What will Donald Trump’s Presidency Mean for the Federal Reserve?

asset bubbles, Donald Trump, Gold standard, Janet Yellen, Taylor Rule
Donald Trump by Gage Skidmore CC BY-SA 2.0 (https://www.flickr.com/photos/gageskidmore/23691565882); Yellen Wikimedia (https://commons.wikimedia.org/wiki/File:FED_9638_(25542320420).jpg)

trumpyellen3On election night, former New York mayor Rudy Giuliani told MSNBC interviewer Chris Matthews that Donald Trump’s victory, after a campaign against the elites and insiders, was like Andrew Jackson’s first presidential victory. At the end of his first term in office, Jackson cut the federal government’s ties to the Bank of the United States (by vetoing an Act to renew its charter), an institution that was in some respects the Federal Reserve System of its day. Might Donald Trump’s presidency have equally dramatic consequences for the Federal Reserve?

During his campaign, candidate Trump mulled an idea for thoroughgoing reform of our monetary system: a return to the gold standard. As Ralph Benko noted, Mr. Trump told a New Hampshire television station in March: “We used to have a very, very solid country because it was based on a gold standard.” He added that a return would be difficult because “we don’t have the gold. Other places have the gold.” He similarly told GQ magazine that “Bringing back the gold standard would be very hard to do, but boy, would it be wonderful. We’d have a standard on which to base our money.”

It should be pointed out to the president-elect that in fact the US government does have enough gold in Fort Knox and its other depositories, at least if the US Treasury has been reporting its holdings honestly. At the current market price of about $1,280 per fine Troy oz., the U.S. government’s 261.5 million ounces of gold are worth $335 billion. Current required bank reserves are only $168 billion. Looked at another way, $335 billion is just a bit more than 10 percent of the $3,347 in current M1 (the sum of currency and checking account balances), which is more than a healthy reserve ratio by historical standards. In that respect, restoration of the gold standard is eminently feasible. After unwinding the QEs, the Fed could swap commercial banks’  required reserves for gold, and hold gold against its own currency liabilities, Federal Reserve Notes, which would once again be made redeemable in gold. Better yet, the federal government could allow commercial banks to issue their own currency again (or, if it already technically legal, promise not to penalize them).

Whether restoration of the gold standard will be politically feasible depends of course on how serious the new president will be about pushing it, and how receptive the Republican majorities in Congress will be.

Regarding reforms of Fed policy that keep fiat money in place, candidate Trump’s position seemed to evolve. In an April interview, he told Fortune that “The best thing we have going for us is that interest rates are so low,” and that the prospect of rate hikes was “scary.” During an October debate, by contrast, he accused Fed chair Janet Yellen of keeping interest rates artificially low for political reasons, namely to keep the recovery chugging along until the election and so to help the incumbent party. Even back in the April interview, when he thought that Yellen had been doing “a serviceable job,” he was already saying that “I would be more inclined to put other people in.” Thus it would be a surprise for Trump to reappoint Yellen as Fed Chair when her four-year term expires in February 2018. What he would look for in a new Chair is less clear.

As president, Trump will immediately have the authority to nominate two new Governors to the Federal Reserve Board, thereby to the Federal Open Market Committee. Normally the FRB has seven members, including the Chair. Currently it has only five members, all Obama appointees. Senate Republicans have deliberately left the two vacancies open by refusing to hold hearings on Obama’s latest nominees. The FOMC’s makeup is thus currently 5 Obama-appointed Governors plus 5 regional Federal Reserve Bank presidents, who tend to be more hawkish on inflation (apart from the New York Fed president, the only regional Bank president who is permanently on the FOMC). A pair of thoughtful nominations by the Trump White House could increase the hawkishness of the median (tie-breaking) voters on the FOMC.

In his October criticism, Trump said that the Fed was “keeping interest rates so low that the next guy or person who takes over as president could have a real problem.” He said elsewhere that artificially low rates were creating a “very false economy.” In these remarks Trump appeared to have recognized that overly low interest rates can misdirect investments and create unsustainable asset bubbles. He might then be favorable to Congressional proposals made in recent years, particularly by Rep. Jeb Hensarling, for fastening a monetary policy rule on the Federal Reserve. A Taylor Rule with teeth, for example, would mandate automatic adjustments in the Fed’s interest rate target based on publicly observable variables. Such a rule would strip discretion from the FOMC and avoid the problem of politically tinged policymaking.

  • Walker Todd

    Larry, as usual, does the Lord's work here. I, too, have studied the issue (feasibility of return to the gold standard) over many years. I think (he can correct me) that Larry is not proposing a fixed amount or percentage of demand liabilities gold reserve. Instead, he is proposing that banks simply issue liabilities redeemable in gold and that the Federal Reserve do likewise. The mathematics of the matter suggest that a ten percent gold reserve would be feasible, and that might suffice in most instances. At the high water mark of specified gold reserve for the Fed early in the 20th century, the reserve was 35 percent against all demand liabilities and an additional 5 percent gold reserve for the Fed's own circulating notes (Federal Reserve notes). While a reserve that high might appear to be overkill, I doubt that it would be anywhere nearly enough in a world of derivatives and gonzo ETFs within the banking system. A fundamental decision needs to be made soon: Do we want safe and sound banking (at least for that part of it linked to the payment system), or do we want free, risk-taking banking that, in some sectors, might be willing to put gold on the table as margin against its risks? In my opinion, this is not a one-size-fits-all prescription: Some people rationally prefer safe and sound banking, and some want the potentially greater returns that come with greater risks. However, that does not mean that both sets of customers should find themselves inside the same bank. There is a good and legitimate reason why banking was separated earlier in the 20th century: Payment system banking in one direction, and investment or merchant banking in the other. Most of our recent banking calamities arose over the last 40 years or so as commercial (payment system) bankers tried to do what their investment banking brethren had been doing for a long time in order to increase fee income and trading profits. Investment bankers really are smarter than commercial bankers, but the latter have cheaper funding sources related to their payment system and deposit-taking activities.–Walker Todd, Middle Tennessee State University

    • Kevin Dowd

      Thanks Larry and Walker: I agree with Walker's interpretation of Larry's elegant piece – Larry is arguing that there is plenty of gold to back a restored gold standard and he is right. I would go further: the US could always buy more gold if it wanted a higher gold reserve ratio.

      Here is my take: with the President-elect on record as being supportive of the gold standard, now is the ideal time to run with this issue and highlight the potential of a new gold standard.

      The reserve ratio issue is not a problem for reasons already mentioned.

      There is however another feasibility issue which is important and needs to be addressed. As a rough approximation, the Fed's capital is just over $40 billion and its balance sheet about $3.8 trillion, or $3,800 billion. The Fed's capital to asset ratio is therefore about 0.03%. Considering that many of the assets in the Fed's portfolio were bought up at excessively high prices and are still overvalued on paper, then it is fair to say that its asset portfolio must be (grossly) overstated in value. Which consideration implies that the Fed is technically insolvent.

      Now the Fed being insolvent is no barrier to it continuing to operate as it does on a inconvertible fiat standard (although it is disturbing nonetheless), but it would be a problem if the Fed were peg the price of its liabilities as a GS would entail. Therefore, I believe the Fed would need to be recapitalized if a gold standard were to be restored.

      The alternative is simply to restore the gold standard with the Fed 'as is', but an insolvent bank – central or private – bank issuing a gold-backed currency does not strike me as a good gold standard because of this obvious Achilles' Heel.

      Sadly, the fiat money crowd will argue that this problem is a reason to oppose the gold standard, when in reality, the Fed should never have compromised itself in this way in the first place.

      • What I would not like to see is that countries start digging for gold and damage the environment only because it has to be deposited in a transformed physical shape in some country's treasuries.

        • George Selgin

          Bispec, check the history of the real price of gold (which determines the extent of gold mining). It has been far higher since we went off gold than it was before. Nor was this an accident. See my 10 myths about the gold standard article for more details.

          • George, because scarcity makes it valuable, I think that we all know by now with an abundance of products and "work" opportunities that are suddenly becoming cheap.
            There is gold in the universe but that implies that we need go and take it from there rather than dig in the soil on Earth. That was all the point that I wanted to make. Digging in the soil to get oil or place pipes is no longer the option available to humans as there is enough technological advancement made to move the entire system towards clean air, water, etc.

  • Juanita Skelton

    Can someone tell me how and why Fed assets get over-valued? If our governments assets are not valued correctly, who gets to establish it's true value? Who assesses the value of assets? If they, the assets were, at one time, valued against a "solid" gold standard, what was the driving forces that changed the valuation standard?….was it politics?
    I am an annoying ignorant, I know not where to go to learn what you are discussing, other than to Cato commentors, or college and I can't afford it!

    • M. Camp

      Hey, Juanita. Like you I'm not one of the experts here, but I will take a stab at the answer, and hope that I will be corrected as need be.

      The true value of an asset is whatever it trades for on the open market, where the buyers are risking their own money. Fed officials aren't risking their own money, and their deals are no longer transparent (so they can't get caught, in the short term). So if they are tempted to be a bit dishonest, they may pay more for them than they are worth. As it happens, they WERE tempted, and they WERE a bit dishonest, and they still won't open their books. And they bought unprecedented quantities of private debt–trillions–in secrecy.

      That's how it happened.

      In days of yore, the Fed did indirectly buy assets, but never at inflated prices. Its main job at the start was to ensure that "solvent" banks didn't go under because of short-term demands from "depositors". A solvent bank experiencing a run from its demand loan creditors (gullible Main Street types, most of whom naively believed that they really were depositors, and didn't know what they REALLY were, even in "their own" courts of justice: high-risk speculative lenders) went to the Fed and got enough money to meet the needs of its business, and in return gave collateral (properly reviewed, performing business loans and so on). When things settled down, the Fed liquidated its unwanted position.

      Later on, the Fed started intervening in the economy (always a bad idea) by conducting Open Market operations. It did buy assets DIRECTLY now. But it still didn't get overvalued assets. It only bought short-term Treasury debt (one year and less) and it was required to operate transparently. The Fed today has a lot of flaky assets (over-valued, hard to value derivatives and so on) but back then it didn't have any, because the market value of a T-bill is well-known. Trillions worth are traded in private markets every day, and there is no risk of non-payment.

      That model was dramatically different from the interventionist role of the Fed today.

      The fact that they have overvalued assets isn't related to gold. The assets are (presumably) overvalued today, in USD, which is not tied to gold.

      If the Fed sells all of its assets on the open market, we will find out for sure what their value is.

  • Dick Timberlake

    Larry– Avery apt and well presented analysis. Of course, "we" could have a gold standard! However, for it to work properly, the federal government, including the Fed. Res. System, must absolutely leave it alone. And , as you point out, the government's gold, which it appropriated in the 1930s, must get back into the commercial banks as reserves. Then, the impregnable arsenal at Ft. Knox could be de-commissioned, much to the relief of taxpayers. If the U.S.government was to return the monetary system to a true, market-actuated, hands-off gold standard, it would not only serve the welfare of U.S. citizens more than any other single policy, but would also serve the world as an example of market democracy that would be irrefutable.
    Thanks for your good-sense and accurate article.
    Dick Timberlake

    • Milton_Hayek

      The only gold standard that truly worked as needed (i.e. to constrain government spending and eliminate systemic inflation) was the pre-WW1 gold coin standard, which allowed private issue. The key is to eliminate the current monopoly on currency issue that the federal government maintains and to allow market competition between privately issued gold currencies.

      The cherry on top would then be an end to fractional reserve banking which would end the business cycle. But the howls from the banking industry would probably nix that…

  • Benjamin Cole

    Larry White is correct that even on this one issue, monetary policy, Don Trump comes down in a dizzying number of positions. And Larry White was kind enough to not note that Trump once mused about paying off the national debt in eight years through QE.

    http://www.telegraph.co.uk/business/2016/05/28/donald-trumps-wild-idea-about-dealing-with-debt-may-be-here-soon/

    I find myself at odds with the Alt-m crowd, and a nicer and smarter group I can hardly imagine.

    I think the whole premise that central banks are inflationary-statist institutions is 30 years out of date, and then only because the US went through WWII and then Korean War and then the Vietnam War. In that superheated era (and many a worthy battle was fought), yes central banks (the Fed) were accommodative.

    But since then, major global central banks have been disinflationary and then deflationary. Claudio Borio of the BIS even rhapsodizes about deflation.

    Perhaps in this new era, central banks are deflationary as they know if they can kill inflation, interest rates will go to zero or even negative, and government borrowing costs all but vanish. They are statist-deflationary institutions!

    Switzerland is now getting paid money to borrow.

    Maybe the gold standard or the free banking is a solution. Perhaps a more-growth-oriented Taylor Rule. I like prosperity!

    I think a good case can be made that for the last 30 years, and the last 10, central banks have had a monetary noose around the world's economies. We se that in interest rates and inflation converging on or below zero.

  • Spencer Hall

    The return of a gold standard is obviously an impossibility. The last legal link to gold (prior to the "gold cover" bill of March 19, 1968), was fictional, the economic tie tenuous, & its protection was a myth.

    The dollar was severed from gold because of the Military Industrial Complex. The U.S. had a net liquidity deficit in every year since 1950 (with the exception of 1957), up to 1976 (when the private sector contributed its first trade deficit ). These deficits were entirely the consequence of excessive U.S. government (Pentagon’s) unilateral transfers to foreigners (re: foreign policy – solely our far flung military bases, operations, & personnel).

    During all this time the private sector was running a surplus in all accounts: merchandise, services and financial. The Vietnam Ten-year War administered the coup d’etat to our gold bullion standard. By 1968, in an effort to keep the dollar at the $35 par, we had exhausted nearly two thirds of our monetary gold stocks, or approximately 700 million ounces to about 260 million ounces.

    • Milton_Hayek

      Wrong gold standard; a return to a pre-WW1 gold coin standard is eminently possible…politically impossible maybe, but not technically impossible..

      • Spencer Hall

        LOL. Even Greenspan knows different. See WSJ Tuesday, September 1, 1981.

  • Hu McCulloch

    Larry — The current Wall St. favorite for the never-filled position of Vice Chair for Supervision is said to be David Nason, a Hank Paulson protege and co-architect of the 2008 bailouts. The urgent need is to put forward some alternative names for this and the other two open position on the Board, and for a replacement for Janet Yellen, immediately.

    In my post "Filling the Federal Reserve Board Vacancies on the Independent Institute's Beacon blog, I suggested John Taylor and Sheila Bair for Chair and Vice Chair for Supervision, with Taylor appointed immediately to one of the vacancies to get his voice heard as soon as possible. Tom Hoenig (or Jeff Lacker) would also be good candidates for the Vice Chair slot. Jerome Powell is already on the Board, but could be elevated to Vice Chair immediately and someone else appointed to one of the vacancies.

    Other realistic suggestions are most welcome!

    See http://blog.independent.org/2017/02/11/taylor-and-bair-for-federal-reserve-board/