What Happens when Uncle Sam’s Sugar Daddy Runs out of Canes?Commentary, Featured, Scholars' Corner — By Tyler Watts on February 13, 2013 at 3:16 PM
The Wall Street Journal’s Real Time Economics Blog recently reported that, according to new CBO projections, the Federal Reserve will cease its annual “payments” to the US government by 2018.
You’re probably wondering two things: 1. Why the heck would the Fed be funding the government—shouldn’t it be the other way ‘round? 2. How the heck could a fiat money central bank of issue ever run out of money?
Well, as I explained in some detail in this post, the Fed does indeed remit some of its earnings on its large portfolio—traditionally mostly comprising US treasuries, but now also including over $1 trillion in mortgage-backed securities and mortgage-linked agency debt—to the US Treasury. Prior to the financial crisis these sums were small and insignificant, as the Fed used the vast bulk of these earnings to fund its own operations. With the explosion in the Fed’s balance sheet starting in October 2008, however, the Fed has been remitting much larger and growing sums to the government—a record $89 billion last year. Yes, interest rates are at historic lows, but when you hold $2.7 trillion in government and mortgage-backed bonds, you can’t help but rake in some serious payments. The Fed only managed to spend about $4 billion of it on its own operating expenses, hence the huge remittance to the government.
Again, the main thing I’d like to point out here is that this is essentially laundered money. After all, what would you call it if you had this creepy uncle—let’s call him Sam—who finances an increasingly expensive and destructive drug habit by borrowing money from a loan shark—let’s call him Ben. And where does Ben get the money he loans to Sam? Easy—he prints it up! But here’s the real kicker: after Sam makes the regular interest and principal payments on his loans from Ben (and he gets much of this money by borrowing afresh, mind you), Ben holds back about 8% of it to cover his own expenses and then (wink wink, nudge nudge) hands the rest right back to Sam! Call me old fashioned, but that seems like a counterfeiting scheme to me.
At any rate, the CBO report cited above raised an interesting question: Can a central bank actually lose money? Well sure, I suppose in theory a central bank could go broke—it’s a bank, after all. But why would it, when it can print money? It prints money for the sake of bailing out failing commercial banks. Why wouldn’t it bail itself out should the need arise? And if the CBO is right, the need will arise when (not if) interest rates on US government bonds go up (and given the current state of interest rates, that’s the only way they can go). As you no doubt learned in Finance 101, when interest rates go up, bond prices go down; bonds are the main assets of the Fed, so that means the Fed’s net worth goes down, exposing it to a situation in which its assets are worth less than its liabilities + equity, otherwise known as insolvency. But the unique thing about a fiat money central bank is that its liabilities are simply the paper money it prints, or its electronic equivalent. These are only “liabilities” in a bookkeeping sense—they don’t represent a real claim on the Fed’s assets, like the liabilities of any real business or individual. It’s simply not the case that the Fed actually has to pay out its liabilities in any meaningful sense.
Yes, the Fed does maintain proper double-entry accounting. So it is technically correct that if its bond if its bond portfolio lost, say, $100 billion in value, it would have to write down its equity by $100 billion. The total paid-in capital of the 12 regional Fed banks is $27 billion. So losing $100 billion would make the Fed technically insolvent to the tune of -$73 billion. But note that Federal Reserve stock is held by member commercial banks throughout the US, and that these banks cannot sell it. Instead, they will take a hit in the form of (possibly) a loss of dividends from the Fed, but this loss will be slight. Federal Reserve stock is a small fraction of their individual portfolios. What does it mean for the Fed? Whereas any other business would immediately lose all funding and go into liquidation with this kind of insolvency event, not so with the Fed. The Fed, remember, can print money. Technical insolvency—in the accounting sense—need not hinder its operations one bit. It can (and will) keep on printin’ the night away in order to continue manipulating borrowing costs for its most significant clients—the US Treasury and the big commercial banks. The mechanisms that would drive any other business into bankruptcy, liquidation, receivership, and such, simply aren’t operable when it comes to a mighty central bank of issue.
Technical insolvency might, however, be a major embarrassment to the Fed by exposing the sham of fiat money central banking. (Robert Murphy noted this in his excellent piece on the topic). My guess is that, if the Fed senses a portfolio loss in the air, it will do what paper money issuing central banks always do in times of crisis: issue more paper money. Insolvency need not hinder day-to-day monetary operations of the Fed at all, but to avoid the shame of technical insolvency, it can simply step up its bond purchases to keep interest rates down—and hence bond prices high—to forestall the portfolio losses. I’m guessing it would also find a way, should the need arise, to simply print up money to pay the member banks’ dividends and thus keep them quiet.
But how long can this go on? Well, as we sound money wingnuts have been repeatedly warning, if you issue enough money at some point you will begin to see some real, good old-fashioned inflation. But of course, this only puts greater upward pressure on interest rates—hence downward pressure on the Fed’s portfolio value. It will end badly at some point. Technical insolvency or not, the current course of the Fed is setting us up for a wave of monetary destruction the likes of which have not been seen in generations. The CBO report should be taken as one more small voice of a growing chorus of warning. It will be quite interesting indeed to see how this all unwinds, whether by 2018 (in the probably over-optimistic view of the CBO) or before. Now pardon me while I go buy some gold…
Tyler Watts is an assistant professor of economics at Ball State University.