The Insolvency of the Fed
Daily Article by Philipp Bagus and Markus H. Schiml | Posted on 2/5/2009
12:00:00 AM
Since August 15, 1971 the US dollar has been an irredeemable paper
currency. Every irredeemable paper currency in history has failed. Yet,
the experiment of the US dollar and the rest of the fiat paper world
continues.
During the current crisis, however, financial systems all over the world
are increasingly struggling, and the end of the experiment seems closer.
In fact, the Federal Reserve System has used up much of its "ammunition"
for monetary interventions in an attempt to keep the experiment going,
lowering its target interest rate almost to zero. Other central banks
are also quickly approaching the "zero limit" for interest rates.
Figure 1:
Average of World Central-Bank Interest Rates (FED, BOJ, BOE, ECB,
Switzerland)
During these inflationary decades, economic structures have developed
that can only survive with falling interest rates. As the world
approaches a zero interest rate, it appears that finally there might be
a full adaptation of the structure of production to the demands of
consumers, and the experiment might come to an end.
Yet, has the Fed really "run out of ammunition"? First of all: what is
the Fed shooting at? It is trying to artificially stimulate the economy
with its monetary policy, thereby it is also unwittingly shooting at the
value of the currency. Through its monetary policy, the Fed is trying to
bail out an insolvent and illiquid banking system to maintain an
unsustainable structure of production. As long as the currency is not
totally destroyed, the Fed will never run out of ammunition. In order to
assess the ammunition left, one should have a look at the balance sheet
of the Federal Reserve — especially at the assets the Fed can still
obtain. The Fed's balance sheet also gives insights on the condition or
quality of the dollar.
Since the crisis broke out, the Fed has continuously weakened the
quality of the dollar by weakening its balance sheet. In fact, the
assets the Federal Reserve holds have deteriorated tremendously. These
assets back the liability side of the balance sheet, which mainly
represents the monetary base of the dollar. The assets of the Fed,
thereby, hold up the value of the dollar. At the end of the day, it is
these assets that the Fed can use to defend the dollar's value
externally and internally. Thus, for example, it could sell its foreign
exchange reserves to buy back dollars, reducing the amount of dollars
outstanding. From the point of view of the buyer of the foreign exchange
reserves, this transaction is a de facto redemption.
In the first stage of the crisis that lasted until September 2008, the
Federal Reserve did not increase its balance sheet. Instead, the Fed
changed its balance sheet's structure. These changes are very important
for the value of the currency. Imagine that the Fed announces tomorrow
that is has sold all its gold and has bought Zimbabwean government bonds
with the revenues. The Fed would explain this move by arguing that the
stability of the Zimbabwean economy would be crucial for the US economy
and the welfare of mankind. This action by itself would not change the
quantity of money at all, which shows that concentrating exclusively on
the quantity of money is not sufficient to evaluate the condition of a
currency. Qualitative issues can be even more important than mere
quantities. In fact, an asset swap from gold to Zimbabwean government
bonds would mean a strong deterioration of the quality of the dollar.
While this example might sound extreme, something similar happened
during the first stage of the sub-prime crisis. The Fed weakened the
composition of its balance sheet not in favor of the Zimbabwean economy
but in favor of the US banking system. The Federal Reserve sold good
assets in order to acquire bad assets. The good assets were not gold but
mainly the still highly-liquid US treasury bonds in the category of
"securities held outright." The bad assets were not Zimbabwean
government bonds but loans given to troubled banks backed by problematic
and illiquid assets. This weakened the dollar.
Figure 2:
Fed Balance-Sheet Assets (6/28/2007–1/15/2009, in $US Million)
Source: Fed (2009)
As can be seen in the chart, starting in August 2007, the lower-quality
assets increased. They grew especially in the form of repurchase
agreements and, later, new types of credits such as term-auction credits
— through the Term Auction Facility (TAF) — starting in December
2007. As the Federal Reserve did not want to increase its balance sheet,
it sterilized the increasing amount of bad assets by selling good assets
to the troubled banking system. Swapping good assets for bad assets can
in fact be considered a bail out of the banking system on a gigantic
scale. Moreover, the Federal Reserve started lending securities (good
assets) to banks in the so-called Term Securities Lending Facility
(TSLF). This measure provided the banks with high-quality assets they
could pledge as collateral for loans. As a consequence, the amount of
securities decreased via selling and lending, as can be seen in the
following chart.
Figure 3:
TSLF and SHO (1/03/2008–1/15/2009, in US$ Million)
Source: Fed (2009)
Thus, the average quality of the Federal Reserve balance sheet
deteriorated in the first stage of the crisis and continues to do so as
shown in the following compositional graph.
Figure 4:
Fed Balance-Sheet Assets (6/28/2007–1/15/2009, in percent)
Source: Fed (2009)
In the second stage of the crisis, which started with the Lehman
bankruptcy, it became clear that the policy of merely changing the
balance-sheet structure was coming to an end. The Fed was running out of
Treasury bonds. Moreover, this policy did not allow for the strong
liquidity boosts that the Fed deemed appropriate in this situation.
Hence, the Fed started to increase its balance sheet. It no longer
"sterilized" the additional loans it granted with the sale of good
assets. In fact, it would not have had enough good assets left to sell.
In our imaginary example, the Fed would run out of gold. It would stop
selling gold and keep on buying Zimbabwean government bonds. Of course,
the Fed did not buy Zimbabwean government bonds but other assets of low
quality, mainly loans to an insolvent banking system. As a consequence,
the sum of the balance sheet has nearly tripled since June 2007.
The increase of the balance sheet in favor of the financial system
required some unconventional policies. Thus, the Fed has invented new
credit programs with a tendency for longer terms, such as the
aforementioned TAF. It has granted special loans to AIG and bought Bear
Stearns assets that J.P. Morgan did not want. It has allowed primary
dealers to borrow directly from the Federal Reserve in the Primary
Dealer Credit Facility (PDCF). In addition, the Asset-Backed Commercial
Paper Money Market Mutual Fund Liquidity Facility (AMLF) was created.
This facility allows depository institutions to borrow from the Fed with
collateral of asset-backed commercial paper.
Later the Fed decided to supplement the AMLF with the Commercial Paper
Funding Facility (CPFF). Now unsecured commercial paper is also eligible
as collateral. (Unsecured commercial paper is not backed by specific
assets but only by the name of a company.)
Furthermore, the Fed has set up the Money Market Investor Funding
Facility (MMIFF), which allows money market mutual funds to borrow from
the Fed via special purpose vehicles. Three characteristics of these
policies can be found:
they contain credits of longer maturities;
they contain credits of a broader range of eligible institutions backed
by a broader range of assets than was the case before; and
they, thereby, reduce the average quality of the Fed assets and
consequently the quality of the dollar.
Despite of all these efforts, credit markets still have not returned to
normal. What will the Fed do next? Interest rates are already
practically at zero. However, the dollar still has value that can be
exploited to keep the experiment going. Bernanke's new tool is the
so-called quantitative easing. Quantitative easing is when a central
bank with interest rates already near zero continues to buy assets, thus
injecting reserves into the banking system. In fact, quantitative easing
is a subsection of qualitative easing. Qualitative easing can be defined
as the sum of the policies that weaken the quality of a currency.
But what new assets is the Fed acquiring? The Fed has already started
buying the debts of Fannie Mae, Freddie Mae, and the Federal Home Loan
Banks. It has also bought mortgage-backed securities issued by Fannie
Mae, Ginnie Mae, and Freddie Mac. Bernanke is also considering buying
other securities backed by consumer loans, credit card loans, or student
loans. Long-term government debt is also on the list of assets that the
Fed might buy.
In the analysis of the Fed balance sheet and the condition of the
dollar, another detail is extremely important. The equity ratio in the
Fed balance has fallen from about 4.5 to 2%.
Figure 5:
Fed Balance-Sheet Equity Ratio (6/28/2007–1/15/2009, in percent)
This figure implies an increase of the Fed's leverage from 22 to 50. As
we have seen there are large new positions of dubious quality on the
Federal Reserve balance sheet. More specifically, should only 2% of the
Fed's assets go into default — or if there is a loss in value of 2%
— the Fed becomes insolvent.
$32 $25
Only two things can save the Fed at this point. One is a bailout by the
federal government. This recapitalization could be financed by taxes or
by monetizing government debt in another blow to the value of the
currency.
The other possibility is concealed in the hidden reserves of the Fed's
gold position, which is only valued at $42.44 per troy ounce on the
balance sheet. A revaluation of the gold reserves would boost the equity
ratio of the Fed to 12.35%.[1]
Figure 6:
Fed Balance-Sheet Equity Ratio (6/28/2007–1/15/2009, in percent,
hidden reserve included)
Source: Fed (2009)
It is ironic that in troubled times a revaluation of the "barbarous
relic" could save the Fed from insolvency. Yet, this would only be an
accounting measure and would not change the fundamental problems of the
paper dollar. While shooting its last bullets and weakening the dollar,
the Fed is outmaneuvering itself. The end of the experiment is getting
closer.
Philipp Bagus is an associate professor at Universidad Rey Juan Carlos,
Madrid and a visiting professor at Prague University. Send him mail. See
his article archives. You can subscribe to future articles by Philipp
Bagus via this RSS feed.
Markus H. Schiml is a PhD student at the University of Bayreuth, where
he founded the Ludwig von Mises Forum. He is also a leading lecturer at
the Institute of Educational Economics campus. Send him mail. See his
article archives. You can subscribe to future articles by Markus H.
Schiml via this RSS feed.
Comment on the blog.
Notes
[1] At a market value of $810 per troy ounce, January 15, 2009.
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