The Fed's Exit Strategy

[Ted Spread]

Re: The Fed's Exit Strategy

What a beautiful theory: but irrelevant. Every other central bank on the planet has its own exit strategy too, and they are all standing around near the fire escapes.

[metalman]

Re: The Fed's Exit Strategy

What a beautiful theory: but irrelevant. Every other central bank on the planet has its own exit strategy too, and they are all standing around near the fire escapes.

oldie but goodie...

[ASH]

Re: The Fed's Exit Strategy

Hey Ash,
You seem to have a grasp of what the Fed is doing. Can you comment on the collapse of the banking system? I've heard that whatever printing the Fed has done is dwarfed by the dollar destruction in the credit crisis and shadow banking system.

Hi stanley. This is a rather long post -- unfortunately, its length does not reflect my actual knowledge of the subject, but only my amateur interest. With the understanding that I'm not presenting myself as any kind of expert on the banking system, I'm happy to share my thoughts...

My sense is that we're on a trajectory to end up with a lot of the smaller banks gone, and a few big zombies. I assume there will also be a few banks mixed in with the zombies which are reasonably healthy -- either through better risk management during the bubble, or through preferential treatment afterwards. However, they may not be very profitable.

My thumbnail narrative for the banking crisis is that once loans started going bad, the write-offs and write-downs both ate into bank capital and induced the banks to cut back on the issuance of new loans. As the rate of credit creation dropped, so did the economic activity and asset valuations driven by constant credit expansion, with the result that cash-strapped consumers are continuing to default on loans, and are also less eager to borrow. This set up a positive feedback loop that threatened a deflationary spiral, and widespread failure of banking institutions. So far, the policy response has been directed at arresting the panic (which would have accelerated a collapse), trying to break the deflationary feedback loop, and buying some time to get credit expansion going again.

The authorities were successful in arresting the panic. It will take time to determine how successful they are at stopping the deflationary feedback loop and getting credit expansion going again -- people are still losing their jobs, and will continue to default on loans. If I read bart's charts correctly, it looks like credit is flat after a sharp drop -- but it hasn't been flat for very long, and hasn't made a sustained turn upwards yet. In any case, I accept the view that with debt securitization dead for the moment -- and continued access to foreign credit in question -- a rapid return to the conditions of the credit bubble simply aren't in the cards.

In my mind, the part of this that most directly relates to the health of the banking sector is the intervention to recapitalize the major banks, or at least conceal their deficiencies. The Fed's lending against dubious assets, printing, and interest rate policy accommodation, the government's injection of capital, and the suspension of the mark-to-market rule, seem to have addressed the immediate problem of capitalization for the big banks. That said, the capitalization problem for those banks that were saved by relaxation of mark-to-market will resurface as more loans go bad over time. After all, mark-to-myth doesn't pan out if you hold a bundle of bad loans to maturity. Also, some of the institutions that are okay now even without balance sheet sophistry will find they have problems, as further losses accrue in other categories of debt.

The only way to avoid future capitalization problems is either (a) putting enough cash in the hands of the indebted to pay their bills and avoid default, (b) the transfer of the debt from those who cannot pay to those who can, or (c) allowing the banks to get the bad loans off their books by selling them at something close to their mark-to-myth valuation.

A bonafide economic recovery, wage inflation, or inflation of the assets which secure the loans would accomplish (a). I'm doubtful that an economic recovery can precede clearing of the debt overhang, although I think this is what the policy-makers hope for. One might argue that they think a resumption of credit-driven asset price inflation would be a recovery. In any case, as regards homes, that well is dry. So, in this category, they are probably going to end up settling for wage inflation, whether by accident or design. (Note that my supposition there will be wage inflation doesn't mean that inflation will be driven by wage inflation.)

Government bailouts fit the bill for (b). However, government bailouts are constrained by politics and means. I believe that further direct bailouts of the banking system will not be possible by the time that new capitalization problems surface. Therefore, the authorities will have to accomplish their ends by other means.

Various initiatives from the Treasury were focussed on (c), but the more recent ones were short-circuited by the mark-to-market rule change (haven't heard much more about PPIP since then). The Fed's monetization of agency MBS also have that character, although I think that program is more about manipulating mortgage rates than getting mortgages off the books of banks. That said, to the extent that there is oversight and auditing of any such sales, in any kind of legitimate market "to make sure the public doesn't over-pay", these programs will be less effective at averting a capitalization problem. From the standpoint of patching bank balance sheets, the whole point of the intervention is to over-pay. Like direct bailouts, programs like PPIP may become decreasingly politically viable as time passes.

Elsewhere, I hypothesized that the Fed's monetization of mortgages might turn into a weird combination of (a) and (c) in which banks can sell the MBS to the Fed at "face value" but the Fed then rewrites the loan terms to the benefit of the debtors. That's complete speculation, but it's one mechanism by which both the capitalization needs of the banks and the cash flow needs of the consumer can be addressed. This is the sort of thing that I think we might be driven to, after direct bailouts are no longer feasible.

It should be pointed out that avoidance of future capitalization problems is not assured -- the answer could be "none of the above", in which case bank failure is also on the table. Smaller banks are going under, and will continue to do so. It may be that if fresh capitalization problems are encountered when there are fewer easy policy choices (i.e. bailouts or transfering private debt to the public is no longer expedient), the worst of the larger banks that have been protected so far will actually be shut down.

Turning at last to the specific issues raised in your post, I don't think it's technically true that the money destroyed to date is more than the Fed has printed in response to the crisis... depending upon what you regard as money. By their nature, the Fed's moves to shore up bank capitalization all focus at the base of the inverted monetary pyramid, so it's certainly true that the Fed's "printing" could be overwhelmed by the contraction of credit as banks reduce their lending against their reserves, or fail. However, again refering to Bart's charts, it appears that we've lost about $1T from the sum of M3 and credit, whereas the Fed has commited to printing $1.25T to cover the purchase of MBS alone. My thinking is that the economically significant factors so far are the drop in asset value, and the reduction -- and temporary reversal -- in the rate of credit expansion.

So, to date, it seems like the actual contraction of money plus credit hasn't been larger than the Fed's printing. On the other hand, neither has the Fed gotten credit expansion and asset price inflation roaring again. Consequently, loans will continue to go bad, eating into bank capital. The question, I suppose, is whether the continued failure of small banks -- and the eventual capitalization problems of the big banks -- will be so severe as to both threaten the banking system and outpace the policy response. Your reference to the shadow banking system also touches on this point, as the shadow banking system is posited to be a potential source of vast and abrupt losses.

With the caveat that I am even less an expert on the shadow banking system than on the regular banking system, my impression is that if we were going to sustain a sudden whammy from left field -- such as a $50T derivatives Gotterdammerung -- it would have happened by now. (Won't this be fun to quote, two months from now, when we're all wearing barrels on suspenders.) The fact that it hasn't happened yet suggests a couple of things to me. First, by dint of being a shadow banking system, things don't have to play out mechanically, with transparent transactions executed in the public view. Broadly speaking, although there would be winners and losers on paper once everything had been netted out, the participants as a group would be immolated if the chain reaction were ignited. They have the motive to see that this doesn't come to pass, and the occult nature of the market gives them the opportunity to make sure it doesn't. Second, certain events that are widely supposed to trigger derivatives Armageddon have come and gone -- this adds credence to the supposition that the participants are being circumspect about the exact letter of their contracts. Also, I interpret some of the government's interventions as heading off the tumble of early dominos. Anyway, it seems likely to me that if a serious problem from this avenue developed which the market participants failed to contain themselves, we would see another demonstration of the government's recent attitude toward contract law.

In conclusion, I don't think the banking system will collapse, although I don't expect it or the economy to be healthy for quite some time. I'm not much of an original thinker on these matters, so you could say that my expectation for the future is an inflationary depression. As metalman pointed out, the Fed is prepared to control inflation that results from a pick-up in economic activity and lending against the reserves it has created, but inflation is likely to come from another direction -- POOM. And as jk points out, even then, the Fed might have the tools to contain inflation, but since they wouldn't already have a recovery, they probably wouldn't have the political will to use them.

[Sharky]

Re: The Fed's Exit Strategy

OK, sorry, how does the treasury create money? Can they issue notes like bank notes that are "money"? I thought the treasury was constrained to getting money through either taxation or borrow money through bond sales, not just create money like the fed can.

Does the treas issue bonds for the exclusive purchase by the fed which will print the money? then the treas will use the money to buy the crap assets? Is this any different than just pushing out the bonds to the primary dealers?

Treasury can issue its own notes. Have you ever seen the old "red seal" notes? Those are "US Notes," which are issued directly by the Treasury. They differ from FRNs in that they are not debt-backed. However, notes probably wouldn't be involved at all in a bailout of the Fed.

The constraints on the way Treasury creates money are imposed partly by policy and partly by Congress. That's why I said that Congress would have to be involved in order for a Fed bailout to happen.

The way things work today, Treasury already creates Bonds/Notes/Bills, which it then sells to investors. But that part of the process doesn't create new money; it just exchanges existing money for the securities. New money is created only when the Fed buys those securities from the investors (FRNs aren't new money, either). When the Treasury creates new money, they do so in a debt-free way: they just create it from thin air -- by printing or the digital equivalent.

How long would this take? Would there be an extended bank holiday like back in the Great Depression, or does modern technology make this a "flipped switch" after the setup is complete?

Hard to say how long it would take, although it definitely wouldn't be a flipped switch scenario. I could imagine them having an extended bank holiday, and when the banks re-open, existing currency would be exchanged for new currency.

[ThePythonicCow]

Re: The Fed's Exit Strategy

OK, sorry, how does the treasury create money?

The Treasury doesn't create money; the Federal Reserve does.

Well, there is the little slight of hand whereby the people actually running the paper currency printing presses work for the Treasury, but they print on the demand of the banks to the extent that actual physical paper currency is needed. Most dollars are not in paper form anyway. So the detail of to whom the money printing office reports is of minor consequence other than as a bit of magicians slight of hand. The Fed creates America's money.

In 1913, the United States government granted to a consortium of banks known as the Federal Reserve (the Fed) an exclusive contract to create dollars and allows the Fed's banks to profit by collecting interest on debt paper it purchases with this newly created money. Usually, this debt paper is Treasuries purchased on the Open Market. Recently it has included other debt paper, such as mortgage backed securities. Even this so called Quantitative Easing (QE) doesn't change this deal. QE just means that now the Fed has kindly consented to take delivery of even -more- debt paper, bypassing its Open Market operations when it so chooses.

Isn't that just special. The loan shark (aka the Fed) has you (the United States) in debt over what you can handle, and now kindly offers to extend you even more debt, to help you meet the payments and default demands on the existing debt. The loan shark is the bank,so can generate as much debt as the market will bear, without effort or other restriction.

Well, in the actual case of the Fed, there is one restriction in normal times. Normally the only debt paper it buys with its magic new money is Treasuries, and Congress imposes a debt ceiling on how much Treasuries the Dept of the Treasury can issue. However besides the problem that the Banksters now "own" Congress (as Senator Durbin recently stated) so can get this debt ceiling raised as they desire, there is also the problem that the Fed is "kindly" accepting other debt paper at its National Monetary Pawn Shop. Oh - and one bigger problem with this "Debt Ceiling" limit. Most money is created by banks to back other debt that they have extended to individuals, corporations, and state and local governments. There really is no limit to how much debt banks can create out of thin air these days, short of this entire scheme collapsing in a catastrophy.

Consider this analogy. Imagine you are a self-sufficient farmer out in the country. You grow your own food for your family. Sometimes you have more food than others, occassionally it gets pretty bad, but you get by. After one particularly bad harvest, some "big agricultural consortium" (Big Ag) makes you a deal. You commit to sell all your production to them, and in return they will provide you (at a higher price) an eternal abundance of food, seeds and fertilizer. Big Ag now has the -exclusive- contract for providing food to your family, feed for your cattle and fertilizer for your fields. You made the deal out of desperation, in the middle of the night before Christmas (when Congress passed the Fed Reserve Act in 1913, as best I recall), without consulting with your wife, who would have told you to tell Big Ag to go to hell. From that day forward, your family is in debt to Big Ag. At first, it's not too bad, but over nearly a century, the entire family homestead, lock, stock and barrels, is owned by Big Ag. [Actually, this analogy is not entirely fantasy, as another recent iTulip post of a video presenting a woman in India complaining of the devastating impact of Big Ag there shows. Moreover, we are about to witness, I predict, some of the monetary collapse problems of recent also showing up in the worlds food supply chains. M

Going back to Big Banksters, aka the Fed, we have three serious problems here.

1. The Fed's exclusive right to create money, in return for debt, moves increasing portions of the wealth to the Banks, thanks to compounding interest.
2. Money supply is no longer constrained to something roughly proportional to the productive capacity of the nation, but rather grows unending, which we call inflation.
3. Because the means of production are no longer owned by the actual producers, but rather by the banks (perhaps as collateral on a loan), the motivation felt by the actual investors and producers to maintain and improve the nations productive capacity has wilted. The nation is no longer self-sufficient in many important ways. People work harder and smarter for their own profit than they do for the banks or the governments profit.

One of the key selling points of the Fed was that it removed the prior constraint on the money supply of being tied to the gold supply, which was a depressing problem at a time when the productive capacity of the United States, in the late 1800's, was growing faster than the gold supply. The proper response to this depressing lack of money when it was gold backed was not to grant a bank consortium an exclusive right to make the money (and charge interest thereon) but to have a branch of the Federal government make money, as a debt to no one, in proportion to the nations productive capacity. I'm sure former President Andrew Jackson could have explained this to us, were he still alive.

[makimanos]

Re: The Fed's Exit Strategy

oldie but goodie...

It is a sad think that when the chips are down our politicians always choose inflation. A a currency goes the country follows.

[Sharky]

Re: The Fed's Exit Strategy

The Treasury doesn't create money; the Federal Reserve does.

Normally true, but not always. The Treasury can create money. As a small example, many US Notes were issued after the creation of the Fed.

[ThePythonicCow]

Re: The Fed's Exit Strategy

So, to date, it seems like the actual contraction of money plus credit hasn't been larger than the Fed's printing.

Perhaps the question of whether the debt contraction or Fed printing is larger is less important than the question of the productive capacity of the nation.

In classic capitalism, labor and investment is made where wages and profit are forseen. The more labor, natural resources, inventiveness and energy a nation has, then the greater than nations capital productivity.

In the current American economy, labor and investment has been largely refocused to wherever debt financing is offered, such as by banks, car dealers, other nations providing us vendor financing (Japan, China, OPEC), mortgage brokers, and what not. The more influential the nations banks, the greater that nations FIRE capacity.

We went from a labor, industrial and mining capital capacity to a debt funded FIRE capacity. Workers built McMansions because the bank would loan more money on them, not factories because they could manufacture more stuff, nor mines and oil refineries because they could make more energy and metals.



The FIRE Engine is broken.

We still have some "real" productive capacity (I hope -- those pictures from Detroit are discouraging however.) We are about to find out just how much. I expect it will be a lot less than most Americans will find comfortable.

[ThePythonicCow]

Re: The Fed's Exit Strategy

Normally true, but not always. The Treasury can create money. As a small example, many US Notes were issued after the creation of the Fed.

Yeah - thanks for the correction. I suspect you are correct that the transition from Treasury to Fed generated money was more gradual than my incorrectly oversimplified gloss.

Plus of course TARP, as I mentioned earlier.

Well, I'm unsure of just how this TARP thing actually worked. I thought maybe it authorized Treasury to provide money to banks, supposedly in exchange for some toxic debts, though that exchange aspect seems to be in doubt. But the question I have is -where- did that money come from? Didn't Congress increase the National Debt Ceiling at the same time, which would suggest that this TARP money was not new money, owing interest to no one, but rather just more government money borrowed from the banks -- "just put it on our tab."

Whatever the case, it seems for sure that "they" aren't telling us the whole truth about TARP, which suggests we're getting the shaft once again. Perhaps we're getting the shaft in multiple ways -- borrow debt money from the banks so we can give it (and the interest incurred) back to them without adequate public accounting.

In any case, are you confident that this TARP money was new money created as a debt to no one?

[Sharky]

Re: The Fed's Exit Strategy

In any case, are you confident that this TARP money was new money created as a debt to no one?

Well, I recall reading that somewhere, but I couldn't find the source, so went back to the original legislation. It turns out that TARP was financed through public debt (USC Title 31, Chapter 31), not through creation of new money.

Sorry about that.

[ThePythonicCow]

Re: The Fed's Exit Strategy

But the question I have is -where- did that money come from? Didn't Congress increase the National Debt Ceiling at the same time, which would suggest that this TARP money was not new money, owing interest to no one, but rather just more government money borrowed from the banks -- "just put it on our tab."

After chasing down some fading recollections, I believe that the last time the United States Treasury issued any non-debt based currency was in the 1960's, up until when it still sometimes issued Silver Certificates.

[ThePythonicCow]

Re: The Fed's Exit Strategy

It turns out that TARP was financed through public debt

Ok - thanks for following up on that.

[Sharky]

Re: The Fed's Exit Strategy

After chasing down some fading recollections, I believe that the last time the United States Treasury issued any non-debt based currency was in the 1960's, up until when it still sometimes issued Silver Certificates.

What changed in the early 60s had to do with silver certificates and abandoning the ability to redeem them for silver (the final step to an all-fiat currency). However, US Notes continued to enter circulation until 1971.

[ThePythonicCow]

Re: The Fed's Exit Strategy

What changed in the early 60s had to do with silver certificates and abandoning the ability to redeem them for silver (the final step to an all-fiat currency). However, US Notes continued to enter circulation until 1971.

So for a while the US issued redeemable silver certificates, then it stopped issuing them but would still redeem them, then it stopped even redeeming them, then in 1971 those certificates went out of circulation entirely. Is that about right?

In any case, we're sure swimming in a sea of debt-based dollars now, where that debt basis comes in many forms, including Treasuries, state and local bonds, and private and corporate debt. But don't worry, be happy. Anytime trouble brews, our friendly banker will gladly extend us some more debt, even to the point of extending Uncle Sam debt to help bail out the self-same bankers.

It's a good business if you can get it .

[ASH]

Re: The Fed's Exit Strategy

Perhaps the question of whether the debt contraction or Fed printing is larger is less important than the question of the productive capacity of the nation.

....

We went from a labor, industrial and mining capital capacity to a debt funded FIRE capacity. Workers built McMansions because the bank would loan more money on them, not factories because they could manufacture more stuff, nor mines and oil refineries because they could make more energy and metals.

The FIRE Engine is broken.

We still have some "real" productive capacity (I hope -- those pictures from Detroit are discouraging however.) We are about to find out just how much. I expect it will be a lot less than most Americans will find comfortable.

I agree. I'm hoping we experience this as just economic stagnation and high inflation. Of course, hope is not a policy.