Thomas Hoenig knew what quantitative easing and record interest rates would bring.
Hoenig's dissenters are impressive because the Fed's main policy committee, called the Federal Open Market Committee, or FOMC, doesn't just value consensus; almost demands it. The committee likes to present itself to the public as one because it is arguably the most powerful government body in American economic affairs. Hoenig's dissident streak shattered that semblance of unanimity at a crucial time as the Fed expanded its interventions in the US economy on an unprecedented scale. It was a turning point in American history, and the economy has never been the same since.
Between 2008 and 2014, the Federal Reserve printed more than $3.5 trillion in new banknotes. To put that in perspective, that's roughly triple the amount of money the Fed created in its first 95 years. Three centuries of monetary growth has been compressed into a few years. Money flowed through the veins of the financial system, fueling demand for assets such as stocks, corporate bonds and commercial real estate, and driving up prices in the markets. Hoenig was the only Fed chairman who consistently voted against this approach from 2010 onwards. With that he placed himself against then-powerful Fed Chairman Ben Bernanke, widely regarded as a hero for the ambitious bailout plans he designed and oversaw.
Hoenig lost his fight. Throughout 2010, the FOMC vote was routinely 11 to one, with Hoenig being elected. He resigned from the Fed in late 2011, and since then Hoenig's reputation as the man who got it all wrong has solidified. He will be remembered as a sort of dour Old Testament prophet who incessantly and falsely warned of one thing: impending inflation.
But this version of the story is not true. Although Hoenig was concerned about inflation, it wasn't just inflation that prompted him to present his series of dissidents. The historical record shows that Hoenig was primarily concerned that the Fed was embarking on a risky path that would deepen income inequality, fuel dangerous asset bubbles, and enrich the largest banks before anyone else. He also warned that this would suck the Federal Reserve into a money-printing quagmire from which the central bank could not escape without destabilizing the entire financial system.
Hoenig was right on all these points. And at all these points he was ignored. Today we live in a world that Hoenig warned against.
The Fed is now in a vise. Inflation is rising faster than the Fed thought a few months ago, with higher gas, goods and car prices fueled by the Fed's unprecedented money-printing programs after years of steadily raising the prices of assets such as stocks and bonds through its Federal Reserve Zero interest rates and quantitative easing during and after Hoenig's time at the FOMC. In response to rising inflation, the Fed has signaled that it will start raising interest rates next year. However, should that be the case, there is every reason to hope that this could potentially bring down equity and bond markets precipitously, or even trigger a recession.
"There is no painless solution," Hoenig said in a recent interview. "It's going to be difficult. And the longer you wait, the more painful it becomes.
To be clear, the kind of pain Hoenig is talking about involves high unemployment, social instability, and possibly years of economic malaise. Hoenig knows this because he has seen it before. He saw this throughout his long Fed career and most clearly during the Great Inflation of the 1970s, as a team player in 2010, why he was willing to go down in history as a freak, and why he was willing to accept disdain from his teammates and people like Bernanke.
Hoenig voted no because he saw firsthand the consequences of the Fed getting it wrong and holding the money too easy for too long.
The last time the United States sufferedAfter a long and galloping period of inflation, Thomas Hoenig was given the pitiful task of cleaning up the mess he had left behind. This was the period that came to be known as the Great Inflation, a period of the 1970s marked by long lines at gas stations and price increases in supermarkets happening so quickly that prices were surpassed at midday. Hoeing realized that the institution he worked for, the Federal Reserve, was not just a spectator of this inflation. He helped make it happen.
As a bank auditor, Hoenig spent the 1970s observing how Federal Reserve policies helped lift the inflationary bait that would later explode. This policy is known as the "easy money" policy, meaning that the Federal Reserve has kept interest rates so low that borrowing has been cheap and easy. The Federal Reserve kept interest rates so low in the 1960s that when inflation is factored in they were actually negative by the late 1970s. When interest rates are effectively negative, this can be described as super-loose monetary policy. This type of environment fuels inflation because all that easy money is looking for a place to go. Economists call this phenomenon "big dollars chasing some commodities," meaning that everyone spends their easy money and drives up the prices of the things they buy because demand is high.
Importantly, the Federal Reserve creates these conditions by creating more and more dollars, or increasing the money supply, as economists say.
As a bank auditor, Hoenig noticed something else that was very important. The policy of easy money does not only increase the prices of consumer goods such as bread and cars. Money also increases the price of assets like stocks, bonds, and real estate. In the 1970s, low interest rates fueled demand for assets and eventually fueled asset bubbles throughout the Midwest, including in agricultural states like Kansas and Nebraska and the energy-producing state of Oklahoma. When asset prices shoot up like this, the dreaded thing called an asset bubble develops.
The self-reinforcing logic of asset bubbles was painfully evident in agriculture, mirroring the dynamics that would later play out in the housing bubble and overheated asset markets of 2021.
When the Federal Reserve kept interest rates low in the 1970s, it encouraged Kansas City farmers to take out cheaper credit and buy more land. As cheap credit increased demand for land, land prices rose, which is expected to cool demand.
But the logic of asset bubbles has the opposite effect. In fact, rising land prices enticed more people to borrow and buy more land, because borrowers expected the value of the land would only increase and yield a sizeable return in the future. Higher prices led to more borrowing, which led to higher prices and even more borrowing. The wheel kept turning as long as debt was cheap relative to expected returns from rising asset prices.
The logic of the bankers followed a similar path. Bankers viewed farmland as collateral for loans, believing that the value of the collateral would only increase. This gave bankers the confidence to continue lending, believing that if land prices rose, farmers would be able to repay them. In this way, asset bubbles grow in a cycle that intensifies with each rotation, with the reality of today's higher asset prices progressively depressing the value of tomorrow's asset prices, adding further momentum.
The bubbles weren't just limited to farmland. The same applied to the oil and natural gas business. Rising oil prices and cheap debt have encouraged oil companies to borrow money and drill more wells. The banks built an entire side business dedicated to risky energy loans to pay for those wells and associated mineral leases, all based on the value of the oil they would produce. It was the same with commercial real estate.
Everything ended in 1979 with a hardship that has never been repeated. Paul Volcker became chairman of the Federal Reserve and wanted to combat inflation by raising interest rates. Under Volcker, the Fed raised short-term interest rates from 10% in 1979 to 20% in 1981, the highest in history. This unleashed massive economic chaos, sending the unemployment rate up to 10% and forcing homeowners to take out mortgages with interest rates of 17% or more. Volcker realized that when he was fighting inflation, he was actually fighting two types: asset inflation and price inflation. He called them "cousins" and acknowledged that they were created by the Fed.
"The real danger is that [the Fed] inadvertently encourages or condones rising inflation and its tight premium, extreme speculation and risk-taking - effectively sitting back while bubbles and excesses threaten financial markets," Volcker later wrote in his memoirs.
As the Federal Reserve doubled the cost of borrowing, demand for credit slowed, which in turn depressed demand for assets like farmland and oil wells. Asset prices plummeted, farmland prices fell 27% in the early 1980s and oil prices fell from over $120 to $25 in 1986. Assets such as farmland and oil reserves were used to cover the value of bank loans, and these loans were considered "assets" on banks' balance sheets. As loans began to default, banks had to write off the value of those loans, leaving some banks insolvent because they suddenly did not have enough assets to cover their liabilities. When land and oil prices fell, the whole system collapsed.
“You could see that no one expected this tightening, even after Volcker started fighting inflation. They didn't think that would happen to them," Hoenig recalls. Overall, more than 1,600 banks failed between 1980 and 1994, the highest rate of default since the Depression.
This was the time when Hoenig was touring the Midwest, testing banks to see if they were still solvent during the recession. Unsurprisingly, Hoenig found himself at odds with many bankers when his staff declared that the banks' assets were insufficient to meet their obligations.
"They can be pretty stressed and raise objections," Hoenig later recalled of the bankers. "You could really empathize with her. You could understand the agony. Lives have been destroyed in this environment, people have lost everything in this environment. I don't blame them when they scream or get nervous.
John Yorke, a former senior vice president of the Kansas City Fed, noticed a stubbornness in Hoenig during this time that persisted throughout his career. Closing the community banks wasn't easy, but Hoenig didn't seem to shy away from responsibility. "Tom is German," Yorke said, referring to the ethnic origin of Hoenig's name. "He's strict. There are rules.
It would have been easy for Hoenig to blame the bankers for making so many risky loans after the bubble burst. Examples of banking grotesques abounded. But Hoenig did not believe that the bankers were solely to blame for the stupidity of lending. The Fed encouraged asset bubbles through its easy money policy.
"The fact is that [the bankers] made the loans," Hoenig said. "They did so in an environment of incredible optimism about the asset." By "optimism" Hoenig meant something called "inflation expectations". Bankers expected asset prices to continue rising indefinitely, and that very expectation fueled demand for credit, which in turn pushed the price higher. "And that was indeed partly to blame for a decade of overly accommodative monetary policy."
There have been many counterarguments to explaining inflation that did not blame the Federal Reserve. These arguments were based on the idea of "high-cost" inflation, meaning that all sorts of forces outside the Fed were pushing prices up. For example, the cartels in the Middle East pushed up the price of oil while unions pushed down labor prices. The federal government has spent years fighting inflation under this theory, even enforcing wage and price controls. It did not work.
There is strong evidence to support Hoenig's view that the Fed has been feeding inflation all along. In a 2004 report, Fed economist Edward Nelson wrote that the most likely cause of inflation in the 1970s was what he called "monetary policy negligence." Essentially, the Fed has been pedaling the money pedal for most of the decade, failing to understand that more money breeds more inflation. This type of inflation is called "demand inflation," meaning the Federal Reserve feeds demand, causing prices to rise.
Author and economist Allan Meltzer, who reconstructed Fed decision-making in the 1970s in his 2,100-page history of the central bank, delivered a grim verdict. It was the monetary policy set by the Fed that caused the problem. "The Great Inflation was the result of policy decisions that placed much more weight on maintaining high or full employment levels than on preventing or reducing inflation," Meltzer wrote. "For much of the period, this election reflected both political pressure and public opinion expressed in the polls."
Hoenig took this lesson with him. In 1991, he was promoted to President of the Kansas City Fed, which gave him a voting seat on the FOMC. He served there during the long tenure of Fed Chairman Alan Greenspan and eventual Greenspan successor Ben Bernanke. Between 1991 and 2009, Hoenig rarely disagreed.
Then came 2010 when he believed the Fed was repeating many of the same mistakes made in the 1970s.
The FOMC faced a terrible dilemmaafter the 2008 crash. The central bank left interest rates at zero after the banking crisis, but that didn't seem enough to spur strong growth. The unemployment rate remained at 9.6 percent, close to the level that marks a deep recession. Although FOMC members generally agreed that another recession was unlikely, the committee began considering new and experimental ways to exercise its power.
Hoenig began saying no in 2010 when it became clear that Bernanke wanted to keep interest rates at zero for an extended period of time. A review of Hoenig's remarks during the 2010 FOMC meetings (transcripts of which were released five years later), along with his speeches and interviews at the time, shows that he rarely mentioned inflation. Hoenig warned of even deeper dangers that leaving interest rates at zero could stoke. But his warnings were also very difficult to understand for people who didn't follow monetary policy closely.
Hoenig, for example, liked to talk a lot about the so-called "allocation effect" when interest rates are kept at zero. The attribution effect was not discussed in the hair salon, but it affected everyone. Hoenig spoke about the distribution of money and the way the Fed moves money from one part of the economy to another. This was what he witnessed in the 1970s: Federal Reserve policies encouraged or discouraged things like speculation on Wall Street that could lead to catastrophic financial collapses.
But it did more than that: Encouraging speculation and rising asset prices also moves money between the rich and the poor because the rich own the vast majority of assets in the United States. Hoenig feared that a decade of zero interest rates would have the same effect.
Bernanke was undeterred by these arguments. When Bernanke published his memoir in 2015, he titled itthe courage to act🇧🇷 This hit the theory of Bernankeism, which states that central bank intervention is not only necessary, but bold and noble (Bernanke refused to answer questions about Hoenig dissidents sent to Bernanke in June).
Bernanke pressured the FOMC to leave rates at zero through 2010. Then, in August 2010, when unemployment was high and growth slow,made the plan publiccreate new $600 billion bills through an experimental program called "Quantitative Easing." This program had been used before during the financial crisis. But it had never been used in the way Bernanke suggested in 2010, as a non-emergency stimulus plan.
If Hoenig has learned one thing during his decades at the Fed, it's that hanging on to easy money for too long can lead to devastating side effects that won't show up for years. This is what happened in the 1970s and mid-2000s when low interest rates fueled the real estate bubble. Hoenig was now asked to vote for quantitative easing, super-loose monetary policy that would encourage risky lending and asset bubbles.
The basic mechanics and goals of QE are quite simple. The goal is to pump huge amounts of money into the banking system at a time when banks have almost no incentive to save the money because fees are so low. (When interest rates are low, banks don't make much money because money earns little interest.) The Fed creates money as usual with its own team of money traders who work at the Fed's regional bank in New York.
These dealers buy and sell assets from a select group of 24 financial firms known as the "major dealers," an ultra-exclusive club that includes the likes of JPMorgan Chase and Goldman Sachs. Primary dealers have special bank vaults with the Federal Reserve called reserve accounts. To conduct quantitative easing, a New York Federal Reserve trader would call a major broker like JPMorgan Chase and offer to buy the bank's $8 billion worth of government bonds. JPMorgan would sell the Treasuries to the Fed dealer. The Federal Reserve operator would then hit a few keys and instruct the Morgan banker to look into his reserve account. voila🇧🇷 The Federal Reserve immediately created $8 billion out of thin air in the reserve account to complete the purchase.
Morgan, in turn, could use that money to buy assets in the broader market. Bernanke planned to do these transactions over and over again until the Fed had purchased $600 billion worth of assets. In other words, the Fed would buy things with the money it created until it filled Wall Street's reserve accounts with a new $600 billion.
In closed sessions of the FOMC in 2010, quantitative easing was discussed for what it was: a large-scale experiment with unclear benefits and risks. There was more resistance to the plan than was publicly known at the time. Hoenig wasn't the only FOMC member who strongly objected to the plan. Regional Bank Presidents Charles Plosser, Richard Fisher and Jeffrey Lacker have raised concerns about this, as has a Fed Governor named Kevin Warsh.
The Fed's own research on quantitative easing was surprisingly depressing. If the Fed were to pump $600 billion into the banking system in about eight months, it would likely lower the unemployment rate by just 0.03%. It wasn't much, but it was something. The plan could create 750,000 new jobs by the end of 2012, a small change in the unemployment rate but a big problem for those 750,000 people.
The plan had many disadvantages, but in the long run all risks disappeared. The main concerns were the risky loans and asset bubbles raised by Hoenig. But there were also concerns that QE could lead to price inflation, encourage more government lending (because the plan worked by buying government bonds) and that it would be very difficult to stop once it started because markets were hooked after the flow would become New money. 🇧🇷
The final vote on quantitative easing was scheduled for November 3, 2010 and opposition was still strong. Lacker, president of the Richmond Federal Reserve Bank, said the case for quantitative easing is thin and the risks are great and uncertain. "Please tell me in the nerve field",Lacker said at the time.
Plosser, the president of the Philadelphia Fed, was more direct. "I am not supporting another round of asset purchases at this time," he said. "Given these very small expected benefits, we need to focus even more on the downside risks of this program."
Fisher, the president of the Dallas Fed, said he was "deeply concerned" about the plan. "I see a significant risk in pursuing policies that result in income being transferred from the poor, those most dependent on fixed income and savers, to the rich," he said at the time.
According to transcripts of internal FOMC discussions, Bernanke defended the plan with an argument he would make repeatedly for years to come, saying the Fed would face risks if that were the casenointervention. Bernanke also knew he had the votes to pass quantitative easing. Due to a quirk in the FOMC's voting rotation, critics Fisher, Lacker, and Plosser did not vote that day. Bernanke personally lobbied for Warsh, the Fed governor, who, according to Bernanke's memoir, agreed that he would support quantitative easing, despite writing an article expressing concerns about it.
Hoenig believed that once the Fed initiated quantitative easing in late 2008, there would likely be no turning back term. Confer long-term gains as you accumulate long-term risks.
Had Hoenig voted for quantitative easing on November 3rd, he would certainly have been praised by his peers. Ending its long string of disagreements this year would have allowed the Fed to appear united in its decision to embark on a new and experimental course. But something stopped him.
Hoenig has a dogged streak when it comes to such decisions, which goes back to his many years of working with serious numbers. Raised in Fort Madison, Iowa, Hoenig spent his vacations working in his father's small plumbing business. Hoenig was sent into the back room with a clipboard to take inventory of plumbing parts. If he made a mistake, his father could run out of supplies. After graduating from high school, Hoenig served as an artillery officer in Vietnam, where he timed the firing range of mortars to fall near enemy positions rather than at his American comrades. Hoenig's upbringing taught him that finding the right numbers is serious work. And he felt obligated to do well. When he enlisted to fight in Vietnam, he explained the decision in lay language to his sister, Kathleen Kelley.
"I remember him saying, 'You know, I'm a US citizen and I hope I can enjoy all the benefits this country has to offer, so it's my responsibility,'" Kelley recalled. He would later characterize his line of dissidents in that language. He called it his "duty".
There were 10 votes for quantitative easing. When it was Hoenig's turn to vote, he replied: "With all due respect, no."
Hoenig resigned from the Fed at the end of 2011.As he predicted, the round of quantitative easing he voted against was just the beginning. In 2012, economic growth was still tepid enough that Bernanke argued that more QE was needed. This time the Fed printed about $1.6 trillion. The Federal Reserve also kept interest rates at zero for about seven years, which was by far the longest period in history (interest rates were near zero in the late 1950s and early 1960s, but stayed there only briefly).
The Federal Reserve tried vigorously to roll back its easy-money programs, but largely failed. The central bank attempted to slowly raise interest rates while withdrawing some of the excess cash it had pumped in over the years of quantitative easing. When the Fed attempted to withdraw this stimulus, markets reacted negatively. In late 2018, for example, stock and bond markets fell sharply after the Fed steadily hiked rates and reversed QE by selling off purchased assets (a move it dubbed "quantitative tightening"). Fed Chairman Jay Powell quickly halted those efforts in a move traders dubbed the "Powell Pivot."
For Hoenig, the most disheartening part seems to be that zero interest rates and quantitative easing had exactly the kind of "allocation effects" he warned about. Quantitative easing drove asset prices higher, benefiting the very wealthy in particular. By making money so cheap and readily available, it also encouraged riskier lending and financial engineering tactics like debt-buying stock buybacks and mergers that did little to improve the lot of millions of people who make a living off their paychecks earned.
In May 2020, Hoenig published an article detailing his grim judgment on the easy money era from 2010 to the present. He compared two periods of economic growth: the period between 1992 and 2000 and the period between 2010 and 2018. These periods are comparable because both were long periods of economic stability after a recession, he argued. The biggest difference has been the Federal Reserve's extravagant experiments in money printing in the past period, when productivity, profits and growth were weak. During the 1990s, labor productivity grew at an average annual rate of 2.3%, about double the rate of the easy money era. Real median weekly wages for white-collar workers increased by an average of 0.7% per year in the 1990s, compared with just 0.26% in the 2010s and just 2.3% in the last decade.
The only part of the economy that seemed to benefit from quantitative easing and zero interest rates was the asset market. The stock market more than doubled in value in the 2010s and even after the crash of 2020, the markets continued their stellar growth and returns. Corporate bonds were another overheated market fueled by the Federal Reserve, rising from around $6 trillion in 2010 to a record $10 trillion in late 2019.
And now, for the first time since the great inflation of the 1970s, consumer prices are rising rapidly along with asset prices. This is due to tight supply chains, but also strong demand from central banks, said Hoenig. The Fed has boosted government spending by buying billions of Treasuries each month while pumping new money into the banks. Just like in the 1970s, large amounts of dollars are now chasing a limited supply of goods. "This is an enormous demand pull for the economy," said Hoenig. "The Federal Reserve makes it easy for itself."
Hoenig's 2020 article received little attention. After retiring from the Fed, he served as vice chairman of the FDIC, where he introduced a failed proposal to break up the big banks. Now based in Kansas City, he edits newspapers and occasionally gives media interviews. She still warns about the dangers of uncontrolled money printing and is still ignored.
Hoenig isn't optimistic about what American life might be like after another decade of slow growth, stagnant wages and soaring wealth, mostly benefiting the wealthy. He talked about it a lot, both publicly and privately. In his opinion, business and banking were closely linked to American society. One influenced the other. When the financial system only benefited a handful of people, ordinary people began to lose faith in society as a whole.
"Do you think we would have had the politics, say, riot, revolution, that we had in 2016 if we hadn't created this huge divide? Didn't we have the effects of zero interest rates, which benefited some more than others? asked honey. "I do not know. It's counterfactual. But it's a question I'd like to ask.
Copyright (C) 2022 by Christopher Leonard. From the forthcoming book THE EASY MONEY GENTS: How the Federal Reserve Broke the American Economy, by Christopher Leonard, to be published by Simon & Schuster, Inc. Printed with permission.