The size of the Fed’s balance sheet limits the scale of the public’s losses

Yves Smith points us to a couple of pieces discussing the Fed’s “balance sheet constraint”, the notion that the central bank may run out of treasury securities to exchange, whether temporarily or permanently, for the questionable securities held by private banks. This asset swap has emerged as the Fed’s core response to the current crisis, and is the essence of what James Hamilton referred to as monetary policy on the asset side of the balance sheet. In an excellent summary, Greg Ip describes the various options the Fed would have if it were to run low on Treasuries.

Fundamentally, the Fed would have two options: It could increase the size of its balance sheet by issuing cash, which would require sacrificing its target Federal Funds rate target and letting that rate drop to zero. This option is referred to in the trade as “quantitative easing”, but that’s just a fancy term for printing money and tolerating any inflation that results. Alternatively, the Fed could expand its balance sheet by borrowing from someone else — from the US Treasury, from banks with excess cash, or from the public directly. This would permit the Fed to increase the scale of its asset swaps without sacrificing its ability to conduct ordinary monetary policy.

If you want to understand the details, do read Ip’s piece. The Fed’s “balance sheet constraint” is not a hard limit. The Fed can circumvent it. But that doesn’t mean that the size of the Fed’s balance sheet is not important. Consider this, from Ip (emphasis mine):

The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

It’s only true that this operation doesn’t cost the Treasury anything if what the Fed buys with the excess cash pays as much as the Treasury’s cost of borrowing, and there is no loss of principal. But if the Fed uses the cash (directly or indirectly) to buy or lend against market-shunned securities, then the Treasury is only made whole if those securities perform, or the loans against them are repaid. If the market is irrationally shunning these securities, then the Treasury will eventually break even. But if the securities turn out to be worth less than what the Fed lends or pays, taxpayers might be forced to eat the loss.

Fundamentally, the Fed’s balance sheet constraint is and should be a political constraint. The size of the Fed’s balance sheet defines how much capital taxpayers and holders of currency are making available to the Fed to do whatever it is it’s doing. Whether Fed’s balance sheet should be expanded is an investment decision — should the public throw more money at the project that the Fed is undertaking? There’s a real downside — losses by the Fed will eventually be borne either by taxpayers or by owners of dollar denominated assets (which means especially workers with little bargaining power, whose wages are negotiated in nominal dollars and would not rise with inflation). But bearing those risks may be less damaging than the harm that would result from turmoil in the financial system if the Fed loses its capacity to act.

I don’t know whether expanding the Fed’s balance sheet is a good idea, if it comes to that. There are risks and benefits associated with the Fed’s proposed use of funds, and reasonable people can come to very different judgements. What I do know is that a decision to expand the Fed’s balance sheet ought not be treated as technocratic monetary policy. However funds are raised, their repayment would be guaranteed, so all downside risk would be borne by the public. Expanding the Fed’s balance sheet would represent a sizable investment of the public’s wealth, and the public ought have as much say over that decision as over any other investment of public money.

Update: Now here’s some creative thinking! These so called “reverse MBS swaps”, under which the Fed would refill their stock of Treasuries by swapping back iffy securities wrapped with a Fed guarantee, would have no direct balance-sheet impact whatsoever, and if repeated would provide the Fed with a potentially infinite supply of Treasury securities to swap! Of course, the proposal is simply a scheme to create off-balance-sheet liabilities in order to evade what might be on-balance-sheet limits. Wow.

I frequently marvel about how, in order to respond to the credit crisis, the Fed as well FHLB, Fannie, and Freddie, are doing precisely what got private actors into their messes in the first place. Off-balance-sheet liabilities are a logical next step.

(This was reported in Greg Ip’s piece, but somehow I didn’t grok the implications until reading Lou Crandall’s description , “[The reverse MBS swap] is sufficiently exotic that it might sidestep some of the traditional legal issues.” That kind of line is a spur to really think things through!)

Update History:
  • 6-Apr-2008, 4:20 p.m. EDT: Added update re “reverse MBS swaps”.

34 Responses to “The size of the Fed’s balance sheet limits the scale of the public’s losses”

  1. PrintFaster writes:

    Time for the fed to buy foreign currencies to plump up its balance sheet. A basket of G10s would do nicely.

    Other than that, the Fed could buy gold and silver in the open market, putting those assets on its balance sheet. It currently has some of Ft Knox in its sheets.

    Ahh the possibilities of plumping up their balance sheets are endless. Mostly, I think that they will buy mortgage paper, indirectly through the TAF sticky mess. Let treasury hold tar baby.

  2. jkh writes:

    The political constraint horse left the barn with the JPM conduit loan, the subsequent $ 30 billion financing, and the opening of the discount window to the dealers.

    From a technical perspective, Greg Ip’s article explains that if the Fed exhausts its existing asset capacity, it can then proceed if necessary to expand its balance sheet through liability management techniques, and still retain control over the level of bank reserve accounts and therefore the desired Fed funds rate.

    The only technical limit to Fed balance sheet expansion is the capacity and willingness of the market to absorb treasury debt.

    At the end of the day, the Fed is using public funds (monetary base plus debt if desired) to fund its private sector intervention.

    One should not overreact to this idea nor overestimate its risk. The idea is fundamentally an extension of pre-existing Fed operations. Various types of collateral are valued and funded by Fed advances. There was already a very wide range of collateral acceptable at the Fed window in the normal course. Because this has been done well into the cycle of valuing the securities in question, the discounted values of this collateral do provide the Fed and the taxpayer with considerable protection, even if not total protection.

    Another noteworthy point is that the Fed remits about $ 30 billion annually to Treasury due to the normal profit associated with funding $ 800 billion in assets with interest free money. This can be interpreted as an annual savings to the taxpayer. It is an opportunity cost for the holders of the monetary base – who receive no interest on the very large amount of notes in circulation and the smaller amount of bank reserves on deposit with the Fed. This represents the benefit associated with the Fed providing liquidity to the banking system via its very existence and the nature of its usual liabilities. The public participants in the monetary system pay the cost, and the taxpayer receives the benefit in the form of $ 800 billion in government funding at 0 interest cost.

    It is reasonable to view various modes of asset risk taking by the Fed in the context of this cumulative 0 cost funding operation (or equivalently, a $ 30 billion annual windfall against normal funding costs). The Fed’s balance sheet is about $ 800 billion. Suppose via liability management it were expanded to $ 2 trillion. Given the late cycle haircuts taken on various forms of collateral, how much risk is rally being taken here? Is it reasonable in the context of what otherwise has been a $ 30 billion risk free annuity? Moreover, and importantly, the Fed has the advantage of not being held hostage to mark to market volatility in viewing this risk; at least not in quite the same way, even though the marks will be disclosed periodically. It will be interesting to see how the annual $ 30 billion remittance is affected if at all by pure mark changes on the collateral (as opposed to cash shortfalls as would occur in defaults).

    Finally, at a global and more philosophical level, if China’s central bank can subsidize exports to the tune of $ 1.5 trillion in foreign exchange reserves, and if that policy has helped create the global savings glut, and it that phenomenon has led to the US credit crisis, then why can’t the Fed get creative by doing some balance sheet ‘subsidization’ of its own?

  3. Fullcarry writes:

    I feel there is a misunderstanding here. The whole point of having an elastic currency is precisely for moments like this.

    No rational person could have possibly assumed that the credit binge wouldn’t eventually deflate necessitating the FED to step in as the lender of last resort.

    I wonder why we are all pretending like we still have the gold standard?

    There is minimal demand for private sector liabilites right now without the FED/government stepping in the system would grind to a halt.

  4. jkh & Fullcarry — There are questions of degree, as well as questions of kind.

    As jkh writes, the Fed has already made the decision to bear risk on behalf of private sector actors. They did so first mildly, by accepting dodgy collateral in full recourse loans, so they could only be stiffed if their counterparty went under. They did it more boldly with the Bear/JPM arrangement, accepting the full risk of ownership on questionable collateral, as well as whatever uncertainties come with their undisclosed derivatives book. But that doesn’t mean we should be unconcerned with the quantity of those losses.

    The risk that the Fed absorbs the public absorbs. That seignorage benefits accrue to the state is not a “windfall”. It is one of the reasons we have public money creation as opposed to, say a gold standard, which privatzes gains from mere currency value. The loss of those benefits, and potentially losses that exceed those benefits, is a genuine opportunity cost to taxpayers. Categorizing seignorage benefits to taxpayers as a “windfall” is a poor idea. It’s a way of reconciling with the theft of those benefits by private actors.

    In fact, one way to view the “credit binge” is a tacit scheme by private actors to capture the benefits of seignorage. By making crappy loans in advance in such a way that widespread defaults would have devastating consequences, the banking system effectively “preprinted” money that the central bank would be forced to ratify. Such a scheme requires little coordination, it amounts to the old schoolboy credo, “If everybody does it, nobody gets in trouble.” Letting such a scheme payoff is a policy choice, not a foregone conclusion, whether our currency is elastic or not.

    I agree with jkh that the Fed can do a whole lot of things, so why shouldn’t it do unorthodox things, as other central banks have, if that’s in the public interest? But if it’s in the public interest to do what it is doing, that should be a widely agreed political decision, not a technocratic choice by insiders. The question is not what the central bank can do, but what it should do, in the public interest. Even if it has deemed a willingness to absorb some losses on behalf of private parties to be in the public interest, that does not imply that the right amount is a blank check.

    An elastic currency is a tool, and perhaps it is useful in moments like this. But there are distributional and future-incentive consequences to the manner in which the Fed is using that tool. If the credit binge was destined to deflate (apparently lots of people assumed otherwise a year ago, but perhaps they weren’t rational), fine. Surely the Fed should fight that deflation. But the question of how it uses that elastic currency — to make foolish creditors whole, or to replace lost money post-default, is a nonobvious policy choice. The Fed could explicitly nationalize, and then absorb some of the losses of the newly public enterprises while forcing some private counterparties (shareholders, some creditors) to bear losses. In this case, the public would gain from the recapitalization-by-seignorage when the restored enterprises were sold. Or the Fed could do what it is doing, which is to covertly absorb losses in order to keep foolish private actors as whole as possible, for the sake of public confidence.

    There is a case to be made for the Fed’s policy. Minimizing disruption has positive externalities, and outright nationalization is traumatic. But the price tag matters, and incrementally increasing the Fed’s exposure without pausing for review strikes me as profoundly dangerous. Expanding the Fed’s balance sheet is very doable, but it requires new sorts of unorthodox policy, and amounts to a recapitalization of the Fed by the public. That strikes me as not a choice to make lightly.

    We may well, as jkh suggests, decide that a central bank subsidy of the financial sector is in the public interest, as the Chinese decided that a subsidy of its export sector was. But you know, if it were up for debate in the light of public scrutiny and the halls of congress, we might come to a different conclusion too. I think we should have that debate.

    Fullcarry, no one is disputing the Bagehot rule, the role of a central lender of last resort against high-quality collateral. But that’s not what’s going on here, as you acknowledge when you write of a “credit binge… deflat[ing]”. The Fed is assuming the role, in Mark Thoma’s phrase, of “risk-absorber of last resort”. Really it is the public that is bearing the risk. That is something different entirely, and not at all foreordained or necessarily appropriate however elastic the currency.

    Sorry to ramble on… one of the benefits of conversing in the comments is one doesn’t have to edit much…

  5. Fullcarry writes:

    Steve thanks for a very thoughtful response.

    Like jkh said I do think you overestimate the potential for loss to the government/FED. Any collateral pledged to the FED gets repriced daily with variation margin exchanged. And even if the collateral loses substantial value the financial institution pledging the collateral is liable for the full value of the loan. If the FED doesn’t get repaid it will because a major depository institution or primary dealer has gone bankrupt. Furthermore, accepting dodgier collateral originally became a part of FED operations because most nominally riskless US assets are owned by foreign central banks and not US financial institutions. The FED started accepting these assets in the late 90s.

    On the other hand I think you underestimate the systemic seize up happening in the financial markets. I am sure you are familiar with debt deflation dynamics and its hard to argue that the US could avoid such a fate without the FED/government. There is practically no private demand for non-government debt. Private debt is being funded exclusively by the discount window, TSLF, TAF, FNM, FRE and FHLB. A few weeks ago treasury general collateral came close to trading at negative rates. Obviously, negative rates on nominal governemnt debt is only rational because people fear not getting their money back. The cycle had (has?) to be broken.

    Finally, I must admit that I underestimate the possible political and moral hazard side effects of the FEDs operations. That isn’t my bailiwick as I am more concerned and involved in the financial plumbing. I am open to alternative suggestions for clearing up this seize up in the financial markets but I am not sure the non-FED side of the government is up to the task.

  6. Fullcarry writes:

    One small correction. The Bear Stearns non-recourse loan is, of course, real risk being born by the FED. Even I found the FED’s actions in that instance surprising.

  7. jkh writes:

    Thank you also for your thoughtful response. I agree the use of the word “windfall” was a poor choice conveying the wrong idea, having hesitated on it momentarily before pressing “post comment” in laziness. I do think it’s somewhat debatable whether the idea of “good collateral” has been breached unambiguously at a technical level. I think it is a question of degree more than a question of stepping over a line. I say that because the range of collateral “normally” acceptable at the discount window is very broad, as I’m sure you’re aware. It’s not clear to me that this range has been materially expanded, if at all, in this case. I don’t know, not being familiar enough with what has been disclosed on this. (The derivatives aspect is slightly troubling.) But that’s mostly technical. The really significant aspect is the substance of “bailing out” a dealer (although one needs to be careful in defining that term in this case), and in expanding access to the discount window to dealers. And it is significant that a good portion of the Fed’s balance sheet has already been use up, with contingency planning for an expansion of that balance sheet if necessary. I think your points are very good. The only argument potentially supporting the Fed’s approach is the claim that avoiding a bankruptcy process was necessary in avoiding unacceptable systemic risk. One would have to have crossed that systemic risk bridge before being able to make the choice of a nationalization solution instead. And one should weigh the differential private sector cost burden in comparing nationalization versus what they actually did. Bear shareholders did suffer obviously – they just didn’t go quite to zero. Creditors so far haven’t suffered due to the new arrangement. It seems to me the choice between accepting perceived systemic risk at the door of nationalization versus accepting the imperfection of a less complete private sector risk cleansing was the judgement call to be made in the time of crisis – a critical operational risk as well as financial risk decision. (Minor point – the type of seignorage capital gain upside you refer to in the nationalization choice also applies on a smaller scale to the $ 30 billion backstop facility, does it not?)

  8. What are you all talking about? I read Ip’s piece and decided it wasn’t worth a post at my blog. Why? It’s irrelevant. The Fed has no constraints. None! Period! It will do whatever it wants. It wants to protect the banks. I read discussions about the 28-day facility. So? Will the Fed force say Citibank out of business at the end of 28 days? Will Cox demand a publicly-held company file an 8-K when borrowing from the Fed? Will Superman save Lois Lane? Is Mr. Ratzinger Catholic? Fuggedaboutit as we would say in Brooklyn. Inflation’s coming. Get used to it. Reading suggestion for those who like “flexible” currencies, The Communist Manifesto by Karl Marx. Read his 10 point plan for implementing communism. As The Mogambu Guru would say, “HaHaHaHaHa”.

  9. jkh & Fullcarry — First, I want to apologize, because I responded very quickly, and reading back, my tone may have been a bit intemperate. That wasn’t at all intended. I’m delighted by your careful comments.

    You both may well be right that I’m overly cynical about the quality of collateral. I really don’t know. I’m broadly pessimistic — about the underlying real assets (poorly considered homes may literally go to seed, have values less than zero), about the short-term prospects of the US economy, about contagion in consumer credit, commercial real-estate and other markets, etc. etc. So my view of the “correct” valuation is quite close to what others might think of as market bids that are unreasonably low due to illiquidity. Hopefully I am wrong about all of that. But conditional on that sort of valuation, it looks to me like the Fed is taking on an awful lot of risk. I don’t know the details of their portfolio, or whether or not they are aggressively haircutting as they ought to in normal times. I am cynical that they are not, and that we’ll eventually socialize the bill for that. I could be wrong. I hope I am.

    I did and do see great scope for systemic risk, market freeze-ups, etc., and a psychologically difficult to escape debt deflation. But do you see the opposite problem? If as you say there was an unsustainable credit binge, at what cost does it become a better deal for the public to take some chances? The problem with debt deflation is only psychological, after all. When private parties default on previously liquid claims, that is deflationary, but the Fed can always print and buy something else afterwards to combat that. If you save the world prior to defaults occurring, you bail out those who took bad risks. If you save the world afterwords, you bail out taxpayers. There are costs, large costs, to loss of confidence in the financial system. But there are large costs, direct and indirect, to paying off rent-seekers with public money.

    I see the problem in very game-theoretic terms: the situation we are in was neither exactly intended, nor innocently produced. Prior to, a lot of important actors effectively truncated the “systemic” lower tail in evaluating investment decisions, on the presumption that if s*** hit the fan, the rules would change. That presumption made it rational to pile onto iffy bets that other important players were also making, rather than to take more idiosyncratic risky choices, in an era where capital was nearly free and it was hard to find projects offering any yield. I don’t think we can escape this crisis until that reasoning is discredited. So long as positioning for the Fed’s subsidy is a significant factor in bank/IB decisionmaking, we have a very serious problem. Earning money the “right” way is very difficult in competitive markets. Rational actors may frequently go for subsidy capture, when that choice is available. I don’t think the crisis will be over until that strategy is thoroughly discredited in the school of hard knocks. We’ll see lulls and pauses, and then ever larger plays for subsidy, until the collapse we tried so hard to avoid comes in a manner less manageable than it would have come the first time around. Meanwhile, the distributional effects of the earlier booms turned to bail-outs will increase the hazard of social and political instability. (I’m cheery, I know, but I think those hazards are very real too.) If you buy this line of reasoning (and it’s very speculative, you’d be quite reasonable not to, but do consider it before dismissing it), then the current course of action is not as risk averse and conservative as it may seem.

    I agree that “one should weigh the differential private sector cost burden in comparing nationalization versus what they actually did… the choice between accepting perceived systemic risk at the door of nationalization versus accepting the imperfection of a less complete private sector risk cleansing was the judgement call to be made in the time of crisis – a critical operational risk as well as financial risk decision.”

    I’m not certain that my judgement call would be any more “right” here than the Fed’s. This is a really hard situation, and my view of it might be wrong. Bear was handled imperfectly, but that’s not the point, I’m not so upset about that unless the derivative book turns out the be toxic.

    But going forward, I don’t think we should be on autopilot about this, and I don’t think Ben Bernanke should have the power to commit taxpayers money in large amounts unilaterally. These decisions are too big for the Fed. They could literally bankrupt the country (meaning leave us with no choice but defaulting on public debt or printing without regard to inflation). That’s fundamentally my balance-sheet point. The size of the Fed’s balance sheet is (was) a sizable stockpile of ammo. At this point, I’m good with the Fed using its judgement with that stockpile, it’s chosen a strategy, let’s see it through. But although it’s true that in substance, the loss to the taxpayer is the same whether a dollar is lost now or post-balance sheet expansion, I suggest we use the Fed’s balance sheet size as a heuristical stop-loss point. If the 800-900B-ish (I think, I’m not checking now) in Treasuries it started with is insufficient, then I think a political review is in order. I think we should consider the Fed’s balance sheet a political red-line, and have a very public conversation before committing more money to the current strategy if it’s reached. There’s got to be a limit somewhere, no?

    Minor point: jkh — the Fed’s potential upside on the Bear assets is ordinary investment upside, not a seignorage gain. The Fed doesn’t plan to buy those assets with new cash. It’s using existing money to fund a project that might turn profitable, just as you or I might.

    However, if the investment sours, JPM/Bear will have privatized a seignorage gain ex post. How? Here’s an oversimplified model that I think captures the dynamic.

    First, when the loans were extended, that increased the money supply, ceteris paribus the Fed had to tighten, that is retire cash, that is increase the real national debt. If the investment were good, the goods and services it yielded would have offset the inflationary effect of the loan, and the Fed would have repurchased Treasuries, making a gain for taxpayers, or really offsetting the initial cost. In this very idealized model, a good loan is inflation neutral, goods and services and money are increased in roughly “like amounts”, so there’s not “too much money chasing too few goods”. A good private loan is ultimately seignorage neutral. For a fully private bad loan, the scenario starts out the same, the Fed retires cash to offset the inflationary effect of the original loan extension. It then reissues cash to combat the deflation associated with its collapse. Again, seignorage neutral.

    Now consider what happens if a bad loan is made, then the Fed buys it. The loan is made, the Fed retires cash to offset the initial inflation. Later the Fed swaps Treasuries for the asset (issues cash to purchase, retires cash to sterilize). Then the loan fails while on the Fed’s balance sheet. Neither disinflationary goods and service production nor private default permit the Fed to reissue the cash it earlier retired, and the taxpayers bear a cost in forgone seignorage, which cost is the bad loan seller’s gain.

    If the loan performs, disinflationary goods and service production permit the Fed to issue the cash it initially retired. If the loan outperforms, the Fed enjoys more noninflationary seignorage capacity. But it would have enjoyed that regardless of whether the loan was on its books or that of the originating bank. Of course, if the loan outperforms, the Fed gains more directly, as it receives funds from the borrower in excess of what it paid, and it sends those onto the Treasury, helping taxpayers. But that’s an investment gain, not a seignorage gain, no different from if you or I held the loan. The cash that leaves the Fed comes from the borrower, not a printing press.

    In summary, when a loans are made, the Fed temporarily increases taxpayer liabilities by redeeming cash, but it offsets this when investments bear fruit or the loans default in private hands. If the loans default in Fed hands, the expected seignorage never occurs.

    If you want to see this very stylized dynamic in action, check out this graph:

    monetary base, % change YoY (St. Louis Fed)

    If you look at simple monetary base graphs, the exponential trend hides the interesting structure. But, in this YoY/percentage change graph you can see how the “seignorage rate” oscillates around a flat trend, with periods of expanding private credit translating to a lower seignorage rate that later recovers, and that almost always increases sharply during recessions. The recent period of high credit growth since 2002, 2003 is quite visible, extremely prominent, as the seignorage rate has fallen very low. We are now in a recession. The question is, will we see the usual spike? We certainly might if the Fed expands its balance sheet by issuing cash! But to call this a “seignorage rate”, we implicitly presume that increases in the monetary base are backed by Treasuries. If they no longer are, we’d need to adjust the series to only show growth rate of treasury holdings. My contention is basically that if the Fed absorbs defaults, the subnormal rate at which the monetary base backed by Treasuries has grown will never be offset by a period of increased seignorage, and that absence will represent seignorage gains due the public but captured by private parties.

  10. IA — I don’t disagree with you, but you’re a bit more cynical than me (and it’s pretty hard to be more cynical than me about this stuff!). You may be right that the Fed will do what it will do, serve certain interests and ignore others, regardless of the consequences. But even if you are right, it’s a Pascal’s wager kind of thing. It doesn’t hurt anyone to have people like me tilting against the windmills…

  11. The diagnosis is not at issue: moral hazard risks abound.

    The cure, then, will maximize the likelihood that gratuitous moral hazard is too impolitic.

    Historically, a job largely for the fourth estate (e.g., Jacob Riis, H.L. Mencken).

    How, then, to make it maximally profitable for the fourth estate of today to muckrake?

    Imho, the key insights:

    1) The introduction of particular online markets, starting with a new kind of market for the ad spaces on blogs, will provide people with new and improved ways to develop, showcase and profit from expertise.

    2) Owning popular markets of the aforesaid kinds is an ideal way to increase profits for an American media conglomerate that owns a broadcast TV network.

    3) The less benefit individual speculators can derive from moral hazard, the more they will utilize said markets.

    Details are online at

    Given the above, the sooner media conglomerates start introducing/popularizing the aforesaid markets, the sooner a lot of top-quality entertainment programming will:

    1) increase awareness of (proposed) public policies that (would) put taxpayers on the receiving end of gratuitous moral hazard (e.g., increase awareness via a next-gen Jed Bartlet channeling Jon Stewart and Vietnam-era Walter Cronkite)

    2) showcase elected representatives who protect taxpayers from gratuitous moral hazard



  12. livingston writes:

    If you think about it the reverse MBS swap is a fancy way of saying that the Fed should step up and guarantee the mortgage securities. That is precisely what you are doing. First you give out tsys for mortgages, then you take the same mortgages and send them back to somebody else with a guarantee for a swap. Why not just provide a fed guarantee. For this reason alone, despite being a very clever idea, I do not believe it is a viable option for the fed. Nor is quantitative easing, which works for a capital surplus country (i.e. Japan) and not a capital deficient country, as it risks crashing the currency. A far better alternative would be for the Fed to issue recapitlaization bonds to the TSY (or the market) and use the proceeds to recapitalize the banks. It has three advantages: 1) You get the gearing — the new equity capital can be used to buy 12 times the amount of assets that they would have bought themselves directly. 2)It may not require congressional action or involve the TSY directly into the recapilatization. 3) It fundamentally deals with the core issue — inadequate bank capital for the amount of assets in the system.

  13. Steve:

    You got it now! “On the presumption that the rules would change”. That’s all you need to know. Everything else is a second order effect. When I was a wee little CPA 30+ years ago, I believed in the immutability of law. Now I believe in government created anarchy. The rules always change. Why do we have Roth IRAs? Think about it. Why are social security benefits taxed? The big money is made in anticipating rule changes and “creative interpretations” of existing rules. Why do “former” Goldman Sachs guys like Rubin, Paulson, Steel etc. fill Treasury? As I have written, it’s a “Bloodless Coup”. Enjoy. Got gold? Get more! Why isn’t M3 published anymore? Why were the Boskin Commission’s recommendations adopted? Why do we have “core inflation”, whatever that is? Etc., etc.

    When I was a wee little CPA, and fresh out of Chicago, I used to study things like the Fed’s balance sheet. Now I ignore it.

  14. DownSouth writes:

    “…but I am not sure the non-FED side of the government is up to the task.”—Fullcarry

    Why do you fear the democratic process so much?

    I think the answer is obvious, for the verdict is pretty much in from the public. If the people would have had their say concerning the Bear Sterns bailout (much less all the other extraordinary hoops the fed is jumping through to help out Wall Street) it would have NEVER happened. A recent NY Times poll showed respondents more than two-to-one opposed (62% opposed, 30% in favor) to the Federal government helping out banks, even if it could limit any possible recession.


    Daniel Yankelovich warned of the “culture of technical control,” “creeping expertism” and the impending expert vs. public showdown back in 1991 in his excellent analysis, “Coming to Public Judgment.”

    But more apropos I think your arguments harken back to other non-democratic proposals such as W.E.B Dubois’ “The Talented Tenth.”

    I forget who it was that did an excellent critique of Dubois’ communistic leanings, I think it was either Henry Louis Gates or Cornel West. But the criticism would hold true for your non-democratic impulses as well. For the question becomes, if we do away with the democratic process, then from where will “the correction from below” come?

  15. Fullcarry writes:


    You make quite a leap from my saying: “I am not sure the non-FED side of the government is up to the task.” to the assumption in your question: “Why do you fear the democratic process so much?”

    Technical decisions of the FED regarding the credit markets have as much relevence to review by the congress as the FDAs drug approvals. The Bear Stearns bailout was different and needed to be reviewed by congress and has been. But the TSLF, TAF and other new FED operations are comfortably within legal boundaries of their mandate.

  16. Henry writes:

    Big picture. Ignore it at our peril, or at least at the loss of much valuable time and brainpower wasted on chasing relatively minute accounting details. It’s much less of a headache to think from a top-down designer’s point of view.

    The Fed is the flagship of a monetary system, commenced in 1913, and locked in its present form in 1933 with the confiscation of the public’s gold.

    I’m glad PrintFaster mentioned “gold”, for it’s tucked away on that “balance sheet”, and worth now around $250 billion. The more gold goes up, the more valuable it is on the asset side. And (if it is indeed locked away in Ft Knox or West Point) it IS an asset.

    But it won’t be rolled out — or even mentioned — until absolutely needed as the very last backstop of a new currency system.

    The Fed has another next-level-up “ace in the hole”, in contrast to regular banks with regular balance sheets. Its ONLY major liability, those green paper “notes”, can’t be cashed in for anything on the asset side. They’re just supposed to be modestly printed, kept within a Friedmanian percentage of annual increase.

    The only thing the Green FRNs can be traded in for is goods and services, and not at the Fed, but by American workers. Pretty amazing, to call that a “Liability” of the Fed!

    Oh, and that’s also what backstops the Tsys, those American workers, via taxation payments to the IRS.

    So — the first order fallback position when the monetary system starts to come unglued: more Treasuries, as Ip mentions, until, within months or years, the burden of eventual taxation is too-obviously stretched thin.

    Then, more green paper becomes the second line of defense, until it, too, loses some of its credible effect. (The effectiveness of each of these is calculated at various inflection points, where shifts into the next realm — along with its attendant propaganda barrage — are phased in.)

    Then, thirdly comes the hint at some form or percentage of gold backing, still not redeemable with the green paper.

    Then, greater and greater degrees of physical gold backing.

    Now, each of these will be trotted out and used to optimal effect, and no deeper use of real asset hint, promise, or backing will be offered than is proven necessary.

    Indeed, the necessary complement of “credit” is Credulity. As long as we will work for the present form of currency they offer, they need offer no other, more “real”, form of “money”. Lucy. Charlie Brown. Football.

    Along with this system will come the flagship bank(s) to implement it on the “private” side. I long suspected that JPM ran up its supreme derivative mountain only because it knew it had the Fed’s anointment to not ever have it called in for payment.

    Others may have derivatized themselves so extremely in hopes of similar anointment, but I suspect the Fed will neither need, nor be able to integrally save, more than one of these super-entities on its way into rolling out a new monetary order for us to live under.

    All other banks, or at least those who threaten to topple the derivative Himalayas, would be folded into JPM. Perhaps a few regional, or private, banks of strong balance sheets or political clout would be permitted to stand, as “evidence of free market banking”.

    However, most banks have gone along on the wild real estate and commercial lending rides because they knew there was little shelter likely in any monetary Gotterdammerung to arrive on these shores.

    You gotta think like a criminal, or a Central Banker. But I repeat myself.

  17. Henry:

    Right on brother! The “plan” is to remonitize gold when the price gets high enough. $5,000, $10,000, $20,000 … Who knows what the number is? Stay tuned.

  18. jkh writes:

    On the minor point, I understand the seignorage interpretation and agree with your conclusions. Although I find the idea of privatized seignorage slightly awkward, and would tend to view it somewhat differently.

    The Fed balance sheet is essentially a part of a consolidated government balance sheet. To the degree that central bank assets consist of treasury debt, which is an obligation of the government, this item disappears on consolidation. The net result is that the monetary base normally provides 0 interest cost funding for general government operations.

    Seignorage is the interest cost that is saved by having the monetary base as funding. Because of the institutional configuration, it captured in the form of central bank ‘profit’ and transferred annually from the bank to the government.

    If the central bank starts to accumulate private sector assets, it will sell some of its treasury debt into the market to sterilize the money effect. On a consolidated basis, the government balance sheet has actually expanded, with new private sector assets now funded by additional government debt floated in the market. The marginal contribution to the taxpayer is the net income generated by this combination.

    The effect on the normal seignorage case depends on the performance of the private sector assets. These risky assets will typically pay a premium over the cost of government debt. If they remain performing, seignorage will increase. If they default, seignorage will decline relative to the base case. There may also be a capital gain or loss in either event.

    I would not describe the income effect as the privatization of seignorage. Rather the central bank has put its seignorage income at risk by investing the monetary base in risky assets while effectively forcing the government to float market debt as a consequence. As a result, the private sector now holds risk free treasury debt and collects income on that, as compared to the losses it would have sustained had it not swapped its risky assets for treasury debt. This gain might be interpreted as the privatization of seignorage, but more directly it is the modification of central bank seignorage resulting from moving out the risk curve.

    I have difficulty with the idea of framing the privatization/ socialization debate as a binary choice. I think of it more as a decision about where to be on a continuum of possibilities that have elements of both. In this context, the binary choices are extreme points, while the real world is somewhere in between. Such an approach lends itself to option metrics that focus on the famous central bank/government put or moral hazard.

    Take Bear Stearns as an example. Their risk taking culture resulted in a stock price that dropped from $ 170 to $ 10. If Bear Stearns was positioning itself implicitly for a socialized subsidy, I doubt very much they were operating with the idea that this amounted to being long a put option at $ 10. While the Fed’s actions had the effect of ‘rescuing’ Bear Stearns from bankruptcy and a potential $ 0 value outcome, the fat tail risk assumed in reckless management arguably kicked in well before the stock reached $ 10. In this sense, the social subsidy to Bear’s shareholders due to the Fed’s actions was a put option that was well out of the money. I think it’s difficult to argue forcefully that intervention at $ 10 is encouragement for the risk culture of Bear Stearns to be repeated in the future. The equity was mostly wiped out.

    Of course, this is not the only social cost involved in the Bear deal. Risk on the $ 30 billion loan must also be considered. This part of the deal represents a put option for some of Bear’s creditors, since they get their money back while the Fed takes on the burden of the credit risk. This is the cost that is most associated with resuscitating a nearly seized up financial system and avoiding a systemic risk disaster. Although it is an at the money put option for those creditors no longer financing that collateral, it is in a sense out of the money for Bear creditors in total since the $ 30 billion financing and credit risk support is a subset of total credit risk.

    In the case of the effect of Fed intervention on both the shareholders and creditors, one must weigh the specific social cost of the deal versus the potential systemic social cost of the alternative. I won’t attempt that here, but it becomes a question of proportionate response.

    One should ask the same question at the macro level of contingencies beyond Bear Stearns. Fed actions with the risk of loss socialization have been taken in the context of an environment where macro loss projections now commonly run $ 1 trillion or more.

    It is important to acknowledge that the collateral at the Fed has already been subject to haircuts that for the most part are already included in such a macro loss projection. Therefore, expected Fed losses are low relative to a $ 1 trillion macro loss projection. They could even be considered relatively low, based on existing nominal exposure (and perhaps even potential balance sheet expansion, given the marks on collateral) if the projection escalates to $ 2 or $ 3 trillion, which it may, as any reader of Roubini would recognize. The Fed put is not exactly at the money for the current $ 1 trillion projection.

    This is the type of social put metric that must be analysed for proportionality. The question becomes, what is a pragmatic balance between expected private sector losses of this enormity and the social cost of dealing with such an outsized loss experience.

    One may ask importantly, why should the social put exist on any of it? The only answer is that it’s a reasonable cost to be borne when attempting to moderate even greater systemic breakdown, with further cascading losses in large part due to exaggerated illiquidity and its effect on the sudden crystallization of wildly volatile marks.

    I like your idea of using the Fed’s existing balance sheet as a stop loss point for subsidization, although a facility for public debate around the issue would be a challenge. I can almost visualize competing presidential primary candidates four years from now stumping on such claims like “From the beginning, I did not support the expansion of the Fed’s balance sheet” or “While I authorized the expansion of the balance sheet, I never expected the Chairman to act before exhausting other possibilities” : )

  19. Gegner writes:

    This is all very interesting, but, as others have eluded, what ‘matters’ is what 297 million ‘social animals’ are going to do when they can no longer feed themselves? (If we were to confine our observations to just the US rather than the world in general, which is also suffering from US induced inflation.)

    The Fed’s ‘balance sheet’ won’t mean diddley when the nation’s cities are set ablaze after the supply lines collapse.

    John Q. Public may not have a voice in Washington or on Wall Street, but he is indispensable to Main Street.

  20. Benign Brodwicz writes:

    I’m sorry, but in a fractional reserve fiat monetary system doesn’t it all boil down to:

    money = credit (go ahead and quibble…)

    credit requires ability to repay

    too high a DTI and you’re “pushing on a string” trying to reflate

    Let the debt deflation begin! The Depression begins in 2012! Let’s start a preemptive war to stave it off! Let’s hollow out America and take our spoils to Argentina, where we can do what we want!

  21. Cassandra writes:

    I must admit that I, too, have a problem with the dogmatic view that hyper-inflation is inevitable. Unlike Weimar, Serbia, and even Zimbabwe, “ours” is inherently credit-based, in contrast to ever-increasing centrally-conjured showering of pixie-notes upon The People to “pay” for that which cannot oherwise be afforded.

    In “our” case the sources and quantities of pixie-dust are known – i.e. that which is ALREADY out there plus that which is a result of fiscal deficits, adding that conjured by the banking system, and the shadow-banking system. The former is “manageable” and the latter two in wholesale decline, though it seems that on top of the trillion or so ALREADY-manufactured-credit the IMF thinks will be directly destroyed by the time we’re through, there will be many trillions more lost in collateral values of core assets (residential &commercial RE and Equity values) as a result of the cascade. This is turn greatly diminishes not simply the ability to conjure in the future, due to diminished b/s constraints, but the willingness of both lenders to lend and borrows to borrow, hardly fertile ground for hyper-inflation unless there is a resultant fiscal blow-out in response.

    I am sympathhetic to IAs cynicism, and remain skeptical in general of a dual-purpose central bank amidst a laissez-faire macroeconomy where the entire polity seemingly lacks any sense of Public Interest that hasn’t been bought, but think we’re a long way from hyperinflation. If nothing else, with the liquidity creation distribution appearing lognormal, it will take years for officials to re-conjure what will have vaporized in short-order by the deleveraging and rapid core asset-price destruction for a re-calibration of their histsorical scales of fiscal spend and monetary looseness need to be overcome before an appropriate response scale to the destruction can be marshalled. Recall it took a decade in Japan for the political will to be mustered to recapitalise the banks, and the US will not be spared some of the same wrangling.

  22. wimpie writes:

    April 3, 2008 –

    WMR has learned from knowledgeable sources within the US financial community that an alarming confidential and limited distribution document is circulating among senior members of Congress and their senior staff members that is warning of a bleak future for the United States if it does not quickly get its financial house in order. House Speaker Nancy Pelosi is among those who have reportedly read the document. The document is being called the “C &R” document because it reportedly states that if the United States defaults on loans and debt underwriting from China, Japan, and Russia, all of which are propping up the United States government financially, and the United States unilaterally cancels the debts, America can expect a war that will have disastrous results for the United States and the world.

    “Conflict” is the “C word” in the document

    The other scenario is that the federal government will be forced to drastically raise taxes in order to pay off debts to foreign countries to the point that the American people will react with a popular revolution against the government.

    “Revolution” is the document’s “R word”

    The origin of the document is not known, however, its alarming content matches up with previous warnings from former Comptroller General David Walker who abruptly resigned as head of the Government Accountability Office (GAO) in February of this year after repeatedly publicly warning of a “financial meltdown” disaster if America’s $9 trillion debt was not addressed quickly. Financial experts have warned that the national debt, corrected for inflation, could reach $46 trillion in the next 20 years. A month earlier, Walker warned the Senate Banking Committee about the reaction of creditor nations in Asia and Europe if the U.S. did not address its debt problem.”

  23. The Chinese are not fools. I am sure they are surreptitiously selling dollars. Will they launch a shooting war with us over the dollar? I doubt it. More likely, they’ll tell us, “you’re bankrupt. Go to hell”. Then attack Taiwan. The Kuwaitis are selling dollars. The Saudis are. None of these countries wants to upset the apple cart, but each will slowly sell dollars and buy something else. My nominee: gold. In 1966, 42 years ago, Jacques Rueff, Charles DeGaulle’s finance minister warned the US dollar would come to this.

    Steve: In reading the comments to your posts, I conclude you and Mencius Moldbug have the most intelligent readers in the blogosphere.

  24. pogo writes:

    Massive buying of puts and shorting stock in Bear Stearns

    On March 10, 2008, the closing price of Bear Stearns was 70. The stock had traded at 70 eight weeks prior. On or prior to March 10, 2008 requests were made to the Options Exchanges to open new April series of puts with exercise prices of 20, and 22.5, and a new March series with an exercise price of 25.

    Their requests were accommodated and new series were opened March 11, 2008.

    Since there was very little subsequent trading in the call series with exercise prices of 20, 22.5 or 25, it is certain that the requests were made with the intention of buying substantial amounts of the puts. There was, in fact, massive volumes of puts purchased in those series which opened on March 11, 2008.

    For example, between March 11-14 inclusive, there was 20,000 contracts traded in the April 20s, 3700 contracts traded in the April 22.5s, and 8000 contracts traded in the April 25s. In the March 25s there were 79,000 contracts traded between March 11-14, 2008.

    Question: Why did the options exchanges not open the far out of the money puts for trading the first time that BSC hit 70, when the Aprils and Marchs had far more time to expiration. Certainly if the requesters were legitimate hedgers or speculators, buying the March and April with two and three months to expiration was more appealing.

    Answer: The insiders were not ready to collapse the stock and did not request the exchanges to open the new series then.

    Second Request and Accommodation

    On or prior to March 13, 2008, an additional request was made of the Options Exchanges to open more March and April put series with very low exercise prices even if that meant those March put options would have just five days of trading to expiration. The exchanges accommodated their requests, knowing that the intentions of the requesters was to buy puts. They indeed bought massive amounts of puts. For example the March 20 puts traded nearly 50,000 contracts (i.e. contracts to sell 5 million shares at 20). The March 15s traded 9600, the March 10s traded 13,000 and the March 5s traded 6300 all on March 14 (the first day of trading of the new March series).

    The introduction of those far-out-of-the-money put series in the April and March months immediately before the crash, provided a vehicle whereby extreme leverage was available to the insiders. In other words if you had $100,000 and you knew that Morgan would buy Bear Stearns at two dollars, you could make five to 10 times more on the $100,000 by using the $100,000 to buy the newly introduced March puts. This is so because the soon to expire far out-of-the-money puts were far cheaper than the July or October out of the money puts. And that is why the inside traders requested the exchanges to introduce the far out of the moneys just days before the crash.

    But this scenario has enormous implications. It means that the deal was already arranged on March 10 or before. That contradicts the scenario that is promoted by SEC Chairman Cox, Fed Chairman Bernanke, Bear CEO Schwartz, Jamie Dimon of J.P. Morgan (who sits on the Board of directors for the New York Federal Reserve Bank) and others that false rumors undermined the confidence in Bear Stearns making the company crash, notwithstanding their adequate liquidity days before. I would say that the deal was arranged months before but the final terms and times were not determined until maybe March 7 or 8, 2008.

    On March 14, the April 17.5s, the 15s, the 12.5s and the 10s traded 15,000 contracts combined. Each put gives the right to sell 100 shares. So for example, these 15,000 April puts gave the purchaser(s) the right to sell 1.5 million shares at prices between 10 and 17.5. Those purchasers expected to make profits on 1.5 million shares because they knew the deal was coming at $2.00.

    That is the only plausible explanation for anyone in his right mind to buy puts with five days of life remaining with strike prices far below the market price. So there were requests, during the period of March 10 to 13, to the exchanges to open the March and April series for buying massive amounts of extremely out-of-the-money puts, which were accommodated by the Options Exchanges. Did the Exchanges aid and abet the insider trading scheme? We are not able to have a clear opinion on that.

    Media Statements of adequate liquidity

    Reuters, however, on March 10, 2008 was citing Bear Stearns sources that there was no liquidity crisis and that there was no truth to the speculation of liquidity problems. And none other than the Chairman of the Securities and Exchange Commission on March 11, 2008 was stating that “we have a good deal of comfort with the capital cushion that these firms have.”

    We even had the “mad” Jim Cramer proclaiming on March 11, 2008 that all is well with Bear Stearns and that the viewers should hold on to their Bear Stearns.

    And on March 12, 2008, Alan Schwartz CEO of Bear Stearns was telling David Faber of CNBC that there was no problem with liquidity and that “We don’t see any pressure on our liquidity, let alone a liquidity crisis.”

    The fact that the requests were made on March 10 or earlier that those new series be opened and those requests were accommodated together with the subsequent massive open positions in those newly opened series is conclusive proof that there were some who knew about the collapse in advance, while Reuters, Cox, Schwartz and Cramer were telling the public that there was no liquidity problem.

    This was no case of a sudden development on the 13 or 14th, where things changed dramatically making it such that they needed a bail-out immediately. The collapse was anticipated and prepared for, even while the CEO of Bear Stearns and the SEC Chairman of the SEC were making claims of stability.

    What was the reason that Cramer, Cox and Schwartz were all promoting Bear Stearns immediately before its collapse. That will be speculated upon for years to come.

    Cramer has admitted that “truth” was not his friend and that he manipulated stocks to influence investors behavior. Was this one of his acts? But no apologies from Cramer as he claims now that he was referring to keeping money in Bear Stearns Bank not in Bear Stearn’s stock.

    Compelling Evidence of Insider Trading

    To prove the case of illegal insider trading, all the Feds have to do is ask a few questions of the persons who bought puts on Bear Stearns or shorted stock during the week before March 17, 2008 and before. All the records are easily available.

    If they bought puts or shorted stock, just ask them why. What information did they have access to which the CEO and the SEC did not have? Where did they get the info? Why are Cramer, Cox, Paulson, Faber, and Schwartz not subject to a bit of prosecutorial pressure to get to the bottom of this?

    Maybe the buyers of puts and short sellers of stock just didn’t believe Reuters, Cox, Schwartz, Cramer, and Faber and went massively short anyway buying puts that required a 70% drop in a week. Maybe they had better information than Schwartz or Cox. If they did then that’s a felony, with the profits made subject to forfeiture.

    April 4, 2008 Congressional Hearings on the Bear Stearns Bail-out. I watched both sessions and drew the following conclusions.

    In the first session there were the following witnesses. Bernanke of the Federal Reserve Board, Cox from the SEC, Geithner representing the New York Reserve Bank and an incidental player Mr. Steel from the Treasury. The only Senators that seem to be willing to attack these bankers were Bunning, Tester, Menedez and Reed. All the rest were useless and very respectful.


    All witnesses did their best to keep their stories consistent but they did slip up a bit. They all agree that the bail-out was necessary without any proof that it was.

    all agreed that what caused the cash liquidity to dry up within one day was the rumor mongers. Apparently it is claimed that some people have the ability to start false rumors about Bear Stearns’ and other banks liquidity, which then starts a “run on the bank.” These rumor mongers allegedly were able to influence companies like Goldman Sachs to terminate doing business with Bear Stearns, notwithstanding that Goldman et al. believed that Bear Stearns balance sheet was in good shape. (Goldman between March 11-14 warned their average customers that Bear Stearns stock was “hard to borrow” for shorting due to the fact that other customers had used up all of the stock available for borrowing for short sales) .

    That idea that rumors caused a “run on the bank” at Bear Stearns is 100% ridiculous. Perhaps that’s the reason why every witness were so guarded and hesitant and looked so mighty strained in answering questions.

    Loans to J.P. Morgan total $55 Billion from the Fed

    The Private New York Fed lent $25 Billion to Bear Stearns and another $30 billion to J.P. Morgan. So the bail out cost was $55 billion not the $30 billion that is promoted. This was revealed at second session of the Senate hearings in a James Dimon response to a question from Senator Reed.

    Who gets the $55 billion? J.P. Morgan got the money on a loan pledging Bear Stearns assets valued at $55 billion; $29 Billion is non-recourse to Morgan.

    Effectively the Fed got collateral appraised by Bear Stearns at $55 Billion for a loan to J.P. Morgan of $55 Billion.

    If the value of the secondary facility of $30 Billion ($29 Billion of which is non-recourse) is worth only $15 Billion when all is said and done, then J.P. Morgan has to pay back only $1 Billion of the $30 Billion and keeps the $14 Billion the the Fed loses. If the $25 Billion primary facility is worth only $15 Billion when all is said and done, J.P. Morgan has to pay $10 Billion of the $25 Billion received. If J.P Morgan can not pay, then the Fed loses the $10 Billion.

    If after all is said and done the $25 Billion primary assets are sold for more that $25 Billion, the difference goes to J.P. Morgan regardless of the outcome on the secondary facility of $30 Billion. No matter how you cut it, J.P. Morgan wins. If the $55 Billion assets turn out to be worth only $20 billion when all is said and done, J.P. Morgan owes $1 Billion on the $30 Billion and the difference between $25 Billion and the value received on the primary facility.

    The Fed would have been far better to just buy the assets at Bear’s and J.P.Morgan’s valuation. Now best the Fed can do is get their money back with interest and the worse they can do is lose about $25 -$40 billion.

    John Olagues – Truth IN Options

  25. df writes:

    just print money, easier and necessary. No need for complicated schemes. Deflation is ahead. Print money damn it.

  26. df writes:

    just print money, easier and necessary. No need for complicated schemes. Deflation is ahead. Print money damn it.

  27. RueTheDay writes:

    Great blog. I’ve been trying to wrap my mind around around what’s happening in the markets for some time now. The following is a brain dump of what got us here and what I think ought to be done to reverse it. Excuse the rambling.

    If Paulson is going to propose granting broad new powers to the Fed concerning the control of all financial markets, perhaps it’s time to rethink the way the financial market itself is structured. What I’m suggesting is a back to basics analysis of why we have what we have now. Let’s talk foundations – gold standard vs fiat money, fractional reserve vs full reserve banking, fixed vs flexible exchange rates, etc. This is a conversation that must occur before we create a “super-regulator” and go down the path of having the Fed essentially “manage” all capital markets.

    We left the gold standard because it didn’t work – it simply wasn’t flexible enough to support a modern financial/industrial economy. The conceptual problem with the gold standard is that it assumes perfectly neutral money, i.e., changes in the money supply affect only nominal prices, not relative prices or real economic activity. This is simply untrue; money does affect real economic activity, at least in the short to mid-term. If it did not, monetary policy would have no effect whatsoever apart from changing the nominal price level, but clearly it does. Once we accept that money is not perfectly neutral, the practical problem with a gold standard becomes obvious – you are tying the real performance of the economy to something arbitrary and potentially volatile. The supply of gold under a pure gold standard is tied to the quantity mined in any given year, industry demand for the metal for industrial use, and perhaps most importantly the balance of external trade. Combining a gold standard with an inherently volatile fractional reserve banking system multiplies the degree to which monetary changes can whipsaw the real economy. You end up with wild swings in credit, and then no way to mitigate their effects when bubbles burst because of the rigidity of the monetary base.

    Fractional reserve banking is another matter altogether. I see it as being fundamental to the periodic instabilities we see in the economy. But how do you move from a fractional reserve system to a full reserve system without causing a complete economic meltdown? I don’t see how it can be done, realistically. It would mean calling in all loans which were issued without base money to back them up, IOW, all existing bank loans. That alone precludes it from being implementable. It would also require reflating the money supply back to the point where it existed before the transition to full reserve, which would not be as simple as simply printing an equivalent amount of currency, since currency isn’t exactly equivalent to demand and time deposits. And obviously the banking system would no longer be a financial intermediary in the business of making loans, it would simply become a warehouse for deposits and a payment clearinghouse, effectively an arm of the central bank.

    Someone mentioned “free banking” in another post. That would be an unmitigated disaster, as our experience during the Wildcat Banking era showed – the average life of a bank was 5 years and over half of all banks failed during that period.

    So where does that leave us? We need to analyze the problem at a foundational level. What is it that makes the financial system and fractional reserve banking in particular so fragile? A few things. A maturity mismatch where short term funds are used to purchase longer term assets that is hypersensitive to changes in liquidity preferences. The use of extreme amounts of leverage that make everyone vulnerable to small changes in cash flow. Any time you have agents speculating in asset markets with borrowed money, you’re setting up a house of cards that is sure to fall the moment slipping asset prices cause margin calls, additional collateral requirements, and an inability to rollover short term funding. Classic Minsky progression, which if accompanied by deflation can quickly tun into a Fisher progression.

    We need fundamental structural changes:

    1. Re-instate Glass-Steagall. Separate commercial banking from investment banking.

    2. We need more separation in the capital markets between primary market activities and secondary market activities. The problem manifested itself last time as a conflict between the investment banking and research arms of firms where the latter was acting as a cheerleader to generate business for the former. This time it manifested itself as hedge funds and structured finance groups with the latter buying the toxic waste tranches of the MBS created by the former, all under the same roof.

    3. Capital adequacy requirements for investment banks. If you want to act like a bank and have access to the Fed lending window, then you ought to be regulated like a bank. Likewise if you want to behave like an insurance company (e.g., by writing credit default swaps) you ought to be held to the same actuarial standards.

    4. This is a tough one – some control mechanism on bonuses at financial firms. You shouldn’t be able to post billions in profits, pay out hundreds of millions in bonuses, and then a couple of years later write down tens of billions in questionable assets (demonstrating the earlier profits to be a farce) and not have to pay back the bonuses.

    Paraphrasing Keynes, we can’t allow the capital development of our nation to continue to be the byproduct of casin0 activities. And we certainly can’t allow the casinos to build their own little nuclear power plants out back to supply their own needs while eliminating all of the safety features that prevent meltdowns.

  28. Aaron Krowne writes:

    What do you guys think the $160B stimulus bill was?

    It was a helicopter drop. The Federal government arranged it because Bernanke refused to pull the trigger (he has been shrinking M1).

    He will, however have to monetize it. And there will likely be more of these.

    There is already too much Treasury supply; we are not going to get much more “safe haven” buying than we already have. We cannot handle $160B for stimulus and $100B for the war on top of the generally expanding fiscal budget, which is on top of the continuing to expanding need to recycle dollars from the trade deficit.

    So the Treasury will not be issuing “extra” Treasury securities unless, it is willing to countenance higher interest rates or direct monetization. Something has to give.

    It is one ugly corner to be painted into.

  29. Aaron Krowne writes:


    I would love to see you prove anything you said about gold. What is it about the “modern” financial/industrial economy that is so needy of ever-expanding credit? Was the US economy somehow hobbled from 1800-1913 when it didn’t have structural inflation?

    That gold is some sort of constraint on economic activity is an old wive’s tale. Economic progress causes currency to get gradually stronger. all other things equal, which means less money needs be lent or borrowed to achieve the same effect.

    In fact you hint at the real issue when you distinguish between “short term” and long term economic activity. You can juice economic activity in the short term by inflating money and credit. You cannot, however, create real wealth, so the economy soon ends up doubling back over the supposed “growth”.

    I don’t want that kind of “short term growth”. I am pretty tired of all these bubbles. They are destroying anything “real” about the economy that inflation has not already taken care of.

    A gold link is infinitely less susceptible to this phenomenon. Fractional reserves are a problem but the problem is far worse in fiat money with a central bank that effectively forces all banks to multiply credit at the same rate. Surely you note that the Great Depression follows and does not lead the creation of the fiat money Fed?

    Those who parrot that a gold standard “does not work” can never explain how the Fed Standard is working better. They prefer simply to avoid the question of performance.

    In response to “wildcat banking” — you illicitly conflate the non-Federally-chartered banking period pre-1863 with the effectively free banking that prevailed afterwards. Quoting the wikipedia entry on “Wildcat banking”:

    Work done by Hugh Rockoff, Arthur Rolnick, and Warren Weber, have shown a greater success rate among state banks than previously thought. Though some states produced bad bank notes, generally State regulated banks produced reliable notes that could be expected to trade near par.

    In addition I would add that until the mid-20th century the states had unit banking laws that kept banks local and undiversified, which did not help matters of stability. Of course state-only banks pre-1863 would be subject to the same problems.

    Yet somehow amongst all this anarchy bank failures didn’t matter (the economy still progressed and the currency got stronger), perhaps because of the presence of a national gold and silver backed currency.

    Still, I would say stability for its own sake is not good: you should always have to do diligence on any financial custodian. More banks probably need to fail today, but apparently failure is not an option in today’s version of capitalism.

    The highest level of bank failures we ever had was in the 1980-early 90s period, incidentally. Good work on the part of the inflationary, fiat system!

  30. RueTheDay writes:


    I believe you are misrepresenting my claim with regard to the gold standard. My argument is not that a hard money standard supplies insufficient credit. My argument is twofold:

    1. The gold standard ties economic performance to an arbitrary variable that is influenced by a myriad of factors (quantity of gold mined, industry demand for gold, external trade balance) that one typically would not want controlling the money supply and thus impacting economic performance.

    2. A fractional reserve banking system is inherently unstable, and contributes greatly to the boom/bust cycle. Combining it with a gold standard makes the problem much worse by taking away the tools that can be used to dampen that cycle (or at least mitigate the damage after the fact).

    Let’s not forget the many panics that led up to the creation of the Federal Reserve, many of which occurred during a time where there was a hard money standard in place or no central bank or both.

    Panic of 1819

    Panic of 1837

    Panic of 1857

    Panic of 1873

    Panic of 1893

    Panic of 1901

    Panic of 1907

    The Panic of 1837 is particularly instructive with regard to my first point above, as the lead up was not caused so much by speculative lending by American banks as it was by an influx of specie from foreign investors, particularly the British.

    I’m not defending the Federal Reserve or its present actions. In many ways, I believe it is antiquated, and was designed to solve the problems of 100 years ago rather than those of today. I also recognize that as long as we have fractional reserve banking, that a central bank and deposit insurance are both needed to avoid regular economic depressions. However, I cannot accept the simplistic viewpoint that if we only returned to a gold standard or if we only returned to free banking, that all of our financial problems would go away; history shows that this is not the case.

  31. RJH writes:

    I wonder if the Fed is really risking taxpayer money in a situation like this. When there is a recession and liquidity crisis the government receives less money in taxes. Therefore by the Fed and other agencies stepping in to reduce this crisis they are making a proit by increasing the taxes they will receive later. It would be interesting to see a study on the losses the Fed makes in this crisis compared to the saved tax revenue.

    For example the Bear Sterns deal might lose money for the government but private sector losses were sharply reduced and businesses would have claimed these losses against taxable income at some point. So this may amount to a profit of saved tax revenue for the Fed and the taxpayer.

    Also with the Frank proposal on buying loans with negative equity, the government might lose a small amount if people default or the market continues to go down. However it loses anyway if it has to give more money to the states as property taxes go down with lower real estate values. So actions that reduce market decline allow it to save on money given in other ways. Also it likely gets a higher interest rate from these borrowers than it would selling treasury bonds anyway. It saves on paying out more unemployment benefits and bailing out more failed banks.

    So I don’t see where the Fed and Congressional interventions are wasting tax payer money. It might be argued the government should not be acting like a business but in a sense it is a business with all voters as shareholders.

    One could get a rough indication of the cost of the recession by the widening deficit during it, and the deficits of all the states. So that amount of money could in theory be spent fixing the problem and everyone would be better off with this intervention.

    Sorry if this is an obvious point.

  32. anon writes:

    Federal Reserve May Seek Authority to Pay Interest on Reserves

    By happenstance, there is more than usual Fed-related news this early AM. A few weeks ago, Greg Ip of the Wall Street journal recited what some of the Fed’s options would be if it ran into balance sheet constraints. One was paying interest on bank reserves:

    The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

    The Financial Times reports that this idea may be getting traction:

    Federal Reserve policymakers will discuss paying interest on bank reserves in a closed door meeting on Wednesday. Such a move could in theory allow the Fed to expand its liquidity support operations without limit….

    Under a law passed in 2006, the US central bank will gain the authority to pay interest on reserves in 2011.

    The meeting on Wednesday is based on that timeframe and will not be followed by any announcements.

    However, the meeting could spark an internal debate as to whether the Fed should consider asking Congress to bring forward this authority to help it deal with the current credit crisis.

    Many experts think that would be a good idea. Vincent Reinhart, former chief monetary economist at the Fed, said paying interest on reserves would allow the Fed to “expand their liabilities to support more asset purchases”.

    A number of other central banks already have the authority to pay interest on reserves, as well as the authority to lend banks money.

    In normal times they can use these deposit and lending rates to put a corridor around the main policy rate, and prevent it from being buffeted too far away from the level they aim to set.

    But at times of financial market stress, the ability to pay interest on reserves takes on added significance. Currently, the Fed cannot expand or contract its balance sheet without altering the overall supply of reserves and changing its main policy rate, the Fed funds rate…

    That would free the US central bank to conduct liquidity operations that were larger than the size of its current balance sheet – roughly $800bn.

    “The point…would be to allow the Fed to expand its balance sheet without having to drive the fed funds rate to zero in the process,” said Goldman Sachs.

    The problem with this concept, as with many of the Fed’s new measures, is that notwithstanding the current improved mood in the credit markets, they have often been ineffective or produced unintended consequences. Per EconWeekly, paying reserves would have a nasty side effect:

    Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

    This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

  33. RueTheDay writes:

    The last comment was interesting. As I read through it, I kept asking myself, “why would banks even engage in interbank lending if the Fed paid interest on reserves?” The author sort of answered that, or at least posed it as a key question, towards the end.

    The fundamental issue here is WHY does the Fed want to go down this path. Theoretically, they can create unlimited reserves at will. What they can’t do, but what they seem to want to do, is to SIMULTANEOUSLY inject liquidity while also increasing the supply of risk-free securities (e.g., Treasuries) while also maintaining a Fed Funds target. In other words, “if we could just replace all of these toxic MBS that no one seems to want with Treasuries, then normal monetary policy would start working again”. This makes me quite uncomfortable.

  34. jkh writes:


    They want a contingency plan to expand their funding of private credit, if deemed necessary. They’ve already used up a fair portion of their balance sheet. This would be a plan to increase the size of the program further by facilitating a ‘non-disruptive’ expansion of their balance sheet.

    They can’t monetize the additional assets with normal bank reserves, because they need to control the level of non-interest paying bank reserves in order to control the funds rate. Otherwise, banks would drive the funds rate to 0 with any kind of significant excess reserve setting. So they pay interest on excess reserves at a rate that would effectively put in a lower bound for the funds rate. The discount rate is a sort of upper bound. This puts an administered economic collar on the funds range.

    As to why they would want to do this for $ 2 trillion, for example, as opposed to $ 900 billion (their current balance sheet size), that horse is out of the barn. The only natural upper limit to this arrangement would be the size of total private sector credit. I doubt their contingency plan goes that far.

    This plan would not increase the market float of treasuries, as they are limited to their current balance sheet holdings. Instead, banks would be stuck with low interest paying reserves, forced upon the system by the Fed, which could still control the funds rate.

    In addition to increasing the monetary base (including interest paying reserves), balance sheet expansion would also increase broad money supply (not a factor in the current treasury substitution program), which is another risk.