I have been postponing a proper discussion of Fed “sterilization” because it’s a tricky thing, but events are moving quickly. So with the caveat that I am writing this in the wee hours of the morning, here it is in a nutshell: Our banking system is a “fractional reserve” one. That is, if you take $1000 in actual cash to a bank and deposit it into a new checking account, the bank doesn’t put the pieces of paper in a drawer with your name on it. On the contrary, the legal reserve ratio is (currently) 10 percent, meaning that banks only have to have 10% “backing up” the total outstanding deposit liabilities held by their customers. By putting your $1000 of actual currency in their vault, the bank can not only give you a checkbook and let you walk around, thinking you have $1000 “in the bank,” but it can also give new lines of credit to other customers, such that now the community thinks they have $10,000 more money in available deposits. (This is because the $10,000 in new checkbook balances is backed up by the new $1000 in cash sitting in the vault.)
Now, in order to satisfy its reserve requirements, banks don’t actually need to have green pieces of paper sitting in their vaults. They can also count their “reserves” on deposit with the Federal Reserve itself. So just as you can have a checking account with your local bank, so too do the big member banks have accounts with their bank, i.e. the Federal Reserve.
OK hang in there folks, we’re getting to the good (actually, awful) stuff. Because of the fractional reserve system, when the Fed injects new reserves into the credit markets, there is a multiplier effect. By itself, then, the massive loans being granted to troubled financial institutions should have caused huge spikes in the money supply, broadly defined.
However, Bernanke has actually been a tightwad thus far. This is an important point that many casual observers have missed. Ever since the Fed started pumping in massive, short-term injections of “liquidity” in September 2007, Bernanke has been very careful to “sterilize” the injections. Specifically, he sold some of the Fed’s holdings in bonds, to the private sector banks. I.e. the Fed itself owned hundreds of billions of dollars worth of Treasury debt, just like any other big institution can have lots of bonds issued by the US Treasury on its balance sheet.
Now when the Fed sells, say, $100 million of bonds to Bank XYZ, it debits XYZ’s reserve balance. It’s as if your local bank “sold” you a new batch of checks because you were running low, and then debited your checking account by $50 to pay for them. But unlike the private sector case, where your bank now has an extra $50 in its “checking account” as it were, when a bank reduces its reserves with the Fed, that just disappears from the system. (In reverse direction, this is how the Fed creates money out of thin air. It literally just adds numbers to a client bank’s account balance. Poof! Why bother digging up gold when you can change some 0s and 1s in a circuit?)
So, to sum up, thus far Bernanke has been offsetting his injections of new liquidity to a given bank, by selling Fed assets to other banks. On net, the rescue actions have not been pumping in new liquidity, and have not been expanding the monetary base. (More accurately, Bernanke has used the sterilizations to expand the base much more slowly than would have occurred without the sterilization. I.e. the base has still grown, but not nearly as much as some libertarians think, reading the headlines every day.)
We’re now getting to the climax. The problem is that with the new promises made in the last few days, the Fed may soon run out of assets to burn. In other words, the Fed can print money out of thin air, but it had a finite stock of Treasury assets that it was burning through in order to sterilize its injections. I’ll let Robert Wenzel take it from here:
Up until now, the Federal Reserve has been sterilizing its bailout activities by either loaning out or selling Treasury securities that it has had in its portfolio, to match the bailouts activities it has been conducting. In the last 52 weeks, the Feds portfolio of Treasury securities has declined by $303 billion and stands at $476 billion. But, commercial banks and bond dealers, just in the last seven days, borrowed $348.2 billion from the Federal Reserve as of yesterday.
If the Fed attempts to sterilize these borrowings it will be down to $128 billion in its portfolio. If it does sterilize the borrowings, in a day or two with only $128 billion in Treasury securities left, and more borrowing likely, the Fed would be forced to print money, as they would have run out of Treasury securities for further sterilization operations. Either way, it is likely the Fed will start printing money at unheard of rates.
Indeed, they may have already started. According to the latest data, during the week ended September 22, the Fed increased the money supply by nearly $100 billion.
We may be about to experience the greatest inflation the United States has experienced since the Civil War. Gold could break above $1,000 an ounce in record time. You have been warned.
After the House wisely decided that a group of “representatives” probably shouldn’t vote for something that the public opposes 9-to-1, the Powers That Be made two important switches. First, they stopped calling it a “bailout” and started calling it a “rescue package.” Second, they emphasized how this was all about helping Main Street. In particular, we heard over and over–from not just Paulson but also President Bush himself–that frozen credit markets would prevent small businesses from making their payroll.
When I first heard that, it sounded fishy; did regular businesses really need to borrow money every month just to pay their employees? I couldn’t believe most businesses were so tight. Maybe some really capital intensive operations, sure, but was a short-term credit market really that important for small business in general?
No, it isn’t. Paulson is lying through his teeth. Bush is either doing the same, or has no idea and is still criminally liable for trusting these advisors.
The first confirmation of my hunch came from an LRC article written by a small business owner who said: “None of the small business owners I know depend upon easy credit to make their payroll. When things get to the point where you need to borrow to pay your employees, the end is near.”
A second chunk of evidence was the reporting of Alex Tabarrok over at Marginal Revolution. (I can’t dig up the actual posts now.) Alex was going over a bunch of different data showing that the “credit crunch” really only affected those large institutions directly tied to the “toxic” mortgage assets; regular people could still get new credit cards etc.
David Henderson reached similar conclusions, just asking around. People could still get financing for their car purchases, etc., so long as they were good credit risks. In other words, Henderson found that businesses in his local community were still extending credit to people, but that they had raised their standards back to what most people would consider rational levels.
Last anecdote: My neighbor runs a very successful chain of electronics stores. The guy is a workaholic, and even though I don’t know him all that well, I think he is very sharp and wise in worldly ways. (Also, he was surprised when I told him I was against the bailout; I think he thought it was necessary.) When I asked him if it was true that either he or other owners he knew needed credit to make their payroll, he said, “No, you don’t need to borrow money to pay your employees. You bring in enough every month to cover that.”
I pressed him and asked if maybe you needed it in certain industries like home building. “OK yeah, I could see something like that, where you need so much upfront. But the truth is,” he continued, “banks will still lend to you if you have a clean balance sheet.”
So there you have it folks. A few other economists and I were able to find out within a day that small businesses are not starved for short-term credit, at least not to make their payrolls. So Hank Paulson either (a) didn’t bother spending a day researching the problem or (b) is lying through his teeth. Take your pick.
P.S. In the comments, I would love to hear feedback from actual businesspeople, especially if you think, “OK Bob, they picked that argument because it would sway voters, but the real reason the bailout was necessary was…” I am trying to avoid the conclusion that any sharp financial person who endorsed this thing, is necessarily a crook.
Tim Swanson has a nice post summarizing our loss of liberties, and below Newt Gingrich actually makes a lot of sense. I liked him once he left government.
Someone emailed me the first picture below, and I thought it was great. I went to the artist’s website, and there is some freaky stuff there. Warning: He is an “anti-Zionist,” and takes pains up front to say that he is pro-Jewish, and not to believe the “smears” of anti-Semitism etc. Well, like I said, I have no idea who this guy is, but this is some freaky artwork. I am neither repudiating nor endorsing whatever other political views he may have, because I don’t know them, but I definitely like his take on Bush and the Fed.
Some samples (and these aren’t even the really freaky ones):
The Fed, in conjunction with other central banks around the world, announced a rate cut. At first the market was up, but as of this writing the S&P 500 is down more than 70 basis points on the day. (Back before the “credit crunch” set in, this would have been an awful day.)
At some point, are policy makers going to realize that certain asset prices need to fall? More and more people are starting to recognize that the Fed’s 1% interest rates under Greenspan fueled the housing boom. And why did Greenspan do that? Well, because it would have been too painful to let the economy readjust after the dot-com bubble and bust.
It would be one thing if lots of analysts were saying, “It’s true, we might be sowing the seeds for an even worse crisis five years from now, but that’s a chance worth taking.” Yet nobody is even saying this. The people who are cheering the rate cuts think price inflation is the only possible downside to massive injections of phony credit.
The effect was almost immediate:
Note: In my efforts to steal the techniques of successful sites, I have started putting up more “fun” posts that involve pictures, rather than my long-winded, narcissistic analyses. And yet, it seems those other sites still bring in more traffic. What the heck?
Dear Free Advice readers,
Due to the fact that I actually have a (pseudo) real job, I have finally accepted that I can’t answer everyone’s questions in the comments. Note that my response rate is still 407% higher than Tyler Cowen’s on Marginal Revolution.
This mp3 features the Hoover Institution’s David Henderson who debates the bailout etc. with first Robert Reich, who then tags Robert Kuttner. It is shocking to hear Reich’s take on this; he really is a Keynesian who thinks it is necessary and sufficient for consumers to spend money, in order for a strong economy. But a great moment later on is when Kuttner says, “I resent that comment, because I wrote the Community Reinvestment Act and it had nothing to do with this crisis.” You don’t hear that kind of thing very often when the talking heads go at it.
Another good one is that Kuttner–after saying the CRA had nothing to do with the present crisis–then says that credit default swaps are the “type of instrument that should never have been permitted” and says it is a classic case of moral hazard, because the CDS buyer then has no incentive to worry about the bonds he holds. By itself, this would also “prove” that fire insurance on your house is an instrument that shouldn’t be permitted.
Henderson makes great points, especially about the fact that the so-called “credit freeze” is really more of a return to rationality, where you have to prove you are a good risk before getting huge lines of credit. His only flaw is thinking the CPI overstates price inflation (!!).