Thomas Hoenig on the Federal Reserve and the State of Banking in the US

David Beckworth: Our guest today is Thomas Hoenig. Tom was Vice Chair of the FDIC from 2012 to 2018, and then 20 years prior to that he was president of the Kansas City Federal Reserve Bank. Tom is currently a distinguished senior fellow at the Mercatus Center at George Mason University, where he focuses on the long-term impact of the politicization of financial services, as well as the effects of government-granted privileges and market performance.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

Beckworth: Tom joins us today to talk about his career and some of the current issues in banking. Tom, welcome to the show.

Hoenig: Thank you. It's good to be here with you.

Beckworth: Well, it's a great honor to have you on board. I can now call you a colleague, which is a real treat.

Hoenig: I'm delighted.

Beckworth: You recently joined Mercatus. We're thrilled to have you on. With all my guests I like to ask, how did you get into economics?

Hoenig: Well, like most, by accident. I was a student at a small college, St. Benedict's College, in Atchison, Kansas and I had to take electives and I chose an economics course as an elective and fell in love with it. I enjoyed the course. Then I took another and another and then I finally got some advice and counseling and decided to make that a major and they of course required me to take more mathematics and I did. That encouraged me to go onto grad school and I finally did get a PhD in economics because of a very good instructor in my first course and a very interesting topic.

Beckworth: Very nice. Now you went from grad school to the Kansas City Fed, is that right?

Hoenig: Yes, I did. From grad school to the Kansas City Fed. Between college and that I spent a little time in the army and then went back to grad school and enjoyed it and majored, if that's the right word, in money and banking.

Beckworth: So you've had a very storied career. I mean, you were the FDIC's vice chair. You were president of the Kansas City Federal Reserve Bank for 20 years. Before that, you were in bank supervision. In fact, you worked your way up the ranks as a bank regulator. You were there starting in 1973, is that right?

Hoenig: That's correct.

Beckworth: So a previous guest we had on our show was Donald Kohn, former Vice Chair of the Board of Governors. And as it turns out, he was at the Kansas City Fed from 1970 to 1975. So did you guys overlap?

Hoenig: We did. Don's a friend, in fact we used to on our lunch breaks, play basketball together, either-

Beckworth: Fantastic.

Hoenig: ... On the same team or against one another. But we always had fun doing it and we got I think to be good friends. And I still see him once in a while, talk to him once in a while. And he's as energetic as ever.

Beckworth: Yes. So we had him on the show, it was a great show. Talked about his time at the Kansas City Fed as well as the Board of Governors. And so you guys interestingly overlapped at the Kansas City Fed and then when you became president, you were traveling up here for the FOMC meetings, you've saw each other.

Hoenig: Absolutely.

Beckworth: So what a great career path for both of you.

Hoenig: Yes.

Beckworth: Well, tell us about your early career at the Fed as a bank supervisor. What did you do? What was your responsibilities?

Hoenig: Well, I actually started out in the Kansas City Fed looking at banking mergers because in that period there was a lot of consolidation within states as the bank holding company. The multi-bank holding company became kind of a standard institutional framework for banking industry. And so I would look at some of the competitive effects, but then I became more interested in the financial elements of it and got in bank supervision and bank holding company supervision and actually headed that up for a while. And so was very much involved in some of the real estate crises of that period and [agriculture] crisis of that period and the energy crisis of that period, especially in that region of the country. So learned a great deal from that I'll call mixed experience.

Beckworth: Now during this time, so you did bank supervision from 1973 to 1991, so that's a wide span of time. Did you see any early signs of too big to fail? Were you worried at all? Did you see it on the horizon?

Hoenig: Well, as a matter of fact, yes. I was involved in the bank when the energy crisis occurred and there was a famous bank in Oklahoma called Penn Square. And it was kind of an originated-to-distribute framework itself. And so it was originally a lot of energy loans and selling those off to some of the larger institutions, one of those being Continental Illinois. And so when that crisis occurred I think that Continental Illinois was in fact one of the first instances of too big to fail in modern times anyway because there was a great concern that they were an upstream bank for a lot of community banks who were selling them fed funds. And then there were other creditors on the east coast and so forth that were at risk. And I think that's one of the reasons why yet some of its creditors were in fact bailed out during that period.

Hoenig: And that introduced the concept of too big to fail and some of the early references to too big to fail. And so, yeah, I was concerned. I thought that opened the door. And they kept saying, "No, we'll never have that again." And I was always a little skeptical and-

Beckworth: Rightly so.

Hoenig: Turns out rightly so.

Beckworth: Yeah, exactly. Well, that's fascinating. So Continental Illinois is 1984.

Hoenig: I believe that's correct.

Beckworth: And that's what we've read about is the kind of formidable… the emergence of too big to fail and you lived through that.

Hoenig: I did.

Beckworth: You worked through that.

Hoenig: I did.

Beckworth: Now that was in Chicago, but it bled over into your district.

Hoenig: Right, because we had a lot of the community banks that were selling the fed funds up. So we were very aware of that in terms of liquidity implications and in some ways we were the district where that was initiated because of the Penn Square Bank that had originated these loans out of the southwest and distributed them widely. And so we were very much involved in looking at some of the quality of the credits in that area and in that part of the country.

Beckworth: Now the Kansas City Federal Reserve district's fairly large.

Hoenig: That's correct.

Beckworth: Imagine a lot of flying around to do all these different banks and then on the road a lot.

Hoenig: A lot. Well, there are seven States west from the Western part of Missouri to Nebraska, Kansas, Oklahoma, Wyoming, Colorado and Northern part of New Mexico. So there was a lot of travel in those days.

Beckworth: Alright. So then you move up and become the president in 1991 and you're president from 1991 to2011. And tell us about your responsibilities in that position.

Hoenig: Well, they're quite wide and varied and that's part of the joy of the job. You have obviously first of all monetary policy. And for me that involved gathering information regionally from our various sectors, whether as we've already talked about energy or real estate or agriculture and bringing that to the national meeting of the Federal Open Market Committee, giving that perspective and weaving that into the national framework or the national evaluation of the economy. And so that's a fairly demanding part of the job. I enjoyed it. Got to talk to a lot of, not just bankers but businesses in that area.

Hoenig: So that's number one. Number two is supervision. Now supervision is led out of the board of governors, but some of the implementation is delegated to the reserve banks. And of course if you're in that business of monetary policy, you really do need to know what the condition of the institutions are. So we spent a fair amount of time looking at the condition of banks in the region and communicating that. And then the third is payments. Payments at that time was primarily paper driven. There was a check processing and that was an enormous transition from going through the paper process, eliminating that, turning to electronics. We're really managing an organization, an operation because as that process proceeded, we laid off well over 400 people.

Beckworth: Oh wow.

Hoenig: Because you don't process paper anymore, you don't need that. So you have to change it. And then we had to change the dynamics of the bank from one of kind of a processor to one of an electronic processor. And that was really quite demanding over a period of time. And I enjoyed it. It was not the laying off of people, but having to make the transition and doing it successfully.

Beckworth: Now that was 400 just in your district.

Hoenig: Just in our district.

Beckworth: So imagine throughout the country there were more.

Hoenig: Thousands.

Beckworth: So this is a great story because you typically hear this view and maybe there's some truth to it that the Federal Reserve has its own funding. It has no incentive to be lean and efficient. But there is an example that shows otherwise.

Hoenig: One of the requirements for the Federal Reserve in the payment system is recovering cost and a return on investment comparable to what the industry would otherwise have. So you couldn't just float along, you had to get your costs down and your pricing because others were pricing as well and you had to stay competitive and they had to stay competitive. So it was really quite a, I think, valuable lesson because that carried over to other parts of the bank because you don't have one part of the bank who's sacrificing and the others are living well. So it puts a real constraint that I think is valuable in that environment.

Beckworth: It's interesting you mentioned the point that the Fed has to recover cost. So it has to actually operate like a normal business would. And this came up in recent discussions I had with someone about this whole debate right now about the clearing house. So the Fed is considering doing its own clearing house. The clearing house in New York has its own real time payment system and one of the issues is that the Fed, if it does this would have to cover cost, it can't just provide a free utility to the public, which makes it tricky, which makes it hard. And I can understand the Fed’s reluctance on that particular front to want to move forward because it's going to have to set up a whole new system and be able to do it in a cost effective manner.

Hoenig: Right. Well I think if they do it, they want to do it correctly. And so they have given a lot of thought to it. I think you have the issue of do you want a single monopoly in place and whether there will really be any pricing constraints under that environment or where they collect rent. Plus, what about crises? When crises come, usually those [in the] private sector have too much risk to try and absorb. So they tend to freeze up. And so do you want the Fed in there? And my answer is yes, you do. My own experience is such in crisis, it's very important. The other is the Fed has a lot of experience with that in retail payments. They were actually the strong promoter of the automatic clearing house, they helped introduce it. They recovered their costs, they priced competitively so they know how to set up the system, they’re a major developer in other areas.

Hoenig: So I think personally they will be very successful in building real time payments. And I think it will serve the long-term interest of the country extremely well, both from a competitive pricing and from a crisis management and a parallel system that you have to rely on, which you otherwise wouldn't have. So I'm a pretty strong advocate for it.

Beckworth: Why has it taken so long? I interviewed Aaron Klein at Brookings recently and one of his critiques is, man, we're light years behind other countries. That's an exaggeration, not light years. We're decades behind say the Bank of England, even the Bank of Mexico. Why has it taken the Fed so long to get on this issue?

Hoenig: Well, number one, the Fed has been the initiator even for the private sector, the private sector has legacy investments. It's not naturally easy for them to do it. And we, in this country, want to see if the private sector can pick up the ball, in other countries they just went to the central bank. So that's number one. Number two, when the Federal Reserve gets involved, they really have to do an analysis upfront so they have to go out with, here's what would be involved, what does the public think of that? And you have to collect all that information and in this instance probably over 800 comments on it. You have to evaluate it. Then you have to go forward.

Hoenig: And the clearing house has been very opposed to the Federal Reserve getting… Now retailers, very supportive, community banks, they really want that other choice. They don't want a monopoly they have to deal with, but the clearing house has been very opposed and has worked very hard and that's caused some of the delay I think, personally. So we'll see how it works out. I hope the Fed acts, they have the authority and they've done a very careful, I've read their stuff in fact I commented on whether they should go in and so I'm hoping, expecting, hoping that they will do that. I think the country will be well served by it.

Beckworth: This is one of these issues that many people don't follow. Maybe not even aware of, but real time payments is a big deal if you really look at it closely.

Hoenig: That's right. It is a big deal.

Beckworth: It's glad to have you and Brian Knight and others here at Mercatus working on this issue. Now, one of the things you did at the Kansas City Fed, I want to go back to your time there as president, is you started this conference, the Economic Symposium. Did it start under you? Is that one-

Hoenig: No, it actually started under my predecessor, Roger Guffey.

Beckworth: But I imagine it became what it is today under you. Right?

Hoenig: Well, it certainly advanced under me. I have to give him the credit. He was a wonderful leader and brought it forward.

Beckworth: But for people who don't follow central banking closely, this conference is like the event of the year for central bankers. If you're anywhere in the world in central banking and you want to attend this conference, is it a beautiful place, Jackson Hole, Wyoming.

Hoenig: That helps.

Beckworth: Yeah. In fact, I was looking at the conference that they have meetings in the morning to early afternoon and the rest of the afternoon you guys take off and enjoy the beauty of the outdoors. But it's the place to be. So tell us about the history of this conference, how you built it up to what it is today.

Hoenig: Well, it started out as conferences do, a small conference actually on agriculture and water conservation because it's a Western issue but then in 1982, when that monetary period of very stringent policy came forward, that's when they actually moved it to Jackson and Paul Volcker was there. So that was a very heady issue on the monetary policy of that year and that was after the very tight policy that was introduced in October, I think of 1979. There was a lot of controversy until it brought a lot of interest and so that kind of gave it a spark and from there it kind of built on topics around monetary policy, macroeconomics and move from there and then towards when the breakup of the Soviet Union occurred in Eastern Europe, they also had another major conference on central banking and the emerging markets of that area of the Eastern Europe and that brought central bankers from all over the world.

Hoenig: And then that continued to build the reputation. And my involvement was then to build on that and bring a market perspective, a central bank perspective, an academic perspective. And it was… fortunately we were able to get very good presenters and the dialogue, it's not just who presents a paper, it's the dialogue in the audience because of the quality of the participants there that brings a dynamic element to it that has been very attractive to central bankers and others over time. Alan Greenspan helped because he always attended, Paul Volcker helped. And so having the chairs of the Federal Reserve and then other heads of central banks around the world just kind of built on itself.

Beckworth: Yeah. So in recent times, say in the past decade, it was really huge because there'd be big announcements made at it. So Ben Bernanke had... I forget which QE program, but he would talk about it.

Hoenig: Correct. I think he introduced QE1 one there…

Beckworth: Yeah. And then Jay Powell has had big speeches there. So it's kind of got this snowball effect momentum. So Esther George now gets to run with it and have fun with.

Hoenig: And she's made it even better.

Beckworth: Yeah. So it’s a great conference and interesting papers come out of there. Okay. You've already mentioned Alan Greenspan, so you were there as president and participating in the FOMC both with Alan Greenspan as chair, and with Ben Bernanke.

Hoenig: Correct.

Beckworth: So tell us what it was like to be at an FOMC meeting with Alan Greenspan, the maestro.

Hoenig: Well, Alan is a very gracious individual, and so he conducted the meetings very systematically. Everyone had all the time they wanted to speak. There's usually two rounds, one to describe your view of the economy, both you and your region and how that fits into the national. And you would go through that, and then you would have another long discussion on what the policy options were and what you thought of those options. And you would very systematically go around, everyone would have their opportunity to speak, whether they were a voter at the time or a non-voter. You still had the ability to influence your colleagues even if you didn't have the vote.

Hoenig: And he would engage in that conversation. And I would say it’s far, he's done his own homework. He had his policy direction that he wanted to go that might be modified by the conversation to some extent, but he would present his views at that time and then we would discuss those. And if you were able to vote with him, you would, and you still had the right to vote no if you chose to. And he was, I think open to that, although he, like any good chairman, wouldn't want to lose the vote but he understood that there would be some differences. So I enjoyed working with him very much.

Beckworth: And then with Ben Bernanke, I mean, style differences or?

Hoenig: Little bit of style difference now and the times were a little different. Now, Alan had crises to work through also, but this crisis that Ben Bernanke had was particularly daunting until the stress was probably greater there. And that showed through and so he and I had some policy differences, but we worked, we explained ourselves and went forward and he moved the FOMC in that direction. And I think that was fine with me as long as I have the right to have a different perspective and share that, that was I think the right way of doing things and we did them that way.

Beckworth: Okay. So you had 20 years of FOMC meetings, maybe you had more, because I know sometimes staff members go up with the presidents, but at least 20 years as a participant. So a couple of questions I have about the FOMC has come up in previous discussions, in some of the readings I've done, number one, it's a big committee. So I was talking to Paul Tucker on the show and he’s at the Bank of England and he talks about how that their committee is smaller. Every meeting's live. And I guess I wondered, do you think the FOMC is maybe, on the margin, a little bit too big or could it be smaller? It'd be more efficient. Any thoughts looking back at the 20 years of participating in the meeting?

Hoenig: Yeah, I have never had a problem with the size of the committee. I think committees are valuable. They give different perspectives. I think they lead to better outcomes in the long run and when it's managed correctly and you're not rushing to get done and you allow for the debate, I think you get more input because California is different than the Southeast. The Midwest is different and you bring those perspectives forward and I think you get a better by-end from that. And then when the meeting's over you don't just sit there, you go back and you have meetings with the business people, with consumer groups. It gives you an opportunity to explain why the Fed did what it did because it's not always understood or even appreciated especially if you're raising rates. And so I think it's worked out very well. I have not seen a real handicap from it.

Beckworth: What about the introduction of taking a record of the meeting… so, the minutes. So, the story is that before this was done, people spoke more freely, now people follow a script closer. Although if you read the transcripts, you do see humor, give and take, you see some evidence of people being genuine. But I wonder if people are a little more guarded knowing that their words are going to be recorded.

Hoenig: That's a great question. I was part of that when the idea of learning that it was being recorded was announced and then that it would be released after five years. And so at first, I think it did have some effects of inhibiting a freer conversation. But like most things after a while when you find out it's five years later, yes, you may have said something that you wouldn't, but the consequences aren't the end of the world. People began to be more free again. And I think you'll see that if you have the patience to read through hundreds of pages of text, you'd see that happen over time. So I don't think it's as much inhibitor as it once was.

Beckworth: Okay. Yeah, I remember reading some comments by Richard Fisher from the Dallas Fed. He even said, "Can that be striked from the transcript?" Some comment he made and that whole comment was still in the transcript.

Hoenig: Yes. It's-

Beckworth: So you see-

Hoenig: You can't cross it out because I think that leads to a whole new set of problems.

Beckworth: Right, right. Okay. So during your time as president, what would you consider to be kind of the big events, the big challenges that you faced during your time?

Hoenig: There's no question that the things like the Asian crisis and the Russian crisis and the dotcom crisis, crises are the things that draw your attention and your time and your energy. And it's what you learn to deal with. And that's why I think having a committee during those times is very helpful to the chairman because like most things in crisis, the chairman usually has the most and should have the most clout. But having the committee there I think helps make sure things are thought through. And so those are the moments I remember most, each of those, they were each different. They usually though did involve easing monetary policy rather dramatically. And where I used to get, what we'll say policy debates, is how quickly to come out of that easing stance.

Hoenig: And we tended to be slow and careful because we didn't want to staunch the recovery too quickly or prematurely. And my concern was what you did with allocating resources and whether or not you did invite other consequences from that. And so those were good discussions. But during the crisis itself, most people were on the same page. We got to make sure this doesn't spread quickly and harmfully.

Beckworth: So speaking of crisis, the big one most recently was the great recession, 2007, 2009 and the subsequent recovery from that. One of the big tools used was quantitative easing or large scale asset purchases because conventional monetary policy had reached the zero lower bound. So the kind of the conventional understanding is well, we've run out of ammunition with rate cuts, let's go to large scale asset purchases. Do you think they are a great tool? I mean, were they successful? Were they an overreach? What is your assessment looking back now?

Hoenig: Well, let me start with the times because I've got to own up to those. I found the movements, moving interest rates down during the crisis, as necessary and we did provide, the reserve did provide enormous liquidity. And I had no objection to that. I thought that's what central banks do in crisis. Where I got, again, a different view, was in the quantitative easings that really did start even with QE1 as the economy was in recovery because I felt that I would not have increased interest rates by any means during the early part of that in the third quarter of 2009. But my view was that you should not be easing in a recovery. You should hold firm, let the economy build its momentum. You have less distortive effects in the economy with your monetary policy under those conditions.

Hoenig: And by doing quantitative easing, you were in fact affecting the distribution of resources and therefore wealth in the economy. And so I was opposed to those starting with QE1 on whether or not they worked, others are going to have to judge over time. I mean, the debate right now is they didn't really have much of an effect. Oh yes, they did have a lot of effect. Well, that's going to take a lot of research and sorting out a lot of moving parts in that whole process. So I'll let those do it. I think in hindsight, I still feel I was correct. I think real cost to capital was effected. I think it favored an asset holder over a wage earner over that period. Although the explanation is you can't have wages if you don't have jobs and this supports jobs. I understand that argument, but I think we would be in a less precarious circumstances in the world today had we not gone that way.

Hoenig: And I don't think negative interest rates in Europe have served necessarily a useful purpose. They think otherwise, but I think the United States is doing better partly because we didn't go so far and so extreme and that's a real competitive advantage in the long run.

Beckworth: Well, let me just follow up with this comment about QE. You said let the experts decide, but I'll share my view.

Hoenig: Sure, I'd love to have that.

Beckworth: I'm not claiming I'm an expert. But my takeaway, my sense looking back is that QE1 probably did make a difference. QE2, QE3 less bang for the buck because it was a recovery. There are other financial firms out there doing similar things. QE effectively turned the Fed into financial intermediary. So any event I worry or I wonder about the future of QE. Because one point of QE is to lower long-term yields, long-term interest rates. And what we see around the world today is this downward march. And maybe some of it is due to central bank activity, but in the case of the Fed, the Fed stopped, it was shrinking its balance sheet and you still saw yields coming down.

Beckworth: I think there's a lot of other reasons, emerging market demand, demographics, a lot of other things driving this, uncertainty around the world but it seems to me at least everywhere you looked in the at least advanced economies, there's this downward march, yields are getting lower and lower. I mean recently, was it Switzerland, had its entire yield curve was negative out to 50 years, which is just mind blowing. And I guess I wonder to the extent that it did do something, I wonder whether it will be able to do much at all in the future if they invoke it and I think they will invoke it because we haven't been able to go up very high. So we don't have a lot of ammunition in terms of interest rate cuts for the next recession and there's been research, as you know, done saying we're going to be at the zero lower bound 30 to 40 percent of the time in the future. So I just really wonder, maybe even worry is a better word, about the future of how monetary policy is going to be conducted in future crises.

Hoenig: Well, it's a very important issue. One of the reasons that I have concerns even with QE1 was it set a precedent. You changed the operating system. You were now buying assets of not just short-term treasuries, but mortgage backs. What's next? Some countries are talking about buying into the equity markets. So you've set a precedent and my experience with precedents are they're very hard to reverse. So now we have this precedent and I would think that going forward, should we have a recession of some sort? There will be enormous pressure on the central bank of the United States and other central banks to QE something else. And whether it's long-term bonds or it’s corporate bonds or it’s equities, it will certainly be pushed very hard by those who are elected to office because they're going to feel the heat. And here's a solution that seems very easily obtained.

Hoenig: So I have real concerns and I think QE1 set that precedent forward. And when you think of the fact, they call it a savings glut, I call it a money glut because you're pushing that stuff out there and people know it's out there. So how do you think about that as an [investor]? What choices do you make? And uncertainty has increased.

Beckworth: That's interesting. So you see maybe the future unfolding in this way that the Fed and other central banks will start buying other assets. Maybe even if the 10-year Treasury yield hits 0 percent, they might start looking at other assets to buy. They'll move on to the next set of-

Hoenig: Well, whether they will do it, I can't say, I don't know. It depends on who's chairman… However, I am absolutely confident the pressure to do so will be there. A lot of pressure to do so will be there, because it is a simple solution. Just buy the assets, raise the prices, that'll save the world. And the consequences of that, what might there be in terms of consequences? When you think of just the QEs that we've had and the pushing of the long-term, when you push long-term interest rates down and you push asset values up and what are the effects of that and what are the allocative effects of that? Those are the questions that central banks I think have the obligation to also ask before they go on these QE programs.

Beckworth: All right. Second follow up question to QE is by doing QE engaging in large scale asset purchases and coupled with introduction of interest nexus reserves, the Fed changed its operating system from what we would say an asymmetric corridor system, which isn't ideal, but it went from the corridor system that it had to now a floor system which requires a permanently larger balance sheet. And we know it'd be larger because currency is growing anyways, but relative to trend, it's larger. And now I've been an advocate of going to a symmetric quarter, like what Canada has. So Canada during the crisis also temporarily went to a floor, then they came back, they got a smaller balance sheet. That's in my mind would be the ideal.

Beckworth: But the argument today as well, there's new bank regulations that require banks to hold more reserves, more say, high quality liquid assets. I've pushed back against this myself but there, but there's regs that make it trickier… but I'd like to hear your thoughts, in an ideal world what kind of operating system would you like to see the Fed use?

Hoenig: Well, I think part of the issue is, do you have a choice? Because you say that you have this floor system, but when you're going to increase your balance sheet to that size and have excess reserves of that amount, you've got to have a system that creates the floor. Otherwise, these excess reserves, what's going to happen? So I think you've kind of defined your operating system by that. So what it would then take to go back to a symmetric system is a much smaller balance sheet, Canada had that, we don't. So if I had my druthers, I would systematically, you can't do it quickly, like to see the balance sheet continue to shrink and then be able to have a system that is more in the traditional sense available to us. I don't think that's going to happen anytime soon and therefore we have what we have and we'll have to learn to operate with it, so to speak.

Beckworth: Yeah, I think the Fed, if it really wanted to, could tweak the regs, put pressure on how regs are implemented, but also in addition to that, I think it could shrink its balance sheet and still adjust interest rates separately. I mean, I know it's tricky.

Hoenig: It is tricky.

Beckworth: It's tricky. But I think if there was enough pressure, I think one could get there. Look at it this way. I've interviewed a few other Fed officials on the show and I've gotten the impression from them and I got this impression just from the whole process of just when they decided, I guess it was in January to stick with the floor system – that “it's working well enough, why rock the boat” kind of attitude, kind of a status quo bias. And I know they have these debates. It's a little more rigorous than that, but to me it's kind of like inertia, the floor system is working well enough, why try to deal with all these complications?

Beckworth: Another whole discussion, other times we've had shows on this issue. In fact, as we were recording this, this week's episode is Ulrich Bindseil from the European Central Bank who's an expert on this issue. But let's move on.

Hoenig: Oh, sure.

Beckworth: Let's talk about your job at the FDIC, the Federal Deposit Insurance Corporation. So you were Vice Chair from 2012 to 2018. So while you went from being a president of a Federal Reserve Bank to being the Vice Chair of the FDIC, kind of coming full circle, you started in bank supervision at the Fed. Now you're one of the big bank supervisors, so tell us about that job.

Hoenig: Well, at the time it was a very interesting job because we the regulatory agencies, banking agencies, were implementing Dodd-Frank. So all these Dodd-Frank said go forth and create new rules by the thousands. And so we had the duty to do that. And I was looking at many, many rules and there are hundreds of pages, very long and difficult, which I was happy to try and do because I wanted to give a perspective that was less, shall we say, dogmatic in the sense of arcane rules and more simple in the sense of strong prudential standards and fewer bureaucratic rules. And so I did that. So that was one of my jobs as a Board member, looking at these, studying them, and then voting on those. I was also in charge of the FDIC Appeals Committee and the supervision committee, which dealt with individual banks. And I tried to bring a realistic experience and views to that job as well. So I enjoyed it. It was varied in that sense.

Beckworth: So tell me a little bit more about how the FDIC is run. So you have a Board of Directors there, you've got a Board of Governors of the Fed. So what do the Board of Directors do? How much authority do you have compared to an average director?

Hoenig: Well, you have the way it works at the FDIC, which is different than the Fed, that it is deliberately bipartisan. So whoever the President's party is, they have three members and then the other party has two members. So you have more of a bipartisan by design approach. And so you come with those philosophies and that I think brings, I think balance to the debate and balance to the rules or better balance, let's put it that way. And so I did a lot of discussions with my colleagues about what am I willing to do and what am I not willing to do before it came to the vote. And I think that was important. I think that's useful, that's the main part. And then on the committee work it was more of a management, what are the issues?

Hoenig: Let's decide and go from there. At the FDIC, just like the Federal Reserve, the Chairman has kind of the operating responsibilities and so they have more influence. The advantage to me is I did have a small staff that I could rely on for myself and I think in that environment we got quite a bit accomplished, quite a bit done. Not always to my liking, but done.

Beckworth: How would you evaluate the state of banking in the US right now? Are we safer? Are we better off?

Hoenig: Well, that's a good question. Yes, we're safer. We are better off. Are we where we should be? That's the debate point because in the crisis, the largest banks are the banking industry, by default, almost to the largest, had about three percent tangible loss absorbing capital. Today, those banks have about 6.5 percent. Now, the losses during that period were about six percent. So was that enough? They'll say-

Beckworth: Maybe.

Hoenig: ... "More than enough." I will say, "Well, as long as you don't lose three percent." And we go from there. I think it's better, but not necessarily where it should be. And that's where I come from. I would like to have strong capital standards much higher than they are. I think levels at the market would otherwise require and far fewer rules. I'm not a fan of living wills. I'm not a fan of the stress test as the determining factor. It's a process, but over time it gets operationalized pretty easily if I can use that euphemism and I think there you need strong leverage. “Here's how much capital we have against our total assets. These are how many losses we can absorb without a crisis.” And that's a very straightforward measure of soundness.

Beckworth: So banks need to fund with more capital. I mean we've made progress but you see room for more.

Hoenig: Right.

Beckworth: So like 10 percent? I mean-

Hoenig: Well, I put out the number 10 percent and the study show 10 to 15 percent. And the thing about that is equity can't run, right? Everything else can run or put pressure on you. And that's where the advantage of equity is. And it's not these individuals who say, well, it's like a reserve. No, it's a source of funds just like liabilities, other liabilities are and it's very stable and you can get a good return as witness that the largest banks under my measure has about 6.5 percent. Regionals have eight. And yet there ROEs are every bit as good as some of the larger banks. We'll let the market decide. But the market always goes to tangible equity capital when the crisis comes – always.

Beckworth: Well, it's smart, it makes a lot of sense. I mean in hindsight it seems kind of bizarre that affairs were allowed to go where they did in terms of really low, low capital funding for some these big banks, so...

Hoenig: Part of that is because of the risk-weighted process. I mean, what other industries do you allow them to reduce your balance sheet in size for capital purposes? It's almost, if it weren't so tragic, it would almost be humorous.

Beckworth: Okay. Well let me ask about a few specific items in Dodd-Frank. So Dodd-Frank introduced the Orderly Liquidation Authority. Explain to our listeners what that is and then maybe contrast that with recent proposals to have a bank bankruptcy code.

Hoenig: Well, there's two challenges to bankruptcy in banking. One is liquidity, who's going to provide it when you don't know where anything is. And the other is cross border issues, where are the funds and how do you move them to where they need to be in a hurry. And so that's why even the best proposals for bankruptcy as an alternative usually has an orderly liquidation component of it, where the Treasury or the Federal Reserve has the authority to provide the necessary liquidity or capital, depending on one's perspective that gets you through the crisis, that allows you to put money in so that payments can be processed so that money can move in an economy. I don't think you can get rid of that as hard as I might want to.

Hoenig: If you have a $2.5 trillion financial institution that's on the ropes, are you really going to let it go into bankruptcy and put this economy into a tailspin? I'm not going to be the Secretary of Treasury to do it. I don't know of any who would be, but there maybe someone out there.

Beckworth: Well, Hank Paulson sure did. He was happy he let Lehman go, but-

Hoenig: Well, initially, but he almost choked in the aftermath.

Beckworth: And you're right, right. In retrospect, he may have wished differently and done things differently, but you're saying that like a Lehman event, you want to have an Orderly Liquidation Authority. You want to have that fund available.

Hoenig: Well, I don't know that I want to, but I don't think it's avoidable because if you don't have it, you're going to have it anyway. I mean, you're going to have it.

Beckworth: So there's implicitly a backup already in place?

Hoenig: It's unavoidable. These institutions are too big. They're too important.

Beckworth: Too big to fail is still with us.

Hoenig: It's alive and well and only getting more so.

Beckworth: Yeah, so we've had this discussion with previous guests, like the money market funds were bailed out during the crisis. So there's no FDIC for today, but implicitly it has to be in the minds of investors and people who use these funds that if push comes to shove, Uncle Sam's going to be there.

Hoenig: Yup, absolutely.

Beckworth: So the precedent has been set as you mentioned earlier. So your point is a practical consideration that, “look, we know it's there implicitly, if not explicitly. And so let's just be realistic about it and pragmatic.”

Hoenig: Well I think when something's inevitable, what do you do? Ignore it? Try and lie yourself out of it? Or do you accept it? And if someone could tell me, show me how you could go through bankruptcy in a straightforward, standard bankruptcy. I would be the first to embrace it. I promise you that. But I have thought about it and attended conferences on it and I just don't see how it's going to be done without a sovereign behind it.

Beckworth: So it's inevitable. Embrace it. And I think maybe what you're saying is let's at least wrestle with it. It's going to happen. Let's don't stick our head in the ground and pretend it's not there. Let's at least try to shape it into a reasonable-

Hoenig: Well, I wouldn't, one of the issues will be will we really take possession and put the equity holders out of… cost them? Because that will be the real debate issue. And you think about it, if you look at some of, and I won't name names, but you look some of the banks, those investors who knew that they wouldn't fail and they had equity in it and saw that equity go down dramatically bought big and won big, that's the part you want to avoid. The speculative advantage.

Beckworth: Another issue in banking today is FinTech. So do you see FinTech is maybe stepping in and filling a void where the traditional regulated banking system isn't? So maybe more financial intermediation is going through FinTech?

Hoenig: FinTech is a term that has such a broad meaning and just like sports, right?

Beckworth: Right.

Hoenig: I think FinTech is where some of the innovations are coming from, but I don't see it any different than any other innovation series we've had in the past. They'll come and they'll go, we'll learn new systems, we'll become better and quicker, but we will still have the fundamental banking system. Even these FinTechs depend on banking either for their source of funding or they have to settle, and I think that's going to continue well into the future. I don't see it as replacing banking.

Beckworth: All right. We were talking earlier about real time payment systems. Since you're an expert in this area, I want to ask about several issues related to that. So one of the pushes for this – a previous guest I had on this show, Aaron Klein – is this question of having real time payments does help those who have lower incomes, people tend to get a raw deal when check is bounced or they don't get payments immediately. And so there's been different ways to fix this problem. Some have called for postal banking, another person, several people, but one person particularly has been on the show, Morgan Ricks, he's called for the public to have a direct checking account at the Fed. So basically you're opening up the Fed's balance sheet to not just the people but the firms.

Beckworth: So he had envisioned like anyone and everyone to get a checking account, super safe account. What are your thoughts on that given all the experience you've had with the Fed and banking, what advantages, disadvantages to opening up the Fed's balance sheet to the public?

Hoenig: Well, I think that's moving payments to the non-fractional reserve system. And that's been debated for decades. I'm not a fan of it, number one. Number two, I think about mission creep, I'd call that a mission jump for the Federal Reserve. I think it would lead to really some difficult operational and strategic issues in terms of credit funding. What should the central bank do under these circumstances? Can it do more? Shouldn't it help this group out? I see lots of unintended consequences from that, that's one where the private sector should do it. The Federal Reserve can be a part of the payments in the settlement system very effectively. But I don't think you want to get a submission so out there that it becomes its own public utility doing far more than what is ever intended and as well as a private sector can do. That's my own view.

Beckworth: So you see it, the potential dangerous of a big, big footprint in the financial system of the Fed and lacking in innovation going forward and-

Hoenig: Not just that, but the Fed will do this for us. Let's have the Fed do more of the lending too. They have a huge balance sheet.

Beckworth: That would be dangerous.

Hoenig: Oh, and it would be probably less time than anyone can imagine where that suggestion will come next.

Beckworth: So you're saying even though the proposals, just for a check in account, it would open the door for, let's have the Fed get into lending and making credit decisions.

Hoenig: It's got all those balances. Let's-

Beckworth: I mean, I think that's a fair concern given there's been calls for central banks to get involved in green energy, bonds and stuff. So you want to be careful, have the Fed stick to its mandate of price stability, full employment and keep the payment system running.

Hoenig: Yeah. Payment system, supervision and monetary policy, that's a three-legged stool. It's quite a bit.

Beckworth: And already quite a bit. Well, in the time we have left, I want to circle back to Fed policy since we've been talking about the Fed and focus in on this discussion they're having on its review. So its review and its strategy, its communication, its tools. And you can speak to any of these, but I'd like to hear your thoughts on its strategy. So it's considering potentially moving from a two percent inflation target, there's something called average inflation targeting. Also price level targeting, different options out there on the table. Number one, do you like any of these? Number two, do you think it's even feasible politically for anything to happen?

Hoenig: Well, number one, I like the fact that they're doing it. I think it's very good to do this because it's changed so much and I wouldn't call it exactly a design change. It was under the circumstances, here's what we have to do. So I think it's a step back. Look at that and look at that recent history and then say, “all right, can we do it better given our circumstances? Or what should we be going towards?” I think is very wise. I'm not a fan of inflation averaging, I'm not a fan of two percent to be honest with you. But I think considering that and having that debate internally, and then I think at some point they'll have to make it more public. I think that will be very good. And you'll find out, is there any likelihood of even going back to a simpler system, maybe even a more manageable system at that point or not? I think it's all very healthy to go through that process for the Fed and for the country.

Beckworth: Yeah. To have this review. So what would be your optimal monetary framework if it's not two percent inflation or an average inflation targeting? If you could wave a magic wand, how would you set the Fed up?

Hoenig: Well, in today's world it is much more difficult because things have changed. But at one point I always said I'd like the Fed to have discretion within very definite bounds and not just like the Taylor rule, but if your long run fed funds rate is two and a quarter percent, real rate. Then you have an upper bound of say four percent and a lower bound of one percent.

Beckworth: This is inflation or?

Hoenig: On your fed funds rate.

Beckworth: On your fed funds rate. Okay.

Hoenig: Okay. And so you say in that boundary you can move based on the circumstances. And so if you're going to go outside that there be some kind of super majority or outside test because that forces you to think pretty carefully and move. Now in an emergency, would you be able to do that? Maybe. I think so. Because I think one of the risks of full discretion is you always go two moves too far up or two moves too far down and then you get the reaction to that and then you have to go adjust and over adjust and so you get yourself bouncing off the walls, I call it. So something like that. Maybe there's another way of doing it and that's why I think this debate that they're having or this discussion, whatever you want to call it, could prove very useful. And I hope they ask for papers and move this thing along.

Beckworth: So you would have a kind of constrained discretion on the instrument itself, how high it could go, how low could it go, but what would you target? So there's your instrument constraint. Would you have price level target? I mean, I'm a fan of nominal GDP targeting, you probably know.

Hoenig: Sure. Yeah.

Beckworth: Putting instruments to the side, do you have any preference for any particular target?

Hoenig: No, I don't. I mean the Taylor rule for me is useful. Okay. So within those boundaries, if the Taylor rule took me up, I'd probably go there if it took me down, but I wouldn't let the Taylor rule take me below that without some super majority or something like that.

Beckworth: I see. So you really averse to going into negative territory unless some super majority says it's a solution?

Hoenig: I really would because I think it requires more care in terms of the unintended consequences. Because when you're under pressure, when the stress is high, your ability to think of the unintended consequences is compromised greatly. And so you just “get it done” and then you have to deal with the aftermath later. A new precedent set on a new trail. What are the long run complications in effects of that? And that's what we don't think about enough, I'm afraid.

Beckworth: Yeah. So you're worried about negative rates. So going back to this observation made earlier, it looks like around the world there's a lot of negative rates. Maybe they're increasingly with us. I mean, I think last I've read there's $13 trillion in nominal debt that has negative interest rates on a lot of these super safe places, Switzerland, Germany. So putting aside my questions about QE and what it means for monetary policy, I mean, do you see an issue with the world moving toward a negative interest rate environment?

Hoenig: I do. I don't know what all the consequences will be, but it worries me that it is so prolific and what I've seen… a casual observation, I don't know what the studies, I'm sure there's study in a daily. But I don't see that Europe is doing better than United States with that. I don't see that Japan is doing better than United States with that, they should be booming. We should be lagging. And yet it's the opposite. So what is the price in terms of return on capital and investment incentives? What is the price to the saver? I mean we always talk about it, but are we really thinking about what the consequences are to long run savings, which is what really affects the real return to capital and so forth.

Hoenig: I'm not sure that where we're heading with negative interest rates globally is going to lead us to where they think we want to be. I'd be very skeptical of that and I would be very, very disappointed to see the US follow that path.

Beckworth: I'm just wondering if regardless of what central banks to be get there if it's independent of what the central banks do, we might... So if the ECB say puts on hold the... Like the bank of Japan, interestingly, they did this qualitative yield curve control, they actually, they target another 10 year yield to prevent it from going down, which is kind of like again, speaks to that maybe there's other forces pushing yields down. And it'll be interesting to see our world in 10 years if something like Armageddon doesn't come before then, but if 10 years from now, if this trend continues, I mean we could see all major advanced economies with negative rates long-term, which would just change the way we think about finance. Right? It would change... Now there's someone on Twitter, Joe Weisenthal, he's also a commentator or a host on Bloomberg.

Beckworth: He made this point well before the world was heavily into finance, negative interest rates were the norm. Like if you had a palace, the return on that palace, you had to maintain... There's some kind of negative and he's wondering if we're headed back to that kind of world where if you have physical assets negative rates are kind of normal. But in the financial world typically we think of it at positive, right? I mean, and there's theories for kind of the neutral interest rate in the model. It's based on time preference which should imply something positive, productivity growth, all these things. But it just seems bizarre we're headed to a world where we've got negative rates and-

Hoenig: I agree, but I think it's somewhat caused by the confusion between money and savings.

Beckworth: Okay. Expand on that.

Hoenig: We print a lot of money and we say there's a lot of savings because it's stored somewhere, but to the saver, negative interest rates discourages it. So, you change the incentives in the system and as long as you're pumping money in, it should be pushing interest rates down. And I don't see that necessarily leading to a good outcome. Someone else may know what those outcomes are and but I don't see it necessarily casual observation tells me, I don't see it anything-

Beckworth: Well, I agree. We haven't seen great outcomes in Europe, but I guess the question is, do you attribute much of the decline in yields around the world to central banks or to other factors?

Hoenig: Well, I mean, you can't just point the one thing can you?

Beckworth: No but-

Hoenig: But central banks have certainly contributed to it. I think demographics may have some effect. I think supply and demand factors in other ways may, but I think central banks have played a major role in that. No question in my mind. I don't think it's been necessarily beneficial. I mean counterfactuals are just, they're-

Beckworth: They're fun.

Hoenig: ... They're fun but they're …

Beckworth: Hard to do.

Hoenig: But I ask myself where would we be had we not done QE, not raise rates but not done QE and let the markets adjust, not have this huge balance sheet that we have in the US and in Europe and in Japan. How would people think about money? Would bitcoin be the popular or whatever next one, whatever Facebook does, those are things that I would ask myself. Where would they be if we hadn't gone on this QE run.

Beckworth: Okay. Well with that, our time is up. Our guest today has been Tom Hoenig. Tom, thanks so much for coming on the show.

Hoenig: It's my pleasure. I enjoyed every minute.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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