Like all state banks, including central banks, the Fed cannot go bankrupt like a private organization or even a person. If a state bank cannot pay back its depositors and lenders, then the government will have to decide whether depositors and lenders will take the losses or taxpayers will do it. If depositors and lenders were paid back by printing money, it'd not be different from any other government expenditure financed by printing money. Any time a government forgives and pays back loans contracted by other people, its spending has to be financed.
I suggest to learn from Argentina's experience in July 1982. In the following months, the plan prepared by two Econ Harvard Ph.Ds led to the country's first hyperinflation episode and the idiots were surprised.
I'm back to complete my previous comment. Indeed, Arnold's post has nothing to do with the Fed going on bankrupt in any serious way. We should thank Arnold for reminding us what happened with the S&Ls in the 1980s --the same that happened to Latin American borrowers except that the S&Ls could deal directly with the U.S. federal government and Congress. Yes, as much as the heavily regulated and politically patronized S&Ls of the 1980s, today the Fed may have "a flow" problem but this time it will be solved secretly, a la Fauci, since the Fed is managed by bureaucrats. Like China or Argentina's state banks, Fed's flow problems caused by relying on it to intermediate funds to government priorities will be solved by additional borrowing or taxation, including inflationary taxation.
BTW, when advising on government's financial intermediation and its impact on a country's public finances, I relied on consolidated financial reports, including all units whose liabilities to private depositors and lenders were paid ultimately by the government (one of the many reasons why the IMF and WB reports on public finances have always been very misleading).
How long will it take the politicians to realize how big a mess the Fed has created? The various populists will have a field day. This will be a wild ride,
Interest rate forecasts implied by term SOFR imply that short term rates will peak below 3.2%. If MBS rates are 3%, doesn't that imply that they are likely to lose very little? The Fed should worry about tail events, but we should take the market implied forecasts seriously and conclude the most likely outcome is that they won't lose a lot.
Yes, the implied correlations in PLMBS and CDOs were low, suggesting a national decline in home prices was unlikely. I'm not saying that a markets are always correct ex-post. But liquid markets are very hard to beat, and it is difficult to take forecasts seriously that don't engage seriously with market implied forecasts.
You claim "If you’re thinking that the Fed cannot go bankrupt because it can print money, your picture of the Fed is simplistic and out of date. The post-2008 Fed works differently." I don't see how you showed that to be the case using the S&L crisis as an analogy.
A bank can be forced to shrink its balance sheet by its creditors (either by withdrawal of deposits or by unwillingness to roll over other debt) so an insolvent bank could find that someone demands to be paid back and is unable to do so. Who can force the fed to shrink it liabilities? Nobody (so far as I can tell).
I think the divergence in our understanding of the Fed boils down to your question "How can [the Fed] attract funds?" My answer (which may be wrong) is that the Fed, unlike other financial intermediaries, never has to worry about attracting funds because nobody can force its liabilities to shrink.
If banks try to withdraw reserves from the Fed, they end up in some other bank's reserve account or as currency in circulation. So member banks and the non-bank public can only affect the composition of the Fed's liabilities, not the total. If you can explain to me how the Fed can be forced to reduce its liabilities, you'll have persuaded me toward your view that the Fed is basically another financial institution. Until then, I'm highly skeptical of this view.
I do agree that an insolvent Fed could be a problem, but not because it will go bankrupt or require a taxpayer bailout. Here's how I see the issue. If nobody can force the Fed to sell assets and "pay back" liabilities, why is assets < liabilities a problem ? Sure, the treasury won't get its usual remittances, but that is typically not a huge source of revenue (historically between $1B and $2B per week).
The real problem is that an insolvent Fed has lost some control over the money supply because there is now a lower bound on the monetary base (roughly equal to liabilities - assets). The Fed reduces its liabilities (and thus the monetary base) by selling assets such as treasuries or MBS. So when it runs out of assets before liabilities go to zero, it can no longer reduce the monetary base.
If the Fed sells all of its assets, is it out of options for reducing M2? Not necessarily - it can always increase interest on reserves. Maybe this would do the trick by driving the money multiplier to zero. But even that could get out of hand because paying interest on reserves increases (liabilities - assets) over time.
So I think that the problem is not bankruptcy or the Fed requiring a taxpayer bailout, but that the Fed can lose its ability to shrink the money supply when it suffers large losses.
https://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 If I read this correctly, the Fed has $2 trillion in reverse repos. If I understand that correctly, that means that the Fed is borrowing $2 trillion in short-term money markets, just the way a bond dealer would. Suppose it was Goldman Sachs that was hanging $2 trillion in mortgage securities out on repo. It gets 3 percent in interest (at an annual rate) and pays 2 percent for its repo loans. Fine. Then one day the repo rate goes to 4 percent, and it still only gets 3 percent on the mortgage securities. Goldman Sachs is finished--until Congress does a bailout. The Fed is in the same boat. It used to be different because its assets and liabilities were more closely matched in duration.
No, the Fed is not in the same boat. I agree that if Goldman Sachs suddenly has to pay a higher interest rate on its liabilities than it earns on its assets, it is in big trouble. Suppose the counterparties to your Goldman example decide that tonight is the last night for all reverse repos. By tomorrow morning, Goldman needs to find someone else to lend them money or start selling assets. The same is NOT true of the Fed. If all counterparties to the Fed's reverse repos decided not to roll them, the Fed could simply say fine, I'll credit the accounts of your corresponding banks when you give me back those securities.
This exemplifies the fatal flaw in "the Fed is a hedge fund" analogy. The Fed is unique because it cannot be forced to shrink its balance sheet by its creditors. Convince me otherwise and I'll change my mind.
To reiterate my original point - that Fed insolvency means that the Fed loses control of the money supply - have a look at George Selgin's "The Menace of Fiscal QE" page 63: "Although it's true that central banks can operate with no or even negative capital, as conventionally defined, that's so only because they can always cover their losses by creating more base money."
If I concede your theoretical point, will you look at the magnitudes involved and tell me what the consequences would be if the Fed suddenly switched to funding its entire mortgage securities portfolio with base money? In practice, I think that given the choice between going to Congress and asking for a bailout and losing control and turning us into Germany in 1921, they would end up asking for a bailout.
Yes, I agree that the magnitudes are startling. Let's say the duration of the Fed's ~ $9T portfolio of assets is roughly 8 years. A 3 percentage point increase in interest rates shaves off a little more than 20% of that. The Fed takes a loss of $1.8T. For a while, MB cannot fall below $1.8T. That's pretty high by pre-2008 standards but not all that high these days.
The Fed still has a couple of important tools at its disposal that would keep M2 under control. It can increase interest on reserves (and on reverse repos). It can increase the reserve requirement from 0% to 100%. For these reasons and because I assume the Fed would like to avoid asking congress for a bailout like the plague, I see hyperinflation or asking for a bailout as very low probability events.
Last point - I agree that the Fed should have exited the MBS market probably a decade ago and I think it was a big mistake to double down in 2020/21. I share your view that we'll probably pay dearly again for the distortions in housing finance.
To add to this, after 2008, it seemed that the Fed would be able to pay different rates on required reserves than on excess reserves. As of 7/29/21, they seem to have taken this option away from themselves, which seems like a good exercise of self-restraint. I don't think this inability to charge different rates on required versus excess reserves changes Glandon's analysis; it just takes away one option that I had thought the Fed could use to deal with large portfolio losses.
The plan on quantitative tightening they put up seems to show that all of the tightening will be in the short duration debt, not the long duration debt.
Like all state banks, including central banks, the Fed cannot go bankrupt like a private organization or even a person. If a state bank cannot pay back its depositors and lenders, then the government will have to decide whether depositors and lenders will take the losses or taxpayers will do it. If depositors and lenders were paid back by printing money, it'd not be different from any other government expenditure financed by printing money. Any time a government forgives and pays back loans contracted by other people, its spending has to be financed.
I suggest to learn from Argentina's experience in July 1982. In the following months, the plan prepared by two Econ Harvard Ph.Ds led to the country's first hyperinflation episode and the idiots were surprised.
I'm back to complete my previous comment. Indeed, Arnold's post has nothing to do with the Fed going on bankrupt in any serious way. We should thank Arnold for reminding us what happened with the S&Ls in the 1980s --the same that happened to Latin American borrowers except that the S&Ls could deal directly with the U.S. federal government and Congress. Yes, as much as the heavily regulated and politically patronized S&Ls of the 1980s, today the Fed may have "a flow" problem but this time it will be solved secretly, a la Fauci, since the Fed is managed by bureaucrats. Like China or Argentina's state banks, Fed's flow problems caused by relying on it to intermediate funds to government priorities will be solved by additional borrowing or taxation, including inflationary taxation.
BTW, when advising on government's financial intermediation and its impact on a country's public finances, I relied on consolidated financial reports, including all units whose liabilities to private depositors and lenders were paid ultimately by the government (one of the many reasons why the IMF and WB reports on public finances have always been very misleading).
How long will it take the politicians to realize how big a mess the Fed has created? The various populists will have a field day. This will be a wild ride,
Interest rate forecasts implied by term SOFR imply that short term rates will peak below 3.2%. If MBS rates are 3%, doesn't that imply that they are likely to lose very little? The Fed should worry about tail events, but we should take the market implied forecasts seriously and conclude the most likely outcome is that they won't lose a lot.
OK, then. I suppose 2008 didn't happen either. Markets did not see any reason to worry before then.
That's unfair. I didn't say not to worry, I said the most likely outcome was the fed would not lose a lot.
Weren't the "market implied forecasts" up until "2008" 'seriously implying' that "the most likely outcome is that they won't lose a lot"?
Yes, the implied correlations in PLMBS and CDOs were low, suggesting a national decline in home prices was unlikely. I'm not saying that a markets are always correct ex-post. But liquid markets are very hard to beat, and it is difficult to take forecasts seriously that don't engage seriously with market implied forecasts.
You claim "If you’re thinking that the Fed cannot go bankrupt because it can print money, your picture of the Fed is simplistic and out of date. The post-2008 Fed works differently." I don't see how you showed that to be the case using the S&L crisis as an analogy.
A bank can be forced to shrink its balance sheet by its creditors (either by withdrawal of deposits or by unwillingness to roll over other debt) so an insolvent bank could find that someone demands to be paid back and is unable to do so. Who can force the fed to shrink it liabilities? Nobody (so far as I can tell).
I think the divergence in our understanding of the Fed boils down to your question "How can [the Fed] attract funds?" My answer (which may be wrong) is that the Fed, unlike other financial intermediaries, never has to worry about attracting funds because nobody can force its liabilities to shrink.
If banks try to withdraw reserves from the Fed, they end up in some other bank's reserve account or as currency in circulation. So member banks and the non-bank public can only affect the composition of the Fed's liabilities, not the total. If you can explain to me how the Fed can be forced to reduce its liabilities, you'll have persuaded me toward your view that the Fed is basically another financial institution. Until then, I'm highly skeptical of this view.
I do agree that an insolvent Fed could be a problem, but not because it will go bankrupt or require a taxpayer bailout. Here's how I see the issue. If nobody can force the Fed to sell assets and "pay back" liabilities, why is assets < liabilities a problem ? Sure, the treasury won't get its usual remittances, but that is typically not a huge source of revenue (historically between $1B and $2B per week).
The real problem is that an insolvent Fed has lost some control over the money supply because there is now a lower bound on the monetary base (roughly equal to liabilities - assets). The Fed reduces its liabilities (and thus the monetary base) by selling assets such as treasuries or MBS. So when it runs out of assets before liabilities go to zero, it can no longer reduce the monetary base.
If the Fed sells all of its assets, is it out of options for reducing M2? Not necessarily - it can always increase interest on reserves. Maybe this would do the trick by driving the money multiplier to zero. But even that could get out of hand because paying interest on reserves increases (liabilities - assets) over time.
So I think that the problem is not bankruptcy or the Fed requiring a taxpayer bailout, but that the Fed can lose its ability to shrink the money supply when it suffers large losses.
https://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 If I read this correctly, the Fed has $2 trillion in reverse repos. If I understand that correctly, that means that the Fed is borrowing $2 trillion in short-term money markets, just the way a bond dealer would. Suppose it was Goldman Sachs that was hanging $2 trillion in mortgage securities out on repo. It gets 3 percent in interest (at an annual rate) and pays 2 percent for its repo loans. Fine. Then one day the repo rate goes to 4 percent, and it still only gets 3 percent on the mortgage securities. Goldman Sachs is finished--until Congress does a bailout. The Fed is in the same boat. It used to be different because its assets and liabilities were more closely matched in duration.
No, the Fed is not in the same boat. I agree that if Goldman Sachs suddenly has to pay a higher interest rate on its liabilities than it earns on its assets, it is in big trouble. Suppose the counterparties to your Goldman example decide that tonight is the last night for all reverse repos. By tomorrow morning, Goldman needs to find someone else to lend them money or start selling assets. The same is NOT true of the Fed. If all counterparties to the Fed's reverse repos decided not to roll them, the Fed could simply say fine, I'll credit the accounts of your corresponding banks when you give me back those securities.
This exemplifies the fatal flaw in "the Fed is a hedge fund" analogy. The Fed is unique because it cannot be forced to shrink its balance sheet by its creditors. Convince me otherwise and I'll change my mind.
To reiterate my original point - that Fed insolvency means that the Fed loses control of the money supply - have a look at George Selgin's "The Menace of Fiscal QE" page 63: "Although it's true that central banks can operate with no or even negative capital, as conventionally defined, that's so only because they can always cover their losses by creating more base money."
If I concede your theoretical point, will you look at the magnitudes involved and tell me what the consequences would be if the Fed suddenly switched to funding its entire mortgage securities portfolio with base money? In practice, I think that given the choice between going to Congress and asking for a bailout and losing control and turning us into Germany in 1921, they would end up asking for a bailout.
Yes, I agree that the magnitudes are startling. Let's say the duration of the Fed's ~ $9T portfolio of assets is roughly 8 years. A 3 percentage point increase in interest rates shaves off a little more than 20% of that. The Fed takes a loss of $1.8T. For a while, MB cannot fall below $1.8T. That's pretty high by pre-2008 standards but not all that high these days.
The Fed still has a couple of important tools at its disposal that would keep M2 under control. It can increase interest on reserves (and on reverse repos). It can increase the reserve requirement from 0% to 100%. For these reasons and because I assume the Fed would like to avoid asking congress for a bailout like the plague, I see hyperinflation or asking for a bailout as very low probability events.
Last point - I agree that the Fed should have exited the MBS market probably a decade ago and I think it was a big mistake to double down in 2020/21. I share your view that we'll probably pay dearly again for the distortions in housing finance.
This is way more fun than grading final exams!
To add to this, after 2008, it seemed that the Fed would be able to pay different rates on required reserves than on excess reserves. As of 7/29/21, they seem to have taken this option away from themselves, which seems like a good exercise of self-restraint. I don't think this inability to charge different rates on required versus excess reserves changes Glandon's analysis; it just takes away one option that I had thought the Fed could use to deal with large portfolio losses.
The plan on quantitative tightening they put up seems to show that all of the tightening will be in the short duration debt, not the long duration debt.
Coming up, the insurance companies that reached for yield along the curve and by bottom feeding on top of the Corp HY/IG boundary