The Federal Reserve's Second 100 Years
Saturday, January 25, 2014
The Federal Reserve has had a remarkable career in the 100 years since Congress created it on December 23, 1913. What are the Fed’s next 100 years likely to bring?
It is daunting but also liberating to make such guesses about the very long term, since one is bound to get many things wrong. The human mind is incapable of imagining in advance the novelties that so much time will bring. For example, the authors of the Federal Reserve Act could certainly not have even imagined, let alone expected, what their creation has become in a century. They would have been utterly dumbfounded at a Federal Reserve that:
— Is formally committed to, and is producing on purpose, perpetual inflation.
— Has no link of any kind to a gold standard.
— Thinks it is supposed to, and that it is capable of, “managing the economy.”
— Invests vast amounts in, and monetizes, real estate mortgages.
— Has chairmen who achieve media star status, as for example, “The Maestro.”
— Wields the authority of a unitary central bank, centralized in Washington D.C., rather than being a federal system of regional “reserve banks.”
Can we have any hope of making some good predictions? Perhaps. Consider the 100-year predictions that the brilliant F.E. Smith, Lord Birkenhead, made in 1930 in his book, The World In 2030.
Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.
Birkenhead predicted, for example, the then-future revolutions in genetic science, atomic energy, and global communications media, and that in the future “women … will be found at the head of government departments [and] as managing directors of great commercial undertakings.” On the other hand, he did not discuss the monetary system at all, and did not predict the vast experiment in world-wide fiat currency in which we have been living since 1971, whose ultimate outcome is still unknown. Also, Birkenhead imagines that an undergraduate in 2030 preparing to write about the 22nd century would sit down at his typewriter, rather than not even know what a typewriter was.
Birkenhead offered some instructive general observations on the matter of the long future:
— “Remembering a thousand other changes, mechanical, ethical, social, political, and constitutional, we shall, it may be repeated, be wise to declare little impossible in the [next] hundred years.” Yes, including fundamental changes in our ideas about central banking and the beliefs of central bankers.
— “The future stretches before us in this year 1930 murky, obscure, and terrible.” In January, 2014, it still stretches before us murky and obscure but, it seems, less terrible than in 1930. I hope.
Another notable 100-year forecast made in 1930, this one specifically focused on economics, was by John Maynard Keynes in his essay, “Economic Possibilities for Our Grandchildren.” Starting by observing the “bad attack of economic pessimism” in “the prevailing world depression,” Keynes nonetheless predicted an optimistic economic future, about which he was entirely correct.
“In the long run,” he wrote in the midst of the world crisis, “mankind is solving its economic problem. I would predict that the standard of life in progressive countries 100 years hence will be between 4 and 8 times as high as it is today [in 1930].” As of 2013, per capita GDP in the United States was 5 times what is was in 1930, which is an average real growth rate of about 2 percent per year since 1930. If the 2 percent growth continues to 2030, the standard of life will be about 7 times what it was when Keynes made his prediction of 4 to 8 times. A great call.
Looking ahead in the spirit of Keynes for an additional 100 years to 2130, another increase of 7 times would bring it to a level of 49 times that of 1930. Can we imagine that?
If such real growth continues, it will be the result of advances in scientific knowledge, technical innovation, and entrepreneurship. Turning to the Federal Reserve, we find a different 2 percent growth rate: the Fed’s targeted rate of inflation, or depreciation of the currency it issues.
Since 1913, the U.S. consumer price index has increased over 23 times: in other words, a quarter now is about what a penny was when Woodrow Wilson signed the Federal Reserve Act. If the Fed produces a 2 percent annual inflation for its next 100 years, a dollar will be far less than a penny was; it would take about $1.70 to equal the original penny. Merely to stay even in real terms with today, an average household would then need an income of about $350,000. Can we imagine that?
This brings me to a dozen predictions about the Fed’s second century:
1. Lender of Last Resort
Consider a 1994 book, The World in 2020 (a 26-year forecast). “The debt crisis of the 1980s,” it says, “forced the banks to adopt much more cautious lending policies.” As is obvious from the multiple debt crises since 1994, extrapolating post-crisis banking caution is a mistake. Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes. As Paul Volcker wittily said, “About every ten years, we have the biggest crisis in 50 years.” A decade seems like about enough for the waning of institutional memory.
Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes.
An “elastic currency” was the most important purpose of the original Federal Reserve Act and remains a robust idea, as recently demonstrated once again in the panics of 2007-2009, although these also demonstrated once again that having the Federal Reserve does not prevent panics. Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.
Thus my first prediction: The Fed’s lender-of-last-resource function, or the ability to create “elastic currency” in a crisis, will continue to be necessary for at least another 100 years.
2. Shull’s Paradox
Professor Bernard Shull, in his provocative book, The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence, propounds what I call “Shull’s Paradox,” which is that no matter how many or how great are the inflationary and deflationary blunders made by the Fed, its power, prestige, and authority nevertheless always increase. Shull’s book, published in 2005, demonstrated this perverse relationship over the Fed’s first nine decades, and how the Fed, “established as a small and almost impoverished institution,” has nonetheless “emerged as the most influential organization ever established by Congress.” He then speculated, “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”
Shull’s speculation was fully confirmed. The Fed first stoked the great housing bubble from 2002 to 2005, then utterly failed to anticipate the magnitude of its collapse, and on top of that, failed to predict the ensuing steep recession. But in the subsequent legislative reaction, the notorious Dodd-Frank Act, the Fed’s jurisdiction and authority were expanded.
How can we explain the paradox? Perhaps it is the emotional yearning of many people, including politicians, to believe in a wise, “Maestro”-like force to orchestrate unpredictable events — even though no one, including the Fed, can actually do this. The Fed does seem able to inspire a puzzling, naive will to believe.
So I predict that Shull’s Paradox will continue to hold, and the Fed will gain even more power from the next crisis, even if it causes that crisis.
Is the Fed independent, as is often claimed? No. A better description is that of
Chicago Federal Reserve Bank President Charles Evans, who has referred to the “measure of independence” of the Fed.
William McChesney Martin, Fed chairman in the 1950s and 1960s, spoke of the Fed being independent “within the government” — i.e. not independent. Arthur Burns, Fed chairman in the 1970s, reportedly said, “We dare not exercise our independence for fear of losing it.”
Yet many economists are attracted to the idea of a truly independent Fed. It flatters the importance of their macro theories to think it should be so. I believe that inside every macro economist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king, or at least an assistant deputy philosopher-king.
But since the Fed is always “within the government,” I predict that in 2113 it still will not be independent, although the economists of that future day will still be writing about how it should be.
4. Systemic Risk
The Federal Reserve has the greatest power of any institution anywhere to create systemic financial risk for everybody else by its fiat money creation and interest rate manipulations. Given the global role of the dollar, this power runs around the world.
The Dodd-Frank Act has resulted in large banks being called “Systemically Important Financial Institutions,” or “SIFIs.” As such, it is maintained they need extra oversight. It is apparent that the Fed itself is the biggest SIFI of them all.
A good example of this is the massive interest rate risk of its own balance sheet.
Because of this risk, I predict that in the intermediate term the Federal Reserve will be insolvent on a mark-to-market basis.
Let’s go through the math. With so-called “QE,” or quantitative easing, the Fed now owns $2.1 trillion in long government bonds as part of its successful manipulation (so far) to get bond yields lower. In an entirely unprecedented fashion, it also owns $1.5 trillion of fixed rate mortgage securities. That is a total of $3.6 trillion in unhedged outright long positions. The Fed does not disclose the duration of this remarkable portfolio, but 7.5 years would probably be a fair guess.
Suppose interest rates rise a mere 2 percent. The mark-to-market loss would be $3.6 trillion X 2% X 7.5. This would be a mark-to-market loss of $540 billion. The Federal Reserve’s total capital is $55 billion. So the economic loss would be about ten times the Fed’s capital. Q.E.D.
One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.
Would the world care if its principal central bank were so insolvent on a mark-to-market basis? Many Fed defenders say absolutely not, but I don’t think anyone really knows. However, I also predict that the Fed will never admit any such insolvency on its own books. It has already developed for itself a version of “regulatory accounting,” not dissimilar to that practiced by savings and loans in the 1980s, to prevent any such admission. One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.
5. Big Surprises
During the history of the Fed so far, four major changes in the fundamental monetary regime have occurred: going off the gold standard in the 1930s; going on the Bretton Woods system of fixed exchange rates and a gold exchange standard in 1945; the collapse of the Bretton Woods system in 1971; and its replacement by the current global regime of pure fiat currencies and floating exchange rates (a regime which is quite prone to recurring crises).
It does not seem reasonable to assume that any monetary regime will last forever, and that the next hundred years will somehow be immune from fundamental changes. So I predict that in the course of the Fed’s next century, further major changes in monetary regimes will occur, surprising our current expectations — only we don’t know what they will be.
6. Central Banking and Dentistry
Keynes ends his essay on the “Economic Possibilities” of 2030 by thinking about economists and dentists. “The economic problem” — presumably including central banking — he puckishly suggests, “should be a matter for specialists — like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!"
However, since then, central banking has still not become scientific like dentistry, nor do its specialists display the progress in scientific knowledge and technique that dentists so admirably do. In another century, I believe central banking, and macro economics, will be no closer to becoming a science like dentistry. Instead, they will, in accordance with their essential nature, continue to be debatable, contestable, uncertain, and ideological.
In other words, in 2113 the Fed will still be heavily political.
From the dissimilarity to dentistry, it follows that in the next 100 years, like the last, no Federal Reserve chairman can or will be a sustained, successful “Maestro,” as Alan Greenspan was unfortunately dubbed by the silly media, until he wasn’t. It is more likely that central bankers, like investment managers, will have good runs alternating with bad ones. This is by no means a matter of intelligence, talent, hard work, or leadership, but of the ineluctable uncertainty involved.
8. The Bernanke Legacy
One intriguing uncertainty in the Federal Reserve’s new century is how the Fed under Chairman Bernanke will be judged by future financial historians. It seems certain that its unprecedented quantitative easing, that vast manipulation of long-term bond and mortgage markets, will be heavily discussed. But will economists now in kindergarten or unborn judge “QE” a success or a failure? No one knows, including the Fed itself.
But will economists now in kindergarten or unborn judge ‘QE’ a success or a failure? No one knows, including the Fed itself.
It appears to me that the probability is bimodal: for his QE experiment, Bernanke is likely to go down in future history as either a great hero or a great bum, one or the other, but we don’t know which.
What 21st-century central bankers had convinced themselves was the “Great Moderation” turned out to be in reality the Era of Great Bubbles and their collapse. In recent decades, the Fed and central banks generally have come to believe in inflation targets, usually of 2 percent a year or so inflation — in other words, perpetual inflation. Is this belief in perpetual inflation sustainable?
Perhaps financial systems with perpetual inflation may break down into crisis too often — the current monetary regime has obviously had plenty of financial crises. So perhaps the cognitive structures and psychological beliefs of central bankers may shift back to a commitment to a long-term stable value of currency, rather than inflation forever.
Such a shift in dominant ideas is certainly possible in 100 years.
10. Government Finance
The first mandate of most central banks is to lend money to the government as necessary. I believe the Federal Reserve will continue to be absolutely essential to the U.S. government, not because of its economic skills, forecasting ability, or financial wisdom, but because it is the reliable and expandable source of deficit finance for the government.
A fiat-currency issuing and government debt buying central bank, of which the Fed is the most important instance, is a hugely valuable asset for the government. I imagine it will still be so in 2113.
11. Legislative Reform
Legislation has been introduced in the U.S. House of Representatives to have a formal congressional review of the performance of the Fed since 1913 (mixed, to be sure) and of its future. Of course, the Fed is a creation of the Congress, and subject to legislative revision at any time. Twice in its first century, in 1935 and again in 1977-78, major reform legislation was enacted. I see no reason to assume that the politicians of the future will always be satisfied with the status quo of today.
In 2113 the Fed will still be heavily political.
So I predict that there will be a “Federal Reserve Reform Act” of 2000-something and/or 2100-something, at least once or twice, in the Fed’s second century.
An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro economics is or can be a science.
Financially famous Fed chairmen who were not professional economists include William McChesney Martin, who among other things was the president of the New York Stock Exchange; and Marriner Eccles, who was a banker and businessman from Salt Lake City. Both have Federal Reserve buildings in Washington named after them.
I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.
Finally: Not Rocket Science
Lord Birkenhead, introducing his 100-year predictions, reflected that in the long term, “The results of scientific research control the wealth of nations.” As we have said, central banking, while highly important for better and for worse, is not science.
Robert Solow recently asserted that “central banking is not rocket science.” True, and it will be neither science nor rocket science in 2113. But Solow meant that central banking was easier, while in fact it is harder than rocket science, now and in the future. This is because it must confront the inescapable uncertainty of human minds and deeds interacting, with their strategies, politics, adaptations, creations, surprises, intentions, mutual learning, guessing, risk-taking, cognitive herding, emotions, cupidity, fear, courage, and frequent mistakes, in their financial and economic dimension. This includes the minds and deeds of the central bank itself interacting with all of the others.
It is certain that the Fed will continue to be an interesting and debatable topic in its next 100 years.
Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
This essay is adapted from Pollock's address at the Loyola University of Chicago Symposium "The Federal Reserve at 100: The First 100 Years, the Present, and the Next 100" on December 6, 2013.
FURTHER READING: Pollock also writes "House Prices: Is the Fed Making the Same Mistake Again?""Big Bureaucracy: The CFPB Turns 2," and "The Federal Financial Triangle." Steve Conover proposes "A Fiscal Proposal Both Keynes and Reagan Could Support." Peter J. Wallison writes "Why the Volcker Rule Will Harm the U.S. Economy."
Image by Dianna Ingram / Bergman Group