Conflicts of Interest at the Fed and Congress

The Federal Reserve is trying very hard to get ahead of a potential conflict-of-interest scandal. Several high-ranking Fed officials have investments in securities the U.S. central bank has been buying to stimulate the economy. Consequently, these officials have conflicts of interest in considering policies that might materially affect the value of their investments.

Reuters describes the action the Fed is taking to eliminate the inherent conflicts of interest that Fed officials have:

Two Federal Reserve officials said on Thursday they would sell their individual stock holdings by the end of the month to address the appearance of conflicts of interest.

Dallas Fed President Robert Kaplan and Boston Fed President Eric Rosengren issued statements saying they would invest the proceeds of those sales in diversified index funds and cash savings and would not trade in those accounts as long as they are serving in their roles.

The announcements come after the officials faced scrutiny over trades they made last year, according to their financial disclosure forms.

The Fed’s Potential Conflict of Interest Scandal Grows

Since that first story broke, the scope of the Fed’s potential conflict of interest scandal has become bigger. CNBC reports:

Amid an outcry about Federal Reserve officials owning and trading individual securities, an in-depth look by CNBC at officials’ financial disclosures found three who last year held assets of the same type the Fed itself was buying, including Chairman Jerome Powell.

None of these holdings or transactions appeared to violate the Fed’s code of conduct. But they raise further questions about the Fed’s conflict of interest policies and the oversight of central bank officials.

• Powell held between $1.25 million and $2.5 million of municipal bonds. They were just a small portion of his total reported assets. While the bonds were purchased before 2019, they were held while the Fed last year bought more than $5 billion in munis, including one from the state of Illinois purchased by his family trust in 2016.
• Boston Fed President Eric Rosengren held between $151,000 and $800,000 worth of real estate investment trusts that owned mortgage-backed securities. He made as many as 37 separate trades in the four REITS while the Fed purchased almost $700 billion in MBS.
• Richmond Fed President Thomas Barkin held $1.35 million to $3 million in individual corporate bonds purchased before 2020. They include bonds of Pepsi, Home Depot and Eli Lilly. The Fed last year opened a corporate bond-buying facility and purchased $46.5 billion of corporate bonds.

I’ll give the Fed credit for seeking to get ahead of its conflict of interest problem. There is not any evidence of which I’m aware that suggests any investments were made to take advantage of the Fed’s pandemic stimulus policies. But it does stand as a case study for how questions of integrity should be addressed.

How Not to Address Conflicts of Interest

Let’s contrast what the Fed is doing with that of another institution. One that is doing nothing to address its official’s conflict of interest problems: the U.S. Congress.

The U.S. Congress places almost no restrictions on how either elected officials or congressional staff members may invest, a benefit that extends to their family members. The Harvard Business Review explains why that’s a huge, unaddressed mistake:

Congresspeople in both political parties have substantial holdings in firms their legislative actions affect — and this number has grown substantially in recent years. While roughly 20% of lawmakers owned stock in 2001, that number had more than doubled by 2013. As of the most recent data (2014 from the Senate and 2016 from the House), over half of Congress owns stock, many with holdings in excess of $100,000 in stocks alone, not to mention mutual funds and other forms of investments. In addition, as of 2014 over half of lawmakers were millionaires.

This data says there’s a lot of potential for congressional officials to profit from conflicts of interest. But do they exploit these opportunities?

How to Get Rich in Congress

The Harvard researchers found that congressional officials were uniquely successful with their investing. They attribute that success to the insider information and power they have over legislation and fiscal policy:

… firms where a greater percentage of lawmakers invest have significantly higher performance in the subsequent year — with each percentage of congressional membership owning stock worth about a 1% improvement in ROA or Tobin’s Q — suggesting that politicians may be privy to nonpublic information about future regulatory or legislative actions that may prove helpful to these companies. It’s also possible that members of Congress use their influence to benefit the firms in which they invest.

This finding dovetails with prior research that shows members of the House and Senate generate abnormally higher returns on their investments. This likely occurs because members of Congress have a variety of tools at their disposal — from pushing or stalling legislation and regulation to awarding contracts, subsidies, and tax abatements — any of which can aid the firms in their investment portfolios.

Flouting the Few Rules They Do Have

Congressional officials are supposed to publicly disclose their investments within 45 days of making them under the Stop Trading on Congressional Knowledge (STOCK) Act. Except many fail to comply and there are few consequences for failing to report them. Fox Business reports:

A government watchdog group asked the Office of Congressional Ethics last week to investigate Assistant Speaker of the House Katherine Clark, D-Mass., for apparently failing to timely disclose up to $285,000 in financial transactions — making the potential successor to House Speaker Nancy Pelosi, D-Calif., the latest among numerous House and Senate members to face ethics complaints about allegedly violating the STOCK Act….

Specifically, Clark, first elected in 2012, failed to publicly disclose 19 personal stock transactions by her husband within 45 days, according to the ethics complaint. This included investments in Google’s parent company Alphabet Inc.; Best Buy; First Solar; investment firm BlackRock; pharmaceutical company GlaxoSmithKline; data management company Iron Mountain; and water technology company Xylem Inc. The transactions valued between $19,019 and $285,000, were made on June 4 but were not disclosed until Aug. 15….

“These disclosure reports are the only way for citizens and watchdog organizations to monitor election officials and determine if they are profiting from positions,” Kendra Arnold, executive director of FACT, told Fox News. “The only way to determine this in a timely manner is if they file the reports on time. Some lawmakers file the reports two years or six months late.”

There don’t appear to be any meaningful consequences for flouting the few rules they do have.

Remedies

There are ways to remedy this situation. In the executive branch, a typical solution involves placing officials’ investments into a blind trust. This way, they don’t have control over how their investments are made.

But perhaps a better solution would be to bar congressional officials from being able to invest in anything other than U.S. Treasuries. At least then, we would never have to worry about the U.S. government defaulting on the national debt.