[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]



 
                   THE FED TURNS 100: LESSONS LEARNED
                   OVER A CENTURY OF CENTRAL BANKING

=======================================================================

                                HEARING

                               BEFORE THE

                        SUBCOMMITTEE ON MONETARY

                            POLICY AND TRADE

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 11, 2013

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 113-42


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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    JEB HENSARLING, Texas, Chairman

GARY G. MILLER, California, Vice     MAXINE WATERS, California, Ranking 
    Chairman                             Member
SPENCER BACHUS, Alabama, Chairman    CAROLYN B. MALONEY, New York
    Emeritus                         NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York              MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California          BRAD SHERMAN, California
FRANK D. LUCAS, Oklahoma             GREGORY W. MEEKS, New York
SHELLEY MOORE CAPITO, West Virginia  MICHAEL E. CAPUANO, Massachusetts
SCOTT GARRETT, New Jersey            RUBEN HINOJOSA, Texas
RANDY NEUGEBAUER, Texas              WM. LACY CLAY, Missouri
PATRICK T. McHENRY, North Carolina   CAROLYN McCARTHY, New York
JOHN CAMPBELL, California            STEPHEN F. LYNCH, Massachusetts
MICHELE BACHMANN, Minnesota          DAVID SCOTT, Georgia
KEVIN McCARTHY, California           AL GREEN, Texas
STEVAN PEARCE, New Mexico            EMANUEL CLEAVER, Missouri
BILL POSEY, Florida                  GWEN MOORE, Wisconsin
MICHAEL G. FITZPATRICK,              KEITH ELLISON, Minnesota
    Pennsylvania                     ED PERLMUTTER, Colorado
LYNN A. WESTMORELAND, Georgia        JAMES A. HIMES, Connecticut
BLAINE LUETKEMEYER, Missouri         GARY C. PETERS, Michigan
BILL HUIZENGA, Michigan              JOHN C. CARNEY, Jr., Delaware
SEAN P. DUFFY, Wisconsin             TERRI A. SEWELL, Alabama
ROBERT HURT, Virginia                BILL FOSTER, Illinois
MICHAEL G. GRIMM, New York           DANIEL T. KILDEE, Michigan
STEVE STIVERS, Ohio                  PATRICK MURPHY, Florida
STEPHEN LEE FINCHER, Tennessee       JOHN K. DELANEY, Maryland
MARLIN A. STUTZMAN, Indiana          KYRSTEN SINEMA, Arizona
MICK MULVANEY, South Carolina        JOYCE BEATTY, Ohio
RANDY HULTGREN, Illinois             DENNY HECK, Washington
DENNIS A. ROSS, Florida
ROBERT PITTENGER, North Carolina
ANN WAGNER, Missouri
ANDY BARR, Kentucky
TOM COTTON, Arkansas
KEITH J. ROTHFUS, Pennsylvania

                     Shannon McGahn, Staff Director
                    James H. Clinger, Chief Counsel
               Subcommittee on Monetary Policy and Trade

                  JOHN CAMPBELL, California, Chairman

BILL HUIZENGA, Michigan, Vice        WM. LACY CLAY, Missouri, Ranking 
    Chairman                             Member
FRANK D. LUCAS, Oklahoma             GWEN MOORE, Wisconsin
STEVAN PEARCE, New Mexico            GARY C. PETERS, Michigan
BILL POSEY, Florida                  ED PERLMUTTER, Colorado
MICHAEL G. GRIMM, New York           BILL FOSTER, Illinois
STEPHEN LEE FINCHER, Tennessee       JOHN C. CARNEY, Jr., Delaware
MARLIN A. STUTZMAN, Indiana          TERRI A. SEWELL, Alabama
MICK MULVANEY, South Carolina        DANIEL T. KILDEE, Michigan
ROBERT PITTENGER, North Carolina     PATRICK MURPHY, Florida
TOM COTTON, Arkansas


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    September 11, 2013...........................................     1
Appendix:
    September 11, 2013...........................................    41

                               WITNESSES
                     Wednesday, September 11, 2013

Bivens, Josh, Research and Policy Director, Economic Policy 
  Institute......................................................    12
Gagnon, Joseph E., Senior Fellow, Peterson Institute for 
  International Economics........................................    11
Goodfriend, Marvin, Friends of Allan Meltzer Professor of 
  Economics, Tepper School of Business, Carnegie Mellon 
  University.....................................................     5
Meltzer, Allan H., Gailliot and Scaife University Professor of 
  Political Economy, Tepper School of Business, Carnegie Mellon 
  University.....................................................     3
Pollock, Alex J., Resident Fellow, American Enterprise Institute.     7
White, Lawrence H., Professor of Economics, George Mason 
  University.....................................................     9

                                APPENDIX

Prepared statements:
    Bivens, Josh.................................................    42
    Gagnon, Joseph E.............................................    57
    Goodfriend, Marvin...........................................    69
    Meltzer, Allan H.............................................    79
    Pollock, Alex J..............................................    97
    White, Lawrence H............................................   104


                   THE FED TURNS 100: LESSONS LEARNED
                   OVER A CENTURY OF CENTRAL BANKING

                              ----------                              


                     Wednesday, September 11, 2013

             U.S. House of Representatives,
                           Subcommittee on Monetary
                                  Policy and Trade,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 1:46 p.m., in 
room 2128, Rayburn House Office Building, Hon. John Campbell 
[chairman of the subcommittee] presiding.
    Members present: Representatives Campbell, Huizenga, 
Pearce, Posey, Stutzman, Mulvaney, Pittenger; Clay, Peters, 
Foster, Sewell, and Kildee.
    Ex officio present: Representative Hensarling.
    Chairman Campbell. Good afternoon, everyone. The 
Subcommittee on Monetary Policy and Trade will come to order. 
Without objection, the Chair is authorized to declare a recess 
of the subcommittee at any time.
    With the concurrence of the ranking member and of the 
witnesses, we are beginning this hearing a little bit early in 
order to accommodate the vote schedule that we will have this 
afternoon. My understanding is that the votes will be called at 
2:10, so we will continue the hearing until probably about 
2:15, at which time we will recess while we go down for votes. 
There are 3 votes, which should take approximately 30 minutes. 
Then we will come back, and we will continue the hearing until 
whenever questions are finished, the witnesses need to leave, 
or the next vote is called, which I think is supposed to be 
around 4:15-ish, and we will adjourn the hearing at that point.
    So as the Chair, I now recognize myself for 5 minutes for 
the purpose of an opening statement. But before I go into the 
opening statement, I would like to note that today is the 
anniversary of the attacks on America on 9/11. And although I 
am sure you all have seen and I have seen and we have seen the 
memorials and the moments of silence in New York and here in 
Washington and elsewhere around the country, I don't ever think 
we can do it too much. So I would first ask that we all observe 
a moment of silence in remembrance of those who perished on 9/
11.
    Thank you.
    Now, I will continue my opening statement--which will be 
brief, because we are mainly here to hear all of you--which is 
just to explain what we are doing here. This year is the 100th 
anniversary of the Federal Reserve. And we felt that after 100 
years of an institution, it is a good time to stand back and 
look at it and say, okay, why was it formed? What has it done? 
What has it changed? How did it start out? What did it do in 
the middle? Where is it now?
    And to take a look at the past 100 years of the Fed with 
the idea of trying to understand better--I don't think anyone 
in this room was here in 1913 when it was founded, so given 
that none of us personally saw it, I think it is good to take a 
look at what happened and what has happened in the last 100 
years and where we are today so that we can begin to think 
about, what does the next 100 years of the Fed look like? What 
should it look like? What have we done right? What have we done 
wrong? What successes have we had? What mistakes have we made? 
And what can we learn from those successes? What can we learn 
from those mistakes? What can we learn from what we did right 
and learn from what we did wrong?
    I am looking forward to the testimony of all of the 
witnesses this morning as we begin a series of hearings on the 
Federal Reserve and on where it has been and then perhaps where 
it might be going.
    So with that, I would like to recognize the ranking member, 
the gentleman from Missouri, for his opening statement.
    Mr. Clay. Thank you so much, Mr. Chairman, for holding this 
hearing on the Federal Reserve Bank then and now.
    As you mentioned, in 1913 Congress enacted the Federal 
Reserve Act to provide for the establishment of the Federal 
Reserve Bank. In 1978, Congress enacted the Full Employment and 
Balanced Growth Act, better known as the Humphrey-Hawkins Act. 
This law charges the Federal Reserve Bank with a dual mandate, 
both maintaining stable prices and full employment.
    Currently, the U.S. unemployment rate is 7.3 percent, the 
lowest level of unemployment in 5 years. Still, millions of 
Americans would like to work, but cannot get work. The Consumer 
Price Index, which shows the price consumers pay for goods and 
services, has increased over the past 12 months by 2 percent.
    The cost of all items, less food and energy, has risen 1.7 
percent over the last year. This compares to 1.6 percent for 
the 12 months ending in June. The energy index has risen 4.7 
percent over the last 12 months. It is the largest increase 
since the 12 months ending February 2012, and the food index 
has risen 1.4 percent. All of these factors play a very 
important role in the U.S. economy.
    And, again, Mr. Chairman, I want to thank you. And I look 
forward to questions that I may submit to the witnesses. I 
yield back.
    Chairman Campbell. Thank you. I thank the ranking member 
for his comments and for yielding back.
    In the absence of any other opening statements, we will 
proceed directly to the witnesses. And we just got word that 
there will not be a second series of votes, so we are going to 
have this one series at apparently 2:10, and then after that, 
there will not be another series, so we will just go from 2:10 
until whenever the hearing finishes after that.
    So, a warm welcome to all of you. And we will start with 
Dr. Allan Meltzer, professor of political economy at Carnegie 
Mellon, and also visiting scholar at the American Enterprise 
Institute. He chaired the International Financial Institution 
Advisory Commission, known as the Meltzer Commission, and is a 
founding member of the Shadow Open Market Committee. He served 
on the President's Economic Policy Advisory Board and on the 
Council of Economic Advisers.
    Dr. Meltzer, you are recognized for 5 minutes.

 STATEMENT OF ALLAN H. MELTZER, GAILLIOT AND SCAIFE UNIVERSITY 
  PROFESSOR OF POLITICAL ECONOMY, TEPPER SCHOOL OF BUSINESS, 
                   CARNEGIE MELLON UNIVERSITY

    Mr. Meltzer. Thank you, Mr. Chairman. I welcome the 
opportunity to have this discussion. I think that you asked the 
right question: What can the Federal Reserve do better in the 
next century than what it has done in the past century? And the 
ranking member's questions about how far we have strayed from 
full employment and how slow we are getting back there, those 
are critical questions for our citizens.
    The Federal Reserve has some very good things about it. One 
of them is that in its 100 years, it is one of the few 
institutions of government that has never had a major scandal. 
That is quite an achievement, and it is one that we should, of 
course, welcome.
    It also has a number of blemishes. I am going to talk more 
about the blemishes, because those are the things that need 
correction.
    The 1913 Federal Reserve Act created an institution with 
very limited powers. President Wilson's compromise resolved the 
main political obstacle to passing the Act. The reserve banks 
became semiautonomous, controlled by their managements and 
directors. Boards of directors had the power to reject 
portfolio decisions. The Board in Washington had undefined 
supervisory responsibility.
    The United States was on the gold standard, limiting 
Federal Reserve actions to the requirements of that rule. In 
addition, the new system authorized reserve banks to discount 
commercial paper, banker's acceptances, and the like. The 
discounting operation was always at the initiative of the 
borrower. Also, the Act prohibited any direct purchases of 
Treasury debt.
    All of these restrictions ended long ago. The gold standard 
limped to an end in the 1930s. Discounting became an 
unimportant part of the Federal Reserve's activities, and a 
limited volume of direct loans to the Treasury replaced the 
prohibition. Far more important, reliance on open-market 
operations circumvented the prohibition on direct purchases of 
Treasuries.
    Currently, and for many years, the Federal Reserve has 
bought or sold unlimited amounts of Treasury securities in the 
marketplace at the time of the offering or at any subsequent 
time. The transformation occurred in many steps, many of them 
in response to major crises, especially the Great Depression, 
the Great Inflation, and the current prolonged recession and 
slow recovery, black marks on the Federal Reserve's record.
    Within months of Benjamin Strong's departure, Board Members 
gained influence. Later, the Banking Acts of 1933 and 
especially 1935 shifted power toward the Board by giving the 
Board a majority on the new Federal Open Market Committee and 
eliminating the power of reserve bank directors to decide on 
their bank's participation in open-market purchases or sales.
    During the Great Inflation, Congress amended the Federal 
Reserve Act by adding the so-called dual mandate. After the 
recent housing and financial crisis of 2007-2009, Congress 
approved the Dodd-Frank Act, containing hundreds of regulations 
on banks, as many as 400, according to some counts.
    Among the many new regulations is the use of Federal 
Reserve earnings to allocate credit toward consumers. The Fed 
had previously resisted credit allocation, but it will 
henceforth finance it out of its earnings without any right to 
decide on the allocation. This right is reserved to the 
Director of the consumer agency now embedded into the Federal 
Reserve Act. The Director does not report to the Chairman, nor 
to the Congress, nor to anyone else. And although the earnings 
that the Director uses would otherwise return to the Treasury 
as receipts, Congress does not vote on the allocation. 
Political decisionmaking is now unavoidable.
    This change is a startling reduction in the mandated 
independence of the Federal Reserve. Federal Reserve 
independence has often been compromised, but never before by 
act of Congress.
    Once Congress understood the importance of monetary 
expansion for employment, it took extraordinary effort and a 
strong Chairman to remain independent. Paul Volcker was an 
independent Chairman. Alan Greenspan also remained relatively 
independent. Others were willing to compromise. The current 
Federal Reserve has engaged in such nonmonetary functions as 
fiscal policy, debt management, and credit allocation.
    To sum up the evolution, I conclude that the Federal 
Reserve evolved under pressure of events and political 
responses to crises from independent agencies with constrained 
powers to become the world's major central bank with a nearly 
unrestricted ability to expand. It retains a vestige of 
independence, but it pays the price of much-reduced 
independence for its greatly expanded authority. Within the 
system, power has shifted from the reserve banks to the Board 
of Governors, and the reserve bank directors have a greatly 
diminished role.
    One of the great failures of recent years has been the 
failure of Congress to find an effective way of providing 
congressional oversight. This is a serious lack of 
responsibility. We have an agency which is increasing--has 
doubled and then redoubled the size of its balance sheet 
without any vote by the Congress to spend that amount of money, 
trillions of dollars. That is a mistake, a mistake by the 
Federal Reserve, but an even greater mistake by the Congress, 
because under Article I, Section 8--
    Chairman Campbell. Thank you, Dr. Meltzer. Time has 
expired. So if you have a sentence to sum up or--I think we get 
the point.
    Mr. Meltzer. Yes, I think the most important thing that the 
Congress could do to enhance its oversight and improve the 
performance of the Federal Reserve is to adopt a monetary rule, 
one which embodies the dual mandate necessary, but adopt a 
monetary rule--
    Chairman Campbell. All right.
    Mr. Meltzer. --a rule which would tell you whether they 
have done what they said they were going to do and whether you 
could correctly monitor them.
    [The prepared statement of Dr. Meltzer can be found on page 
79 of the appendix.]
    Chairman Campbell. Thank you. Thank you, Dr. Meltzer.
    Next, Dr. Marvin Goodfriend, who is also a professor at 
Carnegie Mellon, but a professor of economics, and he 
previously served as the Senior Vice President and Policy 
Advisor to the Federal Reserve Bank of Richmond, and also 
worked as a Senior Staff Economist for the White House Council 
of Economic Advisers. Dr. Goodfriend, you are recognized for 5 
minutes.

   STATEMENT OF MARVIN GOODFRIEND, FRIENDS OF ALLAN MELTZER 
  PROFESSOR OF ECONOMICS, TEPPER SCHOOL OF BUSINESS, CARNEGIE 
                       MELLON UNIVERSITY

    Mr. Goodfriend. Thank you, Mr. Chairman.
    I will speak today on lessons learned from a century of 
Federal Reserve last resort lending. My overarching message is 
that the constraints on the Federal Reserve's lending powers 
were loosened gradually over time, resulting in the 
distortionary and destabilizing implied promise of even more 
expansive lending in the future.
    The story starts in the Depression, when Congress was 
reluctant to expand the credit policy powers of the independent 
Fed beyond depositories and instead established the 
Reconstruction Finance Corporation to allocate credit widely to 
nonbank entities. So much has changed.
    But the Fed exhibited a tendency on its own to expand 
lending beyond short-term liquidity assistance to banks. For 
instance, in 1974 Fed lending supported the insolvent Franklin 
National Bank, and in 1984-1985, the Fed supported the 
undeclared insolvency of Continental Illinois Bank. Then, the 
Monetary Control Act expanded access to the Fed's discount 
window to all depositories in 1980, whether or not they were 
members of the Federal Reserve System.
    Anna Schwartz has documented a widespread tendency in the 
1980s for Fed lending to delay the closure of insolvent banks 
at taxpayer expense. In 1991, the Federal Deposit Insurance 
Corporation Improvement Act (FDICIA) famously acted to limit 
Fed lending to undercapitalized banks, although the law would 
be compromised by capitalization measured largely on a book 
rather than market valuation. Overlooked in FDICIA, however, 
was something more important: It amended Section 13(3) of the 
Federal Reserve Act to enable the Fed to lend widely to 
nonbanks for the first time in the Fed's history, as Alan 
Greenspan has written, granting virtually unlimited authority 
to the Federal Reserve Board to lend in unusual and exigent 
circumstances.
    Expanded Fed lending authorization unaccompanied by 
supervision and regulation would encourage the huge expansion 
of money market finance that fueled the credit boom. And in the 
2007-2008 turmoil, the Fed was put in a no-win situation. Given 
its wide powers to lend, the Fed could disappoint expectations 
of accommodation and risk financial collapse or take on 
expansive, underpriced credit risk, as Paul Volcker put it, 
with the implied promise of similar actions in times of future 
turmoil. The Fed chose the latter course of action, even 
allowing two major investment banks to quickly become bank 
holding companies so they could access the Fed discount window.
    In the 19th Century, the Bank of England followed Walter 
Bagehot's classic last resort lending advice, ``to lend freely 
at a high rate on good collateral,'' so as not to take on 
underpriced credit risk. The bank followed Bagehot's advice 
because the Bank of England was a private profit-maximizing 
institution whose shareholders earned the profit and bore the 
risk of loss.
    The Fed, however, is inclined to take on underpriced credit 
risk when worried that not doing so threatens a systemic 
crisis. Why? Because the Fed's own funds are not at stake. The 
fiscal authorities receive any Fed income after operating 
expenses, and taxpayers bear any Fed losses.
    Moreover, even when the Fed protects itself by taking good 
collateral, the Fed harms taxpayers if the entity to which the 
Fed lends fails with a Fed loan outstanding. Why? The Fed takes 
collateral at the expense of taxpayers exposed to losses from 
backstopping the Deposit Insurance Fund or from other financial 
guarantees that the government may have put in place. The 
bottom line is that fully independent Fed lending facilitates 
lending laxity and moral hazard.
    Fed credit policy works by interposing government 
creditworthiness, the power to borrow credibly against future 
taxes between private borrowers and lenders to facilitate 
distressed borrowers. Fed credit policy involves lending to 
private institutions with freshly created bank reserves or the 
proceeds from the sale of Treasuries from the Fed's own 
portfolio.
    To prevent inflation in the future, the Fed must reverse 
the reserve creation eventually by selling Treasuries from its 
portfolio or else the Fed will have to pay a market interest on 
reserves that is used to finance those credit policies. Either 
way, Fed credit policy involves the lending of public funds to 
particular borrowers, financed by interest-bearing liabilities 
issued against future taxes.
    In short, Fed credit policy is really debt-financed fiscal 
policy. The Fed returns the interest on its credit assets to 
the Treasury, but all such assets carry credit risk and involve 
the Fed in potentially controversial disputes regarding credit 
allocation. So credit policy is necessarily a political fiscal 
policy matter that ought to be handled by the fiscal 
authorities, not by the independent Fed.
    That said, in my view occasional Fed lending to solvent 
supervised depositories on short term against good collateral 
is protected against ex post losses and ex ante distortions, 
and so I believe the Fed should be given a degree of 
operational independence with respect to such circumscribed 
lending to depositories that it regulates.
    But Congress should insist that the Fed adhere to a 
Treasuries-only asset acquisition policy, except for such 
occasional lending. Moreover, I believe that any expansive Fed 
lending initiatives should be authorized by a committee of 
Congress before the fact, be done only as a bridge loan, and be 
accompanied by an explicit taxpayer takeout, which, of course, 
would deter the Fed from doing such things, except in 
exceptional circumstances. Thank you.
    [The prepared statement of Dr. Goodfriend can be found on 
page 69 of the appendix.]
    Chairman Campbell. Thank you, Dr. Goodfriend. Welcome back.
    Next, Mr. Alex Pollock, resident fellow at the American 
Enterprise Institute. He also serves as lead director of the 
CME Group, and was formerly the President and CEO of the 
Federal Home Loan Bank of Chicago. Mr. Pollock, you are 
recognized for 5 minutes.

    STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. Pollock. Thank you, Chairman Campbell, Ranking Member 
Clay, members of the subcommittee, and Chairman Hensarling.
    I think the most striking lesson of the 100-year history of 
the Federal Reserve is how it has been able from the beginning 
to inspire entirely unjustified optimism about what it can know 
and what it can accomplish. In contrast to the warm hopes of 
1913 and since, the Fed has not made financial disorders 
disappear, while it has often enough contributed to creating 
them.
    A high point of optimism about what discretionary 
manipulation of interest rates could achieve came in the 1960s, 
when economists actually came to believe in what they called 
``fine-tuning.'' The fine-tuning notion, ``turned out to be too 
optimistic, too hubristic, as we collectively learned,'' Fed 
Chairman Bernanke recently wrote. ``So,'' he continued, ``a 
little humility never hurts.''
    Indeed, the performance of the Federal Reserve at economic 
and financial forecasting in the last decade, including missing 
the extent of the housing bubble, missing the huge impact of 
its collapse, and failing to foresee the ensuing sharp 
recession certainly strengthens the case for humility on the 
Fed's part. The Fed is as poor at knowing the future as 
everybody else.
    So as Arthur Burns, Fed Chairman in the 1970s and architect 
of the utterly disastrous Great Inflation of that decade said, 
``The opportunities for making mistakes are legion.''
    Nonetheless, the 21st Century Federal Reserve and its 
economists again became optimistic and perhaps hubristic about 
the central bank's abilities when Chairman Greenspan had been 
dubbed ``the maestro.'' In the early 2000s, central bankers 
thought they were observing a durable ``Great Moderation,'' but 
the ``Great Moderation'' turned into the ``Great Bubble'' and 
the ``Great Collapse.''
    Then, the Dodd-Frank Act gave the Fed much expanded 
regulatory authority over firms deemed systemically important 
financial institutions, or SIFIs, in order to control systemic 
risk. But the lessons of history make it readily apparent that 
the greatest SIFI of them all is the Federal Reserve itself. It 
is unsurpassed in its ability to create systemic risk for 
everybody else. Who will guard these guardians, as the classic 
question goes?
    In 1927, the Fed's Benjamin Strong famously decided to give 
the stock market ``a little coup de whiskey.'' In our times, 
the Fed has decided to give the bond and mortgage markets a 
barrel of whiskey. This massive manipulation of government debt 
and mortgages has almost certainly induced a lot of new 
systemic interest rate risk into the economy, as well as a 
remarkable concentration of interest rate risk into the balance 
sheet of the Federal Reserve itself.
    Central banking is not rocket science. In fact, 
discretionary central banking is a lot harder than rocket 
science, because it is not and cannot be a science at all. It 
cannot make reliable predictions, and it must cope with 
ineluctable uncertainty and an unknowable future.
    I believe we can draw four lessons from this instructive 
history. One, we should have no illusions, in sharp contrast to 
the 100 years of illusions we have entertained, about the 
probability of sustained success of discretionary central 
banking, no matter how intellectually brilliant and personally 
impressive its practitioners may be.
    Two, we should try to implement Henry Thornton's classic 
advice from 1802, ``to limit the total amount of paper money 
issued, to let it vibrate only within certain limits, to allow 
a slow and cautious extension of it, as the general trade 
enlarges itself,'' in other words, to have the Fed focus on the 
medium- to long-term noninflationary or very low inflationary 
expansion of base money. The Fed is much more likely to succeed 
at this than in trying to manage the economy.
    Three, given that the Fed is the single greatest source of 
systemic risk, we should reconsider who should guard these 
guardians. Are there appropriate checks and balances, rather 
than a philosopher king-like independence? This includes the 
question of rules, the role of Congress, and as Allan Meltzer 
mentioned, the internal balance between the regional Federal 
Reserve banks and the Federal Reserve Board.
    Fourth and last, a serious 100-year review, as this 
subcommittee is undertaking, of the 6 mandates of the Federal 
Reserve make sense. It has been 78 years since the Fed was 
restructured by the Banking Act of 1935, 36 years since the 
Federal Reserve Reform Act of 1977, and 35 years since the 
Humphrey-Hawkins Act, which the ranking member mentioned, was 
enacted. A careful, rigorous, thoughtful review of the many 
difficult questions involved in governing the pure fiat 
currency, paper dollar, floating exchange rate world we have is 
certainly appropriate.
    Thank you.
    [The prepared statement of Mr. Pollock can be found on page 
97 of the appendix.]
    Chairman Campbell. Thank you, Mr. Pollock.
    Dr. Larry H. White is a senior scholar at the Mercatus 
Center and a professor of economics at George Mason University, 
and also serves as a member of the Financial Markets Working 
Group. He previously taught at the University of Missouri in 
St. Louis, and at the University of Belfast, and worked as a 
visiting scholar at the Federal Reserve Bank of Atlanta.
    I want to mention, before I forget, that without objection, 
all of your written statements will be made a part of the 
record. Also, I did fail to mention--as Dr. Meltzer mentioned 
that the Federal Reserve has had no scandals in its 100-year 
history, I want to point out that this body, the U.S. House of 
Representatives, has not had a scandal in the last week of 
which I am aware.
    [laughter]
    And so I don't know if that is equivalency, but I just 
thought I would mention that.
    With that, Dr. White, you are recognized for 5 minutes.

STATEMENT OF LAWRENCE H. WHITE, PROFESSOR OF ECONOMICS, GEORGE 
                        MASON UNIVERSITY

    Mr. White. Thank you, Chairman Campbell, Ranking Member 
Clay, and members of the subcommittee. Thank you for inviting 
me to testify.
    In my written testimony, I argue that the actions of the 
Federal Reserve during the financial crisis of 2007 to 2010 
abandoned the rule of law. That is, the Fed abandoned the 
principle that those in authority should execute the law as 
written, predictably and in accordance with established 
precedent. The Fed instead took arbitrary, ad hoc measures 
without clear statutory authority or precedent.
    The rule of law would have been a better guide to resolving 
the crisis and I think a better guide to helping us avoid 
future financial crises. So in enunciating this principle, I 
follow the historian and philosopher David Hume in affirming 
that the long-term benefits of consistently adhering to the 
rule of law outweigh the short-term convenience of ad hoc 
measures.
    Now, what measures am I talking about? You are all aware of 
the Fed's having created special purpose vehicles, the Maiden 
Lane, LLC, I, II and III to protect the bondholders of Bear 
Stearns by taking $30 billion of bad assets off of its books, 
thereby sweetening an acquisition deal for JPMorgan Chase to 
take over the remainder of the firm. It declined to do the same 
for Lehman Brothers, but it created two other vehicles to buy 
and hold bad assets from the failed insurance company AIG.
    There wasn't any precedent for this. There wasn't any 
apparent legal authority in the Federal Reserve Act for such a 
special purpose funding operation. That is well-known.
    Equally worthy of note, but not often noticed, is that the 
Fed in 2008 assumed the role of selectively channeling credit 
in directions that it favored. It began to lend funds to and 
purchase bad assets from an array of financial institutions it 
deemed worthy, going beyond the traditional scope of its 
lending to commercial banks. The Fed began lending to firms 
that do not participate in the payment system for the first 
time--well, not the first time, but the first time in recent 
memory, namely investment banks, primary dealers, broker-
dealers, and even mutual funds.
    These funds it lent, as other speakers have mentioned, 
weren't allocated to it by Congress. They were created by the 
Fed itself out of thin air, as they say, and in the amounts 
that the Fed itself decided. The total of the Fed's credits 
outstanding at the end of 2008 stood at over $1.5 trillion, 
more than double the size of the Treasury's bailout authority.
    Now, the Fed has an established role as a lender of last 
resort. What does that role involve? That role involves 
injecting cash into the system to keep the broader money stock 
from shrinking. It does not call for the Fed to inject capital 
into failing firms by overpaying for assets or by lending at 
below market rates, actions that, as Marvin Goodfriend said, 
put taxpayers at risk.
    The Fed's statutory authority to lend is actually limited, 
even in exigent circumstances, and was never meant to encompass 
the sort of capital injections that the Fed took in 2008 
through its Maiden Lane vehicles.
    Now, the Dodd-Frank Act properly places limits on this kind 
of lending, but in other ways, the Dodd-Frank Act enshrines the 
Fed's discretion to lend. It enshrines the too-big-to-fail 
doctrine, the application of which inherently involves 
arbitrary judgments. I think it thereby erodes the rule of law, 
increases the probability that taxpayers will be funding 
bailouts in the future, and it weakens the market discipline 
between risk and reward.
    In justification of these actions, the Fed during the 
crisis repeatedly invoked the lender of last resort rule, but I 
think in so doing, they were stretching the term beyond its 
proper meaning. The Fed, of course, conducts monetary policy. 
Lender of last resort should be thought of as an adjunct to 
monetary policy; that is, it is injecting enough cash into the 
system to keep the money supply from shrinking.
    It does not involve preferential credit allocation, which 
is what the Fed has gotten into. Subsidizing, papering over 
inadequate net worth, delaying the resolution of insolvent 
institutions, that has nothing to do with keeping the money 
supply from shrinking.
    So the lender of last resort rule doesn't require, and the 
traditional guidelines of Walter Bagehot that have been 
mentioned actually forbid, providing insolvent firms with 
capital injections or loans at below market interest rates. In 
fact, the lender part of the lender of last resort is actually 
an anachronism. As Professor Goodfriend mentioned, the Fed can 
inject cash without making loans to particular banks by 
purchasing securities, and it doesn't need to purchase 
securities from those banks. It can purchase Treasuries in the 
open market.
    The Fed claimed legal authority for its actions--
    Chairman Campbell. If you could wrap up, because your time 
has expired.
    Mr. White. --under 13(3) of the Federal Reserve Act, but I 
think even as amended, Section 13(3) did not convey unlimited 
or carte blanche authority.
    So, in conclusion, I think we should be concerned to 
prevent arbitrary credit allocation by the Federal Reserve, 
however well-meaning the Members of the Board undoubtedly are. 
Thank you.
    [The prepared statement of Dr. White can be found on page 
104 of the appendix.]
    Chairman Campbell. Thank you, Dr. White.
    There are three votes on the Floor right now, so we will 
recess the hearing for the moment. According to the people on 
the Floor, these votes should be over about at 2:50, and so we 
will return in about 30 minutes or so, and we will reconvene at 
that point, and continue with Dr. Gagnon and Dr. Bivens. So, 
the hearing is in recess.
    [recess]
    Chairman Campbell. All right. The committee will return to 
order. And we will continue with the testimony on the part of 
our witnesses. We will now turn to Dr. Joseph Gagnon, a senior 
fellow at the Peterson Institute for International Economics. 
He previously served as the Associate Director of Monetary 
Affairs at the Federal Reserve Board of Governors and as an 
Economist at the U.S. Treasury Department.
    Dr. Gagnon, you are recognized for 5 minutes.

    STATEMENT OF JOSEPH E. GAGNON, SENIOR FELLOW, PETERSON 
             INSTITUTE FOR INTERNATIONAL ECONOMICS

    Mr. Gagnon. Thank you, Chairman Campbell, Ranking Member 
Clay, and members of the subcommittee. I welcome this 
opportunity to testify.
    In my view, the Federal Reserve has performed at least as 
well over its first 100 years as could have been expected, 
given the powers it was granted and the evolving understanding 
of how the economy operates. The key to improving performance 
in the future is to give the Fed the tools it needs to do its 
job, to allow the Fed free reign in using those tools, to 
demand that the Fed explain its actions fully, and to hold the 
Fed accountable for any failure to achieve its objectives.
    My biggest worry is that the Fed faces more restrictions on 
its powers than any of the world's other major central banks, 
raising the risk that it may be unable to achieve its 
objectives at some time in the future. Under U.S. law, the Fed 
has been asked to foster a sound and stable financial system 
which will help to achieve its broader goals of full employment 
with low inflation.
    Historically, however, the Fed has had three major 
failures. First, the Fed did not have the tools to prevent a 
leveraged equity bubble in the 1920s, and it did not use its 
tools adequately to prevent the bursting of this bubble from 
causing the Great Depression. Second, through a protracted 
period of passivity in the late 1960s and 1970s, the Fed 
allowed inflation to ratchet upward to damaging levels. Third, 
through insufficiently aggressive use of its supervisory and 
regulatory authorities, the Fed allowed a leveraged housing 
bubble to develop in the 2000s, but it did a better job of 
responding to the ensuing crisis than it did in the 1930s.
    I group the lessons learned from Fed history into four 
categories: monetary objectives; monetary rules; policy tools; 
and emergency lending. On monetary objectives, I support the 
dual mandate. Experience shows that successful central banks do 
not focus solely on inflation, even if that is their only 
mandate. Stabilizing employment is a socially valuable 
objective in itself and it helps to stabilize inflation. Making 
the employment mandate explicit is an acknowledgement of 
reality that has benefits for credibility, transparency, and 
accountability.
    It might be helpful, but not essential, for political 
leaders to specify a numerical goal for inflation. We are all 
aware of the dangers of inflation that is too high. And the 
evidence is mounting of the harm from inflation that is too 
low. The target should not be set below 2 percent, and some 
believe that a slightly higher target would be beneficial, 
perhaps as high as 4 percent. I don't have a strong view on 
that, but I note that an average inflation rate of 4 percent in 
the late 1980s was widely viewed as a huge success.
    On rules versus discretion, it is not possible to design a 
policy rule that can allow for all contingencies. The best 
strategy is for the Fed to use various rules in assessing the 
stance of policy. Whenever it deviates noticeably from popular 
rules, the Fed should explain clearly why it is doing so.
    The difficulty of using policy rules is highlighted by the 
experience of the past 5 years, when some proposed rules called 
for large negative interest rates that are not technically 
feasible. The Fed's response was to engage in quantitative 
easing, or QE, an unconventional policy that was not 
contemplated by the existing policy rules.
    My own call for more QE back in 2009 was based on the fact 
that the Fed did not forecast a return to full employment and 
target inflation within 3 years. Looking forward over the next 
3 years, there still seems to be some room for easier Fed 
policy, but the case is less strong than it was back in 2009.
    On policy tools, I note that of the world's major central 
banks, the Fed faces the greatest restrictions on its powers. 
It can buy only government- and agency-backed debt. Other 
central banks can buy corporate debt, equities, and even real 
estate. As long as there is sufficient transparency and 
accountability, there is no reason to restrict the Fed's 
ability to achieve its mandate. I note that the Bank of Japan 
is buying broad baskets of Japanese equity and real estate as 
part of its fight against deflation.
    Another important tool is the ability to impose loan-to-
value limits and/or debt-to-income limits on consumer and 
business loans. Strict lending limits kept the equity bubble of 
the 1990s from causing excessive damage when it burst in 2000. 
We need to make it easier for the Fed to impose similar limits 
on leverage in real estate. We also need higher capital 
standards for banks.
    Finally, on lender of last resort, during the recent crisis 
the Fed made emergency loans to specific institutions, which 
attracted considerable criticism. Yet, the Fed was scrupulous 
in requiring sufficient collateral on its loans, as evidenced 
by the fact that all of its loans were fully repaid at a profit 
to the taxpayer.
    The new limit on the Fed's ability to make emergency loans 
raises the risk of disorderly failures in the future. And it is 
not clear how much of this risk is offset by the advanced 
resolution plans that are now required of large-scale financial 
institutions.
    Thank you. This concludes my opening remarks.
    [The prepared statement of Dr. Gagnon can be found on page 
57 of the appendix.]
    Chairman Campbell. Thank you, Dr. Gagnon.
    And last but not least, Dr. Josh Bivens is research and 
policy director at the Economic Policy Institute and conducts 
research on macroeconomics, globalization, social insurance, 
and public investment. Dr. Bivens, you are recognized for 5 
minutes.

    STATEMENT OF JOSH BIVENS, RESEARCH AND POLICY DIRECTOR, 
                   ECONOMIC POLICY INSTITUTE

    Mr. Bivens. Thank you. I would like to thank the members of 
the subcommittee for the invitation to testify today. I have 
submitted written testimony for the record.
    The year of the 100th anniversary of the Federal Reserve 
would always be an appropriate time to assess its role in the 
American economy, and the current swirl of questions 
surrounding its conduct in the wake of the Great Recession 
makes it especially so.
    I am going to make essentially five quick arguments today. 
First, the economy remains far from fully recovered from the 
Great Recession, and the obvious barrier to this full recovery 
is clearly deficient aggregate demand for goods and services.
    Second, this demand shortfall has been aggravated in recent 
years by too contractionary fiscal policy.
    Third, given this demand shortfall and given this 
contractionary fiscal policy, the Fed's current efforts to 
boost economic activity and employment through unconventional 
monetary policy are entirely appropriate and talk of reducing 
the extent of this economic boost, or tapering as it is sort of 
called in the popular press, is clearly premature.
    Fourth, the lessons of the burst housing bubble and the 
consequent Great Recession for the Fed should be that: one, it 
is crucial to keep asset market bubbles from inflating in the 
first place; and two, we cannot rely solely on conventional 
monetary policy to return the economy to full employment after 
they burst.
    This unique episode again illustrates that monetary policy 
has to balance too many competing demands and will encounter 
too many contingencies over any window of time to make very 
simple, tailored rules the optimal policy.
    And fifth, as the Fed in the future becomes a hopefully 
more vigilant financial regulator, it should follow the 
complete version of what are often referred to--and people on 
the panel have referred to it--the Bagehot rules, should lend 
freely during a crisis, but at a penalty rate against 
collateral that is valuable during noncrisis times, and only to 
fundamentally solvent institutions.
    And to be clear, I find little to fault with how the Fed 
managed the crisis of 2008-2009. I think it was balancing many 
things. We were not well-prepared for such a financial crisis. 
And it chose the path that would support economic activity and 
employment, even at the expense of perhaps giving some 
financial aid to specific financial institutions that engaged 
in too many excesses. That said, we should be better prepared 
for next time. Hopefully, the Dodd-Frank legislation has, 
indeed, made us better prepared for next time.
    To expand just a little bit, as of June 2013, a full 4 
years after the official end of the Great Recession, the gap 
between actual economic output and what could be produced if 
all productive factors were fully utilized is nearly $900 
billion in annualized terms. This is $900 billion of pure 
economic waste that persists because we have not engineered a 
full recovery from the Great Recession.
    This output gap is mostly driven by deficient aggregate 
demand. And, again, that has been aggravated in recent years by 
contractionary fiscal policy. Given this, it is premature to 
argue the Fed should begin tapering its own support for the 
economy.
    There has been a lot of uncertainty about the estimates of 
how much the Federal Reserve quantitative easing programs have 
boosted the economy over the past couple of years. It is 
important to realize that none of the estimates say it has 
damaged economic activity or employment growth over that time. 
There may be considerable uncertainty about just how much it 
has boosted this activity, but it is important to realize that 
it has boosted it and the economy has needed a boost.
    Trying to engineer a recovery using just monetary policy 
when fiscal policy is going in the wrong direction is far from 
optimal, but flying an airplane on one engine is a lot better 
than zero.
    Lastly, the source of the Great Recession is as clear as 
day: There was an $8 trillion bubble in home prices that formed 
and then burst. The Federal Reserve and all other macroeconomic 
policymakers were far too reluctant in the run-up to that 
bubble to deflate it before it formed to such damaging levels, 
and they were too confident in their ability to use 
conventional monetary policy, short-term interest rate cuts to 
neutralize its effects when it burst.
    These lessons should be heeded. In going forward, the Fed 
needs to be willing to intervene to keep destructive financial 
sector excesses from providing tinder for another crisis, and 
it has a greatly expanded menu of tools to do this, with 
legislation that has passed since the crisis, and not least of 
which is simply public comment. We all have seen recently, for 
good or bad, that just public comment on the part of Fed 
officials can move financial markets. It should be cognizant of 
this power. And it should use it to deflate destructive asset 
market bubbles before they reach crisis levels. They should be 
willing to use these new tools in the future.
    Thank you. I would be happy to answer any questions the 
subcommittee may have.
    [The prepared statement of Dr. Bivens can be found on page 
42 of the appendix.]
    Chairman Campbell. Thank you so much, Dr. Bivens.
    I will now recognize myself for 5 minutes for questioning. 
And I have in this 5 minutes just one question, which I will 
ask all of you to answer, and then in the second round, I will 
have a second question for all of you, because I am sure we 
will be able to do a second round here.
    My first question--and I will go in reverse order. We will 
start with you, Dr. Bivens, and go down this way. Is the 
Federal Reserve today more or less independent than it was at 
its founding or somewhere near its creation? And is it more or 
less independent in your judgment than it ought to be? Dr. 
Bivens?
    Mr. Bivens. On the first question, more or less independent 
than at its founding, I am afraid I am going to have to defer 
to experts. My sense is, it is an independent institution. That 
independence means being willing to break the economy when it--
or to break economic growth when it is going too fast and 
threatening inflation, but it also means having the freedom to 
reflate the economy when in the Fed's judgment that is what is 
needed. I think it retains that independence today, and so I 
think the idea that it has become too tied to the winds of 
other economic policymakers is not a criticism I endorse.
    Chairman Campbell. So in your opinion, its independence is 
proper at the current time?
    Mr. Bivens. That is correct.
    Chairman Campbell. Adequate.
    Mr. Bivens. Thank you.
    Chairman Campbell. Dr. Gagnon?
    Mr. Gagnon. Yes, I would agree that its independence is 
proper. Having worked there, I was always quite struck--and I 
worked in other parts of the government as well--by how 
independent the Fed really is. Throughout almost all the 
process of decision-making, it is only thinking about what is 
right and any thought about political influence is very small, 
as far as I could tell.
    Chairman Campbell. From a historical perspective?
    Mr. Gagnon. From a historical perspective, I think at the 
founding of the Fed until the 1930s, independent, well, it was 
certainly independent from Washington. It may have been too 
independent and too closely tied to regions of the country and 
the banking industry, and I think that was changed, 
appropriately so, in the 1930s to give it more control from 
Washington.
    And yet the balance was struck right, because you have 
these long fixed terms, even though they were appointed by 
Washington. They then had the freedom to go out and, without 
short-term pressure, do what they think is in the national 
interest.
    Chairman Campbell. Dr. White?
    Mr. White. There are at least two meanings of independence. 
One is that the Fed gets to choose its own goals, and the other 
is that the Fed gets to choose its own operations, but given a 
set of goals. When the Fed was founded, it was understood that 
the gold standard would constrain the monetary system, so the 
Fed's independence to set its own goals was very limited.
    That, of course, has changed. There is no longer that kind 
of constraint on the Fed. We have gone from a gold standard to 
a PhD standard. That is how monetary policy is made these days.
    I think the Fed is probably too independent. I think it 
should be accountable. And to the extent that is at variance 
with independence, understood as they get to choose their own 
goals, then I am in favor of less independence for the Fed.
    Chairman Campbell. That is a fascinating concept which 
deserves more delving into, but, Mr. Pollock?
    Mr. Pollock. Thank you, Mr. Chairman. The Fed in the 
beginning was a complicated balancing of a lot of interests--
the political board that Woodrow Wilson insisted on, the 
bankers in the regional banks, and the Secretary of the 
Treasury who was, under the original Act, ex officio a Member 
of the Board.
    Throughout the history of the Fed, there have been cycles 
of being more or less independent. During the Second World War, 
the Fed was completely unindependent. It was entirely the slave 
of the Treasury, and the purpose was to finance the war. That 
happens in wars.
    William McChesney Martin, the longest-serving Chairman, the 
one who has the best record on average inflation in the postwar 
era, used to talk about ``independence within the government,'' 
by which I guess he meant independent, but not quite. And by 
the end of his term, he was giving way to the politicians to 
let inflation rise to finance the combined Johnson social 
initiatives and war.
    So if anything, I think when you look at the Fed, it is a 
good example of the constant debate between philosopher kings, 
as in Plato, and checks and balances, as in the theory of 
republics.
    Chairman Campbell. Okay, I need to--
    Mr. Pollock. We need to address that balance.
    Chairman Campbell. Dr. Goodfriend?
    Mr. Goodfriend. I would concur that the gold standard 
constrained the Fed early on. And the gold standard is no 
longer with us. So in that sense, the Fed was less independent, 
and I think appropriately so.
    The 14-year terms for Board of Governors officials meant a 
lot more in the early days, when the pay meant that people 
could stay for 14 years. One of the striking things about 
Federal Reserve Board Members these days is that they stay 
something like 3 or 4 years. I really don't know the exact 
number. And that means there are more chances for appointments 
by politicians. In that sense, I think the Federal Reserve 
Board has become a lot less independent than it was in the 
early days.
    I would also add a couple of things. The discussion of the 
Chairman's succession also indicates that the personality of 
the Chairman has a lot more discretion these days than it used 
to. In the old days--maybe Allan Meltzer can tell me 
otherwise--I doubt the whole country would be focused on who 
became the Fed Chairman. These days, it is indicative to me of 
the idea that there is a lot of discretionary that has been 
piled in.
    In that sense, the Fed is more independent, but 
inappropriately so. As I would say, based on my testimony, the 
Fed's power should be restricted so that it isn't doing--
    Chairman Campbell. Okay.
    Mr. Goodfriend. --fiscal policy of Congress--
    Chairman Campbell. Okay. I am going to run a little over, 
but don't worry, I will give an equal amount of time to you, 
Mr. Clay, so we keep it even here. But just so Dr. Meltzer 
can--and we can get all six on this.
    Mr. Meltzer. In the best academic tradition, I am going to 
give you two answers. Politically, the Fed is less independent 
than it was in 1913-1914. As an example, President Wilson would 
not invite Board Members to White House parties because he 
didn't want to influence them. There was really a very close, 
very distant separation of the board from the political system.
    But in another sense, the Fed is completely unrestrained. 
It has quadrupled the size of its balance sheet. And the 
failure there is, I believe, as I said in my testimony, a 
failure by Congress to monitor, control, and limit what the 
Fed--it is your responsibility under Article I, Section 8, to 
decide what the monetary policy of the United States is. The 
Fed is your agent, and you don't have a very effective means of 
regulating your agent.
    Chairman Campbell. Okay--
    Mr. Meltzer. And let me just say one last thing. In a year 
in which the Fed finances 75 percent of the U.S. Government's 
borrowing, how can we think of the Fed as independent of the 
political process?
    Chairman Campbell. Thank you, Dr. Meltzer.
    I now recognize Mr. Kildee. Because we started the hearing 
early, he wasn't able to get here for his opening statement, so 
he is going to be recognized for 8 minutes, which gives him the 
opportunity to give an opening statement and then proceed to 
ask you all questions and divide that 8 minutes in whatever way 
he would like.
    The gentleman from Michigan is recognized for 8 minutes.
    Mr. Kildee. Thank you, Mr. Chairman, and thank you to Mr. 
Clay for allowing me to step in and for allowing me to sit 
here. It is probably not something I am going to experience for 
quite some time, but I enjoy the chance.
    Chairman Campbell. These seats aren't any different, you 
may have noticed.
    Mr. Kildee. They are not? All right.
    Chairman Campbell. They are not that special.
    Mr. Kildee. Well, that one is.
    So I will make some opening comments, and I will refer back 
to the first two instances when I served here, when the 
Chairman of the Federal Reserve came to address us, and ask you 
to comment, particularly a couple of you to comment on some 
questions that I have around the strength of America's 
municipal governments and their effect on what is a significant 
part of the Fed's dual mandate, the effect on the economy, 
particularly on employment.
    It is interesting that this hearing, of course, marks 100 
years. And when you think back to the period when the Federal 
Reserve was initiated, I think about America's great cities. I 
am from Flint, Michigan. Some of you might be familiar with 
that place, the birthplace of General Motors.
    But when I think back to 100 years ago, GM was 5 years old. 
Many older industrial cities in the United States were really 
just beginning to get their legs under them and were about to 
experience an unprecedented period of growth and expansion. We 
became a highly productive society, and somewhere along the 
way, most point to around the 1930s, 1940s, we began to see the 
tremendous productive capacity of our society also begin to 
deliver pretty significant wages to the workforce, creating a 
growing and really significant middle class in the United 
States.
    In my own hometown, interestingly enough, about the time 
that the dual mandate was recognized and initiated by Congress, 
it was about the peak employment for the auto industry. And you 
could point to that period roughly for a lot of the larger 
industrial communities, older industrial communities in our 
country.
    The reason I lay that preface is that when Mr. Bernanke was 
here--and I would ask some of you to comment on this--I pressed 
the question of whether or not the sustainability of these old 
industrial cities has any implications for the mandate of the 
Fed and whether or not the Fed itself, either through advice or 
through policy, could address what is, I think, a growing 
problem of inequality.
    And I reference--and, Dr. Meltzer, you mentioned two 
answers to one question. It is a common theme. What I have 
seen, what we witnessed in this country for many American 
cities is that during the periods--particularly recently--of 
great economic expansion, significant economic expansion, for 
example, in the 1990s, many older American cities were left 
behind.
    And so we had this situation where much of the country was 
doing extremely well, with unemployment at relatively low 
levels, with wages at reasonable levels, with productivity 
growing, but some significant parts of America, some of which I 
represent, were not doing well at all and, in fact, didn't 
participate in any of that growth in economic expansion.
    So from an economist's point of view, one might say that 
some parts of the country were doing very well, a few parts 
were not doing very well at all, but on average, the country 
was doing just fine. And so what I want to ask you, first--and 
if I could start with Mr. Gagnon and Mr. Bivens, but also ask 
others to comment on whether or not you think the Federal 
Reserve has any interest or role in helping municipal 
governments.
    There had been a point in time not too long ago when I know 
there was some consideration for playing a role in stabilizing 
municipal governments by offering or considering the 
development of a credit facility to finance municipal 
securities, for example. And if you could just--not just so 
much on that, but comment on whether or not you think somewhere 
in the charge to the Federal Reserve is an interest in 
municipal governments.
    And I will just preface one more thing. When I asked Mr. 
Bernanke, he said, well, the Fed historically has not become 
involved, nor the Federal Government involved in the issue of 
municipal insolvency. And I just pointed out that there are 
many things about which we could say the Federal Reserve had 
not been involved or the Federal Government had not been 
involved until a need arose to do so.
    If I could start with Mr. Bivens, Mr. Gagnon, and then if 
others would like to comment, I would appreciate it.
    Mr. Bivens. As to whether there is active interest at the 
Fed in this, I don't know. Whether or not they are--what I 
guess the Fed would say on this is a couple of things.
    I think they would say, one, if you look at distressed 
municipalities around the United States, the number-one thing 
that can help them is a better national economy and a lower 
unemployment rate across-the-board, and they would say they are 
working hard on that, and I tend to largely agree with that. I 
think the Fed right now is, indeed, trying to boost the overall 
economy, and is, indeed, trying to boost employment growth, and 
presumably that should have some good spillover effects even to 
specific municipalities.
    I would say--and I think they are right on this, as well--
that they would say that the problem with a lot of 
municipalities, say, the ones that are entering financial 
crises is that there is a real fundamental mismatch between 
revenues and outlays in those cities. It is not necessarily a 
malfunctioning financial market. If it was a malfunctioning 
financial market, the Fed might really have a role in making 
sure it is well-greased. If you are talking about a fundamental 
mismatch between revenues and outlays, I think the argument 
would be, those are much better addressed by fiscal transfers, 
and I know politically the prospects for that are pretty low 
these days, but it is the most direct and genuinely helpful way 
that could be done.
    And then last thing I would also say that I think you have 
to look at other aspects of economic policy, in terms of 
hitting really distressed municipalities. And I would talk 
about international trade policy. Detroit specifically has been 
hammered by the decline in manufacturing employment, which to 
me, in the 2000s, was overwhelmingly a problem of an overvalued 
dollar, and I think that gets beyond the Fed's mandate into 
exchange rate policy.
    Mr. Kildee. Mr. Gagnon?
    Mr. Gagnon. Yes, I think--having worked inside the Fed, I 
think the reluctance you probably heard from Chairman Bernanke 
reflects a desire to think of Fed policy as only things that 
affect the entire country as equally as can be, and that if one 
gets into municipal lending, then one eventually, inevitably, 
gets into decisions about who is more creditworthy and how do 
you make that equal, and that gets to be politically difficult 
for the Fed.
    I think you could say, well, what about the emergency loans 
to Wall Street firms? Didn't that help New York? And I think 
the only thing in response I could say is the Fed felt that a 
breakdown of the financial system would have hurt everybody and 
they got collateral for those loans. And I don't know what kind 
of assurance the Fed could get in municipal loans that would be 
comparable to--the Fed was made whole in those loans in the 
crisis from the collateral, which I don't know how that would 
work.
    Mr. White. Yes, I would agree with Dr. Bivens. It is a 
fiscal policy issue. It is not appropriately charged to the 
Fed. They are--some people think the Fed can just create 
loanable funds, but if the Fed is directing credit one place, 
it is necessarily reducing the supply available elsewhere, and 
that is not the sort of call the Fed should be making.
    Chairman Campbell. The gentleman's time has expired. We 
will now move from one part of Michigan to another part of 
Michigan, as we will go to the vice chairman, Mr. Huizenga. You 
are recognized for 5 minutes.
    Mr. Huizenga. Thank you, Mr. Chairman.
    And, yes, it is true, I get the pretty sunset side of the 
State, not that the east side isn't a great spot. My mother is 
from Flint, as well, but--it is a great place to be from, the 
gentleman just said, so, but--no, we are--the pure Michigan ads 
are true. Come on up. We would love to see everybody up there.
    So I want to--before I turn into a total infomercial, I 
would like to actually return to our policy question here. And, 
Dr. Gagnon, I would like to--I have a quick question for you. 
On page seven, there is sort of your discussion about the Fed 
and the rule and quite a bit of discussion about the Taylor 
rule and the Svensson rule.
    And after one of the recent FOMC meetings, President 
Bullard from the St. Louis Fed, whom I believe has been in 
front of our committee, the full Financial Services Committee, 
argued that the FOMC has not stuck to its intermediate target 
guidance. As Professor Svensson noted, forecast targeting is 
meaningless without some sort of mechanism for commitment to an 
optimal rule.
    Obviously, Chairman Bernanke feels a little differently. He 
has argued that his guidance is ``similar'' to the Svensson 
approach. But isn't it really true that Chairman Bernanke isn't 
following a real meaningful forecast or targeting rule, like 
the one advocated by even Professor Svensson?
    Mr. Gagnon. Yes, I would say the thing about the Svensson 
rule is that you should set your policy so that you should hit 
your target. And at a minimum, you should hit your target in 
your own forecast, but that is obviously a low bar. The Fed 
isn't even hitting that. The Fed is--
    Mr. Huizenga. Yes, which I think you point out on page 
eight. So basically, they are not operating under a rule, as 
you--
    Mr. Gagnon. Under that rule or--yes, that is right. And 
other forecasters would agree.
    Mr. Huizenga. Okay. Mr. Bivens, you were nodding your head, 
as well. Would you care to chime in on that? And I would love 
to hear from everybody else.
    Mr. Bivens. Yes, from my perspective, I think they are 
missing any conceivable unemployment target, in terms of 
unemployment is too high for any reasonable target, and they 
are missing inflation on the low side. Inflation is too low for 
their target.
    And so that to me says, when you are missing on both sides 
like that, it definitely says you should not be talking about 
tapering off support to the economy, because that is just going 
to make them miss worse on both sides.
    Mr. Huizenga. I am not trying to argue whether we need more 
easy money or less easy money. I am trying to get at, are they 
actually operating under a rule? Because it seems to me, not 
really.
    Mr. Bivens. I think that is fair to say, yes.
    Mr. Huizenga. Okay, all right. Would anybody else care to 
chime in on that quickly?
    Mr. Meltzer. I agree with you, that is, they are not 
operating under a rule--
    Mr. Huizenga. Dr. Meltzer, if you wouldn't mind just 
pulling that microphone a little bit closer to you?
    Mr. Meltzer. There were only two periods in Federal Reserve 
history where they came close to operating under a rule. They 
happened to be the two best periods in Fed history: 1923 to 
1928; and 1985 to 2003. In the first case, they operated under 
some form of the gold standard; in the second, under the Taylor 
rule, more or less, not slavishly, but more or less. And those 
were the two, the only two periods in the Fed history that have 
low inflation, relatively stable growth, small recessions, and 
quick recoveries.
    Mr. Huizenga. And so I am assuming, based on that answer, 
you would advocate that it would be a good idea for the Fed to 
get a rule? We can talk--
    Mr. Meltzer. I believe--
    Mr. Huizenga. --Svensson rule, Taylor rule, PhD rule, some 
sort of rule, though, that is predictable and able to hit.
    Mr. Meltzer. Any rule that the Congress can agree on and 
monitor. That is important.
    Mr. Huizenga. A key element, it seems.
    Mr. Meltzer. A key element is not only to bind them to 
doing sensible, consistent things that everyone can understand, 
but also to get you, the Congress, to say, look, you told us 
that we would have this inflation and that unemployment and you 
haven't done it. That is a statement you can make which is very 
consistent with your authority and responsibility for 
monitoring the way the monetary system works.
    Mr. Huizenga. I am not sure most people would accept 
``sensible'' and ``Congress'' all in the same sentence, but I 
appreciate those sentiments. Anybody else, quickly here in the 
last 30 seconds? Mr. Pollock?
    Mr. Pollock. Congressman, I might just add that the 1977 
rule, which is usually called the dual mandate, which has been 
referred to, is, in fact, a triple mandate. If you simply read 
the letter of the law, it was stable prices, which we don't 
have, maximum unemployment, and moderate long-term interest 
rates, that third mandate from Congress. I think it is 
impossible for the Fed to do all three, but Congress did tell 
them to do all three.
    Mr. Huizenga. Okay.
    And, Mr. Goodfriend, very quickly?
    Mr. Goodfriend. Very briefly, if you go back to May 22nd, 
when Chairman Bernanke hinted, I think somewhere on Capitol 
Hill, at a Joint Economic Committee meeting, that they would 
consider a taper, you saw a tremendous surprise in markets, as 
if it came out of nowhere. The 10-year yield jumped 1 
percentage point within a month. That is evidence that the Fed 
is not following a rule, because--by virtue of the fact that it 
was a discretionary rhetorical action that Bernanke took that 
just was not understood by anybody.
    Mr. Huizenga. So, basically, we need to smooth out the 
edges and a rule can do that?
    Mr. Goodfriend. A rule would tend to mitigate surprises and 
basically give you outcomes for which people could plan.
    Mr. Huizenga. All right. Thank you, Mr. Chairman.
    Chairman Campbell. Thank you.
    And now we will get back to regular order, and we will 
recognize the ranking member, but he gets an extra 2 minutes, 
because I took an extra 2 minutes, so we will give him 7 
minutes. The gentleman from Missouri, Mr. Clay, is now 
recognized for 7 minutes.
    Mr. Clay. Thank you, Mr. Chairman, especially for your 
generosity.
    This is a panel-wide question. Currently, the U.S. 
unemployment rate is 7.3 percent, the lowest level in 5 years. 
Currently, the unemployment rate for African-American citizens 
stands at 13 percent in August. This is an increase of 
unemployment rate from 12.6 percent in July. The difference in 
the U.S. unemployment rate and the African-American 
unemployment rate is 5.7 percent.
    Studies have shown communities with high unemployment rates 
have a higher crime rate compared to communities with low 
unemployment rates. Do you believe high unemployment rates are 
at least a national issue? And what course of action do you 
believe the Federal Reserve Bank should take to lower the 
higher than average unemployment rate in African-American 
communities and in other high unemployment rate communities 
throughout the United States?
    I will start with Dr. Bivens.
    Mr. Bivens. I absolutely think that the excessively high 
unemployment rate in the U.S. economy right now is our biggest 
economic challenge. I think from the point of view of the 
Federal Reserve, the main thing they can do to bring it down, 
both overall and for groups that have disproportionately high 
unemployment rates, is to continue what they are doing in terms 
of asset purchases to boost economic activity and jobs.
    That is what they are trying to do with their monthly 
purchases. They are trying to keep long-term rates low. They 
are trying to ensure that demand does not fall so low that we 
see that unemployment rate tick up even further. I would like 
to see them continue it. I would actually even like to see them 
be a bit more aggressive on that front. I think they are 
greatly hampered by the fact that fiscal policy has gone in 
absolutely the wrong direction and is dragging on growth.
    So, in my view, of all the economic policymaking 
institutions right now that seem most concerned with keeping 
that unemployment rate low, the Federal Reserve seems to be the 
one that is most concerned with that.
    Mr. Clay. And you don't think the banks should raise the 
interest rates?
    Mr. Bivens. No.
    Mr. Clay. Thank you.
    Dr. Gagnon?
    Mr. Gagnon. Yes, I would agree with Dr. Bivens. I think, to 
the extent that the Fed can bring down the total unemployment 
rate, I suspect the African-American rate will come down 
proportionately more. And I think that is the right--that, to 
me, is also job number one for economic policy in this country. 
And I agree that the Fed does seem to be focused on it more 
than almost anyone else, but I don't think they are doing 
enough.
    I think they are too concerned about the potential costs of 
quantitative easing tools, which to me are quite low. Those 
costs are quite low and the benefits are quite high, so I don't 
quite--I don't think they are getting the balance right, but at 
least they are worried about it.
    Mr. Clay. Dr. White?
    Mr. White. Yes, we have had a very slow recovery, and so 
unemployment has not dropped the way it normally does in a 
recovery. We are many months behind where we would normally be, 
in terms of unemployment coming down.
    And it is not clear that looser monetary policy would help 
speed the process. I think a large part of the problem is that 
investment is sitting on the sidelines. There needs to be 
greater regime certainty, greater tax certainty, greater 
monetary policy certainty, so that the investment climate 
becomes more favorable, and that will be helpful to economic 
growth and, thereby, bring down unemployment.
    Mr. Clay. So you contend that some of the reason is market-
driven?
    Mr. White. Yes.
    Mr. Clay. Okay. Mr. Pollock?
    Mr. Pollock. Thank you, Congressman. I think the best thing 
any central bank can do for employment is a medium- to long-
term stability in monetary behavior and stability in prices. I 
think managing short-term economic consequences, such as the 
ones you have mentioned, is beyond the competence of a central 
bank.
    Mr. Clay. And so what effect would raising the interest 
rates have on it? Do you think it would have any effect?
    Mr. Pollock. We have extraordinarily low interest rates, of 
course, negative real interest rates, extremely low long rates. 
That is due to the current manipulation of the markets by the 
Fed. At some point, those rates have to return to normal. That 
would be healthy, again, in a medium- to long-term basis.
    What gets the Fed or any central bank in trouble, in my 
opinion, is trying to react all the time to short-term 
conditions, which it can't know enough about or influence 
enough to do successfully.
    Mr. Clay. Thank you for that response.
    And Dr. Goodfriend?
    Mr. Goodfriend. What I would add to these comments is that 
the Federal Reserve doesn't really control the interest rates 
that matter, which are the long-term interest rates. I get back 
to the comment I said before. What is happening is, markets are 
looking forward 10 years to figure out what is likely to 
happen. So it is kind of, I think, a little bit of an illusion 
to think that the Fed is having a big effect on long rates.
    It was able to appear that the Fed had an effect on long 
rates when the recession started. Now that we are moving toward 
the exit, when we look out 2 or 3 years, the market is already 
projecting what is likely to happen. So I think this is largely 
superfluous, unless you want to argue that the Fed should 
continue to keep short rates so low as to create some sort of 
inflation problem in which long rates would go up even more.
    In other words, the Fed does not, I believe, have a lot of 
leeway to have much effect either way, except being excessively 
inflationary. What it is doing now is basically treading water.
    Mr. Clay. And, Dr. Goodfriend, why has the economy had such 
a difficult time in growing jobs?
    Mr. Goodfriend. Job growth is based in part on two things: 
people need to spend; and then people need to invest. And it is 
clear that the spending--people's willingness to spend in the 
future, among those people who have the money to spend, is they 
are not willing to really gear it up. Why? Because the people 
who have the money to spend are worried about higher future 
taxes, and they are basically keeping their powder dry.
    So one thing we need to do on the spending side is put--I 
believe simplify the tax code so that people who have the money 
are not going to be penalized for having more money in the 
future. And then they might begin to spend some of it. And on 
the other side, they might be willing to invest to increase 
jobs, and you get both job growth and spending going in tandem, 
and then you have a good recovery.
    What is impeding that is that there is an open-ended 
question about how high taxes might stay or even go higher in 
the future.
    Mr. Clay. Thank you. And my time is up.
    Chairman Campbell. Thank you, Mr. Clay.
    We will move now to the gentleman from South Carolina, Mr. 
Mulvaney. You are recognized for 5 minutes.
    Mr. Mulvaney. Thank you, Mr. Chairman.
    And thank you, gentlemen. I am going to go down a line of 
questions that I didn't anticipate doing before the gentleman 
from Michigan, Mr. Kildee, asked his questions, because I think 
he was asking the questions around the fringes of an issue that 
I want to explore.
    His questions pertain to the advisability, perhaps, of the 
Federal Reserve getting involved in helping some of America's 
financially struggling cities. It is something I know that is 
certainly near and dear to his heart, and perhaps rightly so, 
but let me ask it a different way. Does the Federal Reserve 
have the authority to do that? Do they have the authority to 
bail out cities, to bail out States? Dr. Gagnon is saying yes. 
Why is that?
    Mr. Gagnon. I am not recommending it. I am just saying the 
powers--
    Mr. Mulvaney. I am not interested in recommendations. I am 
interested in whether or not the Fed actually has the legal 
authority to do that and, if so, what would it look like?
    Mr. Gagnon. The Fed has the legal authority to buy 
municipal debt up to 6 months' maturity.
    Mr. Mulvaney. And that would be directly or that would be 
on the secondary market?
    Mr. Gagnon. Oh, in secondary markets, but that would 
presumably help conditions in the primary market.
    Mr. Mulvaney. All right. Now, when I asked that question of 
Dr. Bernanke at a previous hearing, he said that he didn't have 
the authority to bail out cities, and then he mentioned the 
exact same thing, that he could only buy 6-month debt. So help 
me reconcile those two statements, gentlemen. Don't everybody 
jump up at once.
    Dr. Meltzer?
    Mr. Meltzer. Yes, it has to be debt which is not in 
default, which is highly rated. It is just the opposite. He can 
buy short-term debt from cities as part of his open-market 
operations, but he can't finance cities which are on the verge 
of bankruptcy.
    Mr. Mulvaney. Because it wouldn't meet the credit 
requirements?
    Mr. Meltzer. Because he would be taking a market risk that 
was not intended to be taken by the Federal Reserve. He has 
to--as some of the witnesses here have said, he was very 
careful about seeing that what he did when he was lending was 
always collateralized safely, protecting the taxpayers from 
losses. If he starts buying up bad debt or debt which is about 
to go bad, he is not doing that.
    Mr. Mulvaney. And I am not a conspiracy theorist--or at 
least I am trying hard not to be after 3 years here--but if I 
imagine a circumstance in which the Federal Government has 
issued a guarantee of that municipal debt, that would get 
around your restrictions, wouldn't it, Dr. Meltzer?
    Mr. Meltzer. Yes, but that would not be a Federal Reserve 
action. That would be something which you in the Congress have 
to do.
    Mr. Mulvaney. True, but then he would be able to buy that 
debt and issue that credit.
    Mr. Meltzer. Yes. But, of course, once you gave it a 
guarantee, he wouldn't need to do that.
    Mr. Mulvaney. Okay. Dr. Bivens, you looked like you were 
agreeing or--you had some thoughts on that?
    Mr. Bivens. I actually disagree with that last statement. 
If there was a guarantee, he could buy it, but he wouldn't have 
to.
    Mr. Mulvaney. Okay. Are there any other methods other than 
buying municipal debt that the Federal Reserve has the 
authority to bail out--for lack of a better term; and I don't 
mean that term to be used in a narrow sense, but a broad 
sense--a city or a State? Is municipal debt the only tool 
available to it? Dr. White?
    Mr. White. It is certainly not part of the Federal 
Reserve's mandate in terms of monetary policy. It doesn't fall 
under their bank--
    Mr. Mulvaney. You just heard Mr. Kildee make the argument 
that will be made at some point in the future--perhaps not with 
Detroit, but with the State of Illinois or the State of 
California, which is that if California tanks, it will drive up 
unemployment nationwide and, therefore, it will call on the 
Federal Reserve or some will call on the Federal Reserve to get 
involved under that part of its dual mandate.
    Mr. White. The Fed can certainly offset any effects that 
California has on the banking system and on the money supply 
without bailing out California.
    Mr. Mulvaney. Okay. Dr. Goodfriend?
    Mr. Goodfriend. I want to make a point by analogy to the 
mortgage-backed security purchases by the Fed.
    Mr. Mulvaney. Okay.
    Mr. Goodfriend. These mortgage-backed securities have a 
guarantee of sorts, and the Fed is buying them. You might think 
that the Fed doesn't need to buy them, so you can imagine, why 
doesn't the Fed swap out the mortgage-backed securities to 
somewhere else in the government and take on Treasuries on its 
balance sheet? The Fed won't do that, and the government won't 
agree to that, because mortgage-backed securities, while they 
have a guarantee, they don't have as much of a guarantee, what 
we like to call full faith and credit, that U.S. Treasuries 
have. And therefore, there is a spread on these.
    So there would still be pressure, perhaps--I don't know 
whether--we just don't know--for the Fed to finance these--
whatever you want to call them, the municipals, even if the 
municipals got a credit enhancement from the government, just 
because they might trade at a higher rate than Treasuries.
    And so, there might be pressure on the Fed to finance these 
things, rather than have the private sector finance at a higher 
rate or to have the U.S. Treasury borrow on behalf of 
municipals to fund them.
    In other words, the guarantee to municipals is not going to 
be as good as the full faith and credit of Treasuries. And 
therefore, there will be pressure for the Fed to buy these at a 
lower rate or--
    Mr. Mulvaney. Thank you, gentlemen. It is an interesting 
topic that I think bears additional consideration, but I am out 
of time. Thank you, Mr. Chairman.
    Chairman Campbell. Yes, I think all of the questions and 
answers have been interesting, and I am sure that will continue 
with the gentleman from Illinois, Mr. Foster, who is now 
recognized for 5 minutes.
    Mr. Foster. At the risk of drifting a little bit further 
off-topic, I think almost everyone present in the room or who 
has been present in the room comes from States that are huge 
losers in the redistribution of wealth that is happening due to 
the Federal Government. I know that about $20 billion a year 
flows out of Illinois, I think about $5 billion a year out of 
Michigan, and I think some number north of $10 billion a year 
flows out simply because of the imbalance between Federal taxes 
and money spent by the Federal Government, which is more than 
enough to bail out Detroit and others. And so, I think that is 
something which has to creep into our thinking, if not the 
Fed's directly.
    And actually, in the opposite direction, it strikes me in a 
lot of the political debate that we are having over things like 
monetary policy that we don't--we have this single compartment 
model in our minds of the economy that is insufficiently 
globalized. When you talk about trying to pressurize the whole 
system with money to support asset values in the United States, 
what Mr. Bernanke will pressurize the U.S. economy and then see 
it pop out as an asset bubble in foreign countries.
    And that this really changes the calculus. It means that 
any of these simple rule-based things don't have a chance of 
working unless the rule is so complex that it includes all the 
major economies in some manner. I spent a little while to see 
if these sort of macro--international macro models even exist 
and they are woefully simplified, by necessity. But I think 
this is a major problem in, really, the thinking of both 
parties, because it generates unsolvable problems.
    And I was wondering generally if you have any comments, 
anyone, on the Fed's role or the central bank's role in 
fighting asset bubbles, which--if I step back from the 
financial crisis, by several years now, if I had my choice of 
getting rid of the banking crisis or the housing bubble, it is 
not even close. I would prefer to get rid of the housing 
bubble. The damage that has done to the net worth of the middle 
class is incomparably larger than the banking crisis, which, by 
and large, we fixed within a couple of years.
    And so I was wondering if you have any words of wisdom on 
how the Fed should balance its duties of keeping the banking 
system solvent and keeping the--and stabilizing, particularly 
housing bubbles, which I think are the big dog and the pain 
that we are still living through.
    Mr. Meltzer. Think of how the problem arises of a bubble. 
Take the housing market. Returns to investment in housing are 
20 percent, 30 percent at the instant. You raise the interest 
rate by 1 percentage point, 2 percentage points, 3 percentage 
points, that is enough to kill the rest of the economy, 
perhaps. It is not going to have a big effect on the 30 
percent. That is the basic problem. That was the problem in 
1929. It was the problem in 1968. And--
    Mr. Foster. Right. And so in other countries, then, they 
have independently controlled, for example, the downpayment on 
housing from the interest rates. And one of the fundamental 
problems with--you had mentioned like triple mandates. And it 
is a fundamental theorem of control theory--I am a physicist, 
so forgive me--is that you cannot control three variables with 
one actuator, all right?
    And so that if--is the problem that the Fed actually has to 
consciously manipulate both the leverage allowable in the 
housing market and other asset markets with the interest rates? 
And--
    Mr. Meltzer. The housing bubble occurred at least in 
largest part because of the desire, the understandable desire 
on the part of the Congress and the Administration to spread 
housing ownership down the income distribution. So it gave the 
opportunity for Fannie Mae and Freddie Mac to make loans, no-
downpayment loans, in which the owner didn't own anything 
except an option to perhaps benefit if the housing prices 
continued to rise at 20 percent or 30 percent a year, which is 
not a likely event.
    Now, people like Angelo Mozilo saw an opportunity to 
package these loans and sell them to Fannie Mae and Freddie 
Mac, and he walked away--
    Mr. Foster. No, I understand that narrative. Let's say, if 
I could--yes, Alex, do you have a--
    Mr. Pollock. Yes, I agree, the international dimensions are 
central and make the problems much harder. Yes, with multiple 
mandates--in my testimony, I suggest the Fed has six--and you 
can't possibly do them all. Yes, the housing bubble was much 
worse than other financial bubbles. Yes, we should attack it 
through controlling leverage, which in housing is also equally 
controlling down payments or loan-to-value ratios. And 
likewise, in other markets, it is how much margin you allow 
that sector to run on. That is a key control variable which I 
think should be used.
    Mr. Foster. Any other comments on--
    Chairman Campbell. One more quick comment, and then we 
will--
    Mr. Gagnon. Yes, just ask yourself why the equity bubble 
crash in 2000 had much--it was billions of dollars--smaller 
effects than the housing bubble crashing in 2008. And I think 
the difference is leverage. You want to reduce leverage.
    Chairman Campbell. Okay. I'm sorry, Mr. Goodfriend. I will 
just--and perhaps if Mr. Pittenger would like to hear that 
answer--the gentleman from North Carolina is recognized for 5 
minutes.
    Mr. Pittenger. You are welcome to respond for 30 seconds, 
if you can.
    Mr. Goodfriend. Just 30 seconds. I think leverage matters 
mainly because of access to money market short-term financing 
of illiquid housing mortgage products. That was an important 
component to remember about this. It is always advantageous to 
finance in the money market where interest rates are low, 
because people expect to get liquidity out of it. The problem 
was, there was too much liquid money market finance of this 
stuff via leverage that caused the system to be fragile. That 
is my own addition.
    Mr. Pittenger. Thank you, Mr. Chairman. I will proceed.
    Chairman Campbell. Yes. Yes, please, go ahead.
    Mr. Pittenger. Dr. Meltzer, you have argued that the Fed is 
at its best when it follows clear monetary policy rules. Do you 
believe that this applies even in emergency situations?
    Mr. Meltzer. No. In an emergency situation--no rule is 
going to work under--in a world of uncertainty, under all 
conditions. It is just not in our ability to write such a rule. 
So, no, there have to be--the way in which I would run that 
rule is to say they should come to you and say, we have to 
deviate, and this is why we are deviating, and then it is the 
public interest served by your saying okay.
    Mr. Pittenger. So there is some accountability. Mr. 
Pollock, in your view, has the Federal Reserve adequately 
planned and modeled for interest rate risk?
    Mr. Pollock. In my view, the Federal Reserve has, in 
current times, through its huge bond market manipulation, 
created a massive amount of interest rate risk, and we will see 
how it all works out. Nobody knows enough to know how it will, 
but it will certainly be coming home to roost as we go forward.
    Mr. Pittenger. Sure. As a follow up, I would like to ask--
earlier this year, you described the Fed as meeting its own 
criteria for classifying an institution as too-big-to-fail. 
What monetary policy decisions in your view have led to the Fed 
becoming too-big-to-fail?
    Mr. Pollock. That was an article I was having a lot of fun 
with, Congressman, but I think it is true, that if you apply 
their criteria, they are exactly a too-big-to-fail bank 
themselves. And, of course, what has caused that is the massive 
bond investments which they have undertaken. The Fed at the 
moment owns about $2 trillion of long Treasury bonds--not 
Treasury bills, but Treasury bonds of long duration, and $1.3 
trillion of long-term mortgages. This is a risk position which, 
if any of their bank charges had it, they would be all over 
them, firing the management and making them unwind it.
    Mr. Pittenger. Sure, thank you.
    Professor Meltzer, you have described a number of mistakes 
that seem to be repeated by the Fed over the course of its 
history, from the inability to consider the effect of policy 
over the intermediate or long term to its lack of independence 
from its fiscal policy decisions by the Treasury. Why do you 
think these mistakes are continually repeated? And what can we 
do to help ensure that they are not repeated over the next 100 
years of the Fed?
    Mr. Meltzer. Thank you. I think that is the critical 
question, that is, the successful policies were periods where 
policies--Mr. Volcker is a wonderful example. When he took on 
the inflation problem, he knew he wasn't going to solve that in 
a month or 6 months. He knew it was going to take a while. It 
took a couple of years, right?
    But he had a consistent policy of trying to lower the 
inflation rate. He deviated at times because events required 
him to, but he always went back to doing that. That is what the 
Fed does not do.
    Take the current example. It has over $2 trillion of excess 
reserves. It is not going to get rid of those in a a week or a 
month. It is going to get rid of them over several years, if 
then. So it needs to have a long-term strategy. Does it have a 
long-term strategy? No. It says it depends upon the next 
unemployment rate and whether it is this or that. What earthly 
reason could there be for thinking that the next unemployment 
rate is going to have very much to do with whether they 
successfully manage to bring down $2 trillion? They need a 
long-term strategy. They don't have it.
    Mr. Pittenger. Yes, sir, Mr. Pollock?
    Mr. Pollock. Thank you, Congressman. May I just comment 
that the well-deserved plaudits Mr. Volcker gets for bringing 
down inflation was bringing down an inflation created by the 
Federal Reserve itself.
    Mr. Pittenger. Yes, sir, Mr. Gagnon?
    Mr. Gagnon. Just one point. I don't think the Fed needs to 
bring down the reserves. It will pay interest on them, and that 
will make people happy to hold them. I think that is its plan.
    Mr. Meltzer. Maybe.
    Mr. Pittenger. Thank you very much. I yield back my time.
    Chairman Campbell. Thank you. Gee, and I thought it was--
was it Carter or Ford who had those little buttons, ``Whip 
Inflation Now?'' It was Ford. That is what I thought, yes. So I 
thought that is what did it. Yes, WIN, whip inflation now, oh, 
boy. Okay.
    The gentleman from New Mexico, Mr. Pearce, is recognized 
for 5 minutes.
    Mr. Pearce. Thank you, Mr. Chairman. I appreciate the 
presentation that you each made.
    I was looking at an article from Forbes earlier this year 
and talking about looking at the stock market, it is just 
booming. The housing market is bouncing back. CPI, it is not 
even moving the needle. Gold, we have crushed it. Everything is 
great. Move forward, Mr. Gagnon--that would be you--move 
forward, print more money, more QE.
    But then they go on and say, but Spain, hopelessly 
bankrupt, can borrow money at 5 percent, 60 percent of the home 
purchases in the major markets are being made by cash, by hedge 
funds, and inside groups. The Dow and S&P are hitting highest--
record highs, while 47 million people are on food stamps. 
Official unemployment rate is going down, while the number of 
people not working is going up, CPI less than 2 percent.
    This is what I find in my district. We are 47th in per 
capita income. Mr. Gagnon, do you have a rebuttal to this idea 
that it is just an insider's game, that is the conclusion here, 
that what we have done is we have made this economy so complex 
that only the insiders are going to do okay, and everybody else 
is going to suffer and suffer pretty badly? You are one who is 
saying, print more money. Would you like to address the 
positions in this article?
    Mr. Gagnon. I haven't read the article. I am worried about 
inequality of income. It seems to me, though, that what the 
Federal Reserve is doing benefits probably the lower end of the 
income distribution more than anything, because buying the MBS 
has helped keep mortgage rates low, which rich people usually 
don't need to borrow as much as poor people do to get a 
mortgage--
    Mr. Pearce. If I could address that piece--
    Mr. Gagnon. --to get a house--
    Mr. Pearce. --that it is somehow helping the people on the 
low end of the spectrum, let me tell you what I hear at my town 
halls. I hear people say, ``We lived our life correctly. We put 
money into savings accounts. We have 401(k)s. We paid for our 
house. Now, the house is worth half what we paid for it. We get 
zero, 0.25 percent, interest on our money.''
    Seniors are more likely to use cash and cash equivalents 
than any other segment of society. What the printing of money 
is doing is driving everyone to these speculative, higher rates 
of return that threaten our seniors more than ever. And so, I 
don't find that the seniors are sitting here applauding the 
strategies.
    You also make the comment in your paper that--in your 
statement that Bear Stearns--or that Lehman didn't have enough 
resources to bail them out. When I look at a list, I see that 
Bear Stearns had 34 to 1 asset to equity ratio, Morgan Stanley 
33 to 1, Merrill Lynch 32 to 1, Lehman 31 to 1. It was the best 
of those four. Why do you say that they didn't have enough 
assets and the others did? Bear Stearns did.
    Mr. Gagnon. Actually, I am about to release a paper that 
looks at the balance sheets of all those institutions you 
named. And what is really striking is that even though it had a 
little bit less leverage, as you say, the value of the assets 
were vastly inflated for Lehman. Lehman was just overstating 
the value of its assets to a degree that was much higher than 
the other institutions. And so--
    Mr. Pearce. Okay.
    Mr. Gagnon. --in hindsight, it has lost a lot more.
    Mr. Pearce. So you think there is a relationship between 
debt and asset value? What do you think about the United 
States' off-balance-sheet accounting?
    Mr. Gagnon. The United States--
    Mr. Pearce. In other words, we have about $202 trillion 
that we don't consider as debt. That is Medicare, Medicaid, and 
Social Security. So you declare that Lehman had off-balance-
sheet assets that were stated incorrectly. Do you have a 
position on the U.S. Government's off-balance-sheet nonassets, 
loans that are stated incorrectly?
    Mr. Gagnon. One thing I would say is that a lot of these 
obligations are not legal liabilities like bonds. They can be 
changed legally over time, and we can find ways to save money 
on health care, for example, and so that can affect them in a 
way that you can't do to a bondholder.
    Mr. Pearce. Yes, so you are saying that they are not 
really--that we really don't owe that money. I would challenge 
you to come out to one of my town halls and sit and listen to 
seniors who, by God, will tell you that you are going to pay 
their Social Security. They are going to be there with 
pitchforks. I will tell you, this--the anger in the American 
people is neck-deep.
    The anger at the insider game that is going on here and the 
way that this economy is being manipulated, it is not 
understood by the unsophisticated. They just know they have 
been had. And the printing of money is one of the biggest ways 
they have been had, and this Federal Reserve is the key to 
that. I yield back.
    Chairman Campbell. Thank you. We are going to go one more 
round. I know Dr. Meltzer has to leave at 4:00, so--but we will 
make one more quick round. There are 4 Members here, so we need 
20 minutes, and then we will be all set.
    So I will yield myself another 5 minutes, and this time I 
will start with Dr. Meltzer, because you have to leave soon, I 
know. And my question this time is, in the 100 years of the 
Fed, what is the best action they have taken, the best thing 
they have done? And what is the worst action they have taken, 
the worst thing that has been done?
    Mr. Meltzer. As a policy, the best action they have taken 
was ending the inflation and more or less following the Taylor 
rule, because that gave us the longest period of any period in 
Fed history with low inflation, stable growth, and small 
recessions, just what we wanted.
    And since--if I looked at the current period, I would say, 
after providing $2 trillion or more of QE reserves, I would 
look around and say, why are we getting so little effect? And 
the answer is, maybe we have the wrong strategy. Maybe, as Mr. 
Gagnon sort of suggested at one point, it is not a monetary 
problem. Those are not his words; those are my words. It is not 
a monetary problem.
    But as he said, it is a tax problem. You tell people who 
are investors, if you invest more, I am going to want to tax 
you more. There is nothing in economics which says that is the 
correct strategy. In fact, there is everything in economics 
which says that is a silly strategy. You may want to tax more 
at some point, but you certainly don't want to get out of a 
recession by taxing people more.
    And regulating them? Regulating them to death. When you go 
around and talk to businessmen, they talk about the costs of 
regulation, so they don't invest in labor. And we have--we all 
know that--of the employment benefits that we see going up, 
most of them are part-time jobs. Part-time jobs. Why? Well, we 
know why. It is because of the silly parts--
    Chairman Campbell. Okay.
    Mr. Meltzer. --of the Obamacare law.
    Chairman Campbell. Okay. Thanks, Dr. Meltzer.
    Dr. Goodfriend?
    Mr. Goodfriend. For the best, I would say Paul Volcker's 
moment. When the Fed restrained inflation, that was very tough 
to do. It was a huge success.
    For the worst, I want to set aside the Great Depression, 
because that is obviously the worst mistake, but there is 
another mistake that I want to emphasize. In the early stages 
of the Great Inflation, there was a mistake that the Fed made 
analytically that it thought the Phillips curve, the tradeoff 
between inflation and unemployment, was stable. So the Fed 
thought it could create a reduction in unemployment by creating 
higher inflation.
    That collapsed, because the so-called correlation--Phillips 
curve correlation proved to collapse as soon as the Fed tried 
to exploit it. That is a very famous analytical mistake which 
everybody teaches--
    Chairman Campbell. I remember. I was at UCLA in economics 
then. I remember that stuff.
    Mr. Goodfriend. Yes, but there is another mistake, which is 
really the same mistake. Now, I was at the Federal Open Market 
Committee as a back-bencher until 2005. And I remember, in the 
run-up to the housing--the credit turmoil, people at the Fed 
would say, there has never been a nationwide house price 
collapse. In other words, it looked like, if you diversified 
your mortgages across the United States, you were safe.
    But that correlation--or the lack of that correlation 
collapsed when the markets tried to exploit it. House prices 
became highly correlated in the end, and they all collapsed 
together. But that is an analytical mistake which is equivalent 
to the Phillips curve mistake, in the sense that you look back 
at history and you see, in this case, a lack of correlation 
that is a safe bet that we won't have a housing crisis.
    It was exactly the same analytical mistake in a slightly 
different context made by our policymakers, only this time it 
was in the credit markets and it caused a boom and bust in 
housing.
    Chairman Campbell. Okay. Mr. Pollock?
    Mr. Pollock. Mr. Chairman, I would say the best thing the 
Fed has done is actually create a working elastic currency, 
which was the principal assignment they got in the Federal 
Reserve Act of 1913, and that has been done and fully achieved.
    The worst thing they did, I think, was the Great Inflation 
of the 1970s, which set up the amazing and horrible financial 
catastrophes of the 1980s.
    If I may nominate a second worst thing, it was making the 
market believe in the Greenspan put in the 1990s and the early 
2000s.
    Chairman Campbell. Dr. White?
    Mr. White. Rather than look for--I agree with what has been 
said about high points and low points, of course. But if we 
look at the 100 years of the Fed and sort of come back to the 
theme of this hearing, if you compare the Federal Reserve track 
record on inflation and on inflation unpredictability, price 
level unpredictability, and on stability in the real economy, 
it hasn't done better than the far-from-perfect system that 
preceded it.
    Inflation has been much higher. The predictability of the 
price level has been much lower under the Fed, which is why you 
don't have 50-year railroad bonds anymore--besides not having 
railroads. You don't have 50-year corporate bonds anymore. And 
in terms of business cycles, the Fed has not succeeded in 
ironing out business cycles, with some rare exceptional periods 
that have been mentioned. So--
    Chairman Campbell. Okay, if I can catch--I am going to be 
strict with time because we have to give up this room.
    Mr. Foster, if you want to continue on that line of 
questioning, you may, or whatever you like. You are recognized 
for 5 minutes.
    Mr. Foster. Yes, sure. Does anybody want to finish up on my 
last question? Then I will go on to--just, first, to make a 
comment actually on what has been happening in our economy. 
When people ask me to report in a simple way, I go to household 
net worth. And in the last 18 months prior to March of 2009, 
households and families in America lost $16 trillion. Then, we 
passed the stimulus and a number of very aggressive 
interventions into our economy. And since then, households in 
America have regained more than $18 trillion. So we have more 
than made up. And so the--this government intervention in an 
emergency is one of the crucial--it would be nice if we didn't 
have emergencies, but there are times when it is necessary.
    And one of the things I would like to--back to the 
unemployment thing is, there used to be this thing that was 
called the Okun rule, which you are probably all familiar with, 
that says when the economy gets better, that unemployment goes 
down, a correlation between the rate of GDP growth, I think, 
and the drop in unemployment.
    And so what we have seen during this time, the $18 trillion 
rebound of household net worth, we have also seen a V-shaped 
rebound in business profitability, in GDP, and just everything 
you can name, but the unemployment has been much slower. This 
is called by some, that Okun's rule broke.
    And I was wondering if you have any comments on this. Is 
this really just a structure change, the triumph of capital 
over labor, the fact that machine thought is now up to the 
point where you can actually replace a lot of human brains with 
automation? Or is it--is there something else going on here?
    Mr. Bivens. My view is that Okun's rule is actually holding 
up pretty well over this recovery. What we really have is a 
very slow growth recovery. We don't have a particularly slow 
employment growth contingent on GDP growth.
    If you look at productivity, which should be the wedge 
between how fast GDP is growing and how fast employment is 
growing, it has actually been slower in this recovery than 
previous ones. We still are just far too below potential. We 
still have far too deficient demand in the economy. And so to 
the degree to which employment growth is disappointing, it is 
because GDP growth is disappointing.
    We did a lot of good things in the wake of the first 
housing bubble burst, but I think we withdrew lots of them too 
soon. The Fed is one thing that was not withdrawn too soon, but 
all the talk of the taper makes me worried that the one engine 
that is still pushing the economy forward may soon be 
sputtering, as well.
    Mr. Gagnon. There is a secular decline in sort of how much 
of GDP goes to workers versus capital, which I don't fully 
understand myself, but it is--
    Mr. Foster. It was first observed by Senator Paul Douglas, 
whom my mother worked for in the 1950s, the famous economist 
from the University of Chicago. Anyway, just a side point. But 
do you have any deep thoughts on this or--and it is outside the 
realm of anything the Fed can do? This is just a secular shift 
and--
    Mr. Gagnon. I don't see--I worry about this, but I don't 
make it my special area of study, because I don't see what the 
Fed can do. I think it is a huge issue, and I think a Member 
over there raised it, too. And I wish I knew what the Fed could 
do about it. It seems more of a micro, regulatory, education, 
structural issue, not a macro, monetary issue.
    Mr. Pollock. Congressman, Goodhart's paradox in economics 
and monetary policy is that whenever you find a statistical 
relationship that looks reliable and you then try to make it 
into a tool to manage the economy, it breaks down.
    Mr. Goodfriend. On the point about the rising so-called 
labor share of national--on falling labor share of national 
income, that has to be related to the globalization of labor 
markets in a way that is hurting--it actually has a bifurcating 
effect on countries around the world. Those people positioned 
to benefit from globalization and what they do are getting 
benefits, but most people are having their real income 
constrained by competition from other parts of the world.
    And this is happening in countries all around the world. It 
is a global phenomenon. There is very little an independent 
central bank can do in a country about it.
    But on a note of optimism, I would say, it is going to take 
years for this to end, but it is already beginning to end in 
China. In other words, China's benefits over the last 20 years 
have been because they have been able to sell goods by 
exploiting their own labor. They are coming to the end of the 
line with that policy, as workers from the interior moving to 
the cities are becoming more scarce, and so wages have had to 
be paid up. And so wages--
    Mr. Foster. Yes, but there is also the flattening of 
corporate structures. Middle management can be smaller with 
good software. A lot of it is internal. It is not all foreign 
wage pressure.
    Mr. Goodfriend. That is true, but my feeling is that--
    Mr. Foster. That is the domino effect?
    Mr. Goodfriend. --this is being driven by global trade, 
which is going to come to an end, if we can be optimistic about 
that.
    Chairman Campbell. Okay, the gentleman's time has expired.
    I now recognize the gentleman from Michigan, Mr. Huizenga, 
for 5 minutes.
    Mr. Huizenga. Thank you, Mr. Chairman. I appreciate that. 
And I wish that Dr. Meltzer was still here. He was giving us 
that classic economist two-sided answer about whether the Fed 
was more constrained or less constrained or less independent.
    And it seemed to me, as he was going through that, it 
struck me, as he was talking about the expansiveness that the 
Fed has taken on, that it hasn't just been on their own 
volition, that there has been some direction, and certainly 
they have been allowed and have not had much push-back, maybe, 
on this committee, led by our Chairman Hensarling and a few 
others, but I want to talk a little more specifically about QE 
and quantitative easing and reading Dr. Gagnon's piece that he 
had submitted to us in arguing that it should have been more 
aggressive and earlier.
    I want to delve into that a little bit more and maybe get 
somebody else's--Dr. Goodfriend or Dr. White, somebody else, 
because it seems to me that what we have done is we have 
artificially lowered interest rates. It seems to me that--I 
know that the chairman takes a bit of umbrage at that 
description, but I don't know how you describe it any other 
way.
    The reverse of that is, my kid set up a lemonade stand at 
the end of the driveway, and they are curious why Mom is the 
only one who bought the $2 glass of lemonade. It is because 
everybody else is waiting for the 50 cent cup of lemonade.
    And we have done the exact opposite. We have gone in and 
said, hey, who wants to buy? Not many hands have gone up, 
except for Treasury. Or the Fed. And so suddenly we are finding 
ourselves in this era that we are trying to call it as a free-
market decision, but it really isn't. Isn't that the case? Dr. 
Goodfriend or Dr. White?
    Mr. Goodfriend. I will start briefly. I think you are 
referring to the mortgage-backed securities that the Fed is 
financing. Essentially, the Fed is financing 75 percent to 80 
percent of new mortgages in the United States. And in doing so, 
it impairs the free market's ability to do that, because by 
virtue of the fact what the Fed is trying to do, it's cutting 
the spread, the mortgage-backed spread relative to Treasuries 
so low that it is not profitable for private markets to go in 
and resume funding of mortgages. It is a problem.
    And my view is, the Fed should set a strategy by which it 
intends to exit that market so that people can--so that 
businesses can plan to resume their financing of mortgages in 
America, and the Fed has not done that. This is an example of 
what Allan Meltzer was saying and what I said earlier.
    The Fed needs to give guidance to markets about its 
strategy so markets can then plan for their re-entry into this 
mortgage market. Not giving guidance is just making it 
impossible for markets--private people to resume and plan for 
re-entry into the mortgage market in America. It should have 
started already, and I hope it starts as soon as possible. The 
Fed needs to provide a plan for its own exit from the mortgage 
market.
    Mr. Huizenga. Mr. Pollock, do you care to try to--we will 
see how far down I will go.
    Mr. Pollock. Congressman, I will comment on the very low 
interest rate strategy, if I may. As was pointed out before, 
short-term rates are extremely low. In fact, in real terms they 
are negative. For a long time, rates on 10-year Treasuries were 
negative in real terms, in inflation-adjusted terms. This has 
crushed savers, as the Congressman pointed out. I think one way 
to think about this--
    Mr. Huizenga. Can I add a little something in there?
    Mr. Pollock. Yes.
    Mr. Huizenga. Has that benefit, I think, as Dr. Gagnon was 
arguing, about the lower-income homeowner purchaser, does that 
outweigh what my friend from New Mexico is hearing in his town 
hall meetings and what I am hearing from my own elderly parents 
and from other constituents?
    Mr. Pollock. In my opinion, no, because the other set of 
regulatory overreactions has cut out a lot of those borrowers. 
But it is a trade-off. Of course, the point has been to favor 
borrowers at the expense of savers. That is a political 
decision made by the Fed.
    Once you have a bubble, if I can just finish this thought, 
there is no easy, pleasant outcome. There are only bad outcomes 
and painful outcomes. The losses have occurred, the losses have 
to be taken by someone. The Fed's strategy has put a large 
amount of those losses on savers, just as a matter of fact.
    Mr. Huizenga. Dr. White?
    Mr. White. Yes, I share your concern about artificially low 
interest rates. One of the big contributors to the housing 
bubble was the Fed holding interest rates too low for too long, 
from 2002 to 2005, and we don't want to repeat that episode. So 
as the recovery proceeds, the Fed should be ready to let 
interest rates rise.
    Chairman Campbell. Okay. The gentleman's time has expired, 
so thank you.
    Next, we will move to the gentleman from South Carolina, 
Mr. Mulvaney.
    Mr. Mulvaney. Thank you, Mr. Chairman.
    Chairman Campbell. You are recognized for 5 minutes.
    Mr. Mulvaney. Thank you, Mr. Chairman. Of course, the 
purpose of the hearing today on the 100th anniversary of the 
Fed is to sort of look back over the last 100 years and maybe 
look forward to the next 100 years. And it strikes me that one 
of the things that may be very, very different, at least for 
the next several years, was referred to by Mr. Pollock in one 
of his earlier answers about interest rate risk and what--the 
interest rate risk the Fed has currently exposed itself to over 
the--as a result of the immense growth in its balance sheet.
    I want to talk a little bit about the combined earnings of 
the Fed and about how the Fed funds itself. My understanding is 
that the Fed earns money in a couple of different ways. They 
provide a couple of services, but they also earn interest on 
their balance sheet. I would consider those in my old line of 
work to be sources of cash or earnings. They also have 
expenses. They have to pay for themselves, and they also have 
to pay interest on the reserves that various financial 
institutions hold at the Federal Reserve.
    It strikes me--and I could be wrong about this--that 
ordinarily, that that was a positive number over the course of 
the last 100 years. Again, I wish Dr. Meltzer was here, because 
he knows more about it off the top of his head than I think 
everybody else put together, but my understanding is that 
generally speaking, that number has been positive, and the Fed 
has made enough money off of its combined earnings to fund 
itself.
    I think it is very easy to anticipate a circumstance in the 
near future where that number will turn negative, that as you 
start unwinding, if you start tapering, not only will there be 
a tremendous balance sheet loss, in terms of the value of the 
assets on the balance sheet--but, of course, that is not 
earnings--but also in the amount of money that the Federal 
Reserve has to pay out on the reserves on which it pays 
interest that the financial institutions are holding with it.
    So I ask you the question, gentlemen, that if we go into 
this--in this hypothetical situation, I suppose, where the 
Federal Reserve is not--does not enough combined earnings to 
fund itself, where will its money come from?
    We will start with Dr. Goodfriend and then go Mr. Pollock, 
and to anybody else who wants to respond.
    Mr. Goodfriend. Okay, you are absolutely right. There is a 
situation in our future where it is doubtful the Fed will be 
able to withdraw reserves and shrink its balance sheet back 
before it has to pay interest on reserves to get overall 
interest rates in the economy higher to act against inflation.
    And so what will happen is--the possibility of what we call 
a negative cash flow problem may very well occur, and the Fed 
should prepare for it, talk about it to you all, because it is 
going to be a fiscal policy drain. It becomes a matter of the 
Congress about how the Fed plans for this. So the Congress 
needs to ask the Fed, how do you plan for this?
    Mr. Mulvaney. I asked that question, and he said he was 
going to create--is it a deferred asset? I forget the name of 
the term. He would create that, and I didn't really understand 
what that meant, because it is a term I think that in 
accounting only makes sense at the Fed.
    Mr. Goodfriend. If I may, let me describe something which 
is interesting. The Fed a few years ago put out a warning for 
commercial banks, ``Please take care of the interest rate risk 
on your balance sheet.'' The Fed is worried about whether the 
commercial bank system will prepare for the day when long-term 
rates rise, and the commercial banks will have to pay higher 
rates on their deposits.
    And the Fed said, ``You should hold more surplus capital, 
build up now against those losses which you will certainly have 
to deal with as the economy normalizes.'' But the Federal 
Reserve has never built up its surplus capital. It has never 
taken its own advice that it gives to the commercial banks to 
prepare for the day in which it is going to need that kind of 
residual financial tinder.
    Mr. Mulvaney. And when it does need that financial tinder, 
where is it going to come from?
    Mr. Goodfriend. That is the point. Banks build up--the Fed 
should withhold--
    Mr. Mulvaney. But they haven't done that.
    Dr. Gagnon, it looked like he had the answer--an answer 
or--help me understand.
    Mr. Gagnon. Yes, because I was at the Fed when we were 
planning for this. And you are right that the Fed can book an 
asset which will make it look as if it is solvent, and that is 
what you were talking about, but what really matters is the 
cash flows. And you are right. The Fed, I believe, will have 
negative cash flows at some point in the future, and it will 
pay that just by creating more reserves to pay the interest on 
the existing reserves, and it can do that without limit if it 
wants.
    This situation won't last forever. It is unfortunate, but, 
Marvin, I--it is my understanding is that the Fed isn't allowed 
to keep capital. It has to hand over its profits to Treasury 
every year, according to a formula. It would have liked to have 
kept reserves, because it has been earning a lot of money 
lately, and it would like--
    Mr. Mulvaney. And those are the remittances--
    Mr. Goodfriend. That is not actually true.
    Mr. Gagnon. What?
    Mr. Goodfriend. There is a gentleman's agreement between 
Congress and the Fed that was established in the period before, 
or right after World War II, and it is a gentleman's agreement, 
to my understanding. It is an understanding. The Fed, if it 
wanted to, could retain surplus capital against interest rate 
risk.
    Mr. Mulvaney. Mr. Pollock is actually saying no. And this 
is what I love about this discussion.
    Mr. Pollock. I think it is true that it could, but if it 
did, it would increase the budget deficit. The Fed makes a lot 
of money. The Federal Reserve banks are almost always, measured 
by return on equity, the most profitable banks in the country, 
and the money goes to the Treasury, by and large, after a small 
dividend and small expenses.
    If it comes to the point that payment on reserve balances 
exceeds the yields on the assets or assets are sold at a loss, 
generating negative cash, then those payments to the Treasury 
will disappear. That will make the deficit go up.
    But you raised an accounting point. There is a debit there 
when that happens. Normal people would think the debit would go 
to net worth, but, in fact, under the Federal Reserve 
accounting, it goes to a ``deferred payment to the Treasury''--
    Mr. Mulvaney. Okay, I have to--
    Mr. Pollock. --intangible asset.
    Mr. Mulvaney. I have to give back. I hear--because we have 
to give up the room. So--
    Chairman Campbell. Thank you.
    Mr. Mulvaney. --thank you, gentlemen. Thank you, Mr. 
Chairman.
    Chairman Campbell. Thank you. So the gentleman from New 
Mexico, Mr. Pearce, is recognized for the final 5 minutes.
    Mr. Pearce. Okay, thank you, Mr. Chairman.
    Mr. Pollock, you had addressed the idea of an elastic 
currency, and so I will ask--first of all, to make an 
observation, I had my dad carry me to where I was born, and it 
was a dirt floor chicken place. They ran the chickens out. And 
so I was--Dad got a raise, and he started working for $2.62 an 
hour, raised 6 kids on $2.60 an hour.
    So I was--I have been contemplating that. How could Dad do 
that? How could he raise so many on $2.62? So the staff--I had 
them digging around on it--so we want to consider 100-year 
periods, because the Federal Reserve has been in operation 100 
years. So the first 100 years of our country's operation, we 
were on a gold standard. And what you could buy for $1 in 
George Washington's day, 100 years later, cost you 50 cents. 
There were economies of scale, transportation, competition came 
in. So you basically had a double--your wage doubled because 
the money was worth more.
    But then if we look at the last 100 years, what $1 would 
buy 100 years ago takes $24 today, so my dad was actually 
making about 12 times, half--it was about 50 years ago, so half 
that time. So he was working for the equivalent of about 242 at 
$2.62--or $24 an hour at $2.62. So, again, I see what the 
Federal Reserve is doing is waging a war on the poor with this 
elasticity.
    And I would appreciate your evaluation, your observation of 
that critical nature I have of the Federal Reserve. If it is 
incorrect, I would appreciate you telling me.
    Mr. Pollock. Thank you, Congressman. I haven't checked your 
math, but something like that is certainly right. Elastic 
currency I think is a good thing, because it is very useful in 
crises, which is why it was created.
    If you look at the long-term inflation rates, they are 
basically flat, and then, starting in the 1930s, they go up for 
the next 80 years. We always forget about the power of compound 
interest. As you are pointing out, a 2 percent inflation, 2 
percent compound interest, extended over many years, creates a 
tremendous change. I point out in my testimony, 2 percent 
inflation, the Fed's stated target, will quintuple prices in a 
normal lifetime. So my answer is yes.
    Mr. Pearce. Okay. Mr. Bivens, you seem to think that the 
idea of lenders of last resort, bailouts, whatever you want to 
call it, is an adequate task. Now, the firms that we bailed out 
made hundreds of billions of dollars in very risky assets, so 
you feel like that a taxpayer, say in New Mexico, who makes an 
average of $31,000--I have one county where it is closer to 
$14,000--the taxpayer who is making $14,000 a year should bail 
out somebody who is getting $1 million bonuses on Wall Street 
from making crazy, crazy risks where they were leveraged 33 to 
1, 40 to 1. Do you think that is an appropriate assignment of 
risk for taxpayers in New Mexico to have to bail that out?
    Mr. Bivens. No, not at all. I would--
    Mr. Pearce. And so you think, then, that the lender of last 
resort, if they take the risk, if they take risks that do not 
pan out--for instance, maybe it is going to pan out okay on 
Fannie and Freddie, but I remember Mr. Paulson coming 
downstairs at the Capitol saying, if you will guarantee the 
whole thing on Fannie Mae and Freddie Mac, you won't have to 
pay a thing. He was about $200 billion wrong on that 
assessment. But so you think that is an appropriate use of 
taxpayer dollars?
    Mr. Bivens. If you could more specific on what--
    Mr. Pearce. Fannie and Freddie. To bail Fannie and Freddie 
out at $200 billion.
    Mr. Bivens. Yes, I--
    Mr. Pearce. Okay, that is fine. When does the stuff hit the 
fan here? We have been printing money. Mr. Gagnon, maybe--it 
doesn't work in Argentina. When is it going to stop working 
here?
    Mr. Gagnon. You want a middle-of-the-road, you want a 
moderate target. Countries who have chosen inflation targets 
that are too low, like New Zealand and Japan, have changed 
their mind and decided to raise them. I think 2 percent seems 
like a moderate level.
    Mr. Pearce. Let me go ahead and reclaim my time. I have 14 
seconds. The reason that it works, I think, is because we can 
export inflation. We are the world's reserve currency. In the 
last year, the BRIC nations have said they are no longer going 
to trade in our currency. I feel like that we are going to get 
all that inflation back inside our country at one fell swoop. I 
think that there is a major problem looking at us in the face 
when those BRIC nations actually begin to trade in something 
other than dollars.
    Again, maybe the scheme won't work out, but right now it 
looks like it is on thin ice. I yield back my time, Mr. 
Chairman.
    Chairman Campbell. Thank you, Mr. Pearce.
    And I thank all of you on the panel, very much. I don't 
know about you, but I think this is pretty fascinating. I 
thought there was some very interesting discussion, and it is 
all helpful, and I appreciate all six of you and Dr. Meltzer in 
absentia that--for your contributions to the beginning of this, 
as I hope you can see, very wide-ranging and open discussion 
about how did we get here, what does it look like now, and what 
should it look like going forward.
    The Chair notes that some Members may have additional 
questions for this panel, which they may wish to submit in 
writing. Without objection, the hearing record will remain open 
for 5 legislative days for Members to submit written questions 
to these witnesses and to place their responses in the record. 
Also, without objection, Members will have 5 legislative days 
to submit extraneous materials to the Chair for inclusion in 
the record.
    With that, and without objection, this hearing is now 
adjourned.
    [Whereupon, at 4:27 p.m., the hearing was adjourned.]



                            A P P E N D I X



                           September 11, 2013


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