16 Comments

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.

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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,

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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.

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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you’re thinking that the Fed cannot go bankrupt because it can print money, your picture of the Fed is simplistic and out of date.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.

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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.

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Coming up, the insurance companies that reached for yield along the curve and by bottom feeding on top of the Corp HY/IG boundary

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