Book Review: Finance and Philosophy: Why We're Always Surprised

Financial Services & E-Commerce Practice Group and Regulatory Transparency Project Teleforum

Listen & Download

Finance and Philosophy provides a concise and witty account of how bankers and financial regulators think, of the alleged causes of the cycles of booms and busts, of the implicit and often un-thought-out assumptions shaping retirement finance, fiat money, corporate governance. Pollock deftly shows how poorly bankers have measured the risk their banks have been exposed to. With candor and clarity, he uncovers the persistent and unavoidable uncertainty inherent in the business of banking. We learn that a banker’s confidence in his ability to measure banking risk accurately is the lure which has repeatedly led to bank failures. Pollock has a modest and compelling suggestion: Acknowledge the unavoidability of ignorance with respect to financial risk, and, in the light of this ignorance of the future, act moderately.


Alex Polluck, Senior Fellow, R Street Institute 

Wayne Abernathy, Executive VP for Financial Institutions Policy and Regulatory Af, American Bankers Association 

Teleforum calls are open to all dues paying members of the Federalist Society. To become a member, sign up here. As a member, you should receive email announcements of upcoming Teleforum calls which contain the conference call phone number. If you are not receiving those email announcements, please contact us at 202-822-8138.

Event Transcript

Operator:  Welcome to The Federalist Society's Practice Group Podcast. The following podcast, hosted by The Federalist Society's Financial Services & E-Commerce Practice Group, was recorded on Tuesday, October 30, 2018 during a live teleforum conference call held exclusively for Federalist Society members.     


Micah Wallen:  Welcome to The Federalist Society's teleforum conference call. This afternoon's topic is a book review on a recently published book by Alex Polluck entitled Finance and Philosophy: Why We're Always Surprised. My name is Micah Wallen, and I'm the Assistant Director of Practice Groups at The Federalist Society.


      As always, please note that all expressions of opinion are those of the experts on today's call.


      Today we are fortunate to have with us Alex Polluck, who is a Distinguished Senior Fellow for the R Street Institute, and Wayne Abernathy, who is Executive VP for Financial Institutions Policy and Regulatory Affairs for the American Bankers Association. Without further ado, Wayne, the floor is yours.


Wayne Abernathy:  Thank you very much, Micah, and welcome everybody who's joining us for this teleforum. Today we're in the midst of a dubious celebration, a commemoration of the sad and sometimes frightening events associated with the most recent bursting of an American financial bubble now just 10 years distant. I can think of no better way for us to commemorate those events than to consider the root causes and ask why so many were so surprised. And when I speak of root causes, I don’t refer to the inflation of prices for housing and housing finance instruments. I suggest that we look behind those immediate causes. Hence, our teleforum today features Alex Polluck, a member of the executive committee of The Federalist Society's Financial Services Practice Group.


      Alex will be discussing his very timely and, I will say to a significant degree, timeless new book: Finance and Philosophy: Why We're Always Surprised. As a very brief intro so that we can get Alex right to his comments, I'll mention that Alex, besides his very generous participation in Federalist Society activities, is currently Distinguished Senior Fellow with the R Street Institute. I first became acquainted with Alex when he was President and CEO of the Federal Home Loan Bank of Chicago. And before that, he worked for a number of years in commercial banking. That is to say that Alex has direct experience with much of what he discusses in his book, which, by the way, I found to be thought provoking and informative while at the same time a very enjoyable read. Now try to find that combination in a book.


      Our format for today's teleforum will be as follows: Alex will take a few minutes to touch on some of the key themes of the book. Then I will put a few questions to draw him out some more. Following which, we will open the floor to questions from you, the listeners. Alex is joining us this afternoon from Chicago. Go ahead, Alex.


Alex Polluck:  Thank you very much, Wayne. It's great to be with you. And thanks to The Federalist Society for sponsoring this discussion. Now, this book explores what, I think, is the fascinating nature of financial reality in its history, present, and future. This is a reality which is a human creation but is not controlled by human intentions. The reality which is intertwined at all times with economics and politics. The reality which induces some of the very smartest people to make the very biggest and, seen in retrospect, dumbest mistakes. A reality which is interactive, recursive, complex, reflexive, in which ideas are part of the reality as are strategies, expectations, expectations of other people's expectations, and anticipating anticipation. And the reality which is exceptionally difficult to forecast with consistent success.


      For example, in January of 2008 Ben Bernanke, an unquestionably, extremely intelligent, and very knowledgeable man backed by all the resources of the greatest central bank in the world of which he was the chairman, announced the Federal Reserve is not currently forecasting a recession. This was a terrible forecast, indeed, because as we know now, the painful recession had already started before he made the forecast that there wouldn't be one. And in general, as we all know, the record of economic and financial forecasting is pretty dismal. This may remind us of the self-confident macroeconomists of the early 1960s, who announced that they were going to, as they said, fine tune the economy, and thus do away with economic and financial cycles. Since then, we've had not just cycles, but financial crisis in the 1970s, 1980s, 1990s, 2000s, and 2010s.


      Next, we can note that financial and banking crises are common, historically speaking. The book details the banking crises of the 100 years of the 20th century and shows that a banking crisis started somewhere in '54 of the 100 years of the century. The point the book is making is not that these are caused by a lack of intelligence or a lack of effort or dominate dishonesty or not having enough computers or not trying enough. It isn't being stupid that's the problem; it isn't the mind that's the problem. It's the nature of the financial reality itself that the mind is trying to know. Not the nature of the mind, but the odd thing that the mind is trying to know.


      Now, the financial and economic future is unknown. The book argues that the financial future is, moreover, unknowable. That is, it is fundamentally and irredeemably uncertain, not merely risky. And the book asks, "Why is this?" and tries to explore it. And we know that financial reality is full of paradoxes: believing that financial things are impossible makes them possible or even likely; believing, for example, that house prices can't go down ultimately makes them go down; believing they can't go down very much makes them go down a lot; and in general, believing financial things are safe makes them dangerous.


      So as we try to think about all the unending interactions subject to fundamental uncertainty, we get to an extremely important conclusion. And that is that everyone is part of the uncertain interaction. No one is above and outside the interactions looking down with a celestial perspective. The regulators and central bankers in particular are not above the arena of financial interactions, sitting in the Emperor's Box so to speak to give thumbs up or thumbs down. There is not Emperor's Box. Everyone is in the arena. There is no special knowledge of the financial future given to central bankers or regulators, let alone politicians or to anybody else. There are no philosopher kings and no philosopher kings are possible. This lack of knowledge, as it seems to me, doesn't make finance and economics less interesting but more interesting.


      The book also takes up what I call "the wonderful trend and the troublesome cycles." "The wonderful trend" is that greater and greater economic and living standards for ordinary people keep happening – ordinary people like you and like me. Thanks to this trend, we are now eight times better off on average than were Americans in my grandfather's youth at the beginning of the 20th Century. And this is in spite of all the wars, busts, and financial crises in between.


      The philosophical importance, as it seems to me, of this transformation of the human condition, which is ongoing, cannot be overstated. But is it possible to have "the wonderful trend" without the cycles of booms and busts? The book speculates on this issue and suggests that the answer is no. The book also takes up the question of faith versus skepticism, in particular, how much faith can you put in governments and how much faith should you put in governments? In this context, it considers the history of sovereign debt, which is a checkered history indeed. As one financial historian wrote, the history of government loans is really a history of government defaults. The book also has a chapter on municipal debt.


      Now, thinking of government, central banks are part of governments. The book also takes up the topic of the most dangerous, financial institution in the world. At this point, I'll only say that this institution is, as some of you may be guessing, the Federal Reserve, which gets its own chapter and certainly warrants it. Now, the book also reflects on the intriguing questions of what is money? What is a price? In particular, what is the price of an asset? How much can the price of an asset change? The answer to that last one is more than you think. What is risk? What is uncertainty? And, of course, how is it that so often even the most capable, best informed, and powerful are nonetheless surprised by financial reality? In its final chapter, the book takes up virtue and finance and suggests the specific financial virtues, which I believe are loyalty, prudence, integrity and temperance. I hope we'll all strive for these in our financial activities.


      The very end of the book is a compendium of aphorisms. Now, these are my favorite sayings about financial reality. Of course, I had to put "Polluck's Law of Finance" first. But there are many others which I hope will strike you as both true and funny.


      With that, Wayne, I look forward to your comments and questions.


Wayne Abernathy:  Well, great. Thanks very much, Alex. A lot of stuff there, a lot of things for us to cover here. We'll be very interested in questions that we'll have from people who are listening in, but let me start off with a few, and I'd like to actually start with "Polluck's Law of Finance." Let me quote it from the book, quote, "Loans that cannot be repaid will not be repaid." Now, you explain in the book that because of that "iron law"—you call it the "iron law"—the question is not whether there will be losses on loans that cannot be repaid—and that is the case in which we find ourselves following the collapse of a financial bubble—there're a lot of losses that are not going to be repaid. The difficult questions are: who will take the losses, how will the losses be moved around, when will the losses be taken by those who are forced to take them? You offer some very interesting observations as to where the losses of the most recent bubble bursting here in the United States have been assigned. How much of those loses have been socialized?


Alex Polluck:  Well, a great deal of them have. And thank you for your very accurate stating of the theory. I'll just repeat that the hardest part in the wake of the bubble, the losses are real—economically, they've already happened—but we go through a vast, political and legal and financial effort to sort out who is going to take the hit and when will we tell the truth about how big the losses are. In the wake of the most recent bubble, the one of 10 years ago, was just like in the wake of all the other bubbles – those of the 1990s, 1980s, and backward for a couple of centuries. We had this process of trying to assign who gets the losses. And, of course, the best way to put losses on people is when it's not explicitly happening. And in this last cycle, one of the ways to distribute the losses of the bubble was to expropriate savers. So the Federal Reserve managed this process of moving the losses to the holders of money and savings by forcing real interest rates to negative terms and keeping them there for an amazingly long period of seven or eight years.


      In my calculation, that transferred over $2 trillion from savers to borrowers of various kinds. Notably advantaged borrowers in this were highly levered speculators who got nearly that -- in real terms, free money to speculate with. And, of course, the biggest borrower of all – the U.S. Government. But by suppressing the cost of its debt to extremely low or negative interest rates in real terms benefits the running of the government as it works its way through the programs put in place to subsidize this group or that group. And this is one of the hardest ways of distributing the losses to deal with because they are explicit losses but they are real losses, and they hit the savers.


Wayne Abernathy:  Well, thank you. And that's, I think, many of us when we look in the mirror, we can see who some of those people are who've been helping to absorb losses.


      I want to draw now upon this point that you begin your book with, which is, I think, very important. It's a foundational point, I think, of the book, which is the unpredictability of financial futures. And I don't mean the financial future instruments but of predicting what's going to happen. And I want to tie this to a very important and significant policy structure that is being imposed upon the financial system currently, and that's a thing called CECL, which is C-E-C-L, stands for the concept of Current Expected Credit Laws.


      This is an idea that the accounting profession has developed to try to deal with what they saw was a problem with the last recession, which was that banks weren't adequately reserved against the losses that they actually experienced. And, in fact, we remember some banks tried to in the good times set aside larger reserves for losses, and the SEC said, "You can't do that." So they've come up with this idea -- and this is the question really that it focuses on the core process of CECL, this new Current Expected Credit Loss Program that's in the process of being implemented, is to require lenders to predict at the very moment they make a loan just how much they're going to lose on that loan over the life of the loan, and then set aside reserves against that predicted loss. Is that just a quixotic exercise? Is there a problem with that? How do you view that concept?


Alex Polluck:  Let me start, first of all, when you say as the famous line attributed to Yogi Berra goes, "Predicting is hard, especially in the future." Of course, predicting is easy and lots of people are predicting every minute, all day long, including, I'm sure, some of the people participating in this call. It's just predicting correctly that's hard or impossible when it comes to the financial and economic future. Other kinds of future – the future of physical reality – can be readily and exactly predictable, but not finance and economics, and predictable successfully.


      So we're looking at an unknown future. What do we do about loan-loss reserves? I should say, first of all, I am a big fan of big loan-loss reserves, just because of the unknowability of the future. And my belief that accounting should be a conservative art – art not science – allowing margins for error on the down side, but the notion that you could exactly predict the losses on a class of loans is, of course, silly. You can't do it. You can know in general there'll be losses, and you should, in my view, conservatively create margin for error against those losses.


      Years ago in banking—I mean, generations ago—they used to create something called reserves for contingencies. It's a dangerous world, and they had a reserve for contingencies. I think that's very logical, but of course the accountants won't let you do that. These days, instead, they strive for this CECL-type precision. And what you cannot have is precision; what you can have is a general being careful.


      One of the aphorisms that are in the book, among my favorite, is something I learned from an old banker and I have treasured as an insight is risk is the price you'd never thought you'd had to pay. You are happy to be taking risk, you thought you knew what you were dong, but the losses are liable to be much bigger than you ever thought or imagined. This is the price you never thought you'd have to pay, and I think this is relevant to searching for precision in such matters.


Wayne Abernathy:  Well, I actually want to draw upon one of the other aphorisms you have in your book. It was actually a question posed to you in your early banking days. In the book, you comment about the impossible job that over time -- the impossible job that over and over has been given to the Federal Reserve in overabundance. And from the original task Congress gave to the Fed of providing liquidity to illiquid-but-not-insolvent institutions, you describe about how Congress over the decades has given more and more and more things for the Fed to do beyond where it could possibly succeed. And I would say having seen Federal Reserve chairman and governors testify before Congress and even had a hand as a Senate staff in writing questions for them, I can sympathize with the lesson you cite that was once presented to you, and I quote again, "Alex, it's easier to be brilliant than right." And that's very true.


Alex Polluck:  Thank you.


Wayne Abernathy:  What are some of the impossible tasks that have been given to the Fed, and is there systemic risk by giving those tasks to the Fed? And what would be the proper role for a federal reserve if we're going to have a federal reserve?


Alex Polluck:  First of all, thank you for picking up on that line which is one of my favorites. It was a criticism of one of my dear bosses to me, and I've thought of it hundreds of times in the years since then. It's so true, it's easier to be brilliant than right. That's why so many brilliant people, their brilliance notwithstanding, get in trouble in the course of financial cycles. They come up with really smart ideas that turn out to be a disaster. And another line that's in the book that I like a lot, "The rocket scientists build a missile which landed on themselves," and this happens regularly.


      The Federal Reserve, as you say, when it was set up in 1913, the purpose was very clear. It was to create what they called an "elastic currency." That's the first line of the original act, to create an elastic currency and to improve banking. All right. Those define two of the, what I count them as, six mandates of the Federal Reserve, and it is my view that all six cannot possibly be successfully pursued. Let us create an elastic currency, meaning in times of panic to print up money and lend it to people to try to calm the panic. And this, the monster believed the Federal Reserve is able to do: to print up money and lend it to people. Now, it doesn't always calm the panic but they're clearly able to do that.


      Improving banking, which really was about -- was phrased very well by an English student of central banking, Charles Goodheart, who said it's being manager of the banking club. And I think at that the Federal Reserve is far less than successful. It might be successful in an oligopolistic system that has only a few banks. But not in the American system.


      As we know, there is a so-called "Duel Mandate" of the Federal Reserve, which they cite as price stability, which they have defined as perpetual inflation. This is really a good example of not being able to carry out your mandate. What the act says—this was the Federal Reserve Reform Act of 1977, assigned, then, the task of stable prices. Stable prices, which the Federal Reserve on its own hook, without congressional action, had redefined to mean inflation forever at the rate of two percent per year. They're also supposed to maximize employment, which turns into the idea that they can somehow manage the economics. Something that no one can do, including Federal Reserve.


      The so-called "Duel Mandate" was actually a triple mandate because they were also supposed to ensure moderate interest rates—moderate long-term interest rates. So you figure out what you think moderate means. All of those things which have to do with knowing enough about the financial future that you cannot only successfully predict it, but you can also control it by your actions, I think, no one, including any central bank or the Federal Reserve, can do successfully. One of the problems is you don’t even know what the results of your own actions will be in the unknowable future. You're in the arena with everyone else, and everything you do creates reflexive, recursive actions on the part of everybody else. Fewer actions give rise to expectations, which change actions and change behavior, and you can't even and they can't even know what the results of their actions will be, such as if you run negative interest rates for eight years and you create giant asset price inflations, what will the result of those asset price inflations be? We may be in the process of finding out now.


      A final thing that all central banks have as a mandate, only somehow they never mention but is nonetheless real, is financing the government. In my opinion, the biggest mandate every central bank, including the Federal Reserve, has is financing the government and buying up its bonds when necessary. This, obviously, becomes utterly apparent in times of war when the printing presses are running and the central banks buy however much government debt needs to be bought. But it still is there at all times as a fundamental central bank function.


      So I think the net of all of that is you have an assignment which no one can succeed at, and in doing it, you may create vast defects which you did not intend to create, and this is what makes the world's biggest, most important central bank – the Federal Reserve – also the most dangerous financial institution in the world.


Wayne Abernathy:  Well, and a follow up to that given how important the roles are and the tasks that have been given to the Federal Reserve, how can they, within a system that rests upon the sovereignty of the population, how can they maintain a concept of independence but that independence means somehow shielded from accountability?


 Alex Polluck:  You can do it, if you are politically really adept, except in times of war because in times of war, the government asserts its control over the central bank -- I mean, the executive, the Treasury asserts its control. But in other times you can do it, if you're politically adept. But you shouldn't do it. No, in my judgment, no part of any democratic government, or the constitutional government in particular of the United States, should be independent. It's a wild and irresponsible idea. Every part of the government should be involved in a system of checks and balances as we know, and that includes the Fed too, so that it, as best it can, operates. It needs to be fully accountable, in my judgment, to its creator, which is the Congress – the elected representatives of the people.


      Now, people when you say that, or when I say that, especially economists—and remember the Federal Reserve is the largest employer of economists in the country—say, "That's terrible. You're going to have all of these politicians trying to carry out monetary policy." But it doesn't mean that, does it? It means that the Congress is like the board of directors and the Federal Reserve officers are like the management of a corporation. And it would certainly be surprising if management declared independence from the board, and that's what it seems to me the Fed has tried to do with its proclamations that it, unlike every other part of a constitutional government, needs to be a fiefdom unto itself.


Wayne Abernathy:  That's a very interesting analogy. Now, we're about to open the lines up for questions from our callers. I'm going to put one question to you before we do that. In the book, you present an interesting lesson for all lenders to keep in mind about collateral. And you posed this question -- you remember the question? You posed this question: what is the collateral for a mortgage loan? And if you'd please discuss, if you would, why the usual answer to that question is not correct, and why understanding the correct answer is so important.


Alex Polluck:  Wayne, thank you. I have to say that I had a lot of fun writing this book. I hope that's apparent, and I hope it makes it fun for people to read. I'd like especially to say to audience and the mortgage lenders—and I work a lot, and have over the years, on housing finance—exactly that question: what is the collateral for a residential mortgage loan? And, of course, people say, "The house, obviously. It's your house." And then I say, "That is incorrect. It's not the house. It's the price of the house." Because the only way you can ever get any money if you foreclose on the house is to sell the house at some price. And if you're foreclosing in the midst of a panic and collapse, the price, as we know, is going to be a lot less than you thought, probably a lot less than your worst case planning scenario provided for. So it's not that -- and that's true of every asset. It's true of lending against oil. In the wonderful oil price collapse in the early 1980s which generated vast numbers of bank failures and insolvencies. It's not the oil; it's the price of oil. It's not the house; it's the price of the house, and so on for everything.


      There is then a second question that I like to pose that goes along with this, and I mentioned this in my opening remarks. It's, okay, it's not the house; it's the price of the house. The second question is how much can a price change? And the answer is more than you think. It can go up more than you think in the boom, and it can go down a lot more than you think in the bust because the price of an asset has no objective existence. There's no objective reality to the price. It's only a creation of human interaction, and it can change, as we say, very far up and very far down. It can create the illusion of wealth on the way up, and it can create the reality of huge losses on the way down.


Wayne Abernathy:  Well, we have put a number of really good things on the table for people to discuss in our call today. Let's now open the channels for calls from our -- for questions from our callers and our listeners, and see what they would like to put to you.


Micah Wallen:  Thank you, Wayne and Alex, for that enlightening discussion. We will now go to the first question.


Herman Bouma:  Yes, thank you. This is Herman Bouma in Washington D.C. I understand that Switzerland tried very hard not to have inflation, and as far as I can tell, their economy does pretty well. Could you please explain why in the world the Federal Reserve would decide that two percent inflation constitutes price stability? Thank you.


Alex Polluck:  Thank you. That is a great question. And it doesn't make sense, does it? It's a contradiction in terms. There's a long history to this, and the Federal Reserve isn’t alone. All over the world now, central banks, like the Bank of Canada or the Bank of Japan, the European Central Bank, the Bank of England, have set out perpetual -- they don’t call it perpetual inflation. They say our target is two percent. But logically that means two percent forever. At two percent a year, in a normal lifetime of 82 or 83 years, prices will quintuple. It's astonishing to think that's -- you could call that price stability and you can.


      Now, the reason behind this goes back to the adjustment out of the original great inflation of the 1970s, which was created above all by the Federal Reserve in the 1970s with the cooperation of other central banks. And as they were trying to bring inflation down, we remember we got to double digits, even in this country, not unlike things that we've previously thought would only happen in a Latin American country or an underdeveloped country, as we then said. As the inflation rates were ratcheting down, the original use of two percent—and this was invented in New Zealand, by the way, by the Central Bank of New Zealand—was to say, well, let's have a target that we're going to bring it down. We'll say two percent because if you're at four or five or three or seven, two is progress. So that's where the two percent came from. And the original New Zealand target was zero to two. So it was a way of getting inflation down in its original idea.


      For those theorists who want to support two percent, there are two important arguments that they have. One important argument is, well, we have to have two percent so the central bank has enough power to lower interest rates in a recession. So you think if inflation is two percent, normal short-terms rates might be three or four. So they want to give themselves the ability to do this economic manipulation.


      The second reason is money illusion. The classic argument for inflation, sometimes, it goes back at least to Keynes and maybe earlier, is that for economic adjustment, you have to be able to lower real wages in the competitive international economy. And the argument is, well, you can't lower nominal wages. There's resistance to that. That's probably not true because people change jobs and go to lower wages. But anyway, that's the argument. You can't lower nominal wages, but you have to lower real wages to adjust. So the way that you lower real wages is to run inflation, and the real wages can adjust and then the resources and the economy can be reallocated along the lines of greater productivity. That's the argument. Personally, I'm in favor of stable prices, an on average zero over long period of time inflation. I'm glad to see that Paul Volcker in his new book is backing this position as well. And if you're interested in of the details of these arguments and the history, there's an interesting book by my friend Brendan Brown called The Case Against 2 Per Cent Inflation, which takes up this specific topic.


Micah Wallen:  All right. We'll move on to the next caller.


Caller 2:  Given what you said about the economy and financial institutions, what do you think that implies for investments just in general? For personal investments.


Alex Polluck:  It implies that personal investing will always be interesting because you're always into an unknowable future. But I come back to the theme of something we do know, which is "the wonderful trend." In the book, I discuss "the wonderful trend," which was created by the invention of science based on mathematics in the 17th century by Newton and his colleagues and set off this really astonishing growth in income and wellbeing, economic and in life, for ordinary people, as I say like you and me. And this is a 200-year trend now which has resulted in an astonishing richness of life, eight times better off than in 2000. And I tell the story of John Maynard Keynes, who in 1930 in the midst of despair made a great prediction which was that people in 100 years, that is to say by 2030, would be four to eight times on average better off, so let's say GDP per capita, and that prediction's true. We're already more than six times better off than in 1930. And that was in the middle of utter, worldwide despair in the depression. So there is this glorious trend. I also talk about it as the magic of two percent per capita or even one or one and a half percent will do.


      Now, but along that trend comes "the troublesome cycles," and this is where this question of can you have the trend without the cycles is I think so interesting for personal investing or institutional investing or any kind of investing. And the answer is, I think, no. So you will, it seems to me without doubt, have these adventures, these hot-air fueled asset price inflations followed by very frightening collapses in asset prices and busts and failures. I don't think there's any way to avoid that if you want to have an economy that actually grows in per capita terms, and the way it's going to grow is through entrepreneurship. The argument, in short, is that entrepreneurship creates growth. Entrepreneurship also creates uncertainty; uncertainty creates cycles and so they go together. Good luck in your personal investing and same to all of us. But we are sure to have exciting times now and then.


Wayne Abernathy:  Thank you. Let's proceed to the next question.


Micah Wallen:  Well, Wayne, that seems to be -- have exhausted the questions for now. Did you have anything further to discuss?


Wayne Abernathy:  I do as a matter of fact. The one came to mind that really followed on this, if I might, Alex, and that is you do some interesting calculations talking about investing about the successes and losses of the housing GSEs, Fannie and Freddie. If you want to talk about that, how they money they made and what happened to all that.


Alex Polluck:  Well, we know that Fannie and Freddie make a fascinating story of government involvement in financial markets with a really, when you look at it in retrospect, pathetic theory, which is the way to have success is to run up the leverage of two government guarantees in housing finance. A truly bad idea that had a bad outcome. Fannie and Freddie when they failed lost more than twice as much money as they had made together in the aggregate and the previous 35 years. And we know that they are today still guaranteed by the government and couldn't exist for even one minute if they weren't guaranteed by the government. They're a wonderful case study, and we should really pay a lot of attention to them.


      I have a recent article called "How to Lose 99% Investing with the Government in Fannie and Freddie" ("The Adventures of Investing in Fannie Mae and Freddie Mac Stock, or How to Lose 99% in a Government Deal"), which was the loss from the top of their stock price to the bottom of their stock price. The whole motion of creating these monstrous concentrations of risk based on government guarantees should be a really instructive lesson. We're not sure it is.


      One final word on that, you know that as part of the Dodd-Frank Act, they assigned the Financial Stability Oversight [Council], or FSOC, the job of naming SIFIs, or Systemically Important Financial Institutions. There is no doubt that Fannie Mae and Freddie Mac were and are, and as long as they're in their current form, always will be systemically important and very unlikely to create systemic risks in crisis. Yet, somehow the FSOC hasn't managed to name them as SIFIs, which they richly deserve to be. I like to say if they're not SIFIs, then no one in the world is a SIFI, including the biggest banks.


      Why not? Why not is politics? And why not comes back to the problem of the Fed. The government is very bad at pointing out that it itself creates systemic risk. It's not the only one, but it can through, for example, Fannie and Freddie, or through the Fed. And how do a number of government officers sitting together in council admit to the fact that the actions of the government itself – their employer – are creating systemic risk?


Wayne Abernathy:  And as a matter of fact, I've been watching since the FSOC was created for them to take up the topics of monetary policy as a source of systemic risk – the Fed's monetary policies – and the various housing policies that are still being pursued throughout the government. And as far as I can tell, a lot of stuff they do, they don’t divulge. But certainly in what they've divulged, those two items have never been on the agenda of the FSOC from what I've been able to see.


Alex Polluck:  And are you surprised that you're still waiting?


Wayne Abernathy:  [Laughter]. No I've stopped being surprised. Although, I will say that is the subtitle of your book: Why We're Always Surprised. So I'm waiting to be surprised.




Micah Wallen:  If I could jump in here, we did have two more questions pop up during that --


Wayne Abernathy:  Oh, please.


Micah Wallen:  -- that exchange. So without further ado, we'll proceed with that.


Warren Belmar:  Well, thank you, Alex. This is Warren Belmar. I enjoyed the conversation. And I learned something from Wayne about the proposal in the accounting industry. CECL, would that proposal apply to the student loan program of the federal government or manages? And in addition, would you modify, in light of that program, your Rule Number One -- to amend it to say, not only can a loan -- so it cannot be repaid, but loans that need not be repaid?


Alex Polluck:  Oh, Warren, thanks a lot. I think that's a good amendment, and we just got done discussing how hard it is for departments of the government to apply things to themselves, which makes sense. The student loan story, of course, has yet to play out. It's instructive to remember that when the government completely took over the student loan program, the rationale was it was going to be much more profitable than a program run by -- with lending from banks and basically a private sector program. And instead a much more profitable -- obviously, we're having enormous losses. But some of the losses can be a result of the political desire to make the loans into gifts.


Warren Belmar:   Hence, the need not be repaid category.


Alex Polluck:  Yes, I got it. I agree. I think it's a good amendment. If there's a second edition of the book, Warren, I'm going to remember that.


Wayne Abernathy:  I will say one thing about that. One of the things that I enjoyed doing when I was at the Treasury Department, I signed the document that finally set Sallie Mae, the student loan mortgage association, the GSE at the time, free. They became a private sector organization. Little did I know that while the company now was private sector, that the government would take over the industry, would take over the product. Again, I was surprised, I will have to say.


Alex Polluck:  [Laughter]. Well, yeah, there we go.


Wayne Abernathy:  I think we have another caller with a question. Is that correct?


Micah Wallen:  Yes, we do. Without further ado, we'll move onto the next caller.


Herman Bouma:  All right. Thanks again. This is Herman Bouma, again. I guess this is more of a personal question involving TIPS – Treasury Inflation Protected Securities, which provide protection against inflation but also a little bit of a real return. I'm wondering what your opinion is of those as an investment. Assuming the investor's going to hold them until maturity, they would seem to be risk free, assuming the United States continues to exist. And I'm just wondering what you think of TIPS as an investment option. Thank you.


Alex Polluck:  Thank you. That's a good question because a security, which is issued by the government and automatically adjusts for the inflation fundamentally created by the government's own central bank and then pays a real return on top of that, is a distinctly good idea. The tricky part of TIPS is what real return you are buying when you buy them, and that goes up and down with the market. So you know you're going to get this inflation adjustment which is built into the principle.


      I think a better design would've just paid you every year the inflation rate, and it's the CPI, right, as opposed to writing up the principle. But that's how they built the TIPS, they write -- they increase your principle by the amount of inflation every year. But in buying them, you have to pay attention to what real return you are buying and that can go from very attractive as it was, let's say, 20 years ago to not so attractive or even negative at times. But the fundamental idea of a government security which pays the inflation rate plus a return is certainly a good one.


Warren Bouma:  Thank you.


Wayne Abernathy:  Very good question.  Yeah, thank you. That answered your question. Great, because I do have another question I've been wanting to ask. There's a very important point you make near the end of your book. You talk about -- you say that with every bubble, there is fraud behind it or involved with it somehow or another. Is that because fraud causes the bubble or merely takes advantage of the bubble?


Alex Polluck:  First of all, it's right. And this goes back -- this is documented by Charles Kindleberger in his now-classic book Manias, Panics, and Crashes that in the bubble, there's always fraud, and it comes out in the end to create scandal and embarrassment and punishment. It's my belief that the fraud is a result of the bubble; of course, it contributes as well. In other words, making mortgage loans in which the income reported to the lender is false, either by lying by the borrower or by lying by some broker in between. You don’t know. That contributes to the bubble. But I don't think it's the main problem. I think the main problem is that the headiness of the bubble induces some amount of fraud, and it's easier to fool people when the prices are going up.


      Walter Bagehot in the greatest book on banking, which is Lombard Street, published in 1873, he says something like, "all [men] are most credulous when they are most happy; and when [a great deal of] money has just been made…some…are really making it…[and many] think they are making it… Almost anything will be believed for a…while." That's 1873. It's the same in 2018, and I guess it will always be the same so long as human beings are human beings.


      So the headiness and the feeling that you're making a lot of money induces various kinds of schemes. Bagehot goes on to say that this situation of the boom or the bubble is an opportunity for what he calls "ingenious mendacity" – wonderful phrase. And that we see every time. But just to note one more line from that great thinker and write, Bagehot, having considered all that, he says, but "error is more formidable than fraud."


Wayne Abernathy:  And that's the next point I wanted to get it. Talk about that.


Alex Polluck:  I think it's the error of doing things which you think are going to make money or going to be successful that turn out to be disasters. That is it is the fundamental nature of the bubble, and that's true to private actors, also of government actors, and into the unknowability of the future, though our fond hopes and sometimes from time to time, they turn out to be extremely wrong. I have in the book an example of financial markets as the game of musical chairs. Wayne, I don't know if you remember that part of it --


Wayne Abernathy:  I do. I thought that was very interesting. I tried to run through the math on that. It's very interesting.


Alex Polluck:  [Laughter]. I ask you to imagine a game of musical chairs where there're 500 people playing, and there's 700 chairs. And there's a nice Mozart serenade or something playing, and you could always get a chair. That's called a highly liquid market. Suddenly, somebody takes away 400 chairs and now there're 500 people and 300 chairs, and the music changes to some kind of horrible, raucous music, and all the people who can't find a chair are out. And every time they're out, they take two chairs with them. And that's the panic.


      I think it's a nice little metaphor. We always keep thinking that the disappearance of the chairs isn't going to happen. But it does happen from time to time. And essential to that is—I mentioned the word liquidity—is that liquidity isn't anything. Liquidity is not a thing. It's not a substance. It's not anything that can be pumped or put in. Liquidity is a state of interactive behavior of financial actors, and it depends upon—I argue in the book and I think is right—it depends upon the belief that other people are solvent and that prices are meaningful. And when you cease to believe that other people are solvent and you cease to believe prices are meaningful, there will be no liquidity. That's the equivalent of the chairs in the musical chairs game being removed and the people frantically scrambling for a chair.


Wayne Abernathy:  Okay. Alex, you point out that there are numerous, numerous studies and others that point to national booms, busts, and financial failures and panics occurring with some frequency around the world. We could probably point to some that are taking place today. Venezuela has got one that's sort of self-imposed. But you also talk about the great difficulties in predicting and managing for them. But so some countries and systems do better in avoiding or managing financial crises? And if so, what accounts for such better record than others?


Alex Polluck:  I think it's true. Of course, if you look my history I've mentioned of the 20th Century, the number of countries which had banking crises in the course of the century was well over 100. Banking crises are common in all kinds of countries. And you can even have a long period when you don’t have them and then you do again. It is said in England, in which you had the first panic of the last financial crisis in 2007 when Northern Rock went down, and they had an old-fashioned bank run where people lined up on the streets, it's said that that was the first bank run in England since Queen Victoria was on the throne. It's not that they didn't have financial problems, but they didn't have any runs.


      Charlie Calomiris in his really interesting book, Fragile by Design, describes every banking system as a deal between politicians and bankers. It's a perfect theme for you, Wayne, given your job at the American Banker's Association. A deal between --


Wayne Abernathy:  I see that book from where I am right now. It's on my shelf.


Alex Polluck:  It's a highly interesting book.


Wayne Abernathy:  Yep.


Alex Polluck:  And then he goes on to argue that different deals between bankers and politicians give rise to different kinds -- to different vulnerabilities in the systems, where some are more stable than others. A case he discusses at length, which he and others are very fond of, is Canada, which did not have bank failures during the depression, or in -- came through the last crisis much better than we did. One must say Canada has right now an extremely inflated house price bubble and we'll see how that plays out. But the banks do seem more stable, and one of the reasons they are is they've got about five, nationwide dominant banks. And there's a very interesting discussion in Charlie's book of the Canadian system as it compares to the U.S. system. Of course, we're a much bigger country. Canada's economically speaking, only about a tenth of the size of the U.S. But nonetheless, it's a significant country and an interesting case.


      So you might make an argument that if you're willing to have an oligopolistic system, it might be more stable.


Wayne Abernathy: -- Might be losing some [inaudible 57:00]




Alex Polluck:  You're giving up a lot of other things if you're willing to create an oligopoly. And it's very tricky, this business of picking countries because another book—I won't mention the author—I read the draft of identified the most stable banking systems in the world. This is a number of years ago, and one of them identified as the most stable system was Cyprus. Between the draft of the book and its publication, Cyprus collapsed; its banking system collapsed. So they luckily were able to fix the book just in time.




Wayne Abernathy:  Wow, wow. Well, we are approaching the top of the hour. Are there any last comments you want to make before we -- unfortunately, we're going to have to conclude this discussion for today.


Alex Polluck:  No. I only thank you very much, Wayne, and thanks to The Federalist Society for the chance to talk about my book, and I hope people will find it both interesting and enjoyable.


Wayne Abernathy:  Well, this has been a real pleasure for me. I've thought of another subtitle for your book. I would title it, as a subtitle, "The Dangers of Uncertainty; The Rewards of Virtue." And I'll mention, by the way, this book makes a good stocking stuffer. [Laughter]. Thank you, everybody, for listening to us today. And thank you, Alex for writing it and for talking about your book.


Alex Polluck:  Thank you, Wayne,


Micah Wallen:  And on behalf of The Federalist Society, I want to thank both of our experts for the benefit of their valuable time and expertise today. We welcome listener feedback by email at [email protected]. Thank you all for joining us. We are adjourned.


Operator:  Thank you for listening. We hope you enjoyed this practice group podcast. For materials related to this podcast and other Federalist Society multimedia, please visit The Federalist Society's website at