Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
ARE YOU LOVING YOUR SERVITUDE? - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Can the Fed Become Insolvent? Should We Care?

Interest-Rates / Central Banks Nov 29, 2010 - 11:06 AM GMT

By: Robert_Murphy

Interest-Rates

Best Financial Markets Analysis ArticleIn light of Bernanke's plans to purchase $600 billion of longer-term government debt, many academic economists are beginning to worry: Could the Federal Reserve itself become insolvent? In this article I'll explain these fears and I'll argue that the Fed, with its printing press, cannot really go bankrupt the way other corporations can.


However, if the Fed should become insolvent from an accounting standpoint, more of the public would begin to realize just how nihilistic our central-bank, fiat-currency system really is. In that sense, further rounds of "quantitative easing"[1] are risky indeed for the Fed.

A Central Bank's Balance Sheet

To understand what's happening with the Federal Reserve in real life, it's easiest to work through a simplified example. Suppose that the following is a central bank's balance sheet:

Hypothetical Central-Bank Balance Sheet, Initial

ASSETS

LIABILITIES + SHAREHOLDERS' EQUITY

$1 trillion in one-year government bonds (with yield of 0.25%)

$500 billion in paper currency notes held by the public at large

$150 billion in paper currency notes held in commercial-bank vaults as reserves

$250 billion in commercial-bank electronic reserves on deposit with the central bank

$100 billion in shareholders' equity

Sum: $1 trillion

Sum: $1 trillion

On the left-hand side of the balance sheet are our hypothetical central bank's assets. Specifically, the bank holds $1 trillion (according to the present market valuation) of government bonds, which mature in one year. The yield to maturity on these bonds is currently 0.25 percent.

On the liabilities side, the central bank has three major items. First, there are $500 billion worth of green pieces of paper held by the public, in their wallets and purses, home safes, and bedside piggy banks.

Second, the commercial banks in this hypothetical country have $150 billion in paper currency stored in their various ATMs, teller drawers, and bank vaults. When the customers of commercial banks show up, looking to withdraw "cash" from their checking accounts, this $150 billion in actual paper currency is the first line of defense.

Third, there are $250 billion in total on deposit with the central bank. The central bank is "the bank's bank," as it were. Just as Joe Smith can have a checking account with Acme Bank, Acme Bank in turn can have a checking account with the central bank. The table above illustrates that if you were to add up all of the electronic entries for how much each commercial bank has on deposit with the central bank, the total would be $250 billion.

It's important to realize that this last category of liability does not (currently) correspond to physical currency. The $250 billion that Acme Bank et al. have on deposit with the central bank consist entirely of electronic bookkeeping entries. Unlike Acme Bank — which needs to keep at least some paper currency "in reserve" in order to satisfy customer withdrawal requests — the central bank doesn't need to keep a stockpile of currency.

The reason is quite simple: The government's printing press is at the disposal of the central bank. If, say, Acme Bank decides it wants to bulk up on its holdings of paper currency, it can tell the central bank, "We would like to withdraw $1 billion from our account with you." In that case, the central bank will subtract $1 billion from the electronic record of Acme's balance and have the Bureau of Engraving and Printing fire up $1 billion in crisp new bills.

(In this simple scenario — where Acme withdrew $1 billion from its account — the central bank's liabilities would have changed, not in total amount, but merely in composition. Specifically, there would now be $151 billion in reserves held as paper currency in bank vaults, while there would only be $249 billion in electronic reserves on deposit with the central bank.)

Finally, note that the three liabilities only add up to $900 billion. Because the central bank's assets are $1 trillion, the remaining $100 billion is shareholders' equity. (It is important to remember that the Federal Reserve, though a creature of the government, is owned by private shareholders.) In terms of standard accounting, this hypothetical central bank is solvent; its assets exceed its liabilities.

A Round of Quantitative Easing

Now suppose that the head of our hypothetical central bank wants to kick start his economy out of a recession by expanding the balance sheet by $600 billion. Normally, he would engage in "open-market operations" and buy short-term government bonds in order to push down short-term interest rates.

Unfortunately for our pump primer, short-term rates are already at rock-bottom levels. Therefore the central banker decides to purchase bonds from his government that mature in ten (rather than one) years.

Here is the balance sheet, after the round of quantitative easing:

Hypothetical Central-Bank Balance Sheet, After Q.E.

ASSETS

LIABILITIES + SHAREHOLDERS' EQUITY

$1 trillion in one-year government bonds (with yield of 0.25%)

$500 billion in paper currency notes held by the public at large

$600 billion in ten-year government bonds (with yield of 2%)

$150 billion in paper currency notes held in commercial-bank vaults as reserves

$250 $850 billion in commercial-bank electronic reserves on deposit with the central bank

$100 billion in shareholders' equity

Sum: $1.6 trillion

Sum: $1.6 trillion

How did this process actually occur? It was quite simple. The central bank wrote checks, drawn on itself, in order to buy $600 billion worth of ten-year government securities from the secondary market.

When the bond dealers in the private sector deposit those new checks (drawn on the central bank) in their own checking accounts with Acme Bank and others, then Acme et al.'s account balances with the central bank rise accordingly. In the table above, I have shown the change: the central bank's liabilities in the form of electronic bank reserves now total $850 billion — rather than $250 billion.

At this point, the central bank's shareholders still have the same equity. But now their enterprise is more leveraged, because the ratio of liabilities to equity has grown from 9:1 to 15:1. In a sense — and this is a description that many economists have been using lately — the central bank has "borrowed short" in order to "lend long."

That is, the central bank has indirectly lent long-term money to the government (by buying its ten-year bonds) by borrowing very "short-term" money from the banking system/public.[2]

Whatever the alleged benefits of our hypothetical $600 billion asset purchase, it undeniably puts the central bank at greater risk.

The Central Bank Goes Broke?

Suppose that price inflation begins rising in our hypothetical world, so that one-year interest rates rise to 1 percent, while ten-year yields jump to 8 percent. This makes the current market value of the central bank's bond portfolio crash. Now the balance sheet looks like this:

Hypothetical Central-Bank Balance Sheet, After Interest Rates Spike

ASSETS

LIABILITIES + SHAREHOLDERS' EQUITY

$993 billion in one-year government bonds (with yield of 1%)

$500 billion in paper currency notes held by the public at large

$355 billion in ten-year government bonds (with yield of 8%)

$150 billion in paper currency notes held in commercial-bank vaults as reserves

$850 billion in commercial-bank electronic reserves on deposit with the central bank

($152 billion) in shareholders' equity

Sum: $1.3 trillion

Sum: $1.3 trillion

As the table illustrates, the spike in interest rates causes the central bank to lose $7 billion on its short-term assets, but a whopping $245 billion on its long-term bonds. Because it recklessly exposed itself to greater interest-rate risk, our hypothetical central bank is now technically insolvent. That is, its liabilities exceed its assets by some $152 billion.

Who Cares?

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.

Conclusion

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.

In the meantime, it will be interesting to watch the academic debate over "QE2" unfold. Although they are focused on the narrow question of solvency, economists and other analysts are slowly realizing that Bernanke's "exit strategy" could collapse if and when interest rates rise sharply.

Notes
[1] I should point out that some avid Fed watchers, such as Jeffrey Rogers Hummel, think that Bernanke is not engaging in "QE2," and that he doesn't intend to expand the Fed's balance sheet.

[2] Especially if the central bank pays interest to commercial banks for keeping their reserves on deposit (rather than withdrawing them as currency), this way of thinking has a certain plausibility.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Robert Murphy - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules