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Well so much for the thesis of the bright new dawn of US Treasury backed "power money" ushering in American Empire 2.0. :rolleyes: Here's Tom Szabo of Silveraxis with a "brief overview" of how the US Treasury has just nationalized the Federal Reserve due to looming Fed insolvency. [ :eek: ].
Warning, this may keep a few of our more sophisticated gold and silver agnostic holdouts tossing and turning in their sleep this week , as to whether they have sufficient "barbarous relic insurance" to cover them from the onslaught of the full might of the United States Treasury's oven-blast of inflationary flames upon the USD's value. For the gold agnostic's sleeplessness after reading this report, I recommend a nice spoonful of NYQUIL, and a strong draught of Cognac before bedtime. :rolleyes: This should bring on merciful restorative slumber, to all those "weathering this storm, parked securely in Federal Reserve notes and US Treasuries". :p :p :p
QUOTE:
The bottom line is that only entities that can borrow at zero discount (for default and repayment risk) are able to provide the dollar-for-dollar credit necessary to increase the Monetary Base on a permanent basis. In the case of the U.S. dollar, this is the Treasury Department of the U.S. government.
It seems the effects of discounting have been overlooked by most commentators as they have sought to understand the current credit crisis.
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THE FED IS BANKRUPT - UPDATE ON THE HELICOPTER - Oct. 4th 2008 (Tom Szabo - Silveraxis)
This might be the most important monetary discussion of the past few decades, and Ed Bugos should get a lot of credit for starting it with the excellent Who’s Bailing out Whom? I agree with Mr. Bugos wholeheartedly although I believe the situation might be even more precarious than he states. I urge all of my readers to at least read the piece by Ed Bugos and as much of the below discussion as you can stomach. Also, I would ask that you forward this to as many people as you know so they too will have a chance to understand the truth before it smacks the U.S. and the rest of the world in the face.
Notice the vertical line at the end of the chart. That’s a $75 billion increase in the past two weeks. Given the parabolic rise of the Adjusted Monetary Base since 1970, perhaps you might think that $75 billion is not particularly special, but the just-released Factors Affecting Reserve Balances report indicates that the size of the vertical line could more than double to $150 billion when this chart is updated next week. See the Ed Bugos article for more charts with vertical lines.
To get an idea of what is in store, let’s examine the latest Factors Affecting Reserve Balances report a bit more closely. The relevant number we need to look for in this report is called “Reserve balances with Federal Reserve Banks”. Reserve Balances are claims by the banking system on cash held in the vaults of the Federal Reserve Banks. The most important thing about Reserve Balances for our purpose is that the Monetary Base includes Reserve Balances plus cash in circulation (including coins and Federal Reserve Notes in bank vaults and in the hands of the public). The Monetary Base, as the name implies, is the first layer of the fractional reserve banking system. Generally speaking, an increase in the Monetary Base is multiplied several times as it propagates through the money supply.
Here are the figures for “Reserve balances with Federal Reserve Banks” since the beginning of September:
September 3, 2008: $3.8 billion
September 10, 2008: $25.0 billion
September 17, 2008: $81.7 billion
September 24, 2008: $87.9 billion
October 1, 2008: $171.5 billion
We can see from this data that around $63 billion of the $75 billion increase in Adjusted Monetary Base as of the two weeks ended September 24 was the result of a rise in Reserve Balances. Let me note that another $7 billion was the result of an increase in Federal Reserve Notes in circulation and much of the remainder was the result of the Adjusted Monetary Base being a weekly average (not end of period) calculation.
Indeed, if we look at another important Fed report, Aggregate Reserves of Depository Institutions and the Monetary Base, we can confirm the leap in the Adjusted Monetary Base figures. There are some differences in accounting and averaging that make the actual amounts of Reserve Balances included in the Monetary Base and the Adjusted Monetary Base somewhat different from report to report, but what matters is the rate of change between periods. To wit, there has been an increase in the Monetary Base of $65 billion for the two weeks ended September 24 according to the latest Aggregate Reserves of Depository Institutions and the Monetary Base report.
We can also see from the data I provided above that Reserve Balances almost doubled this past week (after September 24), rising by $83.6 billion to $171.5 billion. Thus, we should expect both the Monetary Base and the Adjusted Monetary Base to rise by a very substantial amount when new Monetary Base data is published next week.
Up until two weeks ago when the $700 billion bailout package came out of virtually nowhere, the Federal Reserve seemed content to continue swapping its liquid Treasury securities portfolio for the illiquid assets of banks, slowly destroying the Fed’s balance sheet in the process. But the impending failure of AIG and the actual failure of Lehman Brothers apparently did some serious damage to the Fed’s plans, because the most important monetary decision of this entire crisis was made in a big hurry, with virtually no fanfare. I suspect the Fed finally started looking more than a few days ahead and suddenly realized that it might quickly and completely run out of Treasury securities (see below).
So, the Fed and Treasury announced a seemingly innocuous Supplementary Financing Program on September 17. In reality, it was nothing less than a clandestine federal bailout, a de facto government takeover of the Federal Reserve that will officially materialize as reality at a later date. This radical “program”, which is by far the most extreme of all the Fed and Treasury actions in terms of monetary consequences, has received very little coverage so far in the media, on Wall Street, on Main Street, in the Capitol, or on the Internet. But I suspect this could soon change now that the $700 billion bailout package has been penned into law. Indeed, the Treasury bailout legislation seems to be the fuel for the Supplementary Financing Program, which is nothing less than the biggest monetary helicopter lift since the Weimar experiment with the printing press.
Here is how the Supplementary Financing Program is alleged to work. The U.S. Treasury Department sells Treasury securities in a public auction and deposits the cash proceeds with the Federal Reserve. The Federal Reserve thus has “cash for use in the Federal Reserve initiatives”.
Sounds simple enough, but do not be fooled! That is only a part of the story. If the Treasury securities were merely sold into the market and the proceeds were loaned to the Federal Reserve, there would be no impact on Reserve Balances or the Monetary Base. Or as Ed Bugos likes to say, the liquidity would be “sterilized”. In other words, the operation would merely represent a shift of existing money supply within the financial system. Not an injection of new cash. Yet what we have witnessed in the past few weeks is a massive increase in Reserve Balances to the tune of over $160 billion.
And that can only mean one thing: the Fed is now monetizing banking assets (or at least is preparing to do so). This is a bona fide helicopter operation, the first of its kind during the current credit crisis and certainly the largest in the history of First World central banking since the Great Depression. What we don’t know is if these Reserve Balances will turn into Federal Reserve Notes and get stuffed under the mattress as panicked depositors continue to withdraw cash from the banking system or if these Reserve Balances will get loaned out by the banks whose assets are being monetized. If the former, the hyperinflation will be delayed until the cash is taken back out from under the mattress, which will happen once the bank runs have abated. If the latter, hyperinflation could come fast and furious.
In effect, what’s really happening is that the Treasury is borrowing money into existence at the Monetary Base level. This is exactly the same thing that Weimar Germany did. What the Germans (and the Argentinians, Zimbabweans, etc.) found out, and what our “benevolent” leaders will also discover, is that the printing press is a slippery slope to oblivion. The worst-case outcome of giving into this temptation is almost unfathamable.
And here we all thought the $700 billion bailout package had to actually be approved by the elected representatives of the people before the Fed and Treasury could commence their bailout plan. Silly us! It looks like the Fed and Treasury have been preparing to go forward via the back door regardless of what our legislators did. I suppose this is why Secretary Paulson insisted that passage of the bailout was necessary to restore confidence to the credit markets, but no specifics were provided about how exactly the process would work. Now we know why. The bailout was the equivalent of putting lipstick on a pig, and the pig is the Supplementary Financing Program by which the Fed can already monetize bank assets. Legislative approval was essentially a rubber stamp, a mere formality. The Executive branch a la Bush has once again usurped powers not granted to it under the U.S. Constitution.
If the above is not crystal clear to you, let me point out that the Treasury has provided over $150 billion so far under the Supplementary Financing Program whereas the initial Treasury authority to purchase troubled assets under the Congressional bailout legislation is $250 billion. In other words, most of the initial authority has already been loaded on the helicopter in the past couple of weeks and is ready to be dropped from the sky.
Here is the thing that bothers me the most. The idea that the Treasury would buy distressed banking assets using taxpayer money is hugely unpopular with Americans, but the unpopularity itself became the blindfold that kept everybody from asking exactly how the Treasury would actually do this. In fact, several hundred economists (all of them apparently Keynesians) have written letters to Congress urging them not to vote for the bailout because it would not work, mainly on the grounds that banks will need to be recapitalized with banking reserves instead of just having bad assets taken off their books. Well, guess what? Recapitalization of banking reserves was apparently the plan all along!
I find it curious that some members of Congress have said of the bailout, as a way of expressing that there is much work left to do, that it is the end of the beginning and not the beginning of the end. My two cents is that Thursday, September 24, 2008 could in fact mark the beginning of the end: the end of the U.S. Dollar as a liability of the Federal Reserve system. I suspect we will look back on this as a day of infamy, the day we found out that Ben’s helicopter is fueled up, ready to fly and drop piles of money from the sky.
The helicopter is why, out of nowhere, the Reserve Balances and the Adjusted Monetary Base jumped by $75 billion or so in the past two weeks. And the helicopter is why these amounts have jumped and will jump by another $75 billion or more by next week. As you consider the situation, please realize that up until this September, the Monetary Base had not changed much since the beginning of the credit crisis last year. That proves more than anything that the helicopter was grounded until now.
Indeed, all the credit facilities created by the Fed from the Term Auction Facility to the Term Securities Lending Facility to the Primary Dealer Credit Facility to the Bear Stearns Maidan Lane facility and to the AIG credit facility have had no actual effect on the Monetary Base or money supply. This is because the credit facilities are essentially just swaps of assets, not money creation. The banks simply obtained assets they could sell (Treasury securities) in exchange for assets they could not sell (loans, MBS, CDO, etc.) This is the reason some observers are confused about why the Federal Reserve has not been inflating money supply in the face of a credit crisis that has deepened every month since last August.
So why exactly has Ben’s famous helicopter not flown, much less made money drops, until the past two weeks? There are several reasons. For one, even Mr. Bernanke recognizes the inflationary implications of a helicopter drop and he was willing to use it only as a last resort. But there is a more fundamental reason. You see, the helicopter didn’t have a stable fuel supply. What fuel there was in the form of Open Market operations or purchases of bank assets was simply too unstable and would probably cause the helicopter to crash. Furthermore, it turns out the Fed cannot monetize bank assets effectively without assistance from the U.S. Treasury Department. See the Appendix to this essay for a detailed explanation.
What I’m saying is that the idea, as suggested by the Fed Chairman himself, that the Fed is capable of flying the helicopter all by itself, is fraudulent. Moreover, anybody claiming that the Fed had already flown the helicopter before September is simply wrong. The various Federal Reserve reports that I reference in this commentary back me up on this. For example, the Aggregate Reserves of Depository Institutions and the Monetary Base shows that as recently as September 10, when the total borrowings by banks under the various Fed credit facilities stood at $170 billion:
Just to make it absolutely clear, please allow me to repeat that only when the Treasury came into the picture in the past few weeks and actually started to issue new federal debt under the Supplementary Financing Program — ostensibly to provide cash for the Federal Reserve to use in “initiatives” — did the Monetary Base start to grow. Why? Because as I explain in the Appendix below, the banking system as a whole cannot create adequate collateral for banking reserves on its own. And the banking system certainly cannot create sustainable banking reserves out of thin air. Stated another way, the Fed cannot create banking reserves without collateral. It is collateral, and only collateral, that can serve as fuel for the monetary helicopter. And the only collateral that matters is Treasury securities. Once again, this is explained in greater detail in the Appendix.
For those not wishing to delve into the specific details provided in the Appendix below, perhaps I can sufficiently advance the above argument by pointing out that the Federal Reserve cannot afford to simply accept banking assets as collateral for Reserve Balances or Federal Reserve Notes because withdrawal of these banking reserves by the public — accomplished by literally putting Federal Reserve Notes under the mattress — would create a fatal problem for the banking system: not enough money in circulation to repay outstanding bank loans, including the loans used as collateral for the newly created Reserve Balances. We can use the cliche “pushing on a string” to describe the inability of the Fed to effectively monetize bank assets that were created by fractional reserve lending. Cliche or not, it is precisely the act of “pushing on a string” that has forced the Fed to beg the Treasury to borrow money — and thus banking reserves — into existence.
The problem of lacking helicopter fuel aside, the Federal Reserve had another problem a couple of weeks ago that required immediate Treasury intervention. The Fed had bled Treasury securities from its portfolio to the tune of $300 billion by early September with no end in sight. Indeed, as of October 1 the Fed has given away over $500 billion of Treasury securities from a portfolio that held $800 billion just last year. If something wasn’t quickly done, the Fed was in very real danger of exhausting its ammunition for “lender of last resort” duties.
In my estimation, the Fed exhausting its Treasury securities portolio is tantamount to insolvency, nay, bankruptcy. Indeed, the Fed seems to have become prescient about its impending doom just in the nick of time given that the latest Factors Affecting Reserve Balances report shows as of October 1 that the Fed has acquired $538 billion of banking assets which now support around 67% of the $804 billion of Federal Reserve Notes outstanding. By my calculation, the Fed has as little as $241 billion of Treasury securities left to lend under its credit facilities, which is barely enough to fund the recently-announced $150 billion increase in the Term Auction Facility. That leaves less than $100 billion.
Look, I was an auditor for 8 years and I can tell you what we would have called this situation in early September: A GOING CONCERN. I have no doubt that the Fed, were it to be a normal business enterprise, would have filed bankruptcy this past week if the Treasury had not come to the rescue on September 17. For all intents and purposes other than appearances, that means the Fed is now bankrupt. This is ultimately why Helicopter Ben made the choice to ask the Treasury to give him fuel to fly his helicopter. It was now or never.
I would assume that Mr. Bernanke is pleased with the net result of his helicopter flying so far: a $150 billion increase in the Monetary Base in a couple of weeks. If the banks do get back into the business of lending and they maintain a reserve requirement of 10% on new loans, that could mean an increase of up to $1.5 trillion in the money supply at the M1 and M2 level. M1 is currently $1.5 trillion ($700 billion excluding currency) whereas M2 is currently $8 trillion, so such an increase would not be a trifling amount. In addition, there is still another $550 billion to go under the bailout package approved by Congress. Should most of it be used as helicopter fuel, that could mean a nearly doubling of the current money supply over the course of a few months as the Monetary Base increases from around $900 billion to perhaps as much as $1.6 trillion. The gentlest way to describe this is hyperinflation.
Sure, there is a chance we could see a delayed reaction from the markets until people start to get what Ed Bugos, I and others have laid out here, and there is even a chance that somehow this crisis gets averted (temporarily) so that the massive increases in the Reserve Balances and Monetary Base can be drained back out of the financial system before they become entrenched. At the same time, there is an even better chance that most of the $700 billion bailout just approved by Congress will be used by the U.S. Treasury under the Supplemental Financing Program (or something else that replaces it) to provide fuel for Ben’s helicopter. It seems that given the choice of inflate or die, the decision has been made to inflate.
With the first $150 billion loaded on the helicopter and all systems go, it remains to be seen what people will do with all this new money when it flutters to the ground. Will they stuff it under their mattresses? If so, the hyperinflationary effect of the helicopter drop would be temporarily neutralized. But that would also mean even larger helicopter drops will be needed to stem the growing deflationary tide. If the drops are ultimately successful and the monetary system does not suffer a deflationary collapse, then at some point a true monetary tidal wave will be released and that could very well create a hyperinflationary collapse. How many times have we heard false warnings about monetary tidal waves in the past to the point where now it’s like crying wolf? Well, this time there really is a wolf!
The good news for debtors is that the sudden flood of hyperinflated money into circulation will probably wash away the unmanageable debt burdens in both the public and private sectors. The bad news for creditors is that the monetary flood could destroy all those who have “saved” wealth in fiat form. Whatever happens, the real beneficiaries in the long term will be gold and silver because they provide, as monetary metals, the safest and perhaps only alternative for wealth preservation. But they will also react as the battle between deflation and hyperinflation rages back and forth, so it will be critical to keep a close eye on the Federal Reserve data to determine where the monetary waves seem to be heading.
In conclusion, those who follow my writing closely know that I’ve been talking about this stuff as if it will happen at some point in the far future. Frankly, I didn’t think the deflation-hyperinflation battle would happen so soon. Sure, I’m a bit surprised. But I’m also prepared. Are you? It’s about to happen right here, right now.
The Monetary Base consists of currency in circulation (coins and Federal Reserve Notes), cash held in bank vaults, and cash held by banks at the Federal Reserve’s vaults in the form of Reserve Balances. Reserve Balances can be converted to coin or Federal Reserve Notes to be delivered to the bank’s vault at any time. In addition, the U.S. Treasury Department can hold Reserve Balances at the Fed. Treasury Reserve Balances are created when the Treasury sells Treasury securities directly to the Fed. This is the equivalent of “running the printing press” whereby the Fed uses the Treasury securities as collateral for the issuance of Reserve Balances to the Treasury. The Treasury would then spend the Reserve Balances into the economy thus placing the newly printed money into circulation. Should Treasury Reserve Balances be converted to Federal Reserve Notes at some point, the Treasury securities held by the Fed would serve as collateral for those as well. This is what is meant by “borrowing money into existence”.
There is an important distinction, however, between borrowing money at the Monetary Base level and at the fractional reserve level. Essentially, the Monetary Base is the money that banks “start out with” and then sequentially loan out under the fractional reserve lending system. Fractional reserve lending expands the money supply (checking accounts, savings accounts, money market accounts, etc.) with the Monetary Base serving as, well, the base. For this reason and others, a change in the Monetary Base is probably the most sensitive indicator of both monetary and price inflation. It is “high power” money.
The Monetary Base is also the only component of the money supply that the Federal Reserve can directly act upon. By raising reserve requirements, for example, the Fed can force banks to keep more cash in their vaults (or the Fed’s vaults) and therefore to reduce lending. Lowering reserve requirements, on the other hand, allows banks to use excess reserves to make new loans. Not only that, the reserve requirement affects the size of the money multiplier (see below), which ultimately determines the total amount of money that can be created through bank lending activities.
The periodic adjusting of reserve requirements by the Fed is what creates the Adjusted Monetary Base that is shown in the chart at the beginning of this essay. I’m not going to get any more specific about this because for our purposes we can substitute Adjusted Monetary Base for Monetary Base and vice versa.
Please allow me to provide an example, however, of reserve requirements and the multiplier effect. For the sake of simplicity, I’ll ignore complications like the fact that certain bank deposits have no reserve requirements and that a portion of the Monetary Base has been permanently withdrawn from the domestic economy in the form of Federal Reserve Notes hoarded (under a mattress) or held offshore.
Let’s assume the Fed requires 10% of bank deposits to be held in the form of reserves. The theoretical limit on money creation in this instance would be 10 times the Monetary Base (or 900% increase). This is because only 90% of the balance can be loaned out each time. So, if we start with $100 Monetary Base, a bank can loan $90 on that, then $81 (90% of $90), then $72.90 (90% of $81), etc. In other words, each time the diminishing loan proceeds are deposited in a bank — it doesn’t matter if it is the same bank that issued the loan or another bank — there is a reserve requirement that reduces the amount that can be subsequently loaned out. The sum of the diminishing loan balances with a 10% reserve requirement is equal to $1,000. But if the Fed lowers the reserve requirement to 5%, the theoretical limit on money creation becomes 20 times (a 1900% increase of) the Monetary Base, or $2,000 using our example of $100 initial Monetary Base.
By adjusting the reserve requirement, we can see that the Federal Reserve can directly influence the money supply because banks will lend out more (inflate) or less (deflate) of their banking reserves.
The Federal Reserve, however, has not adjusted the reserve requirement for most deposits since 1992. To do so now would be pointless. Raising the reserve requirement in order to make sure that banks are better protected against loan write-offs would cause the money supply to contract and this would make the deflationary threat even worse. On the other hand, lowering the reserve requirement in order to stimulate the money supply would further expose banks to the risk of insolvency since they would have even lower banking reserves to absort loan losses.
It turns out that there are other ways that banking reserves can be adjusted. Recall that Reserve Balances represent the claims of the banking system and the U.S. Treasury Department on the cash held in the vaults of the 12 Federal Reserve Banks. A bank can choose to hold cash in physical form in its own vaults or as electronic Reserve Balances representing cash located at the regional vaults of the 12 Federal Reserve Banks. Reserve Balances in the Treasury’s account, meanwhile, are held at the Federal Reserve Bank of New York. Together, vault cash held by the banks and vault cash held at the Fed as Reserve Balances constitute total banking reserves for purposes of reserve requirements.
Each bank must decide how much cash to hold in the bank vault vs. how much cash to hold in the form of Reserve Balances with the Fed. The decision depends on the amount of demand for cash by depositors (this cash obviously needs to be held in the bank’s branch vaults or in ATMs) as well as the volume of transactions clearing through the Federal Reserve payment system (which requires cash to be held as Reserve Balances at the Fed). Fortunately, the Federal Reserve (still) publishes reports on a weekly and bi-weekly basis that allows us to track changes in how the banking system as a whole maintains its banking reserves. For example, these reports allow us to assess the extent to which depositors are demanding cash (this could indicate a bank run is or is not occurring).
Over the next few weeks, it will be critical to examine these Federal Reserve reports as they are issued in order to determine if either (1) the recent rise in Reserve Balances is being converted to Federal Reserve Notes or (2) Reserve Balances are being used by banks to make new loans. If the former, that means deflationary risk is growing and it would not be very bullish for gold and silver in the short term. If the latter, that means hyperinflationary risk is growing and it would be very bullish for gold and silver in both the short and the long term.
In any case, since the Federal Reserve must stand ready to convert electronic Reserve Balances to Federal Reserve Notes at any time, the two forms of banking reserves (vault cash and Reserve Balances) are essentially the same thing. The only difference is the location of where the cash is actually being held.
Okay, we’ve talked a lot about Reserve Balances but we are still no closer to explaining why precisely they have grown so much in the past couple of weeks. So let me do that now without further delay. Reserve Balances are growing because the U.S. Treasury Department has made available $344 billion or so of Treasury securities to the Fed over the past couple of weeks (Factors Affecting Reserve Balances) under the Supplementary Financing Program. Of this $344 billion, approximately $180 billion has likely been used in Foreign Exchange Swap Lines involving other central banks and as part of the various credit facilities that the Federal Reserve has made available to the banking system. As explained elsewhere in this essay, these swaps and credit facilities are “money neutral” or “sterilized” in terms of their effect on the money supply. They represent merely a movement of cash between accounts within the banking system or between central banks.
But that still leaves approximately $160 billion of funds provided so far by the Treasury under the Supplementary Financing Program. And it is these funds that have been surreptitiously used to boost the banking reserves of the Federal Reserve system and its constituent banks through the direct creation of Reserve Balances (printing money) in the Treasury’s account. While it is not clear that these Reserve Balances have made their way down to the individual accounts of the banks themselves, the funds are certainly available for that purpose. Under the bailout plan, the Treasury is supposed to have control over these Reserve Balance, not the Fed, but my guess is that it is Ben Bernanke who will actually be flying the helicopter. If not, he will at least be the co-pilot.
In any case, the signing of the bailout plan into law on Friday means that the Fed and Treasury are now in a position to determine how and where these new banking reserves will be used. By “used”, I mean the actual step of monetizing certain bank assets by dropping money from the helicopter on specific targets. The net result will be the transfer of Reserve Balances from the Treasury’s Fed account to the Reserve Balances account of whichever bank is “lucky” enough to be targeted. From there, the Reserve Balances will either be used to make new loans or to pay out depositors in the form of Federal Reserve Notes
It will perhaps help some of you to think of banking reserves as shareholder equity. The two concepts aren’t exactly interchangeable but there are enough similarities that we can use the analogy for illustrative purposes. In a corporation, there are essentially two ways to increase shareholder equity and two ways to decrease shareholder equity. Equity can be raised by generating earnings or by shareholder infusions of capital. Equity can be reduced by generated losses or by paying dividends (or less frequently, by repurchasing and retiring stock). It is for the most part the same in the banking system.
An individual bank may elect to maintain its “shareholder equity” in the from of banking reserves (vault cash and Reserve Balances), or to lend it out at interest, as long as it maintains the minimum banking reserves specified by the Fed. The opportunity to lend at interest is the obvious reason why banks do not maintain Reserve Balances very much in excess of the required amount. Even holding low-yielding U.S. Treasury Bills is typically a better option than holding a bunch of non-yielding cash. From a practical standpoint, however, it is usually easier for banks to lend excess Reserve Balances to other banks on an overnight basis at the so-called Fed Funds Rate (this is accomplished with a simple book entry at the Fed that transfers Reserve Balances from one bank to another). Banks can also used Reserve Balances to buy assets from other banks. In effect, this is what the Treasury appears ready to do now with its newly-created Reserve Balances.
I will now explain why banks themselves cannot increase banking reserves and therefore why Treasury intervention is required. To continue the analogy above, banking reserves have a direct relationship to shareholder equity. The banking system cannot increase shareholder equity by simply refusing to lend funds and hoarding cash. Doing so may increase banking reserves at some banks, but it will come at the cost of decreasing banking reserves at other banks. Such changes in banking reserves net out at the system level. In other words, the banking system as a whole — as historical Fed reports demonstrate — is not able to generate banking reserves through its own lending and deposit-taking activities. Over time, banking reserves can certainly be built as a result of earning the interest differential between loans and deposits, but this is a gradual process. Simply put, the banking system did not generate $160 billion in earnings during the past two weeks.
Indeed, when we look at the banking system up close, we find that every dollar of banking liability (such as a checking deposit) actually represents a dollar of fractional reserve money supply. Converting that dollar from electronic form (deposits) to paper form (vault cash and banking reserves) means that it is no longer available to the banking system. Thus, attempting to turn money supply into banking reserves is sort of like a hamster running inside a suspended wheel: the hamster is running, but it isn’t getting anywhere. Moreover, due to the fractional reserve multiplier effect, removing one dollar from the fractional reserve money supply and holding it as excess banking reserves in the form of vault cash will actually reduce money supply by several multiples (up to $5 decrease in the case of a 20% reserve requirement and up to $20 decrease in the case of a 5% reserve requirement).
Strictly speaking, the decision by one bank to increase its banking reserves by one dollar means other banks will have to reduce their banking reserves by one dollar. At the same time, there would be a shrinking in the overall money supply. To understand this more clearly, let’s look back at the concept of reserve requirements I discussed above. If the Federal Reserve were to increase the reserve requirement from 10% of deposits to 20%, what the banks would do is reduce the amount of loans. This would cause banking reserves to increase only as a percentage of bank deposits, not as an absolute amount. The reason for this is the multiplier effect of fractional reserve lending. Recall that each dollar taken out of banking reserves and loaned out will result in several dollars of growth in money supply (deposits). This necessarily means that a dollar added back into banking reserves will result in several dollars of reduction in money supply. It is the reduction in money supply (deposits), not a change in the gross banking reserves, that accomplishes the increase in banking reserves from 10% to 20% of deposits. In other words, total banking reserves stay the same while deposits are reduced by one-half.
I understand this is pretty confusing, so let me take it a step further and provide an example. Let’s go back to the 10% reserve requirement and start out with Bank A having $100 Monetary Base in the form of Reserve Balances. Further, let’s assume Bank A has no loans and just one deposit account with a balance of $100. The $100 deposit balance represents a depositor who opened an account with $100 in Federal Reserve Notes. Bank A, when it received the $100 in Federal Reserve Notes, delivered this cash to its regional Federal Reserve branch so now the $100 in Federal Reserve Notes is held at the Fed’s vault and Bank A has $100 in Reserve Balances. Now, let’s assume Bank A wants to make a loan. Given the 10% reserve requirement, it can only lend $90 of its $100 Reserve Balances. Bank A makes a $90 loan to Joe, who has a checking account at Bank B. So, what do we have after the loan is disbursed?
Bank A: $100 Deposit, $90 Loan, $10 Reserve Balances (10% reserve)
Bank B: $90 Deposit, $90 Reserve Balances (100% reserve)
Total Deposits: $190
Total Reserve Balances: $100
Systemwide Banking Reserve: 52.6% ($100/$190)
Now, let’s assume Bank B loans out the $90 deposit in Joe’s account to Bob, whose account is with Bank C. Remember, Bank B can only loan out $81 because it needs to keep a 10% reserve level. Here is how it looks now:
Bank A: $100 Deposit, $90 Loan, $10 Reserve Balances (10% reserve)
Bank B: $90 Deposit, $81 Loan, $9 Reserve Balances (10% reserve)
Bank C: $81 Deposit, $81 Reserve Balances
Total Deposits Bank A+B+C: $271
Total Loans Bank A+B: $171
Total Reserve Balances: $100
Systemwide Banking Reserve: 36.9% ($100/$271)
This can continue with Bank D, E, F, etc. until the total deposits reach $1,000, total loans reach $900, and the systemwide banking reserve decreases to the 10% reserve requirement. This is the multiplier effect in action. But notice something interesting. The reserve balance never changes from $100. It is merely redistributed between the banks that have received deposits as a result of fractional reserve loans being made.
If you work the above example in reverse, you will see that should an individual bank boost its own banking reserves, this necessarily means that there will be a shrinkage in the overall money supply (deposits) but absolutely no change in the banking reserves of the banks as a whole.
The above means that Reserve Balances are not — in fact, cannot — be created by the banking system itself. In addition, it also means that individual banks are not increasing their banking reserves despite fears expressed by the Treasury Secretary, Federal Reserve Chairmand and so many pundits that banks are hoarding cash and no longer lending to each other. They might not be lending, but they are also not hoarding cash as indicated by the latest Money Stock Measures report issued by the Federal Reserve, which indicates that money supply has in fact been stable to growing in all deposit categories up to and including the past two weeks.
Once again, this leaves the Treasury as the only source of the recent massive increase in banking reserves. Indeed, when you truly understand how the Federal Reserve and U.S. banking system actually work as described above, you will recognize that the recent increase in banking reserves is a form of a capital infusion by the Treasury. In effect, this is the same thing as the temporary recapitalization of the banking sector by the Treasury that many Keynesian economists have been arguing for. The difference is that the U.S. government has not (yet) taking a direct equity stake in individual banks.
As already discussed, the conventional method to inject capital into the banking system is the same as it is for any other corporation: funds provided by common or preferred shareholders. For example, foreign investors including sovereign wealth funds were making direct investments in some U.S. banks earlier this year. Alas, they have consistently said “no” in the recent past.
When lacking outside investors, there is really only one other way to increase banking reserves under a currency regime where both the fractional reserve money supply (deposits) and the Monetary Base (Federal Reserve Notes, Reserve Balances) are created through borrowings. You guessed it, by borrowing! Since banking reserves are a component of the Monetary Base, it is the Monetary Base that has to be borrowed into existence.
Although you will find this in papers and textbooks written about the Federal Reserve system, it turns out there is no point trying to increase banking reserves by making loans and then attemption to pledge them as collateral to the Federal Reserve in exchange for Reserve Balances. Yes, theoretically an individual bank should be able to pledge any eligible loan to the Fed as collateral, subject to acceptance, in order to obtain banking reserves, but there is a critical consideration that blows the theory into smithereens. It is the fact that the Federal Reserve is required to discount loans and other bank assets that it receives as collateral. By contrast, the Federal Reserve is not required to discount Treasury securities. As a result, the only form of liquidity injection into the banking system that will work both in large amounts and on a permanent basis is the acquisition of Treasury securities by the Fed.
Before getting to Treasury securities, let’s take a closer look at the alternative: sales of bank assets to the Fed in exchange for reserves. First, a bank presumably needs to increase banking reserves because it is anticipating withdrawals by depositors or it needs to replace capital lost due to loan defaults or bad investments. The bank could simply sell loans to other banks or stop making loans to increase its reserves if the anticipated withdrawals or losses are gradual enough. There is no need for liquidity injection in this case. If, however, withdrawn cash is not deposited at another bank but rather placed under the mattress, total banking reserves will necessarily decrease over time and the money supply will necessarily shrink by a multiple of the withdrawn cash as the fractional reserve lending process operates in reverse as described above. While deflationary, there is nothing wrong with this sequence because deposits and loans remain in balance and the banking system remains solvent.
Should the deflationary risk to the economy exceed comfort level, however, the Fed will conduct temporary or permanent Open Market operations to boost banking reserves by acquiring Treasury securities and issuing newly printed Federal Reserve Notes. The result is replacement of the liquidity that was lost when the cash was withdrawn from circulation. Loan balances need not be reduced and although there are inflationary implications to the creation of new money, they will not manifest themselves until the cash that has been placed under a mattress is brought back into circulation. At that time, the Fed could presumably reverse its Open Market operation and drain excess liquidity back out of the banking system, but of course that doesn’t ever seem to happen.
Alternatively, let’s see what happens if the bank tries to sell loans to the Federal Reserve in exchange for Reserves Balances. This, by the way, is the textbook explanation of how money is initially created. It is how the creation of Federal Reserve Notes is described by the Fed and Treasury in their own websites and by their own staff. It is also how academic papers describe base money creation. Yet despite all the expert nods, money creation through Fed loan purchases doesn’t work. Why? Let’s go back to the bank’s need for the banking reserves in the first place. The bank clearly doesn’t need the banking reserve to lend out. Why then would the bank take a perfectly good loan and offer it to the Fed at a discount? It is either because the bank needs to increase banking reserves to make up for losses that have drained its capital or to make up for deposit withdrawals that have reduced the banking reserves themselves.
In all cases except a complete withdrawal of the deposit from the banking system, however, all that has occurred is that the banking reserves has shifted from one bank to another. It’s harder to see this in case of a loan loss, but just consider that the loan proceeds had to go somewhere and unless they were withdrawn from the banking system, these loan proceeds are sitting in a bank account somewhere. That means another bank now has excess reserves while the bank with the loan or deposit losses has inadequate reserves. Once again, however, the reserve balances across the banking system as a whole have not changed.
Therefore, the issue isn’t inadequate reserves in the banking system but the issue is rather how the reserves can be redistributed in the most efficient manner from banks with excess reserves to banks with inadequate reserves. In other words, the bank with the losses will either have to attract new deposits or it will have to sell assets. And this is precisely where selling assets to the Federal Reserve will almost never make sense. Why? Again, it has to do with the fact that all assets other than Treasury securities must be discounted by the Fed. That means the selling bank will receive cents on the dollar for its assets. Acquiring Reserve Balances from the Fed in exchange for discounted assets will definitely boost the bank’s cash reserves, but this will also generate additional losses for the bank. For example, if the bank disbursed $100 on a loan, it will receive $90 or less from the Fed as collateral even if the loan is perfectly good. Even if the loan is to Bill Gates.
The net result of collateral discounting is a decrease in the bank’s shareholder equity and capital ratios. If repeated enough, it is a sure path to insolvency for any bank. In fact, the “dirty secret” of the current Federal Reserve credit facilities program is rooted in the very concept of discounting. You see, banks and dealers that swap assets under the Term Auction Facility or any of the other Fed credit facilities are allowed to keep these assets on their books at full value even though the Fed only gives them a discounted value. For example, Fed advanced under credit facilities that exceed 28 days “cannot exceed 75 percent of the lendable value of its available collateral”. I would note here that the “lendable” value is already a discounted collateral value. By contrast, if the Fed were instead to buy these banking assets outright, that would generate an immediate loss of 25% or more that would probably wipe out shareholder equity and capital. Even using the average discount rate of 10%, we can see that a doubling of the Monetary Base in the ordinary course of modern expansionary central banking would wipe out 10% of capital. Considering most banks have capital ratios of 10% or less to start out, that would be quite devastating.
It gets even worse if a deposit withdrawal results in the cash being placed under a mattress. In this case, the banking system has actually lost reserves as a whole. The proper corrective action would be to liquidate loans (or not issue new ones) across the banking system as a whole until loan repayments restore the banking reserves to an adequate level. In the alternative, the Fed should conduct temporary Open Market operations by acquiring undiscounted Treasury securities. The Open Market operation should be reversed as soon as the cash is returned to circulation from under the mattress.
If, instead, banking reserves are created by selling discounted loans to the Fed that could otherwise have been liquidated at full value at some point in the future, a rather serious monetary imbalance is created. Because of discounting, the newly created money would not be sufficient to repay the loan balances that were pledged at a discount to the Fed. A condition where outstanding loans cannot be repaid with existing money in circulation means that the banking system is essentially underwriting a loss equal to the discount whereas the government is guaranteeing the rate of default. This arguably would work under a gold standard and perhaps even under a monetary standard that allows only short term commercial paper to be discounted, but otherwise it is a recipe for major disaster.
Aside from the horrid consequences for interest rates, the creation of a Federal Reserve Note that is then placed under the mattress means that the Federal Reserve Note is no longer available to repay any loan, including the loan that was pledged in order to bring that particular Federal Reserve Note into existence. As a result, more and more new loans will be required to repay existing loans regardless of the economic circumstances. At the same time, if Federal Reserve Notes were continually removed from circulation and kept under a mattress, as they would likely be given the unstable banks that would exist under such a monetary scheme, there would be less and less money in circulation to repay loans. The net result would be hyperinflation of prices amid a collapse of economic activity.
The bottom line is that only entities that can borrow at zero discount (for default and repayment risk) are able to provide the dollar-for-dollar credit necessary to increase the Monetary Base on a permanent basis. In the case of the U.S. dollar, this is the Treasury Department of the U.S. government.
It seems the effects of discounting have been overlooked by most commentators as they have sought to understand the current credit crisis. And this brings us back to Treasury Reserve Balances held at the Fed.
I hope that I’ve been able to convince you that only government borrowing — via the direct issuance of Treasury or other securities that the Federal Reserve can hold as collateral at full par value for new issuances of Federal Reserve Notes — can reliably increase the fiat Monetary Base while providing an unlimited amount of collateral to the banking system regardless of what happens to each newly-created Federal Reserve Note. Any other approach (that did not involve constant currency controls and market interventions) would result in the monetary system collapsing back on itself or being hyperinflated away. I suppose this is the key to the Federal Reserve’s relative longevity and also probably the reason why the U.S. dollar is still the world’s reserve currency despite the mess that it is. But that looks to change soon, and the reason is precisely that the Fed and Treasury have apparently decided to monetize bank assets at a discount.
It hasn’t always been this way. When the Federal Reserve was founded, its Notes were intended to circulate only when rediscounted commercial paper was available to be pledged as collateral. This was a nod to the Real Bills doctrine as advocated by Professor Antal Fekete, even though the Federal Reserve provided a fiat backing of only 40% gold. The effect was to increase the Monetary Base while the commercial paper was outstanding and to reduce the Monetary Base when the commercial paper was repaid. The creation of money under this classic Federal Reserve system was clearly temporary in nature. It was a system that could actually have worked if given a chance. But the temptation of the government — not the bankers themselves — to get something for nothing was too great and so this early version of the Federal Reserve was soon bastardized.
In its modern incarnation, the Fed uses Open Market operations to increase or decrease the Monetary Base ((e.g. during the holidays). Moreover, the Fed has used Open Market operations almost exclusively in the past several decades to permanently increase the Monetary Base as shown in the chart at the beginning of this article. Basically, this involves the Fed buying Treasury securities from Wall Street dealers and paying for the securities with newly issued Federal Reserve Notes (which are credited to the seller’s bank in the form of Reserve Balances). This has the effect of immediately boosting the Monetary Base. Moreover, none of this growth in Monetary Base would have been possible without an increasing amount of Treasury securities available to serve as collateral for the Fed’s issuance of Reserve Balances and Federal Reserve Notes.
The bottom line is that it is ultimately the growth in government debt that has supported the increase in the U.S. dollar Monetary Base and vice versa.
Yet if Open Market operations have worked so “well” in the past, you’d think the Fed would have used them all along to deal with the current banking crisis in order to boost the Monetary Base and to increase liquidity. Well, you’d be wrong. One reason for this is the Fed does not want to be blamed for creating hyperinflation, assuming it can still be avoided. It is perfectly willing, however, to let the Treasury and the U.S. government take the blame. This is precisely what seems to be happening given that Treasury Secretary Hank Paulson is considered to be the author of the $700 billion bailout plan. But make no mistake, even if the Treasury is providing the fuel, it is the Federal Reserve that will be flying the helicopter (or at least co-piloting it).
Another reason for prior Fed reluctance to fly the helicopter is that purchasing tens or hundreds of billions of dollars of eligible collateral on the open market would have influenced interest rates to the possible detriment of the Fed’s stated policy goals. In effect, increased Fed demand for Treasuries might drive credit yields below Fed interest rate targets and actually reduce the banking system’s appetite to lend. That is not what you want when liquidity is already tight. At the same time, Fed Open Market operations could also serve to remove from the credit markets some of the highest quality debt securities. This ironically could result in a net reduction, not increase, in liquidity.
So, the Fed has opted, at least until 2 weeks ago, to fight the credit crisis using so-called credit facilities which have consisted of the Fed exchanging its liquid assets (U.S. Treasury securities) for banks’ illiquid assets (various agency and non-agency debt securities for which demand has shrunk to almost nothing as a result of reduced appetite for risk in the markets). These illiquid bank assets have in turn been used to collateralize existing Federal Reserve Notes that were previously collateralized by (relatively) risk-free Treasury securities. Of course, the financial institutions the Fed has been bailing out with these “facilities” sell the Treasury securities into the market as soon as they receive them in order to obtain cash proceeds to meet liquidity needs. The added benefit of this approach is that the sale of Treasury securities into the market (vs. their purchase as part of Open Market operations) tends to boost overall market liquidity.
As preferable as the credit facilities have been compared to helicopter flights, the Federal Reserve essentially destroyed its own balance sheet during the past two weeks, which is why the Fed reached out to the ultimate lender of last resort, the U.S. government. If the Fed’s ill condition has moved beyond the point of no return as I suspect, the U.S. dollar as a Federal Reserve liability will shrivel up and die as more and more people discover the truth. Sooner or later the Treasury will have to provide an acceptable monetary alternative because formally nationalizing the Fed will accomplish nothing given that the Fed has already been nationalized effective September 17, 2008. Under the circumstances, there is a good chance that gold and silver in the hands of the public will rise to the occasion. My next essay will describe the most likely approach that the Treasury will take to move back toward a Market-Based Monetary Standard (hint: I think it will involve gold.)
Posted in Windbag Wisdom |
Warning, this may keep a few of our more sophisticated gold and silver agnostic holdouts tossing and turning in their sleep this week , as to whether they have sufficient "barbarous relic insurance" to cover them from the onslaught of the full might of the United States Treasury's oven-blast of inflationary flames upon the USD's value. For the gold agnostic's sleeplessness after reading this report, I recommend a nice spoonful of NYQUIL, and a strong draught of Cognac before bedtime. :rolleyes: This should bring on merciful restorative slumber, to all those "weathering this storm, parked securely in Federal Reserve notes and US Treasuries". :p :p :p
QUOTE:
The bottom line is that only entities that can borrow at zero discount (for default and repayment risk) are able to provide the dollar-for-dollar credit necessary to increase the Monetary Base on a permanent basis. In the case of the U.S. dollar, this is the Treasury Department of the U.S. government.
It seems the effects of discounting have been overlooked by most commentators as they have sought to understand the current credit crisis.
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THE FED IS BANKRUPT - UPDATE ON THE HELICOPTER - Oct. 4th 2008 (Tom Szabo - Silveraxis)
This might be the most important monetary discussion of the past few decades, and Ed Bugos should get a lot of credit for starting it with the excellent Who’s Bailing out Whom? I agree with Mr. Bugos wholeheartedly although I believe the situation might be even more precarious than he states. I urge all of my readers to at least read the piece by Ed Bugos and as much of the below discussion as you can stomach. Also, I would ask that you forward this to as many people as you know so they too will have a chance to understand the truth before it smacks the U.S. and the rest of the world in the face.
- The Federal Reserve is bankrupt. The U.S. Treasury Department quietly rescued — actually, took over — the world’s largest Central Bank on September 17.
- The idea that Federal Reserve Chairman Bernanke could fly his helicopter was a fraud; the Fed simply didn’t have any helicopter fuel.
- The U.S. Treasury Department, on the other hand, has copious amounts of helicopter fuel in the form of undiscounted government debt, and this fuel has now been made available to Mr. Bernanke. The more fuel the Treasury provides, the closer the U.S. dollar will get to its death.
- Just released Fed data confirms that initial test flights of Ben’s helicopter have been spectacularly successful. Up to $150 billion has been loaded on the helicopter so far and may already be fluttering down into the Monetary Base as I write this. The inflation of “high power” money by more than 15% in the course of 2 weeks (an annual rate of 300% or more) is unprecedented.
- Inflation of the Monetary Base is leveraged by fractional reserve lending. Should the banks actually start to lend again, we could very well see hyperinflation in the U.S. over the next 18 months.
- This is obviously bullish for gold and silver and bearish for the dollar, although it could take the markets a while to realize it (by which time an even more incredible sequence of events could overshadow this one, although I doubt it). I think the markets might need 2-3 weeks more to absorb what just happened.
Notice the vertical line at the end of the chart. That’s a $75 billion increase in the past two weeks. Given the parabolic rise of the Adjusted Monetary Base since 1970, perhaps you might think that $75 billion is not particularly special, but the just-released Factors Affecting Reserve Balances report indicates that the size of the vertical line could more than double to $150 billion when this chart is updated next week. See the Ed Bugos article for more charts with vertical lines.
Monetary Base Set to Explode
To get an idea of what is in store, let’s examine the latest Factors Affecting Reserve Balances report a bit more closely. The relevant number we need to look for in this report is called “Reserve balances with Federal Reserve Banks”. Reserve Balances are claims by the banking system on cash held in the vaults of the Federal Reserve Banks. The most important thing about Reserve Balances for our purpose is that the Monetary Base includes Reserve Balances plus cash in circulation (including coins and Federal Reserve Notes in bank vaults and in the hands of the public). The Monetary Base, as the name implies, is the first layer of the fractional reserve banking system. Generally speaking, an increase in the Monetary Base is multiplied several times as it propagates through the money supply.
Here are the figures for “Reserve balances with Federal Reserve Banks” since the beginning of September:
September 3, 2008: $3.8 billion
September 10, 2008: $25.0 billion
September 17, 2008: $81.7 billion
September 24, 2008: $87.9 billion
October 1, 2008: $171.5 billion
We can see from this data that around $63 billion of the $75 billion increase in Adjusted Monetary Base as of the two weeks ended September 24 was the result of a rise in Reserve Balances. Let me note that another $7 billion was the result of an increase in Federal Reserve Notes in circulation and much of the remainder was the result of the Adjusted Monetary Base being a weekly average (not end of period) calculation.
Indeed, if we look at another important Fed report, Aggregate Reserves of Depository Institutions and the Monetary Base, we can confirm the leap in the Adjusted Monetary Base figures. There are some differences in accounting and averaging that make the actual amounts of Reserve Balances included in the Monetary Base and the Adjusted Monetary Base somewhat different from report to report, but what matters is the rate of change between periods. To wit, there has been an increase in the Monetary Base of $65 billion for the two weeks ended September 24 according to the latest Aggregate Reserves of Depository Institutions and the Monetary Base report.
We can also see from the data I provided above that Reserve Balances almost doubled this past week (after September 24), rising by $83.6 billion to $171.5 billion. Thus, we should expect both the Monetary Base and the Adjusted Monetary Base to rise by a very substantial amount when new Monetary Base data is published next week.
The Dam Broke Two Weeks Ago
Up until two weeks ago when the $700 billion bailout package came out of virtually nowhere, the Federal Reserve seemed content to continue swapping its liquid Treasury securities portfolio for the illiquid assets of banks, slowly destroying the Fed’s balance sheet in the process. But the impending failure of AIG and the actual failure of Lehman Brothers apparently did some serious damage to the Fed’s plans, because the most important monetary decision of this entire crisis was made in a big hurry, with virtually no fanfare. I suspect the Fed finally started looking more than a few days ahead and suddenly realized that it might quickly and completely run out of Treasury securities (see below).
So, the Fed and Treasury announced a seemingly innocuous Supplementary Financing Program on September 17. In reality, it was nothing less than a clandestine federal bailout, a de facto government takeover of the Federal Reserve that will officially materialize as reality at a later date. This radical “program”, which is by far the most extreme of all the Fed and Treasury actions in terms of monetary consequences, has received very little coverage so far in the media, on Wall Street, on Main Street, in the Capitol, or on the Internet. But I suspect this could soon change now that the $700 billion bailout package has been penned into law. Indeed, the Treasury bailout legislation seems to be the fuel for the Supplementary Financing Program, which is nothing less than the biggest monetary helicopter lift since the Weimar experiment with the printing press.
Supplementary Financing: An Unprecedented “Program”
Here is how the Supplementary Financing Program is alleged to work. The U.S. Treasury Department sells Treasury securities in a public auction and deposits the cash proceeds with the Federal Reserve. The Federal Reserve thus has “cash for use in the Federal Reserve initiatives”.
Sounds simple enough, but do not be fooled! That is only a part of the story. If the Treasury securities were merely sold into the market and the proceeds were loaned to the Federal Reserve, there would be no impact on Reserve Balances or the Monetary Base. Or as Ed Bugos likes to say, the liquidity would be “sterilized”. In other words, the operation would merely represent a shift of existing money supply within the financial system. Not an injection of new cash. Yet what we have witnessed in the past few weeks is a massive increase in Reserve Balances to the tune of over $160 billion.
And that can only mean one thing: the Fed is now monetizing banking assets (or at least is preparing to do so). This is a bona fide helicopter operation, the first of its kind during the current credit crisis and certainly the largest in the history of First World central banking since the Great Depression. What we don’t know is if these Reserve Balances will turn into Federal Reserve Notes and get stuffed under the mattress as panicked depositors continue to withdraw cash from the banking system or if these Reserve Balances will get loaned out by the banks whose assets are being monetized. If the former, the hyperinflation will be delayed until the cash is taken back out from under the mattress, which will happen once the bank runs have abated. If the latter, hyperinflation could come fast and furious.
In effect, what’s really happening is that the Treasury is borrowing money into existence at the Monetary Base level. This is exactly the same thing that Weimar Germany did. What the Germans (and the Argentinians, Zimbabweans, etc.) found out, and what our “benevolent” leaders will also discover, is that the printing press is a slippery slope to oblivion. The worst-case outcome of giving into this temptation is almost unfathamable.
And here we all thought the $700 billion bailout package had to actually be approved by the elected representatives of the people before the Fed and Treasury could commence their bailout plan. Silly us! It looks like the Fed and Treasury have been preparing to go forward via the back door regardless of what our legislators did. I suppose this is why Secretary Paulson insisted that passage of the bailout was necessary to restore confidence to the credit markets, but no specifics were provided about how exactly the process would work. Now we know why. The bailout was the equivalent of putting lipstick on a pig, and the pig is the Supplementary Financing Program by which the Fed can already monetize bank assets. Legislative approval was essentially a rubber stamp, a mere formality. The Executive branch a la Bush has once again usurped powers not granted to it under the U.S. Constitution.
If the above is not crystal clear to you, let me point out that the Treasury has provided over $150 billion so far under the Supplementary Financing Program whereas the initial Treasury authority to purchase troubled assets under the Congressional bailout legislation is $250 billion. In other words, most of the initial authority has already been loaded on the helicopter in the past couple of weeks and is ready to be dropped from the sky.
Here is the thing that bothers me the most. The idea that the Treasury would buy distressed banking assets using taxpayer money is hugely unpopular with Americans, but the unpopularity itself became the blindfold that kept everybody from asking exactly how the Treasury would actually do this. In fact, several hundred economists (all of them apparently Keynesians) have written letters to Congress urging them not to vote for the bailout because it would not work, mainly on the grounds that banks will need to be recapitalized with banking reserves instead of just having bad assets taken off their books. Well, guess what? Recapitalization of banking reserves was apparently the plan all along!
I find it curious that some members of Congress have said of the bailout, as a way of expressing that there is much work left to do, that it is the end of the beginning and not the beginning of the end. My two cents is that Thursday, September 24, 2008 could in fact mark the beginning of the end: the end of the U.S. Dollar as a liability of the Federal Reserve system. I suspect we will look back on this as a day of infamy, the day we found out that Ben’s helicopter is fueled up, ready to fly and drop piles of money from the sky.
Helicopter in Action
The helicopter is why, out of nowhere, the Reserve Balances and the Adjusted Monetary Base jumped by $75 billion or so in the past two weeks. And the helicopter is why these amounts have jumped and will jump by another $75 billion or more by next week. As you consider the situation, please realize that up until this September, the Monetary Base had not changed much since the beginning of the credit crisis last year. That proves more than anything that the helicopter was grounded until now.
Indeed, all the credit facilities created by the Fed from the Term Auction Facility to the Term Securities Lending Facility to the Primary Dealer Credit Facility to the Bear Stearns Maidan Lane facility and to the AIG credit facility have had no actual effect on the Monetary Base or money supply. This is because the credit facilities are essentially just swaps of assets, not money creation. The banks simply obtained assets they could sell (Treasury securities) in exchange for assets they could not sell (loans, MBS, CDO, etc.) This is the reason some observers are confused about why the Federal Reserve has not been inflating money supply in the face of a credit crisis that has deepened every month since last August.
So why exactly has Ben’s famous helicopter not flown, much less made money drops, until the past two weeks? There are several reasons. For one, even Mr. Bernanke recognizes the inflationary implications of a helicopter drop and he was willing to use it only as a last resort. But there is a more fundamental reason. You see, the helicopter didn’t have a stable fuel supply. What fuel there was in the form of Open Market operations or purchases of bank assets was simply too unstable and would probably cause the helicopter to crash. Furthermore, it turns out the Fed cannot monetize bank assets effectively without assistance from the U.S. Treasury Department. See the Appendix to this essay for a detailed explanation.
What I’m saying is that the idea, as suggested by the Fed Chairman himself, that the Fed is capable of flying the helicopter all by itself, is fraudulent. Moreover, anybody claiming that the Fed had already flown the helicopter before September is simply wrong. The various Federal Reserve reports that I reference in this commentary back me up on this. For example, the Aggregate Reserves of Depository Institutions and the Monetary Base shows that as recently as September 10, when the total borrowings by banks under the various Fed credit facilities stood at $170 billion:
- The Reserve Balances with Federal Reserve Banks was still under $10 billion (as it had been throughout the crisis since early 2007);
- The Monetary Base was still around $850 billion (up only $20 billion since August 2007); and
- Federal Reserve Notes outstanding were still around $800 billion (also up a corresponding $20 billion since August 2007).
Just to make it absolutely clear, please allow me to repeat that only when the Treasury came into the picture in the past few weeks and actually started to issue new federal debt under the Supplementary Financing Program — ostensibly to provide cash for the Federal Reserve to use in “initiatives” — did the Monetary Base start to grow. Why? Because as I explain in the Appendix below, the banking system as a whole cannot create adequate collateral for banking reserves on its own. And the banking system certainly cannot create sustainable banking reserves out of thin air. Stated another way, the Fed cannot create banking reserves without collateral. It is collateral, and only collateral, that can serve as fuel for the monetary helicopter. And the only collateral that matters is Treasury securities. Once again, this is explained in greater detail in the Appendix.
For those not wishing to delve into the specific details provided in the Appendix below, perhaps I can sufficiently advance the above argument by pointing out that the Federal Reserve cannot afford to simply accept banking assets as collateral for Reserve Balances or Federal Reserve Notes because withdrawal of these banking reserves by the public — accomplished by literally putting Federal Reserve Notes under the mattress — would create a fatal problem for the banking system: not enough money in circulation to repay outstanding bank loans, including the loans used as collateral for the newly created Reserve Balances. We can use the cliche “pushing on a string” to describe the inability of the Fed to effectively monetize bank assets that were created by fractional reserve lending. Cliche or not, it is precisely the act of “pushing on a string” that has forced the Fed to beg the Treasury to borrow money — and thus banking reserves — into existence.
The Secret Death of the Fed
The problem of lacking helicopter fuel aside, the Federal Reserve had another problem a couple of weeks ago that required immediate Treasury intervention. The Fed had bled Treasury securities from its portfolio to the tune of $300 billion by early September with no end in sight. Indeed, as of October 1 the Fed has given away over $500 billion of Treasury securities from a portfolio that held $800 billion just last year. If something wasn’t quickly done, the Fed was in very real danger of exhausting its ammunition for “lender of last resort” duties.
In my estimation, the Fed exhausting its Treasury securities portolio is tantamount to insolvency, nay, bankruptcy. Indeed, the Fed seems to have become prescient about its impending doom just in the nick of time given that the latest Factors Affecting Reserve Balances report shows as of October 1 that the Fed has acquired $538 billion of banking assets which now support around 67% of the $804 billion of Federal Reserve Notes outstanding. By my calculation, the Fed has as little as $241 billion of Treasury securities left to lend under its credit facilities, which is barely enough to fund the recently-announced $150 billion increase in the Term Auction Facility. That leaves less than $100 billion.
Look, I was an auditor for 8 years and I can tell you what we would have called this situation in early September: A GOING CONCERN. I have no doubt that the Fed, were it to be a normal business enterprise, would have filed bankruptcy this past week if the Treasury had not come to the rescue on September 17. For all intents and purposes other than appearances, that means the Fed is now bankrupt. This is ultimately why Helicopter Ben made the choice to ask the Treasury to give him fuel to fly his helicopter. It was now or never.
I would assume that Mr. Bernanke is pleased with the net result of his helicopter flying so far: a $150 billion increase in the Monetary Base in a couple of weeks. If the banks do get back into the business of lending and they maintain a reserve requirement of 10% on new loans, that could mean an increase of up to $1.5 trillion in the money supply at the M1 and M2 level. M1 is currently $1.5 trillion ($700 billion excluding currency) whereas M2 is currently $8 trillion, so such an increase would not be a trifling amount. In addition, there is still another $550 billion to go under the bailout package approved by Congress. Should most of it be used as helicopter fuel, that could mean a nearly doubling of the current money supply over the course of a few months as the Monetary Base increases from around $900 billion to perhaps as much as $1.6 trillion. The gentlest way to describe this is hyperinflation.
Conclusion
Sure, there is a chance we could see a delayed reaction from the markets until people start to get what Ed Bugos, I and others have laid out here, and there is even a chance that somehow this crisis gets averted (temporarily) so that the massive increases in the Reserve Balances and Monetary Base can be drained back out of the financial system before they become entrenched. At the same time, there is an even better chance that most of the $700 billion bailout just approved by Congress will be used by the U.S. Treasury under the Supplemental Financing Program (or something else that replaces it) to provide fuel for Ben’s helicopter. It seems that given the choice of inflate or die, the decision has been made to inflate.
With the first $150 billion loaded on the helicopter and all systems go, it remains to be seen what people will do with all this new money when it flutters to the ground. Will they stuff it under their mattresses? If so, the hyperinflationary effect of the helicopter drop would be temporarily neutralized. But that would also mean even larger helicopter drops will be needed to stem the growing deflationary tide. If the drops are ultimately successful and the monetary system does not suffer a deflationary collapse, then at some point a true monetary tidal wave will be released and that could very well create a hyperinflationary collapse. How many times have we heard false warnings about monetary tidal waves in the past to the point where now it’s like crying wolf? Well, this time there really is a wolf!
The good news for debtors is that the sudden flood of hyperinflated money into circulation will probably wash away the unmanageable debt burdens in both the public and private sectors. The bad news for creditors is that the monetary flood could destroy all those who have “saved” wealth in fiat form. Whatever happens, the real beneficiaries in the long term will be gold and silver because they provide, as monetary metals, the safest and perhaps only alternative for wealth preservation. But they will also react as the battle between deflation and hyperinflation rages back and forth, so it will be critical to keep a close eye on the Federal Reserve data to determine where the monetary waves seem to be heading.
In conclusion, those who follow my writing closely know that I’ve been talking about this stuff as if it will happen at some point in the far future. Frankly, I didn’t think the deflation-hyperinflation battle would happen so soon. Sure, I’m a bit surprised. But I’m also prepared. Are you? It’s about to happen right here, right now.
APPENDIX
What Is the Monetary Base?
The Monetary Base consists of currency in circulation (coins and Federal Reserve Notes), cash held in bank vaults, and cash held by banks at the Federal Reserve’s vaults in the form of Reserve Balances. Reserve Balances can be converted to coin or Federal Reserve Notes to be delivered to the bank’s vault at any time. In addition, the U.S. Treasury Department can hold Reserve Balances at the Fed. Treasury Reserve Balances are created when the Treasury sells Treasury securities directly to the Fed. This is the equivalent of “running the printing press” whereby the Fed uses the Treasury securities as collateral for the issuance of Reserve Balances to the Treasury. The Treasury would then spend the Reserve Balances into the economy thus placing the newly printed money into circulation. Should Treasury Reserve Balances be converted to Federal Reserve Notes at some point, the Treasury securities held by the Fed would serve as collateral for those as well. This is what is meant by “borrowing money into existence”.
There is an important distinction, however, between borrowing money at the Monetary Base level and at the fractional reserve level. Essentially, the Monetary Base is the money that banks “start out with” and then sequentially loan out under the fractional reserve lending system. Fractional reserve lending expands the money supply (checking accounts, savings accounts, money market accounts, etc.) with the Monetary Base serving as, well, the base. For this reason and others, a change in the Monetary Base is probably the most sensitive indicator of both monetary and price inflation. It is “high power” money.
The Monetary Base is also the only component of the money supply that the Federal Reserve can directly act upon. By raising reserve requirements, for example, the Fed can force banks to keep more cash in their vaults (or the Fed’s vaults) and therefore to reduce lending. Lowering reserve requirements, on the other hand, allows banks to use excess reserves to make new loans. Not only that, the reserve requirement affects the size of the money multiplier (see below), which ultimately determines the total amount of money that can be created through bank lending activities.
The periodic adjusting of reserve requirements by the Fed is what creates the Adjusted Monetary Base that is shown in the chart at the beginning of this essay. I’m not going to get any more specific about this because for our purposes we can substitute Adjusted Monetary Base for Monetary Base and vice versa.
How Does the Monetary Base Relate to Money Supply?
Please allow me to provide an example, however, of reserve requirements and the multiplier effect. For the sake of simplicity, I’ll ignore complications like the fact that certain bank deposits have no reserve requirements and that a portion of the Monetary Base has been permanently withdrawn from the domestic economy in the form of Federal Reserve Notes hoarded (under a mattress) or held offshore.
Let’s assume the Fed requires 10% of bank deposits to be held in the form of reserves. The theoretical limit on money creation in this instance would be 10 times the Monetary Base (or 900% increase). This is because only 90% of the balance can be loaned out each time. So, if we start with $100 Monetary Base, a bank can loan $90 on that, then $81 (90% of $90), then $72.90 (90% of $81), etc. In other words, each time the diminishing loan proceeds are deposited in a bank — it doesn’t matter if it is the same bank that issued the loan or another bank — there is a reserve requirement that reduces the amount that can be subsequently loaned out. The sum of the diminishing loan balances with a 10% reserve requirement is equal to $1,000. But if the Fed lowers the reserve requirement to 5%, the theoretical limit on money creation becomes 20 times (a 1900% increase of) the Monetary Base, or $2,000 using our example of $100 initial Monetary Base.
By adjusting the reserve requirement, we can see that the Federal Reserve can directly influence the money supply because banks will lend out more (inflate) or less (deflate) of their banking reserves.
The Federal Reserve, however, has not adjusted the reserve requirement for most deposits since 1992. To do so now would be pointless. Raising the reserve requirement in order to make sure that banks are better protected against loan write-offs would cause the money supply to contract and this would make the deflationary threat even worse. On the other hand, lowering the reserve requirement in order to stimulate the money supply would further expose banks to the risk of insolvency since they would have even lower banking reserves to absort loan losses.
Why, Specifically Then, Are Banking Reserves Rising?
It turns out that there are other ways that banking reserves can be adjusted. Recall that Reserve Balances represent the claims of the banking system and the U.S. Treasury Department on the cash held in the vaults of the 12 Federal Reserve Banks. A bank can choose to hold cash in physical form in its own vaults or as electronic Reserve Balances representing cash located at the regional vaults of the 12 Federal Reserve Banks. Reserve Balances in the Treasury’s account, meanwhile, are held at the Federal Reserve Bank of New York. Together, vault cash held by the banks and vault cash held at the Fed as Reserve Balances constitute total banking reserves for purposes of reserve requirements.
Each bank must decide how much cash to hold in the bank vault vs. how much cash to hold in the form of Reserve Balances with the Fed. The decision depends on the amount of demand for cash by depositors (this cash obviously needs to be held in the bank’s branch vaults or in ATMs) as well as the volume of transactions clearing through the Federal Reserve payment system (which requires cash to be held as Reserve Balances at the Fed). Fortunately, the Federal Reserve (still) publishes reports on a weekly and bi-weekly basis that allows us to track changes in how the banking system as a whole maintains its banking reserves. For example, these reports allow us to assess the extent to which depositors are demanding cash (this could indicate a bank run is or is not occurring).
Over the next few weeks, it will be critical to examine these Federal Reserve reports as they are issued in order to determine if either (1) the recent rise in Reserve Balances is being converted to Federal Reserve Notes or (2) Reserve Balances are being used by banks to make new loans. If the former, that means deflationary risk is growing and it would not be very bullish for gold and silver in the short term. If the latter, that means hyperinflationary risk is growing and it would be very bullish for gold and silver in both the short and the long term.
In any case, since the Federal Reserve must stand ready to convert electronic Reserve Balances to Federal Reserve Notes at any time, the two forms of banking reserves (vault cash and Reserve Balances) are essentially the same thing. The only difference is the location of where the cash is actually being held.
Okay, we’ve talked a lot about Reserve Balances but we are still no closer to explaining why precisely they have grown so much in the past couple of weeks. So let me do that now without further delay. Reserve Balances are growing because the U.S. Treasury Department has made available $344 billion or so of Treasury securities to the Fed over the past couple of weeks (Factors Affecting Reserve Balances) under the Supplementary Financing Program. Of this $344 billion, approximately $180 billion has likely been used in Foreign Exchange Swap Lines involving other central banks and as part of the various credit facilities that the Federal Reserve has made available to the banking system. As explained elsewhere in this essay, these swaps and credit facilities are “money neutral” or “sterilized” in terms of their effect on the money supply. They represent merely a movement of cash between accounts within the banking system or between central banks.
But that still leaves approximately $160 billion of funds provided so far by the Treasury under the Supplementary Financing Program. And it is these funds that have been surreptitiously used to boost the banking reserves of the Federal Reserve system and its constituent banks through the direct creation of Reserve Balances (printing money) in the Treasury’s account. While it is not clear that these Reserve Balances have made their way down to the individual accounts of the banks themselves, the funds are certainly available for that purpose. Under the bailout plan, the Treasury is supposed to have control over these Reserve Balance, not the Fed, but my guess is that it is Ben Bernanke who will actually be flying the helicopter. If not, he will at least be the co-pilot.
In any case, the signing of the bailout plan into law on Friday means that the Fed and Treasury are now in a position to determine how and where these new banking reserves will be used. By “used”, I mean the actual step of monetizing certain bank assets by dropping money from the helicopter on specific targets. The net result will be the transfer of Reserve Balances from the Treasury’s Fed account to the Reserve Balances account of whichever bank is “lucky” enough to be targeted. From there, the Reserve Balances will either be used to make new loans or to pay out depositors in the form of Federal Reserve Notes
Banking Reserves and Shareholder Equity
It will perhaps help some of you to think of banking reserves as shareholder equity. The two concepts aren’t exactly interchangeable but there are enough similarities that we can use the analogy for illustrative purposes. In a corporation, there are essentially two ways to increase shareholder equity and two ways to decrease shareholder equity. Equity can be raised by generating earnings or by shareholder infusions of capital. Equity can be reduced by generated losses or by paying dividends (or less frequently, by repurchasing and retiring stock). It is for the most part the same in the banking system.
An individual bank may elect to maintain its “shareholder equity” in the from of banking reserves (vault cash and Reserve Balances), or to lend it out at interest, as long as it maintains the minimum banking reserves specified by the Fed. The opportunity to lend at interest is the obvious reason why banks do not maintain Reserve Balances very much in excess of the required amount. Even holding low-yielding U.S. Treasury Bills is typically a better option than holding a bunch of non-yielding cash. From a practical standpoint, however, it is usually easier for banks to lend excess Reserve Balances to other banks on an overnight basis at the so-called Fed Funds Rate (this is accomplished with a simple book entry at the Fed that transfers Reserve Balances from one bank to another). Banks can also used Reserve Balances to buy assets from other banks. In effect, this is what the Treasury appears ready to do now with its newly-created Reserve Balances.
An Even Closer, More Painful, Look at Banking Reserves
I will now explain why banks themselves cannot increase banking reserves and therefore why Treasury intervention is required. To continue the analogy above, banking reserves have a direct relationship to shareholder equity. The banking system cannot increase shareholder equity by simply refusing to lend funds and hoarding cash. Doing so may increase banking reserves at some banks, but it will come at the cost of decreasing banking reserves at other banks. Such changes in banking reserves net out at the system level. In other words, the banking system as a whole — as historical Fed reports demonstrate — is not able to generate banking reserves through its own lending and deposit-taking activities. Over time, banking reserves can certainly be built as a result of earning the interest differential between loans and deposits, but this is a gradual process. Simply put, the banking system did not generate $160 billion in earnings during the past two weeks.
Indeed, when we look at the banking system up close, we find that every dollar of banking liability (such as a checking deposit) actually represents a dollar of fractional reserve money supply. Converting that dollar from electronic form (deposits) to paper form (vault cash and banking reserves) means that it is no longer available to the banking system. Thus, attempting to turn money supply into banking reserves is sort of like a hamster running inside a suspended wheel: the hamster is running, but it isn’t getting anywhere. Moreover, due to the fractional reserve multiplier effect, removing one dollar from the fractional reserve money supply and holding it as excess banking reserves in the form of vault cash will actually reduce money supply by several multiples (up to $5 decrease in the case of a 20% reserve requirement and up to $20 decrease in the case of a 5% reserve requirement).
Strictly speaking, the decision by one bank to increase its banking reserves by one dollar means other banks will have to reduce their banking reserves by one dollar. At the same time, there would be a shrinking in the overall money supply. To understand this more clearly, let’s look back at the concept of reserve requirements I discussed above. If the Federal Reserve were to increase the reserve requirement from 10% of deposits to 20%, what the banks would do is reduce the amount of loans. This would cause banking reserves to increase only as a percentage of bank deposits, not as an absolute amount. The reason for this is the multiplier effect of fractional reserve lending. Recall that each dollar taken out of banking reserves and loaned out will result in several dollars of growth in money supply (deposits). This necessarily means that a dollar added back into banking reserves will result in several dollars of reduction in money supply. It is the reduction in money supply (deposits), not a change in the gross banking reserves, that accomplishes the increase in banking reserves from 10% to 20% of deposits. In other words, total banking reserves stay the same while deposits are reduced by one-half.
I understand this is pretty confusing, so let me take it a step further and provide an example. Let’s go back to the 10% reserve requirement and start out with Bank A having $100 Monetary Base in the form of Reserve Balances. Further, let’s assume Bank A has no loans and just one deposit account with a balance of $100. The $100 deposit balance represents a depositor who opened an account with $100 in Federal Reserve Notes. Bank A, when it received the $100 in Federal Reserve Notes, delivered this cash to its regional Federal Reserve branch so now the $100 in Federal Reserve Notes is held at the Fed’s vault and Bank A has $100 in Reserve Balances. Now, let’s assume Bank A wants to make a loan. Given the 10% reserve requirement, it can only lend $90 of its $100 Reserve Balances. Bank A makes a $90 loan to Joe, who has a checking account at Bank B. So, what do we have after the loan is disbursed?
Bank A: $100 Deposit, $90 Loan, $10 Reserve Balances (10% reserve)
Bank B: $90 Deposit, $90 Reserve Balances (100% reserve)
Total Deposits: $190
Total Reserve Balances: $100
Systemwide Banking Reserve: 52.6% ($100/$190)
Now, let’s assume Bank B loans out the $90 deposit in Joe’s account to Bob, whose account is with Bank C. Remember, Bank B can only loan out $81 because it needs to keep a 10% reserve level. Here is how it looks now:
Bank A: $100 Deposit, $90 Loan, $10 Reserve Balances (10% reserve)
Bank B: $90 Deposit, $81 Loan, $9 Reserve Balances (10% reserve)
Bank C: $81 Deposit, $81 Reserve Balances
Total Deposits Bank A+B+C: $271
Total Loans Bank A+B: $171
Total Reserve Balances: $100
Systemwide Banking Reserve: 36.9% ($100/$271)
This can continue with Bank D, E, F, etc. until the total deposits reach $1,000, total loans reach $900, and the systemwide banking reserve decreases to the 10% reserve requirement. This is the multiplier effect in action. But notice something interesting. The reserve balance never changes from $100. It is merely redistributed between the banks that have received deposits as a result of fractional reserve loans being made.
If you work the above example in reverse, you will see that should an individual bank boost its own banking reserves, this necessarily means that there will be a shrinkage in the overall money supply (deposits) but absolutely no change in the banking reserves of the banks as a whole.
The above means that Reserve Balances are not — in fact, cannot — be created by the banking system itself. In addition, it also means that individual banks are not increasing their banking reserves despite fears expressed by the Treasury Secretary, Federal Reserve Chairmand and so many pundits that banks are hoarding cash and no longer lending to each other. They might not be lending, but they are also not hoarding cash as indicated by the latest Money Stock Measures report issued by the Federal Reserve, which indicates that money supply has in fact been stable to growing in all deposit categories up to and including the past two weeks.
Once again, this leaves the Treasury as the only source of the recent massive increase in banking reserves. Indeed, when you truly understand how the Federal Reserve and U.S. banking system actually work as described above, you will recognize that the recent increase in banking reserves is a form of a capital infusion by the Treasury. In effect, this is the same thing as the temporary recapitalization of the banking sector by the Treasury that many Keynesian economists have been arguing for. The difference is that the U.S. government has not (yet) taking a direct equity stake in individual banks.
How to Capitalize a Bank Without Getting the Upside of Equity
As already discussed, the conventional method to inject capital into the banking system is the same as it is for any other corporation: funds provided by common or preferred shareholders. For example, foreign investors including sovereign wealth funds were making direct investments in some U.S. banks earlier this year. Alas, they have consistently said “no” in the recent past.
When lacking outside investors, there is really only one other way to increase banking reserves under a currency regime where both the fractional reserve money supply (deposits) and the Monetary Base (Federal Reserve Notes, Reserve Balances) are created through borrowings. You guessed it, by borrowing! Since banking reserves are a component of the Monetary Base, it is the Monetary Base that has to be borrowed into existence.
Although you will find this in papers and textbooks written about the Federal Reserve system, it turns out there is no point trying to increase banking reserves by making loans and then attemption to pledge them as collateral to the Federal Reserve in exchange for Reserve Balances. Yes, theoretically an individual bank should be able to pledge any eligible loan to the Fed as collateral, subject to acceptance, in order to obtain banking reserves, but there is a critical consideration that blows the theory into smithereens. It is the fact that the Federal Reserve is required to discount loans and other bank assets that it receives as collateral. By contrast, the Federal Reserve is not required to discount Treasury securities. As a result, the only form of liquidity injection into the banking system that will work both in large amounts and on a permanent basis is the acquisition of Treasury securities by the Fed.
Before getting to Treasury securities, let’s take a closer look at the alternative: sales of bank assets to the Fed in exchange for reserves. First, a bank presumably needs to increase banking reserves because it is anticipating withdrawals by depositors or it needs to replace capital lost due to loan defaults or bad investments. The bank could simply sell loans to other banks or stop making loans to increase its reserves if the anticipated withdrawals or losses are gradual enough. There is no need for liquidity injection in this case. If, however, withdrawn cash is not deposited at another bank but rather placed under the mattress, total banking reserves will necessarily decrease over time and the money supply will necessarily shrink by a multiple of the withdrawn cash as the fractional reserve lending process operates in reverse as described above. While deflationary, there is nothing wrong with this sequence because deposits and loans remain in balance and the banking system remains solvent.
Should the deflationary risk to the economy exceed comfort level, however, the Fed will conduct temporary or permanent Open Market operations to boost banking reserves by acquiring Treasury securities and issuing newly printed Federal Reserve Notes. The result is replacement of the liquidity that was lost when the cash was withdrawn from circulation. Loan balances need not be reduced and although there are inflationary implications to the creation of new money, they will not manifest themselves until the cash that has been placed under a mattress is brought back into circulation. At that time, the Fed could presumably reverse its Open Market operation and drain excess liquidity back out of the banking system, but of course that doesn’t ever seem to happen.
Alternatively, let’s see what happens if the bank tries to sell loans to the Federal Reserve in exchange for Reserves Balances. This, by the way, is the textbook explanation of how money is initially created. It is how the creation of Federal Reserve Notes is described by the Fed and Treasury in their own websites and by their own staff. It is also how academic papers describe base money creation. Yet despite all the expert nods, money creation through Fed loan purchases doesn’t work. Why? Let’s go back to the bank’s need for the banking reserves in the first place. The bank clearly doesn’t need the banking reserve to lend out. Why then would the bank take a perfectly good loan and offer it to the Fed at a discount? It is either because the bank needs to increase banking reserves to make up for losses that have drained its capital or to make up for deposit withdrawals that have reduced the banking reserves themselves.
In all cases except a complete withdrawal of the deposit from the banking system, however, all that has occurred is that the banking reserves has shifted from one bank to another. It’s harder to see this in case of a loan loss, but just consider that the loan proceeds had to go somewhere and unless they were withdrawn from the banking system, these loan proceeds are sitting in a bank account somewhere. That means another bank now has excess reserves while the bank with the loan or deposit losses has inadequate reserves. Once again, however, the reserve balances across the banking system as a whole have not changed.
Therefore, the issue isn’t inadequate reserves in the banking system but the issue is rather how the reserves can be redistributed in the most efficient manner from banks with excess reserves to banks with inadequate reserves. In other words, the bank with the losses will either have to attract new deposits or it will have to sell assets. And this is precisely where selling assets to the Federal Reserve will almost never make sense. Why? Again, it has to do with the fact that all assets other than Treasury securities must be discounted by the Fed. That means the selling bank will receive cents on the dollar for its assets. Acquiring Reserve Balances from the Fed in exchange for discounted assets will definitely boost the bank’s cash reserves, but this will also generate additional losses for the bank. For example, if the bank disbursed $100 on a loan, it will receive $90 or less from the Fed as collateral even if the loan is perfectly good. Even if the loan is to Bill Gates.
The net result of collateral discounting is a decrease in the bank’s shareholder equity and capital ratios. If repeated enough, it is a sure path to insolvency for any bank. In fact, the “dirty secret” of the current Federal Reserve credit facilities program is rooted in the very concept of discounting. You see, banks and dealers that swap assets under the Term Auction Facility or any of the other Fed credit facilities are allowed to keep these assets on their books at full value even though the Fed only gives them a discounted value. For example, Fed advanced under credit facilities that exceed 28 days “cannot exceed 75 percent of the lendable value of its available collateral”. I would note here that the “lendable” value is already a discounted collateral value. By contrast, if the Fed were instead to buy these banking assets outright, that would generate an immediate loss of 25% or more that would probably wipe out shareholder equity and capital. Even using the average discount rate of 10%, we can see that a doubling of the Monetary Base in the ordinary course of modern expansionary central banking would wipe out 10% of capital. Considering most banks have capital ratios of 10% or less to start out, that would be quite devastating.
It gets even worse if a deposit withdrawal results in the cash being placed under a mattress. In this case, the banking system has actually lost reserves as a whole. The proper corrective action would be to liquidate loans (or not issue new ones) across the banking system as a whole until loan repayments restore the banking reserves to an adequate level. In the alternative, the Fed should conduct temporary Open Market operations by acquiring undiscounted Treasury securities. The Open Market operation should be reversed as soon as the cash is returned to circulation from under the mattress.
If, instead, banking reserves are created by selling discounted loans to the Fed that could otherwise have been liquidated at full value at some point in the future, a rather serious monetary imbalance is created. Because of discounting, the newly created money would not be sufficient to repay the loan balances that were pledged at a discount to the Fed. A condition where outstanding loans cannot be repaid with existing money in circulation means that the banking system is essentially underwriting a loss equal to the discount whereas the government is guaranteeing the rate of default. This arguably would work under a gold standard and perhaps even under a monetary standard that allows only short term commercial paper to be discounted, but otherwise it is a recipe for major disaster.
Aside from the horrid consequences for interest rates, the creation of a Federal Reserve Note that is then placed under the mattress means that the Federal Reserve Note is no longer available to repay any loan, including the loan that was pledged in order to bring that particular Federal Reserve Note into existence. As a result, more and more new loans will be required to repay existing loans regardless of the economic circumstances. At the same time, if Federal Reserve Notes were continually removed from circulation and kept under a mattress, as they would likely be given the unstable banks that would exist under such a monetary scheme, there would be less and less money in circulation to repay loans. The net result would be hyperinflation of prices amid a collapse of economic activity.
The bottom line is that only entities that can borrow at zero discount (for default and repayment risk) are able to provide the dollar-for-dollar credit necessary to increase the Monetary Base on a permanent basis. In the case of the U.S. dollar, this is the Treasury Department of the U.S. government.
It seems the effects of discounting have been overlooked by most commentators as they have sought to understand the current credit crisis. And this brings us back to Treasury Reserve Balances held at the Fed.
Ultimately, Only Government Can Borrow a Fiat Monetary Base Into Existence
I hope that I’ve been able to convince you that only government borrowing — via the direct issuance of Treasury or other securities that the Federal Reserve can hold as collateral at full par value for new issuances of Federal Reserve Notes — can reliably increase the fiat Monetary Base while providing an unlimited amount of collateral to the banking system regardless of what happens to each newly-created Federal Reserve Note. Any other approach (that did not involve constant currency controls and market interventions) would result in the monetary system collapsing back on itself or being hyperinflated away. I suppose this is the key to the Federal Reserve’s relative longevity and also probably the reason why the U.S. dollar is still the world’s reserve currency despite the mess that it is. But that looks to change soon, and the reason is precisely that the Fed and Treasury have apparently decided to monetize bank assets at a discount.
It hasn’t always been this way. When the Federal Reserve was founded, its Notes were intended to circulate only when rediscounted commercial paper was available to be pledged as collateral. This was a nod to the Real Bills doctrine as advocated by Professor Antal Fekete, even though the Federal Reserve provided a fiat backing of only 40% gold. The effect was to increase the Monetary Base while the commercial paper was outstanding and to reduce the Monetary Base when the commercial paper was repaid. The creation of money under this classic Federal Reserve system was clearly temporary in nature. It was a system that could actually have worked if given a chance. But the temptation of the government — not the bankers themselves — to get something for nothing was too great and so this early version of the Federal Reserve was soon bastardized.
In its modern incarnation, the Fed uses Open Market operations to increase or decrease the Monetary Base ((e.g. during the holidays). Moreover, the Fed has used Open Market operations almost exclusively in the past several decades to permanently increase the Monetary Base as shown in the chart at the beginning of this article. Basically, this involves the Fed buying Treasury securities from Wall Street dealers and paying for the securities with newly issued Federal Reserve Notes (which are credited to the seller’s bank in the form of Reserve Balances). This has the effect of immediately boosting the Monetary Base. Moreover, none of this growth in Monetary Base would have been possible without an increasing amount of Treasury securities available to serve as collateral for the Fed’s issuance of Reserve Balances and Federal Reserve Notes.
The bottom line is that it is ultimately the growth in government debt that has supported the increase in the U.S. dollar Monetary Base and vice versa.
Why the Federal Reserve Was a Fraud
Yet if Open Market operations have worked so “well” in the past, you’d think the Fed would have used them all along to deal with the current banking crisis in order to boost the Monetary Base and to increase liquidity. Well, you’d be wrong. One reason for this is the Fed does not want to be blamed for creating hyperinflation, assuming it can still be avoided. It is perfectly willing, however, to let the Treasury and the U.S. government take the blame. This is precisely what seems to be happening given that Treasury Secretary Hank Paulson is considered to be the author of the $700 billion bailout plan. But make no mistake, even if the Treasury is providing the fuel, it is the Federal Reserve that will be flying the helicopter (or at least co-piloting it).
Another reason for prior Fed reluctance to fly the helicopter is that purchasing tens or hundreds of billions of dollars of eligible collateral on the open market would have influenced interest rates to the possible detriment of the Fed’s stated policy goals. In effect, increased Fed demand for Treasuries might drive credit yields below Fed interest rate targets and actually reduce the banking system’s appetite to lend. That is not what you want when liquidity is already tight. At the same time, Fed Open Market operations could also serve to remove from the credit markets some of the highest quality debt securities. This ironically could result in a net reduction, not increase, in liquidity.
So, the Fed has opted, at least until 2 weeks ago, to fight the credit crisis using so-called credit facilities which have consisted of the Fed exchanging its liquid assets (U.S. Treasury securities) for banks’ illiquid assets (various agency and non-agency debt securities for which demand has shrunk to almost nothing as a result of reduced appetite for risk in the markets). These illiquid bank assets have in turn been used to collateralize existing Federal Reserve Notes that were previously collateralized by (relatively) risk-free Treasury securities. Of course, the financial institutions the Fed has been bailing out with these “facilities” sell the Treasury securities into the market as soon as they receive them in order to obtain cash proceeds to meet liquidity needs. The added benefit of this approach is that the sale of Treasury securities into the market (vs. their purchase as part of Open Market operations) tends to boost overall market liquidity.
As preferable as the credit facilities have been compared to helicopter flights, the Federal Reserve essentially destroyed its own balance sheet during the past two weeks, which is why the Fed reached out to the ultimate lender of last resort, the U.S. government. If the Fed’s ill condition has moved beyond the point of no return as I suspect, the U.S. dollar as a Federal Reserve liability will shrivel up and die as more and more people discover the truth. Sooner or later the Treasury will have to provide an acceptable monetary alternative because formally nationalizing the Fed will accomplish nothing given that the Fed has already been nationalized effective September 17, 2008. Under the circumstances, there is a good chance that gold and silver in the hands of the public will rise to the occasion. My next essay will describe the most likely approach that the Treasury will take to move back toward a Market-Based Monetary Standard (hint: I think it will involve gold.)
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