Kevin Warsh, Myron Scholes and John Cochrane
Subject: Mr. Warsh Goes To Washington
Bio: Warsh: Next Chairman of the Federal Reserve Board, Scholes: Recipient of the Nobel Prize in Economics, Cochrane: Professor of Finance and Economics at Stanford’s Graduate School of Business and Senior Fellow at the Hoover Institute
Transcript:
Larry Bernstein:
Welcome to What Happens Next. My name is Larry Bernstein. What Happens Next is a podcast which covers economics, politics, and history. Today’s topic is Mr. Warsh Goes to Washington.
President Trump recently nominated Kevin Warsh to be the next Chairman of the Federal Reserve Board. In October 2022, Kevin spoke on What Happens Next along with my old boss Myron Scholes who was the recipient of the Nobel Prize in Economics.
In this episode I include excerpts from that previous meeting as well as an additional interview with John Cochrane who is a Professor of Finance and Economics at Stanford’s Graduate School of Business and a Senior Fellow at the Hoover Institute, and he will discuss the challenges that Kevin will face in his new job.
I want to learn from John about Kevin’s plans to reduce the Fed’s balance sheet of US Treasury bonds as well as rethink the Fed’s role in regulating the banks. I also want to discuss Fed independence especially as the Fed’s responsibility grows beyond simply setting the overnight interest rate.
Let’s begin with our interview of Kevin Warsh and Myron Scholes.
The interview with Kevin Warsh and Myron Scholes was taped in October 2022. Below are excerpts that have been edited for clarity and to be easier to read.
Larry Bernstein:
Kevin, tell us about your paper that you wrote with your co-author John Cogan from the Hoover Institute entitled Reinvigorating Economic Governance: A New Framework for American Prosperity.
Kevin Warsh:
To summarize it, the 21st century has been decidedly unkind to most Americans. A series of shocks have shaken their American ethos. The policy making response has been extraordinary with both positive and negative connotations. It’s changed expectations for policy going forward.
Those shocks: 9/11 led to wars, the global financial crisis where I still have the scars from my 10 years in government, the pandemic, and the Russian invasion of Ukraine.
I begin the paper with one of my favorite lessons from Myron, which he used to call the ice cream truck.
What happens is there’s kids on a playground doing their thing. And then Myron’s ice cream truck comes by and rings the bell. They get an ice cream. The ice cream truck leaves and you’d think they go back to the place in the playground where they were before. But they never go back; It’s changed. The environment’s changed, the ecosystems change, their wants and preferences have changed. And that is a metaphor for what’s happened to the US economy during these shocks.
We begin the paper with a quote from Hayek, where he says, “If old truths are to retain their hold on men’s minds, they must be restated in the language and concepts of successive generations.” Well, that’s what we tried to do.
The world is different. The G2 rivalry with China is different than the rivalry with the Soviet Union. Our economy is different.
What we say is that the core of the American experiment and its leadership in a peaceful world has three I’s: ideas, individuals, and institutions. And these three I’s must be applied to the conduct of public policy in Washington: fiscal policy, trade policy, monetary policy, regulatory policy.
But we need a framework.
The first were ideas. Ideas are different than goods. There is no fixed pie of ideas where one slice of that idea for you means less of a slice for me. The promulgation of ideas is key to American prosperity in the 21st century.
The conduct of economic policy suppressing these ideas by keeping rates at zero for more than a decade is the first part of the triptych.
The second is individuals. Cogan and I maintained that individuals are different. They’re the core of civil society. They’re not cogs of a machine. They have a set of preferences and inclinations that are unique to them. But if we treat individuals as part of groups, are we going to extinguish the flame that would cause them to create new ideas? Connecting the other part of the triptych. We wonder whether the culture, to use a loaded word, is civil society doing harm to individualism.
The third is institutions. Ben Bernanke’s work brought institutions back into an understanding of financial crises and the Great Depression.
Cogan and I fear there’s a conflation of roles of institutions between the public sector and the private sector where we think there’s a very red line that should separate the roles and responsibilities. And inside the public sector our government trying to compensate for the failures of other institutions in government. An example, whether the Fed has become an appeals court for broken fiscal policy and has wandered in areas that are outside of its remit. Cogan and I worry about that institutional creep, and it happened to coincide with this period of price instability.
Larry Bernstein:
Let’s start with Myron’s ice cream truck metaphor. When the government spent in 2021 and 2022 $1.9 trillion on a stimulus program, it changed ordinary American’s economic behavior. Some might save less for a rainy day, there is an expectation that the government will protect us when we fail in the future and that impacts risk taking, investment, and consumer decisions. After the ice cream truck left the playground, the economy is now radically and permanently altered.
Kevin Warsh:
The size and scope of these shocks have changed expectations among businesses, households, participants in financial markets, and told them that there will always be a backstop. The Fed will always be there to ensure rates are zero, quantitative easing will become not the exception but the rule. When the extraordinary becomes ordinary, we lose the sense of the magnitudes of these events.
Larry Bernstein:
What does that mean of having year over year inflation running hot at nearly 9% in 2022 when the Fed’s inflation target is only 2%?
Kevin Warsh:
Too long after the pandemic’s darkest days, after we knew that vaccines were going to mitigate the morbidity. In 2021, the US economy was booming. Real economic growth was 5.7%. The country was moving on from lockdowns. And yet we had massive stimulus. And importantly, the Fed bought 54% of all the net new issuance from the Treasury Department.
I go back to the dark days of the 2008 financial crisis with Chairman Bernanke when I was sitting by his side. Quantitative easing was debated. We weren’t sure about its efficacy. We were certain of one thing, Larry, it was really only to be used in break the glass times. But I’ve lost track of how many times the G-20 central banks have used quantitative easing. Why is it that the spending in Congress became so profligate? It is because both among Democrats and Republicans didn’t have to internalize the cost of their spending.
Larry Bernstein:
Myron Scholes, how do you think about your ice cream truck metaphor in the context of governmental pandemic policies?
Myron Scholes:
I agree with what you are saying, Kevin. In my way of thinking when the kids leave the ice cream truck, then the teachers intervene, is that they do not return to the previous spot. They get new locations. Thinking the economy is going to go back to where it was before is fallacious. It is going to be on a new trajectory.
Larry Bernstein:
Kevin, in your opening remarks, you mentioned that Quantitative Easing should be used rarely, that you should only break the glass under certain circumstances. During the financial crisis, ECB governor Draghi stated that the ECB will do whatever it takes, and that became their mantra. How do we put whatever it takes, back into a box with a glass seal?
Kevin Warsh:
I will remind your listeners when we were enduring the darkest days of the financial crisis when you’re referencing Mario Draghi announcing from the scribbled notes on his speech that day, “we will do whatever it takes, and it will be enough.” I believe that is the role of central banks to do extraordinary things in extraordinary times.
Larry Bernstein:
Is that shorthand for Walter Bagehot’s idea from the 1870s when he said that the appropriate role of the Bank of England was to “lend freely, at a penalty rate, against good collateral.”
Kevin Warsh:
Yeah. And how did we go from that to providing overwhelming liquidity and free money in all seasons? And for all reasons! I fear it is because the profession thought there was a free lunch to be had that’s what quantitative easing was. Policymakers broadly around the world misunderstood the risks of inflation and were late to react to it.
Myron Scholes:
To what extent does this interdependence now of the Fed and the fiscal authorities make it more difficult for the Fed to affect policy?
Kevin Warsh:
Is the Fed independent? It’s up to the Fed Chairman. Powell gets to decide whether they’re independent. They can invite him to the Oval Office and browbeat him. But what does he do when he goes back to the Fed?
The independence is today in the Fed’s hands. The question is, can they ever get back to a slimmed down balance sheet? Will the markets permit that? Will the fiscal authorities permit that? They’ve promised quantitative tightening is now going to happen on autopilot, leading to a runoff on of their balance sheet of more than a trillion dollars a year, presumably for the next few years.
Through the best of intentions, the fiscal and monetary role have been conflated. Since the immediate post-war period when the Fed and Treasury figuring out how to conduct themselves. We broadly stuck with that accord with some imperfections until the current period. I wonder whether we’re at a moment where a new accord needs to be struck, and whether at some level of interest rates will become non-serviceable, even by the government of the United States.
Larry Bernstein:
I think one of the incredible surprises was how low and how stable inflation was for the period between 2008 and 2020. It was below 2% with a very small variance. Why was inflation nearly 9% in 2022 and its variance so high?
Kevin Warsh:
Congress told the Fed that they should ensure price stability. Congress didn’t give the Fed a number. Chairman Bernanke wanted to come up with a number so that markets would understand what price stability is. The number that the Fed came to was 2.0%. I use the decimal point there just for jokes among friends. When we in the economics profession look to the right of the decimal point, we are confusing economic science with physics. I was always skeptical of the prudence of a hard certain inflation target.
Price stability and the number associated with it changes over time. I liked the definition of price stability that Chairman Greenspan used to use that we want the change in prices in the US economy to be such that no one’s paying attention to it.
Households and businesses aren’t talking about inflation. Your question makes that so painfully clear. There is barely a kitchen table or a boardroom where the change of prices isn’t paramount to discussion. We have an inflation problem.
Now to your question, how is it that during that long period we had stable prices? And who deserves the credit? Well, some credit belongs to the Fed. The Fed I joined in 2006 had inherited this price stability legacy, which began with Chairman Volcker continued through Chairman Greenspan. Markets came to think that central bankers deserve substantial credit for it, and we broadly knew what we were doing to ensure it.
I’d say the third are the structural factors. Starting in the early 1980s, the integration of the global economy was bringing new competition, the emergence of China, both factory workers to keep prices of final goods low and a vast consumer market for exports that drove structurally lower prices. Demography and other factors had something to do with it. I want to give some credit to the world’s central banks, to the regime that we inherited, in the regime we practiced, but also to some structural factors.
In the last several years, we took an integrated global supply chain, integrated product markets, service markets, integrated financial markets, and they are being ripped apart because of this G2 rivalry. It’s happening. And as we rip apart this into two big spheres of influence, that’s perhaps not inflationary in the long-term, but that’ll take several years. Structural factors are important.
Milton Friedman used to say, “The only thing we know in economics, we teach in Econ 1, everything else is made up.” And he was a Nobel Prize winner, like Myron here. And I remember thinking, I was 20 at the time when I heard that, maybe the old man has lost it. Well, no, it wasn’t until the 2008 financial crisis. I said, Milton has it exactly right.
We goosed the demand side of the economy with massive stimulus, massive transfer payments, long after the vaccine was there. You goose demand, you shrink the supply side by making it harder for capital to be deployed, by reregulating, by encouraging a lot of workers not to work. I don’t know what else you’d expect. And then inflation moved higher, and it was commented on by most of our colleagues that it’s transitory and temporary and has to do with pandemic this and war that. But it’s found its way into the fabric of every kitchen table and boardroom discussions.
Myron Scholes:
Milton Freedman said, “If you give the checkbook to the Treasury, then that’s akin to helicopter money.” Do you think that that the inflation surge that we’ve had is because the checkbook was given to the Treasury?
Kevin Warsh:
I worry whether we have created a situation where the Fed and the Treasury have a hard time acting independent of each other as the Congress had originally intended.
Myron Scholes:
If you have quantitative easing, you get trapped and then a short-term policy becomes a long-term policy.
Kevin Warsh:
We had this fight in the Fed in 2008 about whether to do quantitative easing. We hardly thought that it was going to be as successful as it was. As Chairman Bernanke likes to say, QE worked in practice, but it doesn’t work in theory. He said that “How could it possibly be that if one part of the government issued debt, the other part of the government buys that same debt later that week that things are miraculously better?” To Myron’s point, we made a risk management judgment. When the world was coming undone in 2008, it was worth the risk.
And in my judgment, we also made a pact when the world financial markets were functioning again, we’d get out of that business.
Myron Scholes:
Back to 1982, when Volcker was the Chairman of the Fed, my reading of history is that he stopped raising rates and then inflation roared back again, and then he had to increase rates again. It wasn’t a continuous policy. The second part is that Reagan in his policies, deregulated which freed the economy to produce more and have a greater pie that brought down the inflation rate.
Kevin Warsh:
Chairman Volcker was an awfully tough man. When he took the job as chairman, he’d run the New York Fed before. I didn’t come to know him until I was joining the Fed in 2006 and had a wonderful relationship with him until the end. Tough Paul Volcker was a great Fed Chairman, saved the country and the institution, even he paused, even he got cold feet.
Paul Volcker deserves enormous amount of credit for beating inflation. Milton taught us that inflation is always a monetary phenomenon. But I would say if Milton were with us today, especially if he saw the conflation of fiscal and monetary policy like we have discussed, he would say, the way these guys are running policy, fiscal matters a lot too. I think he would amend his famous aphorism.
Question is can we have an expansion of the supply side of the economy, a deregulation in product markets, new incentives for workers. If we have that the Fed would have a much more successful effort in bringing inflation down to target. My objective assessment, the broad conduct of monetary policy is not productivity enhancing. It is not expanding the supply side of the economy.
What would you do to be more growth oriented? The expansion of the supply side of the economy is about creating production in its most efficient place. We are talking about how to make potential GDP as big as possible because of our view that the fruits of that would be high.
What is potential GDP? It is simply the calculation of hours worked and the productivity of those hours. The way to make those hours more productive is to have that incredible mix of capital and labor, new ideas that make the factory floor more efficient, that give that worker the best tools so that he can be more productive. And history says when he’s more productive, his wages are going to move up smartly. His company’s going to be more efficient, and we are going to have a more prosperous nation.
Larry Bernstein:
Kevin, what are you optimistic about?
Kevin Warsh:
The 21st century requires economic strength. And that’s not just going to make us richer. That is going to take the divisions in our society, and it is going to mitigate those.
How do we have a more peaceful, prosperous civil society? Where there’s more opportunity more people want to be part of the American experiment. Instead of where we find central banks on the front of the newspaper every day and say they do not matter so much because our communities are stronger, and we feel safer and more prosperous. That is the objective function of what we are trying to do. And the economics we have talked about are just a prerequisite to getting there.
Larry Bernstein:
Thanks to Kevin and Myron. We’re now going to move to our second speaker which is John Cochrane who is professor of Economics and Finance at Stanford’s graduate school of business.
Kevin Warsh has recently been nominated to be Chairman of the Fed and he will be taking over from Jerome Powell if in fact his nomination goes through. What do you expect to be a change in policy?
John Cochrane:
Congratulations to my friend and colleague, Kevin Warsh, the dog who caught the car. There’ll be several challenges. The first is to navigate interest rates. President Trump’s evident desire for lower interest rates, some of which is to lower interest costs on the debt and help the fiscal problem. So, we have an interaction of monetary and fiscal pressures.
Warsh has a program of institutional reform, which is one of the big challenges at the Fed. He wants to change the balance sheet and fix financial regulation. His plate is full. It will be interesting to see where he goes as well as keep the collegiality of the Fed. It would be terrible for the Fed to turn into a five to four Republicans versus Democrats institution.
Larry Bernstein:
Trump began as a real estate entrepreneur and interest rates drive everything. Trump is very cognizant of the level of interest rates, and he perceives that as driving the economy particularly around election dates.
John Cochrane:
Trump has two instincts going here. Real estate developers like low interest rates, the lower the better. Many people confuse individual businesses versus the whole economy. There is always supply and demand. Low interest rates are good for people who want to borrow money, but they are terrible for people who want to save and are investing for retirement.
Most economists faced with the lower interest rates question, clutch their pearls, and say inflation, inflation. There has got to be a downside to everything, right? If low interest rates were an unmitigated good, then set the interest rate to negative a hundred percent and hand out free money.
And what is the theory and evidence on how long it takes low interest rates to produce inflation? Something I work on as an academic, and typically takes quite a long time for low interest rates to result in inflation. If interest rates go down one of the dangers that not just private people borrow, but the government goes on a borrowing binge too. Then you could replay 2021 inflation quickly. These things always got to work together.
Larry Bernstein:
The Phillips Curve was an empirical result between the level of unemployment and inflation. And if you caused a recession and unemployment went up, you were able to reduce inflation. Where are you on the relationship between the level of unemployment and inflation?
John Cochrane:
There is this longstanding historical correlation that boom times in the economy tend to be times of high inflation. Bust times tend to be times of deflation or disinflation. That correlation then in economists’ minds turn into a set of levers.
The Fed currently thinks that inflation is driven by the Phillips curve. So, if we cool the economy, that will cool off inflation, which sounds reasonable except the central theoretical problem is that inflation is the level of all prices and wages. So, you can see why the slack economy prices would go down, but why should everything go down, not just prices relative to wages and so forth. There are also lots of times when inflation comes and goes with no change in employment whatsoever.
Larry Bernstein:
The Fed has a dual mandate. It is supposed to have stable inflation and full employment, and if you believe in the Phillips Curve, these are in conflict. The ECB on the other hand only has one mandate and that is to maintain stable inflation without that employment overlay. How do you think about the role of the dual mandate and its conflict?
John Cochrane:
The mandate is get both things at the same time and the Phillips Curve says you cannot have both at the same time. That mandate came in at a time when people believed in this Phillips curve more strongly. Now economists are thinking about employment, horrible schools, taxes, social program disincentives, labor laws, the overnight federal funds rate and how many people have jobs?
The Fed is trying to square this circle, you got one tool and there is a tradeoff between the two things. The Fed was always getting it wrong. As Milton Friedman put it, you are turning the shower on hot and cold and hot and cold and not waiting long enough. The standard thinking became, if you pay attention to only inflation and keep that under control, then you never have to turn the shower to cold again because it got too hot. Just leave the button alone on the inflation and the employment will take care of itself. I still think that was a good idea.
That is how inflation targeting came along in the 1990s, and that’s the way the ECB operates because there’s a lot of countries and it doesn’t want to get in the business of employment in Spain versus employment in Germany. Let’s just worry about inflation for the whole Eurozone, that was a wise setup. It was mandated price stability and it interpreted as perpetual 2% inflation.
Larry Bernstein:
During the 2008 to 2010 financial crisis, global central banks decided to do dramatic quantitative easing, which meant acquiring a substantial amount of government bonds. Draghi was famous at the ECB for saying, we will do whatever it takes. To go back to a normal situation where you’re not supposed to be doing whatever it takes. You are supposed to be managing the inflation target and minimizing the role of governmental interference in the markets.
John Cochrane:
Let me just back up for our listeners and explain what this is all about. The Federal Reserve is a giant money market fund. When the Fed does quantitative easing, it buys treasuries and gives banks interest paying reserves in return.
I would say that quantitative easing basically was a PR gimmick rather than anything particularly important to the economy.
Larry Bernstein:
Myron Scholes gave an example to Kevin Warsh about an ice cream truck arriving at a park and the kids were busy playing and the Good Humor guy was ringing his bell and the kids ran and got their ice cream. What Myron said was that forever changes the nature of park dynamics that kids will be expecting to get the Good Humor bars. With a central bank when you announce things like “we’ll do whatever it takes,” it changes financial markets in a way where lenders may expect that in a time of crisis that they’ll be taken care of, and they can come up with different conclusions about credit spreads or liquidity or other factors that may go into judgments of whether or not to hold risky assets.
John Cochrane:
I want to distinguish quantitative easing, trying to nudge down long-term treasuries in normal markets versus crisis interventions like March 2020 or the financial crisis when they buy securities that are falling in value with the goal of keeping up the values of those securities. The bailouts of 2008 and buying treasuries in March 2020, they started buying essentially all the new issues and then Powell gave an essentially “whatever it takes,” the corporate bond prices shall never fall because we will buy whatever it takes later in 2020 to keep those prices from falling. And this is the problem of our financial regulatory architecture in general.
The Fed basically puts a floor under all asset prices. Now that’s nice if you’re an investor, no risk here. Anything bad happens, the Fed will come in and keep prices up. But exactly as you put it, then the incentive for people to keep some liquidity around and be ready to buy on the dip is gone because the Fed will front run you. And why are financial markets fragile? Well, because there’s not enough people holding some liquidity ready to buy in the dips and keep the prices up.
I’ll compete here with Myron for stories. If you build a really good fire department, then people keep gasoline in the basement because they know the fire department will always come. Our financial system has become more fragile. People borrow more money than they should. They don’t issue as much equity as they should. They do not keep enough resources around to buy the dip because everybody knows that in a crisis, the Fed will come in and keep the prices up. The result is that every time a crisis comes, the prices are more likely to fall because there’s no one around to keep them up again.
Larry Bernstein:
The Fed historically has been responsible for managing the short-term interest rate, but sometimes interest rates in the long end of the curve get to levels that seem unappealing to policymakers. And so they’ve engaged in what they referred to as Operation Twist where they would try to also manage the longer term interest rate. And the way they did it was the Fed went ahead and acquired a substantial amount of long-term Treasury bonds to lower long-term interest rates. You mentioned that the Fed is acquired a substantial money market position, and Kevin wants to get those positions down.
Currently, the Fed has more than $6 trillion of assets and that has influenced the absolute level of interest rates When Warsh says that he wants to reduce this balance sheet that requires a change in the duration of government securities that will be available to the public. Tell us about unwinding of Operation Twist by changing the nature of the Fed’s holdings.
John Cochrane:
When the Fed buys a bunch of long-term debt and pays for it by issuing short-term debt, that’s what quantitative easing is. How much effect does that have on long-term interest rates? Now, the evidence on this, it is surprisingly weak. I am very dubious of the idea that the Fed’s operations on the margin have a huge effect on long-term bonds.
Larry Bernstein:
The U.S. government owns a hundred percent of the Fed, and the U.S. government is responsible for all the treasury debt. The left hand owns the bonds. The right hand is short the bonds. And so, when I think about the duration of the U.S. government’s liabilities, I net out the Fed’s holdings. I think we could step back and say, what is the optimal duration structure for the U.S. debt?
John Cochrane:
Oh, Larry, I love you. You are asking all the right questions. So, let’s introduce our listeners to the consolidated balance sheet. The Fed and the Treasury pretend they are different, but they are married to each other. And the way they are married to each other is if the Fed buys treasury debt, earns interest on that, and uses some of that interest to pay the banks interest on reserves. The rest the Fed gives back to the treasury. So, there’s no sense of the Fed making money or losing money. It’s like a husband and wife; she goes out and makes the money and he goes shopping for a new Porsche. This is all one balance sheet.
The government borrowing is just like you or me borrowing. Let’s go buy a house together. And so now we face the choice. Are we going to buy a get a 30-year fixed mortgage or we’re going to get the adjustable rate, which has a low initial rate?
Larry Bernstein:
Do you feel lucky punk?
John Cochrane:
Exactly. The adjustable rate looks like a lower yield, but if interest rates go up and you have got the 30-year fixed, you are not going to lose the house. The US Treasury, when it issues bonds, thinks about, do we save a little money by issuing short or by going long? Do we insure ourselves that if interest rates go up, we are not going to lose the government?
In my view, the treasury was scandalously short. When interest rates were 1% or 2%, they should have refunded the whole federal debt with perpetuities and locked in the interest costs forever. They did not, interest rates went up. And now here we are spending a trillion dollars a year on higher interest costs because we didn’t issue the 30-year fixed bonds.
Now finally, where’s the Fed fit in? The wife goes out and she’s thrifty. She goes to the bank and says, let’s get the 30-year fixed. The husband says, I want the floating rate. I want the extra cash flow. That’s what the Fed did. Unwittingly the Fed doesn’t think about fiscal policy, it thinks about financial markets, but when it bought long-term treasuries and issued short-term stuff instead, what it did was expose the government overall to more interest rate risk. And as we have seen, the Fed lost a ton of money. It bought these long-term treasuries and issued short-term reserves. The value of the long-term treasuries falls just like Silicon Valley bank did when interest rates went up.
Now there cannot be a run on the Fed, but the Fed doesn’t have any profits to give back to the treasury anymore. And so that is a measure of how much the Fed exacerbated this issue of too much short-term debt.
In an era of big debts and deficits, we are used to thinking of the monetary and fiscal policies as being different. You handle deficits, we handle money and financial stuff, but when there’s huge debt outstanding, these things are related. Raising interest rates raises interest costs on the debt to the tune of a trillion dollars. Buying long-term debt and issuing short-term debt exposes the treasury to more risk. That’s a hard fact of monetary policy today.
Who oversees and decides the maturity structure of the U.S. government debt after we recognize that the Fed and the US Treasury are all in this together? I have asked officials at both places, and they deny the tension. The treasury says that they just issue the debt. What the Fed does is their business.
And the Fed says, we do not do fiscal policy. So, we need a new Fed-Treasury Accord on who is going to be responsible for the government’s overall maturity structure.
Larry Bernstein:
Asset prices give information to buyers and sellers. This information of price is amazing because there’s so many products in this world, and all you need to do is look at relative prices to make decisions. Kevin Warsh on my program previously said that when the Fed buys various assets that they’re manipulating prices and undermining this price discovery for people who supply and demand those financial assets. How should we think about the Fed’s role in distorting financial prices?
John Cochrane:
The Fed is deliberately distorting financial prices. It is the last remaining central planner in many ways and not necessarily bad. Nobody knows why prices change because you can’t know all the information that’s out there. But there is a feeling that sometimes prices are not reflecting fundamental information. The ECB likes to use the word dysfunctional and fragmented markets. Central bankers think that they are God for knowing what prices should be, but the Fed was founded to stop financial crises. There are times that we think some prices are too low, that there is some dysfunction going on, and they are there to stabilize markets.
Larry Bernstein:
We have had several financial crises. 2008 was one of the worst. And there was a sense that the regulatory agencies in the US government were insufficient. We have lots of different regulators. We have the FDIC, the Fed, the OCC, the CFTC, the SEC, all these regulators. And there was a sense in Congress that the Fed was more talented or could understand financial problems better than these other agencies. They wanted to concentrate the new regulatory body in the Fed. You have been talking about the Fed as being responsible for monetary policy, but Congress enacted legislation that made it responsible for much more than that. And this makes things more challenging. You mentioned the dual mandate being problematic. Now we have got another mandate, which is chief regulator. How do you think about this additional responsibility?
John Cochrane:
One of the problems for the Fed if it raises interest rates, there is the Phillips curve that might cause unemployment. That is going to raise interest costs on the government debt. Congress can be mad about that. And if it raises interest rates, the too-big-to-fail banks go under. We saw that in a small way with Silicon Valley Bank. It’s a regulated bank. The Fed miserably failed to see, here’s an elephant in the room. This bank is holding long-term treasuries by issuing deposits, and if it raises interest rates, the long-term treasuries are going to fall in price. There is going to be a run. That’s another constraint on the Fed for raising interest rates. Part of the problem here is the fundamental architecture of financial regulation went wrong. The problem is Congress viewed this as a lack of regulation, and so they just added more regulation.
Here’s how banks work. They put in $1 of their own money and borrow $9 and then they invest in a portfolio of debt securities. They might lose some money on that portfolio of debt securities. If they lose one and a half dollars, they have wiped out the equity. There isn’t enough to pay back the debt there. There is a run in the bank.
Now what is the problem with this system? Well, Congress said the problem with the system is we don’t have enough regulators looking at how safe those assets are. So, we need to pile more regulators to see if the assets are while leaving the 9 to 1 leverage in place, the scandalously low amount of your own money put into the investment in place. And this is what abjectly failed with Silicon Valley Bank. Hundreds of thousands of pages of regulations, an army of regulators, and they could not see plain vanilla interest rate risk staring them in the face.
Where is a dangerous asset in the U.S. economy? SpaceX rockets to Mars. Is that a safe investment? No way. Do we have any regulators looking over the safety and the value at risk in Tesla? No. Why? Because it’s all funded by stock. And if the data centers to Mars blow up, stockholders lose their money. That’s not a financial crisis.
This is the problem with banks. Their assets are safe, but they’re leveraged to the hilt. We’ve known the answer to this for a hundred years, which is that banks need to get their money more by long-term debt and issuing stock and less by overnight interest borrowing if they are going to invest in faintly risky stuff.
What I like to call equity finance banking. Nobody wants this. Why? Because the banks love the current system. The banks get to borrow 9 to 1. They get to live off the hugely levered profits in good times, and in bad times, they call up Uncle Sam and say, “we got a crisis here, bail us out again.” So the banks love it, and when you look at the actions of the Fed, the Fed does a lot in its regulation to prop up the profits of the big banks.
They wanted segregated accounts. That’s the way you can put your money in the bank. The money is backed by short-term treasuries or reserves, zero risk of ever failing.
The problem with banking regulation is easily solved. If you are going to make risky stuff, ramp up the equity in it, and if you want risk-free deposits, let them have risk-free a hundred percent backed deposits.
Larry Bernstein:
Stable coins are a huge potential opportunity, but Congress swayed by the big banks announced that stable coins cannot pay interest. Cash is a medium of exchange with low transaction costs. As a public policy matter, we should seek a means of exchange with even lower transaction costs. A stable coin that pays interest backed by the full faith and credit of the United States is the ultimate transaction cost-free vehicle.
John Cochrane:
Stable coins are a fantastic innovation as far as technology, but they are not a financial innovation. A stable coin is a money market fund with a blockchain transaction feature.
The Fed providing the underlying securities that private parties use to provide good user interface. Customer facing transactions is the right way to go, which is why I would like the Fed to open up its reserves to money market funds, stable coins, narrow banks, everybody else who’s a reasonable financial intermediary.
Cash was anonymous, and if you can go back and phone up the founders and say the federal government will have a record of every single transaction you ever made anywhere, they might be horrified at what that means for your personal liberties. Now on the other hand, if you have totally zero transaction costs, interest paying electronic money, that is totally anonymous. No one will ever pay taxes again and it’ll be a field day for scammers.
I like not enforcing China’s currency laws. Enforcing all laws all the time is not the best thing in the world. So, there is a delicate balance here that our design. I like private parties in charge of the transactions and government provides the backing securities and you need a subpoena and a court order before the government looks at my transactions.
Larry Bernstein:
One big topic recently has been the role of Fed independence. Our constitution does not talk about federal bureaucracies as being its own branch. Do you like Fed independence? When we talk about regulatory, treasury liability management, these fall within what have historically been the responsibility of the executive branch. Tell me what you think about Fed independence.
John Cochrane:
We have a legislative, executive, and a judicial branch, and where is the independent agency and all that? You do not want Congress writing the rules on how many hours it takes to get a pilot’s license. There is a reason we have independent agencies.
The Fed is independent, and I think that is a good thing, but it is with limitations. In a democracy, you cannot just say, Larry Bernstein, you are chair of the Fed go print money, do whatever you feel like with it and you can stay there forever.
The Fed’s independence is quite limited. It has independence, but the people are appointed by the President and confirmed by the Senate, and then they must report to Congress and then they roll over. The design of the system responds to political imperatives and responds to voters. But slowly, and that is one of the geniuses of our constitutional system, is we don’t just elect the king 51% - 49%, all the laws change overnight. We slow things down. And that is the cycle of Fed appointments. The most important thing is that they are independent within their limited mandate. When the Congress says inflation and employment and nothing else.
A Central Banker might decide that reshoring manufacturing, climate change or whatever is the most important thing in the world. That is not part of their job description. All the central bankers can do is fiddle with short-term rates and buying or selling treasury bills, and you are not allowed to do anything else. Why? Because suppose you want to cure inflation. What is the easiest way to cure inflation? Go out and take a hundred bucks out of everybody’s wallet. The Fed’s not allowed to do that. The treasury must do it because that is taxation. The Fed has no taxation authority because it cannot be independent in a democracy and tax people. You must be politically accountable to do that. The Fed is allocating these tools, short-term interest rates that do not have an obvious connection to employment and inflation. You want employment? Go hire people. Government does that all the time, make work jobs, but the Fed’s not allowed to do that because in a democracy that must be subject to political accountability.
Larry Bernstein:
The Fed owns a couple trillion dollars of mortgages. That is not part of that mandate.
John Cochrane:
The criticism is that the Fed went far beyond the mandate into the political arena.
Larry Bernstein:
Once they do that, they lose their independence.
John Cochrane:
That is where we are now, if you are going to have a very grand agency that is allocating credit to housing and not to industry, and that is interfering with the treasury’s maturity structure of the debt, well, then you must be less independent. We do not have an independent treasury secretary.
The president tells them what to do. Why? Because raising taxes is political, now that would be a shame because the of independence is a pre-commitment mechanism, and that is a fancy word for Congress knows that it will want to inflate just before the election. So, we put that decision in the hands of an independent agency to tie our own hands. Odysseus tied his hands to the mast so that he would not listen to the sirens. And that is the point of an independent Fed with a limited mandate. Let’s put this issue of goosing the economy in an independent agency that slowly responds to political pressure but will insulate Congress and the President.
Larry Bernstein:
It turns into an empirical question. Does having a so-called independent fed within this new framework effective in achieving its inflation target? If you looked this decade, how would you grade an independent Fed’s ability to target the inflation?
John Cochrane:
Well, the Fed, we had 10% inflation and a 2% target. So, there was a major institutional failure there.
Larry Bernstein:
I think what you are saying is Fed independence should be limited to determining the short-term interest rate. Away from that, whether it be the regulatory authority, the composition of the assets, you have abandoned the strict requirements of independence, you’ve entered the political realm, and therefore you’re responsible to the president’s beck and call. Is that where you are?
John Cochrane:
The Fed is founded to step in for financial crises in ways that we do not particularly like. But those tools are limited goals like inflation, employment, and financial stability. Those limitations are what allows the Fed to be independent and not going off and doing things. And right now, we are at a test of independence. The Fed does want to keep interest rates higher than the President wants. And so, the standard constitutional order is the president must wait until he gets to appoint new people to the board. And our president is not that patient.
Larry Bernstein:
What are you optimistic about as it relates to the Fed and Kevin Warsh’s participation?
John Cochrane:
There is a chance of making deep institutional conceptual changes at the Fed. Everybody has known about problems with the regulations for years and nothing ever happens. The Fed is in a bubble about how it thinks about monetary policy. That bubble is going to get shaken up, so the chance of institutional reform is bigger now than it was, and the chance of screwing up is also bigger.
Larry Bernstein:
Thanks to John, Kevin, and Myron for joining us.
If you missed the previous podcast, the topic was Why Is Trump’s Rhetoric Effective? Our speaker was Henry Olsen who is a senior fellow at the Ethics and Public Policy Center.
Henry explained why Trump is successful despite with his non-traditional and outrageous speaking style. No other world leader talks like Trump with the use of threats and hyperbole Henry predicted that we are going to see other politicians mimic Trump’s methods in social media and public speaking in the 2028 presidential campaign and beyond.
You can find our previous episodes and transcripts on our website
whathappensnextin6minutes.com. Please follow us on Apple Podcasts or Spotify. Thank you for joining us today, goodbye.
Check out our previous episode, Why is Trump’s Rhetoric Effective?, here.
