treasury coin but includes Federal Reserve notes in Treasury vaults).
Everybody follow that? Well, it doesn’t matter. Here is the important point. To get a weekly total of the monetary base from the Fed’s H.4.1 Release, go to section 1 and add up the following items: “Currency in circulation,” “Reserve balances with Federal Reserve Banks,” “Required clearing balances,” and “Other” under “Deposits with F.R. Banks.” Have fun!
In fact, it was the National Currency Act of 1864 that banned any branching whatsoever (interstate or intrastate) on the part of nationally chartered banks, except for a few grandfathered state-chartered banks who already had branches and who charter switched. The McFadden Act of 1927 was actually a relaxation of this restriction, granting nationally chartered banks the same intrastate branching authority enjoyed by state-chartered banks in whatever state they happened to reside.
I should add that none of these laws applied to state-chartered banks, who until the end of the twentieth century had never enjoyed interstate branching privileges, and whose intrastate branching was always governed by state law. Most of the state bans on branching emerged in the antebellum era, and many were part of state free-banking laws.
Ip also considers whether the U.S. might resort to inflation rather than default in a fiscal crisis, pointing out that Russia in 1998 is just one recent example of many where governments chose debt repudiation over inflation. He however overlooks an even stronger argument. Now that the Fed is paying interest to banks on their reserves, it effectively eliminates much of the remaining revenue (seigniorage) from inflation. Increasing the monetary base is now just an alternative way of issuing government debt.
Meanwhile, Senator Tom Coburn (R-OK) said the following on the floor of the US Senate on Sunday, January 11th:"I believe we are at the ultimate tipping point in this country. I believe if we don't make drastic changes over the next year and a half, that 2012 will see the default of the U.S. Government on its bills. I honestly believe that. There are a lot of economists who agree with me on that point." Full text and video is available here.
Hat Tip: Marc Joffe
The good news about this factor is that it gets the timing right for the beginning of the housing boom, unlike the attempt to pin the blame on Greenspan's monetary policy. The bad news, as Mark Brady has pointed out, is that U.S. tax changes can only explain the U.S. housing boom and not the European housing booms. Moreover, it can only explain a boom and not a bubble. A tax change should cause a real appreciation in home values that is permanent (until the exemption is repealed), not self-reversing. But then again, that should help prevent real housing prices from returning to their 1997 level.
Hat Tip: Warren Gibson
Here is the abstract: Many libertarians, especially those inclined toward the Austrian school of economics, counter the market-failure justification for government intervention by denying any legitimacy whatsoever to the neoclassical concept of efficiency. But properly interpreted, neoclassical efficiency,rather than providing an open-ended justification for all sorts of government intervention, provides one of the most powerful and comprehensive objections to government coercion in general.