Fed Easing Liquidity in Funding Markets

By Jeannine Aversa, AP Economics Writer

The Fed announced the creation of a new tool, called the Term Securities Lending Facility (TSLF), geared to provide primary dealers — big Wall Street investment firms and banks that trade directly with the Fed — with 28-day loans of Treasury securities, rather than overnight loans. They would pledge other securities — including federal agency residential-mortgage-backed securities, such as those of mortgage giants Fannie Mae and Freddie Mac — as collateral for the loans of Treasury securities. Fed officials said that’s the first time they’ll be accepting mortgage-backed securities through this type of lending program.

Unfortunately, that does tend to make the Fed less credit-worthy, say if the banks were unable to repay their 28-day debts. And since the Fed is where the government keeps its money:

U.S. Treasuries Riskier Than German Debt, Default Swaps Show

By Abigail Moses

March 11 (Bloomberg) — The risk of losses on U.S. Treasury notes exceeded German bunds for the first time ever amid investor concern the subprime mortgage crisis is sapping government reserves, credit-default swaps prices show.

Which brings up the question of, what if the Federal Reserve runs out of money (i.e. has negative equity, or if that’s not convincing enough then the absolute worst case when all the assets it holds on its balance sheet become worthless)? Is that the bankruptcy event that needs the “full faith and credit of the US Government” to bail out? And if the US Government (which is in debt itself) had spent all current revenue, would not or could not issue more debt to raise more money, and had no federal assets to sell? At that time, there would be few choices for the US Government, some seemingly more palatable than others but really all the same:

• it could seize private property, otherwise known as raising taxes;
• it could renege on obligations, otherwise known as defaulting on outstanding bonds or cutting programs like Social Security;
• or it could inflate by directing the Federal Reserve to create the needed money in its account outright (might be just what is needed if there is insufficient debt creation) — this is most like printing money and the accounting trick is simply for the Federal Reserve to “agree” to “buy” worthless assets like new government bonds that nobody else wants and for the government to turn right around to “fund” the Federal Reserve with the new money it got.

And that brings the final question: Is the United States bankrupt?

The answer is of course, yes, pretty much. Look at the balance sheet:

• assets: $80 trillion in national wealth;
• liabilities: $48 trillion in total debt, grows at more than 8%/yr nominal rate, mostly from new debt (inflation-adjusted interest is relatively cheap);
• net production: $13 trillion/yr in GDP, grows at about 5.7%/yr nominal rate, depending on inflation;
• consumption: $9 trillion/yr in private consumptive expenditure, grows at about 6.6%/yr nominal rate, depending on inflation;
• …about $2 trillion/yr in federal government expenditure;
• committed expenditures: $37-$65 trillion in long-run fiscal gap, depending on what you count;

So currently, there’s $32 trillion in net equity (assuming all assets can be pawned off); there’s a yearly $2 trillion (and diminishing) in disposable income. That seems still “fine.” Unfortunately, there’s a bill for $65 trillion coming due in the forseeable future. Oops.

I bet the world as a whole is technically bankrupt, too. We just don’t see it because, after all, you can always borrow against the infinite future. And you can expect to borrow against the future, because you expect people to keep producing and to keep lending into the future. So to pierce that bubble and cause global collapse would require, as mentioned in the paper, for a significant portion of the world either to refuse to work, or, to refuse to lend. Although… the article holds out hope that China, which is among few in the community of nations that actually has a positive “savings account,” will bail out the developed world in the future by doling out loans — hehe, probably will be high interest loans.

Who is the Federal Reserve, who owns the Federal Reserve

and this,

Where does the Federal Reserve get the money to fund its operations?

If that’s the case, then the Federal Reserve doesn’t really “creates money” when it uses open market operations to buy bonds. To presume that would put the Federal Reserve outside the economy.

Money is “created” at the moment that a newly originiated debt IOU (or any non-money, really) is accepted as money for the first time, that is, in exchange for actual money — e.g., individuals obtaining a new loan, companies or governments selling newly issued bonds, selling of newly created stock, etc.; and if I were a stickler, this should really only apply to the portion of the debt that is unsecured, as the exchange of money for the secured collateral is like a purchase by the lender who has rights on it. When the bond or debt is repaid, the reverse happens as money is destroyed. Interestingly, money expansion like this is only pseudo-permanent to the extent that the debt is either permanently revolving or replaced with new issues (Treasury notes in practice) or has an infinite time horizon (stocks).

In fact, bank loans can go a step further and continually (permanently) expand the money supply through fractional reserve lending, where new loans given out faster than the pace that old ones are repaid — if I get a loan today, I can put it into a savings account, but before I pay it back, it will be loaned out again. This is okay as long as banks have a reasonable value proposition for their loan, i.e. an expectation that whatever the loan is used for has or will have underlying value in the economy and hence an expectation of repayment. (If that’s not the case, then fractional reserve lending becomes but a pyramid scheme.)

In none of these cases is the money supply expanded top-down by the government. The money supply expands organically with the new value created in the economy (actually keeping slightly ahead of it, as they are tied to the expected value to be created from a capital venture — temporary asset bubbles excepted). The Federal Reserve is just a bank in this ecosystem with the objective not of profit but of being a sane participant (indeed to define “sane” through its market behavior); but it is still just a bank, and it has to balance its own checkbook, too.

(See here for another discussion. Interestingly, the Fed doesn’t have nearly sufficient net equity to conduct its operations, but it doesn’t matter because when the bonds it buys mature, the government, i.e. taxpayers, pays the Fed; or if the bonds roll over, then taxpayers in the indefinite future presumably will. If we look at this situation on a grand scale, if money supply in the economy grows in any permanent way it must be entirely due to growing private debt lent by banks plus growing debt incurred by the government, which of course is implicitly borne by the public as well. If that growth is in step with the economic productivity, meaning people will be increasingly able to pay their private debt, and government will get increasing tax revenue to pay bonds, then everything is okay.)