Three Signal Facts on the Fed's New Balance Sheet 16 comments
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James Hamilton has an excellent post on the Federal Reserve and its changing balance sheet Monday. If you haven't been following this stuff obsessively, it's probably the single best primer to get up to speed.
To my mind, there are three signal facts about the brave new balance sheet:
- The size of the Federal Reserve's balance sheet has ballooned, more than doubling over a period of three months. If we take the FOMC at its word for it, it's not going to shrink anytime soon. Given new programs already announced, we should expect the Fed's balance sheet to continue to grow.
- On the asset side, only a small fraction of the Fed's holdings are now U.S. Treasury securities. Excluding securities lent to dealers, just 12.5% of the Fed's assets are Treasuries. The Fed has expanded the scope of its lending, from depository institutions, to primary dealers, to money-market funds and commercial paper issuers, to issuers of asset and mortgage backed securities, and very soon to private investment funds that invest in asset-backed securities. The Fed also periodically lends to support firms in, um, special circumstances, such as JPM/Bear and more recently AIG.
- On the liability side, the Federal Reserve has dramatically increased the degree to which it funds its activities with zero-maturity bank reserves, upon which it is now paying interest.
The Federal Funds rate is now effectively zero. We have hit the so-called "zero bound".
There are many ways of trying to make sense of all this. One broad-brush view is that for all its radicalism, the Fed is just a thermostat. As the private sector delevered, the Fed had to lever up (McCulley). As foreign central banks shift their portfolio from agencies to Treasuries, the Fed has to shift its portfolio from Treasuries to agencies (Setser). More broadly, as the private financial sector has become unwilling to issue short-term, liquid liabilities against long-term illiquid assets, the Fed has had to do so to avoid a disorderly collapse of asset prices (see Kling). One might imagine a canoe carrying a wild beast (that would be our "rational" private markets). The beast writhes and bends, and the Fed must throw its weight in the opposite direction to force the tipping craft upright despite all the upheaval.
"Stability" — price stability, financial stability — is to my mind like "liquidity": qualities widely considered virtues that are often actually vices. Nevertheless, the Fed pursues these goals, and in the immediate term, the thermostat analogy works pretty well. I don't doubt that we'd have tipped into steep deflation, outright collapse of core financial institutions and an in-the-streets economic crisis without the Fed's extraordinary measures. Had the Fed not played thermostat from 2001-2003, perhaps the beast would have been chastened by a mild dunking, and today's heroics might have been less inevitable. But it was stability über alles then, when the bubble first tried to burst, and now we are where we are.
So, thanks to the Fed, things are better than they might have been. But I think there is as much to squirm about as there is to celebrate in how the Fed has comported itself.
On the asset side, as has been widely noted, the Fed has been taking on extraordinary levels of credit risk. We do not know against precisely what collateral the Fed is extending its trillions in loans, and how conservatively that collateral is being valued. We wish Bloomberg luck in their lawsuit. (ht CR, Alea).
We do know that the Fed is becoming ever more brazen about its risk-taking. When the Fed made a non-recourse loan in connection with the collapse of Bear Stearns, Chairman Bernanke was summoned by Congress to discuss the unusual move. A non-recourse loan is economically something between lending and purchasing. The Fed has the authority to lend to whomever it pleases under "unusual and exigent" circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars. Anticipating objections, Dr. Bernanke was very careful during the Bear debacle to ensure that since the taxpayer would "own" most of the downside, it would also capture the upside. Still, he was called to account for what was widely understood to be an unusual move of very questionable legality. But now, under TALF, the Fed will extend non-recourse loans to just about anyone. The Fed will assume much of the downside, while private investors capture the upside. In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed. Non-recourse loans should be approved by Congress and executed by the Treasury department. The recipients of loans from the Federal Reserve should be bankrupt before taxpayers take losses. Remember, the Fed is an unelected technocracy "cognitively captured" (as Willem Buiter puts it) by the sector it purports to regulate. Yes, Congress sucks. But the Fed sucks too, and the rule of law does matter.
For all of that, it is the liability side of the Fed's balance sheet that is most interesting. The Fed is financing its gargantuan balance sheet expansion by conjuring unsterilized bank reserves. A year ago, there were less than $18B of reserves deposited at the Fed. Today there are $800B. A year ago the Fed wasn't paying interest on bank reserves. Today it is.
Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge. So, let's imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed's balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed's de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an "investment": The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.
Now the bankers will object, as they always do. Bankers have forever cried that they are required to hold reserves at the Fed, that to be forced to lend their cash interest-free to the central bank is a hidden tax. I hope we all understand by now that the pronouncements of the banking industry are about as reliable as a monthly statement from Bernie Madoff. The reserves in the banking system are created by the Fed, and the quantity outstanding is now enough to cover banks' regulatory and settlement needs many times over. This is not in any sense "their" money. It is money the Fed printed in order to pursue its own objectives. The banks have no right whatsoever to earn interest on this money, and absolutely do not merit an $800B subsidy. Further, the core rationale for paying interest on reserves has disappeared entirely. Originally, the Fed wanted the power to pay interest on reserves so that it could expand its balance sheet to pursue "stability" goals without stoking inflation by letting the short-term interest rate fall to zero. Now the short-term interest rate has fallen to zero, and the dominant concern is that we are in a "liquidity trap". Yet we are still paying the banks 25 basis points to hold this freshly created money at the Fed. James Hamilton, towards the end of his piece, points out that this is counterproductive. I want to point out that it is also obscene.
Now I have to admit that, personally, I feel a bit caught out, bent out of shape, gypped, by the whole paying-interest-on-reserves thing. A long while back, I argued against giving the Fed this power, because I knew they would abuse it. During the TARP debate, I did a one-eighty. At least the Fed, I reasoned, would only lend taxpayer money. If we took losses, the institutions that shoved them onto us would go down first. Paulson clearly wanted to assume bank liabilities outright by overpaying for toxic assets. Having the Fed lend taxpayer money seemed like a better deal than letting Paulson give it away. The cost of paying interest on reserves, when I had written about it previously, was about only $11B in present value terms, insignificant in the grand scheme of things. (By the end of September, when I flipped, reserves had already grown to $100B... but I missed that.) Now we have the worst of all worlds: Not only has our corrupt, dysfunctional banking system won the small subsidy it has long lobbied for, but the size of that subsidy has grown by almost 8000%. The Fed is no longer lending only to financial institutions that would have to go under before taxpayers eat their losses. Under TALF, the Fed will lend to anyone who owns the kind of securities whose prices the Fed wants to support. The borrowers will take the upside, while taxpayers eat the downside. (Does anybody know what kind of leverage the Fed will support under TALF? I've looked, but haven't found.) The non-recourse lending that was extraordinary and barely legal when Bear went down is now the new normal, except that the Fed no longer bothers to ensure an upside for taxpayers. By institutionalizing non-recourse lending, the Fed has arrogated the power to do everything the original TARP would have done, except without the opportunity for people like me to write Congress in anger.
Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy: They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless. I think that the current financial system and the Fed itself are quite doomed, and I'm less inclined to get bent out of shape by the particular ordering of the death throes. There will be a great crisis. Hopefully it will only be a financial crisis. I'd prefer it to be an inflationary rather than a sharp deflationary crisis, both because I think that a great inflation would be less destructive, and because that's the way my own portfolio tilts. So really, I should root for the Fed. Let the printing presses turn and the helicopters fly, but please don't confiscate my gold.
Since the current Fed loves bold and unorthodox action, I thought I'd end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)
Of course there would be tricky consequences: Gresham's law would kick in, as people would hoard physical cash to avoid the tax. Coins and bills would cease to be used for exchange, but would be held as stores of value. That would introduce some friction into small transactions: we'd end up using debit cards to buy candy bars, accelerating our transition to a cashless economy. But electronic money would be legal tender, and the appreciation of paper money would be no more relevant to the overall price level than the fact that older "wheat pennies" are worth much more than 1¢. With a sufficiently large electronic monetary base, there need be no zero-bound on nominal interest rates, and we can use "conventional" monetary policy to fight deflation by letting nominal rates go negative. I laugh in the maw of your liquidity trap.
Full Disclosure: Long precious metals, short 30-yr Treasuries (youch!).
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This article has 16 comments:
An amazingly lucid essay, with vivid metaphors. I hope readers will have the patience to read the entire piece.
A summary thought I have gotten from your article is that the objective of stability (Fed objective) can be counter-productive. Making fine tuned monetary adjustments for minor fluctuations in the economy can set up sympathetic reactions (in physics they would be called harmonics) that can amplify reactions to future fluctuations. I am thinking of your metaphor of the beast in the boat. Eventually the rushing from side to side can build up the rocking of the boat to the point of capsizing. And this concept doesn't even broach the idea of moral hazzard, an entire subject on its own merit.
Come on folks - read this entire article. It's definitely worth the effort.
One question:
Why do you (and most people, it seems) think that deflation is so much more desirable than inflation?
Deflation rewards responsible members of society for consistently responsible decisions. Anyone with ample cash and little/no debt in the current market is in a very desirable position. If deflation persists, all the dollars you have preserved by living within your means and making prudent financial decisions are now increasing in value. This is the equivalent to a drastic tax reduction, and has the bonus of only helping those that made good decisions. Existing debt becomes even more burdensome and will crush those that collected too much.
The converse of this is inflation, which punishes all those that made prudent decisions. The exact opposite of the previous paragraph happens. All those with ample cash and little/no debt are taxed to subsidize the mistakes of the over-levered borrowers. Failures are subsidized at the expense of winners, which ultimately prevents new winners from emerging and leads to the sort of stagnant environment we are currently headed for (I believe).
Obviously stability is the desirable state, but as the author and John both mentioned, attempting to micro-manage "stability" is disastrous and has led to the current state. Responding and reacting to every minuscule piece of data in an effort to combat normal, healthy fluctuations requires constantly changing policies, which leads to investor unease, which leads to instability, leading to more micro-managing, etc. in an increasingly negative feedback loop.
So to the author, or anyone else: what is the argument supporting hyper-inflation over hyper-deflation (with the knowledge that neither is desirable)?
MM
Why do you think INFLATION is more desirable than DEFLATION?
What they're doing will only have positive results IF the economy turns back up and stays up. I'd rank the probability of that at somewhere around ZERO, same as their interest rates.
The model for this policy is Japan circa 20 years ago. They never recovered. To think that the US economy will somehow have a different outcome is, as Einstein observed, insane.
But we will have a bunch of dinosaur financial institutions still unable to function in any way without zero percent loans. And they'll still probably pay themselves bonuses while most Americans can't get enough to eat.
Current monetary policy is morally, ethically, financially, theoretically and practically WRONG. This will not end well.
The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is “free” legal reserves.
Monetarism entails the following:
The sine qua non of monetary management is total current control by a central monetary authority over the volume of legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits.
Monetary authorities have to have complete discretion over changes in reserve ratios. This is essential since under fractional reserve banking (the essence of commercial banking), these ratios determine the minimum volume of legal reserves a bank must hold against a specified volume and type of deposit liability.
Monetary authorities have long recognized that the volume of bank legal reserves, combined with the reserve ratios applicable to various classes of bank deposits, determined the limits and, since 1942, the amounts of bank credit creation.
The first rule pertaining to reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios.
I.e., member commercial banks should have UNIFORM reserve ratios, for ALL deposits, in ALL banks, irrespective of size
Necessarily, the only type of bank asset that the Fed is in a position to constantly monitor and absolutely control are commercial inter-bank balances in the District Federal Reserve banks (this was the original definition of legal reserves in the Federal Reserve Act and it is the only viable definition-pre-1959 requirements pertaining to assets).
I'll try to give at least a partial answer to your question of why inflation is preferable to deflation.
In a deflationary environment business investment becomes counterproductive. I invest a million bucks to produce goods whose collective prices by the time they are sold in the market will not cover my costs, because prices are deflating as money supply (MS) is declining. Our economic system depends on the ability of producers to make profits. That's what motivates the whole capitalist free enterprise system. Nobody will invest in producing economic goods if they cannot make monetary profit.
Deflation protects the interests of money, not the interests of the productive economy. Money becomes increasingly valuable and goods become increasingly cheap. It becomes prudent to hoard money, not spend or invest it. Economic activity collapses to a subsistence level of production and consumption. Nobody will spend any more of their precious money than they have to just to survive.
Money should function as a means of exchange of economic values, though it should also be a store of wealth. This balance can be maintained by paying interest on savings = MS inflation.
Our economic system requires monetary profit and the only way to make that happen is with money supply inflation that exceeds goods supply inflation. If there is a total of $1000 in the system and all the money is invested to produce 1000 units of goods for sale then each good can be sold for $1. All the goods in the system can be exactly traded for all the money in the system. But there is no possibility of profit. At best the productive system can recover the entire $1000 it invested but there is no additional money available to make profit.
If productivity improves and we now produce 2000 units of goods with a $1000 investment then each good is only worth 50 cents because that's all the money that exists to buy the goods and "clear" the prices. This is what happens in a fixed-supply money system like gold, where productivity gains make more goods with the same amount of inputs. Business productivity gains become counterproductive because the more goods you produce the cheaper they become.
But if during the same period of productivity improvement the money supply increases to $3000 then each good can be sold for $1.50 and the system can collectively generate $2000 "profit" from the $1000 investment. There is 50% price inflation but 300% money supply inflation and huge gains in profitability.
Everybody is making lots of money so they don't care that prices have gone up because they can still buy more stuff with their share of the money than they could before the goods and money supplies were increased. This is how money is supposed to generate economic benefits and it actually works like this on the up end of the business cycle.
In our system the new money that increases the money supply to make the system profitable, enters the system as bank loans which is debt. We are in a debt crunch right now, the down side of the business cycle. Everybody feels they have too much debt and they want to repay their loans. The new money was created by our fractional reserve banking system as a loan, and when you repay the loan that new money ceases to exist.
So when we are in repayment mode we are all effectively trying our hardest to shrink the money supply. This leaves less money in the system to pay existing prices so sellers lower their prices to capture as much of the shrinking money supply as they can get their hands on. The sellers then use the money to pay their own bank debts which further shrinks the money supply in a deflationary spiral.
I share author Steve Waldman's newfound sympathy for the Fed. Chairman Bernanke has pulled out every tool at his disposal to stop deflation from destroying our economy. Remember, system wide monetary profit can only happen with money supply inflation, and deflation causes system wide losses and bankruptcies and Great Depression soup lines and all that other stuff none of us wants to have to live through.
To keep the system working the Fed has become debtor of last resort. The Fed 'borrows' money from itself, essentially being both the borrower and the lender, and spends it into our economy by buying up assets that the commercial banking system has already created/lent money on. Or the Fed lends money to commercial banks directly at about zero interest then pays the banks .25% interest for keeping the money at the Fed in their 'savings' accounts.
This allows banks to at least cover their operating costs if their usual money-making activity, which involves creation of loans which makes deposits which are recirculated as loans, has been disrupted by a financial meltdown like we have now.
The money the Fed pays to the banks and companies whose loans it buys becomes the property of the banks and companies, just like if I sell you a mortgage you get the asset (and the house that is collateral to it) and I get your money. I now own the money, you own the asset. But you had to earn the money (i.e take existing money out of the economy without creating any new money) or borrow it from a bank (which will have to be repaid which will take that money out of existence). The Fed can just create it out of thin air.
What the Fed is doing might be called naked additions to the money supply. Mr. Waldman wonders what kind of capital the Fed might possess to back up this money creation. The Fed doesn't need any. The US government could do this directly if it wanted to, but we do it via the Fed. Creating and issuing money for its people's use is a responsibility of government. How the government chooses to do this is up to Congress.
Asset:capital ratios applied to commercial banks are arbitrary limits on the amount of new money these banks can create as new loans. 10:1 seems to be about manageable on average. This ratio comes from experience, not from some predetermined formula. Banking is a real world system and we have to learn how it works because we cannot predict beforehand everything it will cause.
{though a new good idea is to lower the ratio when MS is growing too fast and raise the ratio when MS is shrinking too fast, to cool the speed of booms and warm up recessions. This would be Keynesian banking/monetary policy and it would probably be beneficial for the economy. It's a more direct way of killing inflation without recession-causing 20% interest rates like the "market approach" Mr. Volcker used.}
Whether the US Treasury creates its own money like colonial scrip, Continentals or greenbacks, or whether the Fed creates US money as Federal Reserve notes, the point is that money is ultimately created out of nothing. Fixed-supply money like gold cannot support an economic system that requires system-wide monetary profits on an ongoing basis. Steadily inflating fiat money is the only system I know of that can serve this kind of economic need.
Mr. Bernanke's Fed is trying to replace all the private debt that is being repaid with Fed debt that never has to be repaid by anybody, at least not in principle. If abused, this power could be used to mortgage USA and effectively own the country. If used for its beneficial purpose the power is simply used to make the economic system work by adding new non-debt money to the system to make ongoing profitability possible and keep the economy working.
Concerns about how much new money how fast are technical and misjudgments can cause serious inflations or permit harmful deflations. That is why technocrats run the money system. But adding new "free" money to the system is not in principle a bad thing. It is necessary. And inflation is thus necessary too.
At the risk of over-simplifying, let me try to summarize the deflation vs inflation issue.
1. Deflation creates a valuation of money for its own sake and the increased future buying power it represents.
2. Inflation creates a valuation of money for what it can do now to provide production for future goods and services which will bring more dollars than they will today.
Derryl, I don't want to diminish the quality of your essay, but it was lo.o.o.ong. Please forgive me for attempting a simple summary.
You said in 2 paragraphs what I said in 20. But in defense of looong posts, you already understand inflation/deflation. I was trying to make it clear to someone who doesn't. I admit, I'm always a little shocked when I scroll through my posts and realize just how long they get!
Derryl
I actually understand inflation/deflation quite well. I'm just intrigued as to why most people seems to think that inflation is preferable to deflation.
I understand why the gov't loves, and advocates inflation. But I don't understand why average citizens would prefer it. If it were perfectly controlled in some Friedman-esque monetary utopia, that would be a different story. But it has never, and WILL NEVER be controlled in the manner Friedman proposed.
Friedman argued for a steady, year-in year-out growth of 2-3% in the money supply. If this were central bank policy, it would be magnificent. There would be a known (and consistent) policy, and lenders and borrowers could both make intelligent decisions about the future with confidence.
But this is not what happens, and instead the Fed tries to micromanage and ultimately ends up creating monetary chaos. The cause/effect of Fed policies even just from 2000 until today is spectacularly bad. Almost everything the Greenspan Fed did was wrong, which begs the question: why should one person/group attempt to police the economy by arbitrarily setting interest rates when the consequences of poor decisions are so demonstrably harmful to most people?
Thanks for your responses,
MM
I also agree with your assessment of the ease with which the excess reserves can be shoved out the door. The Fed has the banks on a nipple right now, poisoning the milk will do the trick.
Alan,
"Last thing we needed here was a popularity contest."
I agree completely, really really bad idea.
Derryl, I doubt if you know anything about economics. Price of a Univac in 1962 $1 milllion ($3 million in today's money). Had less memory and processing power than my $500 Compaq laptop. If you scan the prices of goods and services in the 19th century, deflation deflation deflation. Real wage gains and falling prices. Outmoded free market outcome.
I actually enjoy your posts. They are clear and correct. Concise? Well, I am surprised at how long mine get, too. :)
I believe this period of deflation is just what we need, to a point (short of depression.) Once it subsides, we'll be better suited for more inflation based wealth and resumption of our money making process. Unfortunately, today, we've pressed the system too far too fast. It must correct. We are at the end of our business cycle, in my view.