Could the Fed Become Insolvent?
I discuss this possibility today at Mises.org. I walk through three separate (hypothetical) Fed balance sheets to show how it could occur. An excerpt:
Although our central bank appears to be insolvent, in practice what would hinder its continued operation? Its liabilities consist in the legal-tender fiat money of the land. If someone walks into a branch of the central bank, hands over a $20 bill, and says, “I want to redeem this!” the teller can calmly reply, “Do you want that as two $10 bills, or four $5 bills?”
Things are more complicated for a small central bank that has liabilities denominated in other currencies. But for the case of the Federal Reserve — with dollar-denominated liabilities — it is hard to see what actual constraints it would face, should its accountants suddenly announce its insolvency. Even if there is a “run on the Fed,” where all of the commercial banks want to withdraw their electronic reserves on the same day, the central bankers need not panic: they can order the Treasury to run the printing press in order to swap paper currency for electronic checkbook entries. (This is a neat trick unavailable to the mere commercial bankers.)
However, if the central bank were to actually become insolvent, it would be quite scandalous. The government would probably have to “seize it,” lest the public realize that the whole scheme was a giant, legalized counterfeiting operation.
In my opinion, this is the bankers’ main concern at the moment. They surely don’t like thousands of economists blogging away on the possibility of the Fed going bankrupt, because that gets more and more people thinking through the logic of our crazy banking system.
I also take the opportunity to plug my new upcoming online class:
For those interested in an analysis of the actual Federal Reserve’s balance sheet and its various interventions into asset markets since the financial crisis began, I will be offering a new Mises Academy course, “Anatomy of the Fed,” in early January.
And this would differ from the GSEs Fannie and Freddie how? Oh yeah, they’re “assets” of the Fed.
But the Fed can’t become insolvent in a meaningful sense, as you note. Would it really be quite so scandalous? I can already imagine Bernanke and Co. on television: “we became insolvent to ensure that ordinary Americans did not have to.”
By the way, your “The Fed as Giant Counterfeiter” article was enjoyable. I do not agree the Fed is actually a counterfeiter in the common sense of the term, just like it cannot become insolvent like an ordinary firm. However, it is a well written article and I learned from it, so thanks!
Thanks. I don’t know that it would be “scandalous” in the way Eliot Spitzer’s extracurricular activities were. But I think it would really make a lot more people cynical in our financial system. When I explain to people how it is that Bernanke buys assets–namely that he writes a check and creates those new reserves out of thin air–a lot of time they don’t believe me.
“In my opinion, this is the bankers’ main concern at the moment.” What’s the “this”? Is it that bloggers are making people question the banking system and how the shuffle of money works? Or is “this” that someday the accountants at the Fed will say they are insolvent even though you show through out your blog post that this cannot possibly happen?
Not sure what the point of the original blog post was. I think you do a good job of pointing out the balance sheet portion, but there really isn’t anything there in the post in regard to the Fed becoming insolvent. It can’t.
Oh, and because the Fed can’t go broke neither can the country go bankrupt. We can lose faith in the currency, but the government via its off balance sheet, special purpose vehicle known as the Federal Reserve will always have as many slips of green paper with dead presidents on them that it wants.
I think the idea is that if people realize the Fed can never become insolvent they will support a return to the gold standard.
Bingo. BTW where have you been, Blackadder? I thought maybe the Black Death got you.
With Ireland deflating by the day, Portugal soon to follow, and with China’s persistent inflation, it’s puzzling why people think a pegged currency is a good idea.
Bob, I wish I knew how to quit you.
The only reason for people to question the Fed would be a bold screw up of government fiscal policy. Some would say that has happened. And even if it has every Black Friday we are reminded that the mind numb slaves out there have no clue that anything is wrong. Add to that the bipolarization of our R vs D politics and we continue the charade to make sure nobody cares what is going on behind the curtain.
All that boils down to say this setup will never end until perhaps the dollar is thrown out as a world currency. We’ll know we’re there when we go all in on war. And at that time it’ll still be too late since the mind numb slaves will be eager to carry a gun.
“However, if the central bank were to actually become insolvent, it would be quite scandalous. The government would probably have to “seize it,””
Is this really true? The treasury could pump an unlimited amount of capital into the central bank if it had too.
And do you have any proof or links suggesting bankers worry about the Fed becoming insolvent? Is this a fear by academics or actual bankers? This would be game changing news if true.
“Is this really true? The treasury could pump an unlimited amount of capital into the central bank if it had too”
AP,
I believe you have denied that chartalists believe there is no such thing as scarcity. How so, given your statement above?
Even if there is a “run on the Fed,” where all of the commercial banks want to withdraw their electronic reserves on the same day, the central bankers need not panic: they can order the Treasury to run the printing press in order to swap paper currency for electronic checkbook entries. (This is a neat trick unavailable to the mere commercial bankers.)
The interesting question is why this neat trick is unavailable to mere commercial bankers. Is it simply a matter of there being a law in the statute books that prohibits commercial banks from doing this? I doubt it. Even if banks were legally permitted to print their own fiat currencies they would not be able to issue lots of debt denominated in their own currency, for the same reason that I can’t get away with paying for things with IOUs redeemable only in more IOUs. I could try, but no one would accept them.
Yet the Fed is able to do this. And how it is able to do this while purely private entities can’t is the $64 trillion dollar question.
Blackadder,
Why is there a demand for the Fed’s irredeemable paper money? Because the government has made it near impossible to live in the U.S. without sometimes requiring its money (e.g. to pay taxes).
Lee,
I think you are right. The fact that the government can specify what currency is used to pay taxes is what gives governments a big advantage in the money business over the mere commercial banks.
Private currencies do exist, in a sense — as gift cards. The big difference is that banks don’t usually offer gift cards, and you can’t sell normal gift cards for face value (except, crucially, to the issuer).
If we had a highly liquid, low-transaction cost market in bank gift cards, they could pull off the trick of printing their own money: when someone wants to convert $100 in electronic money to paper money, the bank could debit the electronic account, and then give them gift card that says “this instrument entitles the bearer to cancel $100 worth of debt to [issuing bank]”. The recipient could then (under ideal conditions) sell the gift card at a slight discount to a debtor of that bank.
If the next $100 of repayment that would have gone to the bank is instead used to buy the gift card and cancel the debt, the effect is the same as if the bank could print money. In practice, banks don’t bother with this since they can just borrow the paper money necessary to satisfy such conversions.
(I’ve long thought that, say, Wal-mart could separately become a currency issuer by issuing gift cards due to the unique liquidity such cards possess.)
“But for the case of the Federal Reserve — with dollar-denominated liabilities — it is hard to see what actual constraints it would face, should its accountants suddenly announce its insolvency.”
Murphy, here is the constraint: in the face of Fed insolvency people grow wary of Fed liabilities and start to use the paper currencies of solvent issuers. Americans and the rest of the world embark upon a wave of de-dollarization and, as a result, the Fed can’t issue new currency because people simply won’t accept it. The final resting point – the ultimate constraint on the Fed – is that society completely disgorges its US dollars. They are entirely demonetized and become no more than paper. The Fed has lost its capacity to issue. This is what happened with Zimbabwe dollars.