05 Jul 2013

Can the Fed Become Insolvent?

Federal Reserve 11 Comments

In light of my recent posts on Morgan Stanley’s analysis of this question–which show that a rise of less than a percentage point across the yield curve would render the Fed “bankrupt”–let me direct you to my original Mises.org essay on this question. I walk through various hypothetical Fed balance sheets to show what we mean by saying it could become insolvent.

Then, in this article I walk through the January 2011 change in accounting rules that–many of us suspected at the time–was instituted so that technically, the Fed can’t have negative equity from a fall in its asset prices. Instead, it would have a negative liability owed to the Treasury. (Just think about that for a second.)

To be clear: I am of course not predicting that Bernanke would fall on the sword if the Fed should go bankrupt. It would, however, drive home to more people around the world just how screwy our “modern” monetary system really is. Just like nothing really changed with the idea of a trillion dollar platinum coin, and yet the public–including Jon Stewart–finally got it with that ridiculous proposal.

11 Responses to “Can the Fed Become Insolvent?”

  1. Joseph Fetz says:

    They’ll simply use regulatory hokus pokus, just as they did with Bretton Woods, Nixon’s closure, the end of Mark to market, etc. No doubt, they’ll surely keep printing, but that is more out of habit than the idea behind their solution.

    In the end, it’ll be just as always, screw everybody else, the bank must survive (as well as the Treasury). I’m just curious as to what idiotic scheme they come up with.

  2. Max says:

    The Fed would only be insolvent if its losses exceeded the present value of its future seignorage profits.

    Think about it this way: if the Fed were privatized, how much would the shares be worth? If you say the Fed is insolvent, your answer is: nothing. Never mind the fact that there’s a trillion dollars of $100 bills out there that don’t earn any interest.

  3. Cosmo Kramer says:
  4. Tel says:

    Instead, it would have a negative liability owed to the Treasury. (Just think about that for a second.)

    To all intents and purposes that means a tax credit.

    Governments can offer tax credit to anyone, in return for any service. I might write a particularly interesting essay on why Krugman is a fool (ok, ok, that’s been done to death, but maybe I find a new angle on it or something) and in return the government offers me a million dollar tax credit. They never actually print the million dollars, but now whatever money I was putting aside to pay tax is now available for something else.

    Since tax soaks liquidity out of the economy, a tax credit is another way of reversing this and pushing money into the economy.

  5. Bill Woolsey says:

    If the increase in long interest rates reduces the current market value of the Fed’s assets enough so that it is less than its liabilities, then if the demand for base money fell to zero, then the Fed could not reduce the quantity of base money all the way to zero, and so would be in default. Of course, it isn’t obligated to pay off its liabilities in anything, and so the only “default” would be its ability to maintain the value of its liabilities, or rather, to limit their depreciation to the currently promised 2% per year.

    The more the negative “mark to market” equity, the smaller the maximum decrease in base money the Fed could manage.

    Because it is very unlikely that the demand for base money will fall anywhere close to zero over the next decade or so, the scenario above isn’t of much significant. Really, it suggests that market-to-market accounting isn’t all that useful for the Fed. Allison is pretty critical of using market to market accounting for regular banks. And the chance that the demand for the liabilities of any one commercial bank will fall to zero is much greater than the demand for Federal Reserve liabilities to fall to zero.

    If these accounting figures for the Fed are important, then the Fed should stop (and should have stopped two years ago) paying out “dividends” to the U.S. Treasury and instead used the fund to build up a reserve against expected capital losses on long term securities.

    Of course, the way to avoid this situation in the first place was to have lower interest rates on reserves–in my view, they should have been charging banks to hold excess reserves. This reduces the needed amount of quantitative easing as well adds to the amount of funds the Fed could have been accumulating to cover future capital losses.

    Well, shifting to nominal GDP level targeting rather than inflation and output gap targeting would have done wonders to reduce the needed amount of quantitative easing too.

    • Tel says:

      Really, it suggests that market-to-market accounting isn’t all that useful for the Fed.

      Based on common practice, market-to-market accounting is not useful to anyone any more. Makes you wonder hmmm?

      Of course, the way to avoid this situation in the first place was to have lower interest rates on reserves–in my view, they should have been charging banks to hold excess reserves.

      From a hindsight perspective maybe true, but if the Fed was to drop interest on reserves right now then certainly we would see those reserves pushing out into the economy and up would go inflation. Thus, the Fed would make a loss on their bonds in a different way (a real loss, even if it perhaps a nominal profit).

      I suspect that the interest paid on reserves is basically a back-door bank bailout, without making it look like the US government is directly recapitalising those banks. Given that the Fed is involved in a back-door bailout of FNMA and GNMA this shouldn’t surprise anyone, but I guess information warfare is all about obscuring your intentions.

  6. Ken P says:

    “Instead, it would have a negative liability owed to the Treasury. (Just think about that for a second.)”

    Does that mean the Treasury would owe the Fed for the drop in bond values? Fortunately, bond prices are like housing prices – they always go up. Right?

    Then there is the increased cost to service our debt due to rising interest rates.

    • Tel says:

      Then there is the increased cost to service our debt due to rising interest rates.

      That only applies to government selling new bonds, they could choose to cut their spending (unlikely in practice, but they do have that choice).

      • Ken P says:

        Agreed, but there is turnover in existing bonds. I just checked and the average maturity as of a year ago was 64 months, with the fed planning to increase that. So there is less reissuing taking place than I thought.

  7. Ida Calhoun says:

    This is part 6, the final section, from the paper “Understanding the Modern Monetary System. To read the first sections please see Part 1 here , part 2a here , Part 2b here , part 3 here , part 4 here & part 5 here . Please feel free to ask questions in the comments or use the Ask Cullen section here . If you’re not familiar with MR terminology you might want to review the glossary here .

  8. Janelle K. Gay says:

    “Staff on the Desk start each workday by gathering information about the market’s activities from a number of sources. The Fed’s traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers’ task of financing their securities positions is progressing. Desk staff also talk with the large banks about their reserve needs and the banks’ plans for meeting them and with fed funds brokers about activities in that market.

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