Profiting from the World's Economic Crisis

The official duties of the Federal Reserve (as described by its own document www.federalreserve.gov/pf/pdf/pf_1.pdf ) fall into four general areas:

1. Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.

2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.

3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.

4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

We watch the Federal Reserve’s influence on the markets primarily through its setting of the short-term overnight interest rate on money loaned between banks. This Fed funds rate becomes an indicator for setting many other rates. The rate is set by operations in the open market through its Federal Open Market Committee (FOMC). The committee meets about every six weeks to decide whether to raise or lower this key interest rate, and with much fanfare, the FMOC publicizes its current target.

The actual rate can be different from the target, but the Federal Reserve will intervene to drive the rate higher or lower to achieve its announced target. A decade ago, the Federal Reserve didn’t even announce what its target was, hiding behind the screen so that market participants would have to assess from the Federal Reserve actions what the Fed’s policy target rate was. We now sit at the unusual situation of the Federal Reserve having lowered its interest rate to an official range of between 0 percent and a quarter of a percent, with the idea that low rates should help stimulate the economy, allow for loans to be provided at relatively low rates so that businesses and consumers will borrow to spend, and generally expand economic growth. The rate has never been lower.

The United States banking system has been called a Fractional Reserve System because the regular commercial banks (which create our personal checking accounts and give us mortgages for our houses) are required to keep only a fraction of their deposits on reserve at the Federal Reserve to back up their deposits. The rest they can loan out to make profits.

In the original design of the system, the fraction of deposits required to be placed with the Federal Reserve—called the reserve requirement—was an important policy tool to expand and contract the ability of banks to make new loans and thereby multiply the amount of credit and deposits throughout the system. The reserve requirement percentage has been decreased, and the kind of funds against which reserves are required then also decreased, so that currently we are in a situation where there is in effect almost no requirement for banks to have reserves at the Fed. Although the requirement structurally exists, the dollar amounts are so small as to have little effect on the operations of banks. Basically, commercial banks run into other limitations (such as their capital adequacy) before they are limited as to how much they can loan out. Consequently, since this policy tool is no longer effective it is rarely discussed.

The legal structure of the Federal Reserve is often debated as to whether it is a private entity with independence from the federal government or if it is really a branch of the financial operations of the federal government. There are 12 branches of the Federal Reserve Bank scattered across the regions of the country, and the board of governors operates out of Washington, DC.

Key leaders and presidents are appointed by the President and confirmed by Congress. Legally, the Federal Reserve exists as an independent corporation whose shares are owned by commercial banks which are members of the Federal Reserve System. Mainly, that means there are shares held by the large banks of the country. These shares pay a modest dividend, but in comparison to other flows, the influence of the shareholders is nonexistent.

While the legal structure exists for independence, the reality is that the Federal Reserve is very much at the center of the policymaking activities of the federal government by coordination with the Treasury. There should be no mistake that the Federal Reserve is not an independent entity. It is a branch of the policymaking and implementation aspects of our financial system as directed in coordination with the federal government.

Their other main constituents are the commercial banks of the United States, which they are charged with supporting and regulating. The investment banks (which deal with issuing corporate shares) were not directly regulated by the Federal Reserve, but in the financial crisis of 2008-09 almost all investment banks of any size converted themselves into bank holding companies. That structure allows investment banking and commercial banking to coexist under the same corporate structure, so that there are virtually no important investment banks that are beyond the reach of Federal Reserve regulation. The investment banks converted to give them access to the rescue funds available to banks regulated by the Fed.

The important point of this discussion of bank regulation is to notice that the Federal Reserve acts to support the banking system in its primary role as the banker’s bank, to ensure the strength and viability of all banks in the United States. So the Fed has a separate loyalty to the banks.

Figure 4.1 shows the incredible growth of toxic waste that has been piled into the assets of the Federal Reserve, doubling its entire balance sheet in the process.

As you can see, in the first year of this crisis, the Federal Reserve bought up many strange forms of cats and dogs, and they paid for the mangy creatures by selling off their much more stable T-bills, T-bonds, and T-notes. Put simply, in the first round of this crisis (in 2007), the Fed sold off the family jewels to fund the early bailouts, rather than printing up money, thereby keeping inflation in check.

But by the second round (in 2008)—where the total of the graph in Figure 4.1 spikes much higher, from $1 trillion to $2 trillion—the Federal Reserve threw all caution to the wind and began printing money in earnest. Nothing like this has ever been done before in the entire history of the Federal Reserve. The Fed did it with many different kinds of newly invented programs:

• The Fed bought toxic-waste assets from the banks.

• It accepted as collateral toxic waste against loans to the banks.

• It intervened in specific markets, such as the commercial paper and money market funds.

The Fed has certainly benefited participants in the specific markets where it has poured money into the system. But it has done this at great risk to the dollar, because it has created money that will flow through the banking system in an inflationary way when the economy recovers.

To evaluate the effects of the various programs, I have combined them into categories. Figure 4.1 shows the five steps the Federal Reserve took; here’s what each step illustrates:

1. The Fed delayed major introduction of programs as it worked out how serious the situation had become and what its legal authorities were. The first step was to provide significant direct funding to particular financial institutions, and to fund that by selling off its holdings of government Treasuries. The total money supply was not changed, so inflationary forces were modest.

2. By the second half of 2008, after the collapse of Lehman Brothers in August, the Federal Reserve became aggressive in bailing out financial institutions. The big jump in the assets occurred at this time.

3. At the same time, new liquidity was provided to specific markets that had pretty much shut down, as lenders became fearful of getting their money back. Normally, such a big increase in money would be inflationary, but banks have not been making new loans, so the effects are small so far.

4. As panic receded, the Federal Reserve was able to pull back much of its lending to financial institutions, and it used those proceeds to develop two new programs to purchase mortgage-backed securities and Federal Agency debt, with the clear objective of supporting the housing market and indirectly the banking institutions involved in mortgage operations. Interest rates for mortgages have come down. The purchases are huge, with a promised program of $1.25 trillion for mortgage-backed securities (MBSs) and $200 billion for Agency debt.

5. The Federal Reserve also embarked on a program to buy $300 billion of federal government Treasuries. From one view, this is simply restoring some of the previously sold-off Treasuries on the Fed’s balance sheet. From another view, it’s dangerous for the Federal Reserve to buy up federal government debt because it is this very process that nets out to printing money for the federal government to spend through its deficits, and it is a signal for eventual inflation.

So the Federal Reserve came to the rescue somewhat belatedly but with programs that can potentially be damaging to the dollar. The problem is that the Federal Reserve now has all kinds of questionable assets on its books that could be very difficult to sell if it were to try to exit its big easing programs. The Federal Reserve has been secretive, defying lawsuits and opposing even basic government auditing. It won’t explain the details of who obtained what support and the actual value of the assets on its books. Foreigners are asking questions, and the most likely interpretation is that if the Federal Reserve can act so precipitously, then the long-term purchasing power of the dollar is very much in question. This kind of monetary expansion has almost always led to significant price inflation in the following periods.

Historically, the Federal Reserve’s main purpose was to issue paper dollar currency. That’s what the bottom chunk in Figure 4.2 identifies. As you can see, currency has grown only modestly in the whole time of this graph of 2007-2009. The only important liability that the Fed had on its balance sheet until mid-2008 was the currency. All that changed as the credit crisis became a panic.

What is clearly far from normal is that the Federal Reserve has invented deposits out of thin air to buy up all those toxic assets from the banks. The Federal Reserve invents a deposit at the Federal Reserve in the name of the institution from which it buys Treasuries, MBS (or toxic assets). It then winds up with the assets, and the institution now has an account to spend as it wishes. That provides banks and other financial institutions with a lot of cash to keep on deposit at the Federal Reserve. Normally, such deposits would be drawn down and invested in other loans that would pay interest. Until 2009, no interest was paid on the deposits at the Federal Reserve. But now, with the Federal Reserve paying interest, the banks have not drawn down these excess reserves, and they are still sitting at the Federal Reserve.

The monetary base is defined as currency in circulation plus the reserves at the Fed. The total is what the Fed is supposed to be able to control. The longer-term picture, shown in Figure 4.3, shows how unprecedented the current expansion has become.

If banks acted in a manner consistent with history, they would loan those deposits, helping to expand business and otherwise generate economic activity. But in the current unprecedented situation, the banks are not interested in taking on new risks, and many traditional customers find they are already overleveraged and don’t want to take on additional borrowing. In short, despite having plenty of deposits, banks don’t want to lend, and borrowers don’t want to borrow; so new lending has pretty much dried up. There was the big jump in deposits in mid-2008, and there is a worrisome increase just starting again at the end of 2009.

As a consequence, these huge balances owned by the banks just sit on deposit at the Federal Reserve. That’s important, because it has helped keep the inflationary pressure from the Federal Reserve’s actions in check. That would not have been the case had the banks withdrawn the deposits from the Fed to make new loans, thereby multiplying the lending and borrowing throughout the banking system.

The more inclusive measures of our money supply include deposits at banks, and they have not grown in the dramatic way that the monetary base has grown. Figure 4.4 shows increases in the monetary measures, but nothing like the extreme rate of the monetary base. So at this juncture, we are not seeing the downstream effects of large inflationary pressure.

What might get the banks lending again? Logically, the appearance of tangible green shoots, but not the overhyped green dye that is being sprayed over the dead roots that abound in today’s economy. But it’s also entirely plausible that an activist administration and Congress will decide to forcefully encourage the banks to lend, either through dictate or by unleashing a new wave of loan guarantees that offer the banks all the upside, with little or no downside, if the loans go bad.

An important measure of whether the Fed’s bailouts are working is to monitor whether banks are expanding their lending. It’s important because it’s the basis of the administration’s goal to “get capital markets working again.” Figure 4.5 shows how banks are trying to reinflate the bubble, but it’s not working; the banks are still not making new loans.

My conclusion is that we are not out of the woods. I do not agree with Ben Bernanke’s assessment that things may be getting better.

The top of Figure 4.6 shows the simplest view: If the Fed prints up more money, which then chases the same quantity of goods, then the prices of the goods will rise, creating inflation. This is the simple description that has been attributed to Bernanke for getting the economy going and making sure prices don’t fall. Bernanke is famous for repeating Milton Friedman’s suggestion that the Fed could drop money from helicopters to ensure that there was enough money so that prices wouldn’t fall. The first line in Figure 4.6 describes that process in an overly simple fashion.

But it is really much more complicated than just having the Fed print up some dollars. Whether we have money in a checking account or paper dollars in our hand, we think of both of them as money. The decision to have paper dollars is a convenience for consumers and businesses. If a lot of people want to have extra dollars in their pocket around Christmas, they can go to their banks and exchange their check for paper dollars. The Federal Reserve makes sure that the banks can drive up their Brink’s truck to exchange their demand deposits that were just described for paper dollars.

The official name for our paper dollars is Federal Reserve Notes. Exchanging paper for checking account money doesn’t affect the consumer’s ability to spend, so the measure of money supply that is most commonly used is the sum of paper money and demand deposits at banks. That is often called “narrow money supply,” and the Fed reports it every week with the name “M1.”

The creation of demand deposits, however, is extremely important because there are more of them than paper dollars. The simplest way to create them is for a person to deposit Federal Reserve Notes into their checking account.

A multiplication of the money is included in the second model of the money creation system, shown in the middle of Figure 4.6.

Any GSE- or ABS-issuing entity can participate in facilitating credit, where they take in money to be loaned out. They are sometimes called “non-bank banks,” because they are not regulated like banks, but they borrow and lend like banks except they don’t take deposits. Thus, the amount of credit that can be created is larger than what is measured by the deposits of traditional banks and is reported by the Fed as M1 and M2. These non-bank institutions have no reserve requirement and have no Federal Deposit Insurance.

As an example of a newer kind of money, Figure 4.7 shows how rapidly money market funds have grown. They were invented in the 1970s as a way to provide higher interest rates than the regular banking system was allowed to pay on checking accounts. Now, our brokers offer them to us so easily that we don’t think about what category of money they represent. Figure 4.7 shows that institutional money funds and retail money funds added together are $3.5 trillion. The traditional narrow measure of money, M1, which is a combination of currency, normal demand deposits (checking accounts) and a few smaller items like traveler’s checks, is only half as much at $1.7 trillion.

I think the less-well-informed also skip over the complexity of our physical paper money. How much paper money in our pockets gets printed is just the decision of all of us as to whether we want cash in dollar bills or in our checking account. The physical printing to meet that preference is different from the Fed and commercial banks inventing deposits out of thin air. M1 adds together demand deposits of $440 billion and paper Federal Reserve Notes of $859 billion, and a few cats and dogs like travelers checks, for a total of $1,655 billion. The effect on the system’s ability to expand through multiplying deposits is different for paper cash, as it can’t be loaned and reloaned.

The next complexity is that there are plenty of sources of immediately available transactions accounts that are not formal checking accounts. One way that developed was the ability of banks to “sweep” demand deposits into savings accounts overnight. Because the reserve requirement on savings accounts is zero, the banks were able to avoid leaving cash on deposit at the Fed earning no interest. These made the measure M1 understate the amount of money available for transactions. The newer measure, called Money of Zero Maturity (MZM), at $9,550 billion, attempts to count up the funds that can immediately be used to buy things (as opposed to savings accounts, which have a term). MZM is much bigger than M1. (And bigger than M2.) It is calculated by starting with the M2, adding institutional money funds, and subtracting small denominated-time deposits. It gets more complicated as you peel back the covers of the definitions of money because there is no good definition that is clear.

And that problem is based on the fact that there is no redeemable value for any of the measures for money, except the confidence that others will trade real things for the money. At root, the whole scheme is a CONfidence game, or at least based on the confidence that the dollars will continue to buy things. That arose out of historical convention from when dollars were convertible to gold before 1971. Now dollars are not convertible to anything officially, but of course they are convertible to everything at whatever the conventional mass psychology of the value of money says they are worth. The Fed, as part of the government, can create money for itself and the government to spend, and the banks can loan money that they create to collect interest and make gains. The commercial banking system creates far more of the money in the form of newly invented deposits for loans than does the Fed. So there is plenty of reason for the owners of this system to keep it going. If they overuse the creation, they create bubbles and diminish the purchasing power of the money they are creating. So there is some limit on their dilution of the money pool. But since they get the first use and all the benefit, the incentives are to continue to create more money while talking of being “vigilant” and having an “exit strategy” to keep the image of money having value from being damaged at its source. I think it is all a sham, and when the majority of holders realize that the emperor hasn’t any clothes, there will be a run on the confidence in this dollar fiat system. As to when, I keep thinking it will happen in my lifetime, but really I am amazed at the asset deflation that occurred in 2009.

It is a great business. They start with a million dollars and can immediately make loans of $10 million and collect interest on all those loans. As long as they pick borrowers who pay back the loans, they quickly get rich. The Fed is supposed to watch over this reserve requirement to keep credit in line. But the Federal Reserve changes that decreased the requirement to have reserves on deposit have become so small that there really is no control on the banks. Reserve requirements used to be 40 percent, but now through various regulations the official requirement of 10 percent overstates the actual requirement. Banks are free to expand credit greatly and have done so. Figure 4.8 shows how small reserves really were up until the big bailout, at a trivial $10 billion.

Since 1990, required reserves have fallen even while banking and deposits have grown. The Fed eliminated the reserve requirement on large time deposits in 1990 and lowered the requirement on transaction accounts in 1992. A more important source of the decline in required reserves came from the invention of sweep accounts. Funds in bank customers’ retail checking accounts are swept overnight into savings accounts that are exempt from reserve requirements and then put back into customers’ checking accounts the next day. This explains the relatively small size of total demand deposits and the related decline in reserve requirements.

The current credit crisis is not driven by banks’ inability to meet reserve requirements. The Federal Reserve has done its job to make sure that the requirements are not limiting their ability to make new loans. Because banks are not up against the reserve requirement limit, adding more liquidity does not multiply through the banking system in additional loans. The banks have other problems that are limiting their expansion of credit.

The problem for the banks is that their losses have wiped out their equity so that the banks are close to insolvency. They made bad loans, profits were lost, and many banks will be forced to close. It was claimed by Paulson that the big banks were so important to the country that we must use trillions of dollars to bail them out or the rest of the economy would grind to a halt. I personally don’t believe that. I think Paulson scared Congress and took the money from the taxpayers to bail out the corrupt bankers.

Bank lending is constrained by the capital adequacy requirement more than the reserve requirement. The Bank for International Settlements (BIS) sets this requirement for all the banks of the world, and countries apply the requirement as they can. The capital requirement is more complicated than the reserve requirement, but it explains why banks, which can create money, are going bankrupt. A bank’s capital is its assets minus its liabilities. Assets are “risk-weighted,” with some being considered riskier than others. The capital adequacy rule requires that the ratio of a bank’s capital to its assets with a risk-weighting of 1 be at least 8 percent. In other words, the bank must have $8 in capital for every $100 in ordinary loans. Federal bonds have a risk-weighting of zero; mortgage loans have a risk weighting of .5.

If loans have to be written down, a bank may suddenly find that its assets are insufficient to support its liabilities. That makes it insolvent and unable to make new loans.

Credit default swaps (CDSs) are sold as insurance against default. When the housing bubble burst and the insurance companies couldn’t meet their payments for default, the value of the derivatives protecting securitized mortgages became so questionable that they were unmarketable at any price. Banks counting them as assets on their books then had to mark them to effectively zero, reducing the banks’ capital below the levels called for in the Basel Accords and rendering the banks officially insolvent.

Some numbers from the Z1 report will help explain how big the financial institution’s supply of credit is. The financial sector in 2000 was borrowing $8,158 billion, and in 2008 it was $17,080 billion, which is an increase of 209 percent. GDP grew only 145 percent (from $9,952 billion to $14,441 billion).

So the reason interest rates are low is that there is a huge supply of credit from our financial institutions. That should be no surprise, considering the policy that brought us to the .25 percent overnight rate.

The problem is that this credit creation provides the money to bid up prices not just of Treasuries, but of all kinds of assets. Soaring asset prices, first in stocks in the 1990s and in houses to 2006, are the result of not only the relaxed policies of the Fed, but the expansive policies of the banks in creating lots of money (i.e., credit), which caused prices to rise and the purchasing power of our currency to decrease commensurately.

That is the situation in the lower third part of Figure 4.6 of my models of the banking system. It is like the old story of leading a horse to water but not being able to make him drink. Banks normally want to expand loans, because they make money from the interest on the loans. But in 2009, there were fewer qualified buyers at the higher standards required of borrowers, and the banks were having the problem of not enough ready cash to cover problem loans. Also the Fed now pays .25% on deposits.

They perhaps justifiably are not making loans. The result is that the massive stimulus of the Fed has gone only to bail out the bad loans and hasn’t stimulated the economy with new loans for new spending. So we experienced deflation of asset prices in the first half of 2009 in the housing market and the stock market—even in the face of the most expansive set of stimuluses ever taken by the Fed. In essence, the Fed printing-press theory isn’t working, yet.

The process is entirely different from how the Fed approached its early bailouts at the end of 2007, where it directly provided funds by selling off $200 billion of its short-term T-bills. So, in essence, it gave the market funds with one hand, as it drained it with the other. The net created only moderate new money for the system.

Looking to the future, there seems to be no way for the federal government to borrow $1.5 trillion in 2010 without great assistance from the Federal Reserve. Although the Federal Reserve has announced that it would purchase $300 billion of longer-term Treasuries, the government borrowing suggests that the Fed may purchase up to $1 trillion of Treasuries to fund the federal deficit at the ongoing rate. This amount of expansion of the Federal Reserve balance sheet could damage the dollar. Tim Geithner was laughed at in China when he said that Chinese investment in U.S. securities was safe. This kind of Fed expansion will not be ignored, and the direction is toward inflation.

As you can see in Figure 4.10, I expect a big jump in Treasury purchases by both the private domestic holders and by foreigners. This increased buying reflects the move by investors, concerned about defaults in mortgage-backed and other securities, into the “safe harbor” of government-issued paper.

In an attempt to look forward, I’ve spent a considerable amount of time developing defensible projections, which are also reflected in Figure 4.10. These projections indicate that while both foreigners and domestic investors will continue to buy Treasuries, they’ll do so at a lower level. Let’s look at each group:

• Foreigners: In the case of foreigners, the trade surplus is their source of ready cash. That is in steep decline, from about $750 billion annually down to about $500 billion now. They have fewer funds available to invest, and usually follow that source.

• Private Domestic Holders are made up of two groups: households and businesses. Households’ net worth is decimated by the economic

Figure 4.10 The Federal Reserve Will Have to Buy Treasuries to Fund the Deficit

downturn, and their incomes are hit by the recession, so they simply don’t have the economic firepower to make new investments. There could be purchases of Treasuries by the financial sector, as they are far less willing to take on risk of new loans.

• The Trust Funds will continue purchases, although at slightly lower levels now that baby boomers born after 1945 are turning 65 years old. Thus, the surplus generated by these trust funds will not be as big a piggy bank for the Treasury to pillage.

In short, these sectors will not be able to absorb the $2 trillion deficit. And that leaves only the Federal Reserve to step up and buy the excess new issues of Treasuries.

Figure 4.10 also shows that in order to cover the government deficits of close to $2 trillion, the Federal Reserve will have to buy up to $1 trillion of Treasuries a year, according to my estimates. The mechanics of how this will be achieved may be more complex than directly buying Treasuries at Treasury auctions because that raises flags to the financial community about the demise of the independence of the Fed and the destruction of the dollar. It will involve the Fed buying Treasuries from the open market in what are called Permanent Open Market Operations (POMO).

The federal government is likely to put those newly created dollars into circulation more rapidly than when the Fed gives money to the banks. The Treasury spends the money immediately on Social Security or bombers. So this government spending will be an increasingly more effective stimulant than the bank bailouts. That is because the banks have been reluctant to make new loans with their bailouts, preferring to leave money on deposit at the Fed as I discussed earlier. The point is that deficits that are monetized are more inflationary than Fed loans to banks that hoard the money.

Many economists and bond dealers are operating under the “Pushing on a String” model, predicting deflationary results like those that occurred in the Depression. In those days the tie to gold kept the Fed from pursuing the kind of money creation that they have already done. For comparison, Roosevelt’s New Deal spending was not nearly as big as the current bailouts, not by a big margin even after correcting for the difference in purchasing power of the dollar.

Who will buy all the debt being issued to fund the government’s massive spending? The government itself (the Fed), through an equally massive amount of money creation. That will be inflationary.

Stimulus	Total Program Promise	To Q3 2009 Commitment/Loss
Federal Reserve Total	$ 7,766	$1,679
FDIC Total	$ 2,039	$ 358
Treasury Total	$ 2,694	$1,834
HUD Total	$ 300	$ 300
Total (Billions)	$12,798	$4,170

Losses	Potential Losses	Losses Q3 2009
Stocks	−$ 6,000	−$ 4,000
Houses	−$ 8,000	−$ 6,000
Commercial RE	−$ 3,000	−$ 1,500
Loan loss	−$ 1,800	−$ 1,000
Total Losses	−$18,800	−$12,500

What Is the Fed? A Private Profiteer or a Government Agency?

Who Benefits from the Fed?

How Is the Fed Affecting Our Investment Horizon?

The Fed Is Out of Control

How Did the Fed Pay for Its Big Expansion?

Money Creation at the Fed: Is There Any More to It Than Dropping Money from Helicopters?

How the Fed Really Creates Money

Banks Create More Money than the Federal Reserve

There’s More Money Created by Non-Banks

How Effective Is the Reserve Requirement at Controlling Money?

So Why Are We Seeing Deflation in Stocks and Houses Now?

Foreigners Are Partners in Our Credit Supply

The Government Is Supporting the Economy Rather Than the Dollar

Federal Reserve’s New Inflation Policy

Who Will Buy All the Treasuries?

When Might Deflation Turn to Inflation?

Political Implications of Egregious Fed Spending

The Fed May Be Acting Beyond Its Intended Authority

Conclusion