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I want to check my fact/reasoning...
I've written down a summary of how I understand these bailouts to work, and I'd like someone to tell me if I have my facts wrong. I'm trying to explicitly write out the steps that lead from government bailout to high inflation, so that I can clearly describe what's going on to some friends.
Ultimately the bailout must be funded by the issue of new treasuries, which will create a large amount of new money ex nihilo, as follows:
A large growth in the money supply means inflation.
I've written down a summary of how I understand these bailouts to work, and I'd like someone to tell me if I have my facts wrong. I'm trying to explicitly write out the steps that lead from government bailout to high inflation, so that I can clearly describe what's going on to some friends.
1. Creditors (holders of bonds) are getting bailed out directly by the government, which is assuming responsibility to pay out on the debt which failed issuers would otherwise default upon. However, the owners of the failed issuers (shareholders in banks and government-sponsored entities) are getting wiped out. Private consumer debt is not yet being bailed out directly, although there is talk.
2. Institutional debtors (issuers of commercial debt) are being allowed to borrow treasuries from the Fed using their illiquid debt-based assets as collateral. Technically these are supposed to be short-term loans, but so far in practice the loans are allowed to roll over indefinitely. The net effect is to exchange illiquid (and likely junky) assets for treasuries, which has the effect of recapitalizing the banks and reducing the risk of their failure.
3. The new plan is basically to formalize #2 with a larger, and more permanent arrangement. Rather than maintaining the form of short-term loans, we are talking about permanent sale of the junky assets for "sound" treasuries.
2. Institutional debtors (issuers of commercial debt) are being allowed to borrow treasuries from the Fed using their illiquid debt-based assets as collateral. Technically these are supposed to be short-term loans, but so far in practice the loans are allowed to roll over indefinitely. The net effect is to exchange illiquid (and likely junky) assets for treasuries, which has the effect of recapitalizing the banks and reducing the risk of their failure.
3. The new plan is basically to formalize #2 with a larger, and more permanent arrangement. Rather than maintaining the form of short-term loans, we are talking about permanent sale of the junky assets for "sound" treasuries.
Ultimately the bailout must be funded by the issue of new treasuries, which will create a large amount of new money ex nihilo, as follows:
A. Treasuries are issued by the government directly to banks to pay for the purchase of their illiquid assets, or are issued to cover the general budget deficit.
B. The FOMC buys the treasuries in open market operations from various dealers (to keep the target overnight rate low).
C. The Fed pays for the treasuries with an electronic check drawn on itself -- this means that the dealer gets a deposit credited in their bank account, and the dealer's bank gets credited with reserves at the Fed. Now both the dealer and the bank have funds equal to the value of the treasuries, but since the dealer gave up the treasuries in exchange for their funds, we're really only up by the bank's additional reserves at this point.
D. Thanks to fractional reserve banking, the additional reserves are amplified many times over in the creation of new credit, which the banks issue against their reserves to generate interest income.
B. The FOMC buys the treasuries in open market operations from various dealers (to keep the target overnight rate low).
C. The Fed pays for the treasuries with an electronic check drawn on itself -- this means that the dealer gets a deposit credited in their bank account, and the dealer's bank gets credited with reserves at the Fed. Now both the dealer and the bank have funds equal to the value of the treasuries, but since the dealer gave up the treasuries in exchange for their funds, we're really only up by the bank's additional reserves at this point.
D. Thanks to fractional reserve banking, the additional reserves are amplified many times over in the creation of new credit, which the banks issue against their reserves to generate interest income.
A large growth in the money supply means inflation.
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