The Fed’s Doomsday Prophet Has a Dire Warning About Where We’re Headed

Politico

Thomas Hoenig knew what quantitative easing and record-low interest rates would bring. Thomas Hoenig doesn’t look like a rebel. Hoenig has all the fiery disposition that one might expect from a central banker, which is to say none at all. When Hoenig gets really agitated he repeats the phrase «lookit» a lot, but that’s about as salty as it gets.

This makes it all the more surprising that Tom Hoenig is, in fact, one of America’s least-understood dissidents. In 2010, Hoenig was president of the Federal Reserve regional bank in Kansas City. As part of his job, Hoenig had a seat on the Fed’s most powerful policy committee, and that’s where he lodged one of the longest-running string of «no» votes in the bank’s history. Hoenig’s string of dissents shattered that appearance of unanimity at a critically important time, when the Fed was expanding its interventions in the American economy to an unprecedented degree.

To put that in perspective, it’s roughly triple the amount of money that the Fed created in its first 95 years of existence. Three centuries’ worth of growth in the money supply was crammed into a few short years. The money poured through the veins of the financial system and stoked demand for assets like stocks, corporate debt and commercial real estate bonds, driving up prices across markets. Hoenig was the one Fed leader who voted consistently against this course of action, starting in 2010.

In doing so, he pitted himself against the Fed’s powerful chair at the time, Ben Bernanke, who was widely regarded as a hero for the ambitious rescue plans he designed and oversaw. Hoenig lost his fight. Throughout 2010, the FOMC votes were routinely 11 against one, with Hoenig being the one. He retired from the Fed in late 2011, and after that, a reputation hardened around Hoenig as the man who got it wrong.

While Hoenig was concerned about inflation, that isn’t what solely what drove him to lodge his string of dissents. The historical record shows that Hoenig was worried primarily that the Fed was taking a risky path that would deepen income inequality, stoke dangerous asset bubbles and enrich the biggest banks over everyone else. He also warned that it would suck the Fed into a money-printing quagmire that the central bank would not be able to escape without destabilizing the entire financial system. On all of these points, Hoenig was correct.

We are now living in a world that Hoenig warned about. Inflation is rising faster than the Fed believed it would even a few months ago, with higher prices for gas, goods and automobiles being fueled by the Fed’s unprecedented money printing programs. This comes after years of the Fed steadily pumping up the price of assets like stocks and bonds through its zero-percent interest rates and quantitative easing during and after Hoenig’s time on the FOMC. To respond to rising inflation, the Fed has signaled that it will start hiking interest rates next year.

«There is no painless solution,» Hoenig said in a recent interview. To be clear, the kind of pain that Hoenig is talking about involves high unemployment, social instability and potentially years of economic malaise. Hoenig knows this because he has seen it before. He saw it during his long career at the Fed, and he saw it most acutely during the Great Inflation of the 1970s.

That episode in history, which bears eerie parallels with the situation today, is the lodestar that ended up guiding so much of Hoenig’s thinking as a Fed official. It explains why he was willing to throw away his reputation as a team player in 2010, why he was willing to go down in history as a crank and why he was willing to accept the scorn of his colleagues and people like Bernanke. Hoenig voted no because he’d seen firsthand what the consequences were when the Fed got things wrong, and kept money too easy for too long. The last time America suffered a long and uncontrolled period of inflation, Thomas Hoenig was given the miserable job of cleaning up the mess it left behind.

This was the period that has come to be known as the Great Inflation, a period in the 1970s characterized by long lines at gas stations and price hikes at grocery stores that came so fast price tags were replaced midday. Hoeing came to realize that the institution he worked for, the Federal Reserve, wasn’t just a bystander to this inflation. As a bank examiner, Hoenig spent the 1970s watching as the Fed’s policies helped pile on the inflationary tinder that would later ignite. These policies are known as «easy money» policies, meaning that the Fed was keeping interest rates so low that borrowing was cheap and easy.

The Fed had kept interest rates so low during the 1960s that they were effectively negative when accounting for inflation by the late 1970s. When rates are effectively negative, that might be called a super-easy money policy. This kind of environment fuels inflation because all that easy money is looking for a place to go. Economists call this phenomenon «too many dollars chasing too few goods,» meaning that everybody is spending the easy money, which drives up the prices of the things they are buying because demand is high.

As a bank examiner, Hoenig realized another very important thing. Easy money policies don’t just drive up the price of consumer goods, like bread and cars. The money also drives up price of assets like stocks, bonds and real estate. During the 1970s, low interest rates fueled demand for assets, which eventually inflated asset bubbles across the Midwest, including in heavy farming states, such as Kansas and Nebraska, and in the energy-producing state of Oklahoma.

When asset prices like this rise quickly, it creates that dreaded thing called an asset bubble. The self-reinforcing logic of asset bubbles was painfully evident in farming, and it reflected the dynamics that would later play out in the housing bubble and the over-heated asset markets of 2021. When the Fed kept interest rates low during the 1970s, it encouraged farmers around Kansas City to take on more cheap debt and buy more land. The wheel continued to spin as long as debt was cheap compared to the expected payoff of rising asset prices.

This is how asset bubbles escalate in a loop that intensifies with each rotation, with the reality of today’s higher asset prices driving the value of tomorrow’s asset prices ever higher, increasing the momentum even further. Paul Volcker became chair of the Federal Reserve and he was intent on beating inflation by hiking interest rates. Under Volcker, the Fed raised short-term interest rates from 10 percent in 1979 to 20 percent in 1981, the highest they have ever been. This unleashed massive economic havoc, pushing the unemployment rate to 10 percent and forcing homeowners to take out mortgages with 17 percent interest rates or higher.

«The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets,» Volcker later wrote in his memoir. When the Fed doubled the cost of borrowing, the demand for loans slowed down, which in turn depressed the demand for assets like farmland and oil wells. The price of assets collapsed, with farmland prices falling by 27 percent in the early 1980s and oil prices falling from more than $120 to $25 by 1986. When the loans started failing, the banks had to write down the value of those loans, which made some banks appear insolvent because they suddenly didn’t have enough assets on hand to cover their liabilities.

«You could see that no one anticipated that adjustment, even after Volcker began to address inflation. They didn’t think it would happen to them,» Hoenig recalled. This was the period when Hoenig traveled around the Midwest, auditing banks to determine if they were still solvent during the recession. Not surprisingly, Hoenig ended up arguing with a lot of bankers when his team declared that the value of the banks’ assets were not sufficient to meet their liabilities.

«They could become quite stressed and quite vocal in their objections,» Hoenig later recalled of the bankers. Shutting down community banks wasn’t easy, but Hoenig didn’t seem to flinch from the responsibility. «Tom’s German,» Yorke said, referring to the ethnic origin of Hoenig’s name. It would have been easy enough for Hoenig to blame the bankers for making so many risky loans after the bubble burst.

The Fed had encouraged the asset bubbles through its easy money policies. «The fact is, made the loans,» Hoenig said. «They made them in an environment of incredible optimism in terms of asset values.» By «optimism,» Hoenig was referring to something called «inflation expectations.» The bankers expected asset prices would continue rising indefinitely, and that very expectation fueled demand for loans, which in turn caused the price to rise. There were many counterarguments to explain inflation that didn’t blame the Fed.

These arguments rested on the idea of «cost push» inflation, meaning that all kinds of forces outside the Fed were pushing price higher. The federal government spent years trying to fight inflation under this theory, even going to far as to impose wage and price controls. There is strong evidence to support Hoenig’s view that the Fed was fueling inflation the whole time. In a 2004 report, the Fed economist Edward Nelson wrote that the most likely cause of inflation during the ’70s was something he called «monetary policy neglect.» Basically, the Fed kept its foot on the money pedal through most of the decade because it didn’t understand that more money was creating more inflation.

This kind of inflation is called «demand pull» inflation, meaning that the Fed stokes demand, which causes prices to increase. The author and economist Allan Meltzer, who reconstructed the Fed’s decision-making during the 1970s in his 2,100-page history of the central bank, delivered a stark verdict. «The Great Inflation resulted from policy choices that placed much more weight on maintaining high or full employment than on preventing or reducing inflation,» Meltzer wrote. He served there during the long tenure of Fed Chair Alan Greenspan, and then Greenspan’s successor Ben Bernanke.

Between 1991 and 2009, Hoenig rarely dissented. Then came 2010, when he believed the Fed was repeating many of the same mistakes it made in the 1970s. The unemployment rate was still 9.6 percent, close to the levels that characterize a deep recession. Hoenig was warning about even deeper dangers that might be stoked by keeping interest rates pegged at zero.

But his warnings were also very hard to understand for people who didn’t closely follow the politics of money. Hoenig, for instance, liked to talk a lot about something called the «allocative effect» of keeping interest rates at zero. Hoenig was talking about the allocation of money and the ways in which the Fed shifted money from one part of the economy to another. This is what he’d witnessed during the 1970s.

Bernanke was unpersuaded by these arguments. When Bernanke published a memoir in 2015, he entitled it The Courage to Act. Bernanke pushed the FOMC to keep rates at zero throughout 2010. Then, in August of 2010, with unemployment high and growth sluggish, he publicly unveiled the plan to create $600 billion new bills through an experimental program called «quantitative easing.» This program had been used once before, during the financial crash.

But it had never been used in the way that Bernanke proposed it be used in 2010, as an economic stimulus plan to be employed outside of an emergency. If Hoenig had learned one thing during his decades at the Fed, it was that keeping money too easy for too long could create disastrous side effects that only manifested years later. That’s what happened during the 1970s, and again in the mid-2000s, when low rates fueled the housing bubble. Now Hoenig was being asked to vote for quantitative easing, a super-easy money policy that would encourage risky lending and asset bubbles.

The basic mechanics and goals of quantitative easing are pretty simple. The goal is to pump massive amounts of cash into the banking system at the very moment when there is almost no incentive for banks to save the money, because rates are so low. The Fed creates the money as it always has, by using its own team of financial traders who work at the Fed’s regional bank in New York. These traders buy and sell assets from a select group of 24 financial firms called «primary dealers,» an ultra-exclusive club that includes the likes of JPMorgan Chase and Goldman Sachs.

To execute quantitative easing, a trader at the New York Fed would call up one of the primary dealers, like JPMorgan Chase, and offer to buy $8 billion worth of Treasury bonds from the bank. Bernanke planned to do such transactions over and over again until the Fed had purchased $600 billion worth of assets. In other words, the Fed would buy things using money it created until it had filled the Wall Street reserve accounts with 600 billion new dollars. Hoenig wasn’t the only FOMC member with strong objections to the plan.

The Fed’s own research on quantitative easing was surprisingly discouraging. 03 percent. The final vote on quantitative easing was set on Nov. Lacker, president of the Richmond Fed, said the justifications for quantitative easing were thin and the risks were large and uncertain.

Just like the 1970s, the Fed might end up keeping money too easy for too long as it tried to juice the job market, chasing short-term gains as it piled up long-term risks. If Hoenig had voted to support quantitative easing on Nov. During his childhood in Fort Madison, Iowa, Hoenig spent his holiday breaks working at his dad’s small plumbing shop. Hoenig was sent to the back room with a clipboard so he could record the inventory of plumbing parts.

After graduating high school, Hoenig served as an artillery officer in Vietnam, where he calculated the firing range of mortar shells to ensure they landed near enemy positions rather than on his fellow U. Hoenig’s upbringing taught him that getting numbers right was a deadly serious job. There were 10 votes in favor of quantitative easing. Hoenig retired from the Fed in late 2011. As he predicted, the round of quantitative easing he voted against was just the beginning.

By 2012, economic growth was still tepid enough that Bernanke argued that more quantitative easing was in order. Quantitative easing stoked asset prices, which primarily benefited the very rich. By making money so cheap and available, it also encouraged riskier lending and financial engineering tactics like debt-fueled stock buybacks and mergers, which did virtually nothing to improve the lot of millions of people who earned a living through their paychecks. In May of 2020, Hoenig published a paper that spelled out his grim verdict on the age of easy money, from 2010 until now.

The biggest difference was the Federal Reserve’s extraordinary experiments in money printing during the latter period, during which time productivity, earnings and growth were weak. During the 1990s, labor productivity increased at an annual average rate of 2.3 percent, about twice as much as during the age of easy money. Real median weekly earnings for wage and salary employees rose by 0.7 percent on average annually during the 1990s, compared to only 0.26 percent during the 2010s. The only part of the economy that seemed to benefit under quantitative easing and zero-percent interest rates was the market for assets.

Strained supply chains are to blame for that, but so is the very strong demand created by central banks, Hoenig said. The Fed has been encouraging government spending by purchasing billions of Treasury bonds each month while pumping new money into the banks. Just like the 1970s, there are now a whole lot of dollars chasing a limited amount of goods. «That’s a big demand pull on the economy,» Hoenig said.

Hoenig’s 2020 paper didn’t get much attention. He is still issuing warnings about the dangers of runaway money printing, and he is still being mostly ignored. Hoenig isn’t optimistic about what American life might look like after another decade of weak growth, wage stagnation and booming asset values that primarily benefited the rich. «Do you think that we would have had the political, shall we say turmoil, revolution, we had in 2016, had we not had this great divide created? Had we not had the effects of the zero interest rates that benefited some far more than others?» Hoenig asked.

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Source: CHRISTOPHER LEONARD | POLITICO

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