Tag Archive for: FederalReserveQE

A Frightening Solution to the Debt Ceiling Crunch

Estimated Reading Time: 7 minutes

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

This article was published by Law and Liberty and is reproduced with permission.

The Fed Is Bankrupt

Estimated Reading Time: 3 minutes

Federal Reserve Chair Jerome Powell recently testified before Congress on the current state of the US economy. In addition to monetary policy, Powell was questioned about the Fed’s regulatory proposals regarding cryptocurrencies and climate-related financial risks.

Barely mentioned, however, was the Fed’s balance sheet. The Fed has experienced significant operating losses over the last six months, which have exhausted its existing capital. Those losses represent foregone revenue to the US Treasury.

Operating losses
In the post-pandemic period, the Fed expanded the money supply significantly to support a swift economic recovery. It did so by purchasing vast amounts of US Treasury bonds and mortgage-backed securities. While those assets seemed like good investments at first, they are now a major hole in the Fed’s financial position.

When the bulk of the Fed’s quantitative easing (QE) programs took place in 2020 and 2021, market rates on long-term Treasury bonds fluctuated mostly in the range of 1.5 to 2.0 percent. At the time, the Fed was paying interest on bank reserves and overnight reverse repurchase (ONRRP) agreements of 0.15 or less. The Fed profited on the difference between the higher rate it received from its bond purchases minus the lower rates it paid on reserves and Overnight Reverse Repurchases (ONRRPs).

Now, the Fed has raised the interest it pays to 4.55 percent on ONRRPs and 4.65 percent on bank reserves, but the rates it earns on its QE purchases remain mostly unchanged. Assuming, as a rough approximation, that the bonds it purchased pay an average rate of 1.75 percent, and the average rate paid on bank reserves and ONRRPs is 4.6 percent, then the Fed is paying about 2.85 percent per year more than it receives on its $8 trillion dollar securities portfolio. That’s a loss of $228 billion per year!

The bankrupt central bank
The Fed is bankrupt — and I don’t just mean intellectually.

Like a private bank, the Fed maintains some level of capital as a buffer against losses. When those losses exceed the value of its capital, the Fed becomes insolvent, meaning the liabilities it owes to others are greater than the total value of the assets it holds.

The most recent data show that the Fed owes the Treasury over $41 billion, which exceeds its total capital. The Fed, by common standards, is indeed insolvent.

Deceptively deferred assets
What does the Fed do when its liabilities exceed its assets? It doesn’t go into legal bankruptcy like a private company would. Instead, it creates fictitious accounts on the assets side of its balance sheet, known as “deferred assets,” to offset its increasing liabilities.

Deferred assets represent cash inflows the Fed expects in the future that will offset funds it owes to the Treasury. As the Fed describes, “the deferred asset is the amount of net earnings the Reserve Banks will need to realize before their remittances to the US Treasury resume.” The Fed had already accrued $41 billion in deferred assets, and the amount is only getting larger.

The advantage to deferred assets is that the Fed can continue its normal operations without disruption, although considering the 40-year-high inflation, its recent performance has been less than ideal.

The disadvantage is that, at a time when the Fed is already worsening the US fiscal position by raising interest rates (and therefore interest payments on the federal debt), it is further robbing the Treasury of revenues by deferring them into the future. Those deferred payments, of course, must be shouldered by American taxpayers until the Fed’s remittances resume.

These losses may be offset by any previous gains on the Fed’s QE portfolio, but assessing the net effects of those actions is even more difficult. QE has created massive distortions in the financial system. The Fed’s interest rate tools of interest on bank reserves and ONRRPs have significantly curtailed short-term lending in the banking and financial systems.

A job for Congress?
In addition to its role in managing the money supply, the Fed is the primary regulator of most US banks. If any private bank behaved this irresponsibly, regulators, such as the Fed or Federal Deposit Insurance Corporation (FDIC), would force it to close. Bank managers would lose their jobs and incomes.

Clearly, Congress is not planning to shut down the Fed, and is unlikely to punish it for its poor performance, but there are changes that could be made. The banks that are members of the Federal Reserve System could be forced to cover the capital shortfall, as described in the Federal Reserve Act. The Fed could return to a corridor system of monetary policy, resulting in lower interest paid on bank reserves and ONRRPs relative to market rates and therefore fewer reserves held at the Fed.

Shrinking the Fed’s balance sheet would make another Fed insolvency less likely, while also reducing the Fed’s footprint and the distortions it creates in the financial system. At very least, Fed officials should better manage its operations so as not to be a drain on American taxpayers again in the future.

This article was published by The American Institute for Economic Research and is reproduced with permission.

The Price of Easy Money Now Coming Due

Estimated Reading Time: 4 minutes

The Crazy Stuff & Asset Prices that arose during Easy Money are coming unglued as Easy Money ended.

The era of money-printing and interest-rate repression in the United States, which started in 2008, gave rise to all kinds of stuff, and the easy money kept going and kept going, and all this money needed to find a place to go, and then money-printing went hog-wild in 2020 and 2021. And the stuff it gave rise to just got bigger and bigger, and crazier and crazier. And much of this stuff is now in the process of coming apart, I mean falling apart, or getting taken apart in a controlled manner, and some stuff has already imploded in a messy way.  And we’ll get to some of this stuff in a minute.

All this money-printing and interest rate repression finally gave rise to massive consumer price inflation, and now we have a real problem, the worst inflation in 40 years, and way too much money still floating around all over the place with businesses, with consumers, with state and local governments. This means that this raging inflation has lots of fuel left to burn, and the government is making it worse by handing out hundreds of billions of dollars for all kinds of stimulus spending, from the new EV incentives to $50 billion handed to the richest semiconductor makers.

And some state governments are handing out inflation checks or whatever – in California, households can get up to $1,000. And they’re all spending this money, and thereby throwing fuel on the inflation fire. We’ve already seen automakers raise the prices of their EVs to eat up the EV incentives, and there we go, more inflation.

The poor Federal Reserve has to deal with all this, and it’s out there raising interest rates far more than anyone expected a year ago, and it’s doing quantitative tightening, and it’s saying all kinds of hawkish things, but the markets are blowing it off, and they’re not taking it seriously, which means that the cold water the Fed wants to throw on financial conditions, and therefore on inflationary pressures, isn’t getting there, and it has to throw a lot more cold water on it, so higher rates for longer, and maybe for a very long time.

So now we got all the stuff that money-printing and interest-rate repression gave rise to, and this stuff must have continued money-printing and interest-rate repression to exist, but now we have soaring interest rates and the opposite of money-printing: quantitative tightening.

Perhaps the most spectacular creation of the money-printing era is crypto. It started with bitcoin in early 2009, just after the Fed’s money-printing got started. And the promoters fanned out all over the social media and everywhere and touted it as an alternative to the dollar and to fiat currency in general and to what not, and people started hyping it, and promoting it, and they’re trading it, and the price shot higher.

And then come the copycats since anyone can issue a cryptocurrency. Suddenly there were a dozen of them, and then there were 100 of them then 1,000, and suddenly 10,000 cryptos, and now there are over 22,000 cryptos, and everyone and their dog is creating them, and trading them, and lending them, and using them as collateral, and all kinds of businesses sprang up around this scheme, crypto miners, crypto exchanges, crypto lending platforms, and some of them went public via IPO or via a merger with a SPAC.

And the market capitalization of these cryptos reached $3 trillion, trillion with a T, about a year ago, and then when the Fed started raising its interest rates and started doing QT, the whole thing just blows up. Companies go like POOF, and the money is gone, and whatever is left is stuck in bankruptcy courts globally possibly for years. Cryptos themselves have imploded. Many have gone to essentially zero and have been abandoned for dead. The granddaddy, bitcoin, has plunged by something like 73% from the peak. The whole crypto market is also down about 73%.

Crypto was one of the places where liquidity from money printing went to, and now that the liquidity is being drained ever so slowly, the whole space started to collapse.

Another thing that came about during the era of money printing was an immense stock market mania, and when the money printing went hog-wild starting in March 2020, the stock market mania went hog wild with it.

We at Wolf Street tracked a bunch of these stocks, crazy IPO stocks, and stocks that went public via a merger with a SPAC over the past few years, and they shot higher and they spiked on a wing and a prayer with nothing there, companies that were losing tons of money, that didn’t have a business model, that didn’t have anything, and they were suddenly worth $10 billion or $30 billion or whatever.

It was all driven by what I call consensual hallucination and the effects of money printing and interest rate repression. Those were the fundamentals.

But then in February 2021, when inflation started to heat up, causing the Fed to brush it off, well that February 2021 was when that craziness peaked, and many of these stocks then collapsed by 70% or 80% and over 90%. We tracked over 1,000 stocks traded in the US that have imploded by 80% or more from their highs within the past couple of years…..


Continue reading this article at Wolf Street.


BOOK REVIEW: Easy Money and Hard Economic Times

Estimated Reading Time: 7 minutes

Editors’ Note: As the article below indicates, a new magisterial history of interest rates and central banking has been published. The author, Edward Chancellor wrote a previous book just before the last great financial crash called Devil Take the Hindmost, which was extremely timely if not prescient. This new book is extremely critical of current central bank policies, which have caused a serial set of financial bubbles, that have caused immense economic distortions setting us up for another crisis and putting governments themselves into a debt trap. As this book is beginning to get recognized, the shallowness of our institutions is once again revealed. The Nobel Committee has awarded the Nobel Prize in Economics to former Fed Chair Ben Bernanke, considered the architect of Quantitative Easing, at least in the West. This is roughly equivalent to presenting the Sherwin – Williams award for painting, to a house painter who painted himself into a corner all while setting the house on fire.

A brilliant book explains the causes of our economic travails and names names.

  • It is longer than a tweet, a text, a TikTok, a YouTube, or a news blurb.
  • It requires a basic understanding of finance, economics, statistics, and multi-syllable words.
  • It makes the reader feel intellectually inadequate at times, especially this reader of mediocre intelligence.
  • It is nonpartisan and criticizes both political parties as warranted.
  • It is not about race, gender, Elon Musk, Donald Trump, the Kardashians, or sports celebrities.
  • As a result, it’s not going to be a best-seller.
  • What is it?  It is the following masterpiece:

The Price of Time: The Real Story of Interest, by Edward Chancellor, Atlantic Monthly Press, 2022, 398 pages.

It’s a shame that the book won’t be a best-seller, for it explains the major causes of flat-lined productivity, of slow economic growth, of the corruption of capitalism, of income inequality, of bubbles in real estate and other assets, of the financialization of the economy, of leveraged buyouts and mergers and acquisitions that hollow out companies and stifle competition, of sky-high stock valuations for unicorn companies that have never turned a profit, and of stock buybacks that line executives’ pockets while weakening their companies.

On second thought, it’s a blessing, not a shame, that the book won’t be a best-seller. If it were widely read, it could trigger an uprising that would make the Capitol attack on January 6 look like a playground spat, for Americans would come to understand how they’ve been screwed and who did the screwing. 

The book’s title refers to the time value of money—to the fact that time is valuable, that economic and financial activities take place across time, that money has more value in the hand than in the future, and that interest is needed to induce people to forego consumption and lend their money for more productive uses.

In the author’s words:

The argument of this book is that interest is required to direct the allocation of capital, and that without interest it becomes impossible to value investments. As a reward for abstinence, interest incentivizes saving. When it comes to regulating financial markets, the existence of interest discourages bankers and investors from taking excessive risks. On the foreign exchanges, interest rates equilibrate the flow of capital between nations. Interest also influences the distribution of income and wealth. As [Frederic] Bastiat understood [in the nineteenth century], a very low rate of interest may benefit the rich, who have access to credit, more than the poor.

The author gives the history of interest going back to ancient times, including the history of usury laws and their consequences. He identifies empires and nations that stagnated or worse due to keeping interest rates too low and spending too high. He quotes thinkers of hundreds of years ago who seems to have known more about economics than the 400 PhD economists employed today by the Federal Reserve. He discusses the interrelationships between interest rates, the money supply, and inflation during the era of the trusts and robber barons of the late nineteenth century, as well as the years leading up to and following the stock market crash of 1929.

He goes on to show the economic consequences in recent times of low or even negative rates, especially when the rates are coupled with quantitative easing, the printing of money, deficit spending, a humongous and growing national debt, and the Federal Reserve’s arbitrary inflation target of two percent.  The result is “irrational exuberance,” to borrow Alan Greenspan’s words, an exuberance that inevitably leads to a downturn and often leads to high inflation, which in turn leads to the Federal Reserve removing the punch bowl through higher interest rates.

Such monetary and fiscal policies cause business cycles to be more volatile, corrections to be more protracted, and the painful but beneficial process of creative destruction to be most destructive.

Former heads of the Federal Reserve won’t be endorsing the book, especially Ben Bernanke and Janet Yellen, both of whom are excoriated by the author. That would be the same two who were praised extensively during their tenure by the business press and general media, and the latter is the same person who is the current Treasury Secretary.

In April 2016, Yellen and former heads of the Federal Reserve gathered at a meeting in New York City. She was asked during a panel discussion if the United States was a bubble economy. She adamantly replied that it was not. At that, “the oldest surviving Fed Chairman, Paul Volcker, nodded in agreement but also pulled out a handkerchief and loudly blew his nose.” As noted in a footnote in The Price of Time, when author Edward Chancellor asked Volcker afterward if he had agreed with Yellen, he replied, “No, of course, there’s a bubble. My grandchildren can’t afford to buy apartments in New York City. I just didn’t want to say so in front of the Wall Street Journal.”

Then there is this about Bernanke: In 2006, in the midst of the housing bubble and just prior to its bursting and the advent of the Great Recession and financial crisis, Bernanke told Congress that increases in home prices “largely reflect strong economic fundamentals.”

And this excerpt from the book:

“Bernanke’s Fed,” concludes historian Philip Mirowski, “has evaded suffering any consequences for its intellectual incompetence.” Instead of being hounded from office, Bernanke was credited with saving the world from another Great Depression and anointed Time magazine’s Person of the Year in 2009. His exercise in denial meant that the Fed learned little from the crisis. Besides the odd tweak, monetary policymakers saw no need to change their flawed models. If low interest rates hadn’t caused the crisis, there would be no problem in taking them even lower in the future.

The book doesn’t say this, but Bernanke was credited with saving the world from another Great Depression, because, in 2008, he had bailed out big financial companies that were deemed “too big to fail.” It was something that he had found very distasteful but felt there was no choice, given that the world’s financial/monetary system seemed to be crashing at the time. The book does say, however, that the cause of the crisis was the imploding of the subprime mortgage market, a market that had grown to frothy levels due to investors seeking higher interest rates under a monetary policy that had kept rates near zero in normal credit channels.

After the financial crisis was over, the billionaire hedge fund manager Paul Singer said that the reflation of the US economy after 2008 was based on “fake growth, fake money, fake financial stability, fake inflation numbers and fake income growth.”

Ironically, a year prior to being elected president, Donald Trump made similar comments about the economy. It was ironic, because as a property developer, his wealth depended on inflated property prices and cheap financing. Moreover, near the end of his presidency, he joined the feeding frenzy of doling out free money in response to the COVID pandemic. His contribution from the public purse was about one trillion dollars.

The government’s role in the 2008 financial crisis was lost on Congress and the public. Instead of addressing the root cause, the government did what it does best: It passed a counterproductive law—specifically, the 2010 Dodd-Frank Act, which generated thousands of pages of regulations. By contrast, the landmark Depression-era regulatory act known as Glass-Steagall totaled just 37 pages. Other countries followed suit, leading bond guru James Grant to say that governments were printing rules almost as fast as they were printing money.

The Price of Time draws parallels between today’s central bank shenanigans and the shenanigans of John Law. Law was appointed France’s finance minister in 1720, was the founder and head of the French central bank, and was the head of the Mississippi Company, a vast corporate enterprise that accounted for a large share of the French economy. But it turned out that France’s booming economy and the company’s booming financials and stock price were a chimera created by easy money. The resulting bubble and collapse were among the biggest in history. 

After the global financial crisis of 2008, Antoin Murphy, the author of a biography on Law, wrote, “What central bankers are doing now is exactly what Law recommended.” He went on to say, “Law’s banking successors have been Ben Bernanke, Janet Yellen and Mario Draghi [the head of the European Central Bank].”

The penultimate chapter of the book, Chapter 17, details how America’s easy money unleashed a “global monetary plague.” It is a sobering read.

The last chapter describes how easy money and financial repression in China have created huge financial bubbles and massive malinvestments in that nation. As in America and much of the West, such policies have favored the rich and well-connected. As a result, China has gone from being one of the most egalitarian nations to one of the least equal.

The book’s Conclusion makes the point that the more that policymakers blunder, the more the system appears to fail, which in turn justifies further interventions by policymakers. At the same time, many Americans, especially younger ones, are blaming capitalism for socioeconomic problems and embracing socialism as a better system, not realizing how capitalism has been corrupted by the Fed, the government, and the representatives they have elected to Congress.

The book’s Postscript discusses the COVID pandemic and its consequences—the increased money printing, the forming of new bubbles, the escalation in deficit spending, and the phenomenal growth in the Fed’s balance sheet. Writing the postscript before the current downturn, the author was prescient in predicting that “inflation is likely to pick up and interest rates will have to rise to contain it.”

This book review was written a month before the November elections of 2022. Once again, tellingly, the root causes detailed in the book are largely missing as campaign issues. The last member of Congress to understand the causes, to try to make them a priority, and to warn about them was Ron Paul, who was dismissed by the right and left as a kooky Cassandra.

Time to sign off. This stuff is depressing and hurts my head. I wonder what the Kardashians are doing.

A Brave New Financial World

Estimated Reading Time: 7 minutes

The nation likely will drift into a situation in which its central bank will be expanding its regulatory and safety-net coverage, vainly trying to protect everything in the interest of protecting ‘banks.’ The tremendous power it will come to wield not only will be harmful to the structure of the financial system but also will make the Fed an even more formidable foe to those inside and outside the government who believe that it is too powerful already.
 James L. Pierce, “The Federal Reserve as a Political Power,” 1990


How can the Federal Reserve help you today? A few years ago, such a question would have been rather odd. The Federal Reserve was created a little over a century ago as an independent government agency with a rather small mandate: manage the money supply. It was an important, but limited, role. In normal times, the Fed existed to ensure the money supply grew at a reasonable rate. In times of crisis, the Fed would become the Lender of Last Resort, lending funds to solvent banks to get them through a crisis. But, times have changed. The Fed, no longer tied to the mast, is here to take your order.

This new world is magnificently described in Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis. With impeccable brevity and precision, Menand details how the Fed has abandoned its historical mission, appropriating to itself a new mandate and powers of dubious legality. None of this has been done in secret. Its actions have been front page news, Congress has aided and abetted the unbinding, and as the quotation at the outset notes, it was all predictable in 1990. 

Monetary Policy before 2020

“The American Monetary Settlement” is Menand’s term for the world in which we used to live. Private commercial banks provided deposit accounts (both checking and savings) which constituted the bulk of what we used for money. The Federal Reserve System provides currency (also a form of money) and supervises the commercial banking system. The Fed also provides reserve accounts for commercial banks, which are used to transfer funds from one bank to another. By changing the volume of reserves in banks’ accounts, the Fed is able to exercise indirect control over the amount of money in the economy. The system has a remarkable simplicity, easily explained in any first-year economics class.

There have long been cracks in the money creation system. Over time, other types of accounts developed which also functioned as money, but were easily ignored when discussing the money supply. These other accounts were not provided by domestic commercial banks and thus existed in what became known as the Shadow Banking system. Menand points to three types of accounts (dealer repo accounts, Eurodollar accounts, and money market funds) which are all highly liquid and reasonably stable, and thus provide something that functions as money but pays a higher interest rate than a traditional deposit account at a commercial bank. Because none of these types of accounts are at commercial banks, the Fed has no regulatory authority over them and there are no precise measures of their size.

After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis.

The shadow banking system suddenly found itself in the sun in 2008. Once a small part of the financial infrastructure, the shadow banking accounts had grown to be about twice as large as the measured money supply. When an old-fashioned bank run hit the shadow banking industry, there was a grave danger of the entire system falling apart, which would have generated a collapse in the money supply equivalent to that which caused the Great Depression. The Bernanke Fed exercised an enormous array of powers designed to shore up the shadow banking system to prevent such a collapse. It was a moment of genuine monetary peril, and the resulting recession was much milder than it would have been had the Fed done nothing.

In the wake of previous financial crises, Congress inevitably passed a bill creating a new set of regulations to prevent the same thing from happening again. After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis. 

The 2020 Financial Crisis

The same crisis hit again in March 2020. With the arrival of Covid and the government lockdowns, the shadow banking system once again found itself reeling. This time, the Powell Fed acted promptly, using the same bag of tricks which the Bernanke Fed had stumbled into discovering. It wasn’t enough, so the Fed’s range of actions expanded. The panic ended and the shadow banking system stayed intact. But, as Menand describes in detail, the American Monetary Settlement was destroyed.

The result has been nothing short of a transformation in the Fed’s role in our society. Not only have its unprecedented actions helped once again to avert economic collapse, but they have also changed what members of Congress and members of the public expect of the country’s central bankers. Today, the Fed is no longer just managing the money supply by administering the banking system. It is fighting persistent economic and financial crises by using its balance sheet like an emergency government credit bureau or national investment authority…

In 2008, the Fed invoked an obscure provision in its charter which allowed it to become the lender of last resort to financial firms other than the commercial banking system. In 2020, when that proved to be insufficient to stem the panic, the Fed tried something new: it started directly buying massive volumes of assets in order to prop up their prices. The Chair of the Fed announced that the Fed would not “run out of ammunition”—that they had unlimited resources to buy as many assets as needed. The rhetoric suggesting financial crises are the equivalent of war is revealing; in wartime, even democratically elected governments appropriate seemingly limitless powers over the economy.

That promise opened the floodgates. With unlimited access to the printing press, there seemed to be no limit to what the Fed could do. The financial panic of March 2020 subsided, but the economic problems were only beginning. Those problems extended far beyond the financial sector, so Congress passed the CARES Act, one provision of which was to allow the Fed to lend directly to businesses, both for-profit and non-profit. Suddenly the Fed found itself with the power to lend funds to whatever firm or industry it deemed worthy.

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight.

The Fed did not stop there, however. Being the Lender of Last Resort by definition means the Fed is imposing an obligation to have the loans repaid at some point. That creates burdens on firms to whom the Fed has lent funds. To stimulate economic activity, and not incidentally to keep the interest rates low on government debt, the Fed began what commentators quickly dubbed QE Infinity. In effect, this was an open-ended commitment to keep buying as many financial assets as necessary to maintain low-interest rates.

What exactly now sets a limit on the Fed’s activity? With literally an unlimited amount of money at its disposal, and a mandate which has seemingly broadened to “do good things for the economy,” what should be its priorities? Now that the Fed has crossed the Rubicon by purchasing bonds from AT&T, Verizon, CVS, Comcast, GE, Apple, Microsoft, and so on, why not also your place of work or your favorite non-profit? Now that the Fed has lent to local municipalities, why not get free Fed money for your local school or community center? Is it any wonder that people are now seriously talking about what the Fed can do on the Climate Change agenda?

The world of the Unbound Fed is rife with peril. Menand barely scratches the surface of a world in which an unelected independent agency seemingly can create money to accomplish any goal it wants. We have entered a strange regulatory world in which it is no longer clear which rules the Fed must follow. Obviously, the Fed no longer is restrained to its traditional role of managing the money supply. What else is it now able to do, either legally or with Congress looking the other way?

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight. The now implied promise always to backstop the shadow banking system operating outside of the normal regulatory framework is a recipe for disaster. Using the money supply to finance whatever initiatives Congress wants to accomplish has already resulted in unprecedented growth in the money supply and the inevitable inflationary consequences.

Favoritism is inevitable. In the old days, the Fed avoided favoritism by lending to any commercial bank with good collateral. The only asset it purchased when it wanted to create more bank reserves was US government debt. In 2008, the Fed had to decide which parts of the shadow banking system it wanted to aid in order to prevent a collapse of the money supply (Lehman Brothers: no; AIG: yes). After 2020, the Fed no longer has to restrict itself to financial firms or concerns about the money supply. It will inevitably play favorites.

What Next?

Having laid out the reasons for, and the problem with, the Fed Unbound, Menand naturally enough turns to solutions. Alas, this is where the book founders. We should not fault Menand too much, though; it is not at all clear that there is an easy solution.

He offers two routes forward. First, he asserts the need for “a healthier macroeconomic policy mix.” It is hard to argue with that. After all, the most important reason to have an independent central bank is to prevent the legislature from having access to the printing press to fund every spending idea which comes along. Menand himself illustrates the problem. This discussion is one of the places for Menand’s periodic odd and inexplicable intrusion of his own vaguely leftist political agenda into the book. If the author of a book warning against the dangers of an unbound Fed cannot resist introducing his own legislative agenda into the argument, why should we expect members of Congress to keep their own legislative ambitions separate from a seemingly easy way to finance them?

Secondly, Menand suggests reining in the new financial world. Looking back to the world before 2008, it seems like we could return to those halcyon days gone by “enforcing the regulatory perimeter.” If the problem is types of accounts that function as money but are created outside the traditional commercial banking system, then why not either eliminate the possibility of such accounts or bring them under Fed supervision? Theoretically, that is possible. But, given that the shadow banking system is twice as large as the currently supervised banking system, this is not a small disruption to the monetary system. There is simply no way to predict the economic impact of trying to rewrite the rules on what types of accounts can be offered by what types of financial firms.

The problem with reining in the financial world is complicated by technological developments which have made it easier to create new types of accounts, using new types of assets (e.g. cryptocurrency), which may or may not end up functioning like money in limited sets of markets. No matter where you set the regulatory perimeter, there will be enormous financial incentives to set up shop right on the other side of that border.

These sorts of questions compound the longer you think about this new world of money. Unfortunately, the government does not have a good record when it comes to thinking through the monetary implications of the shadow banking industry. Will they sort this out before the next crisis, as they failed to do in 2008 and 2020? It’s hard to be optimistic, but, if you are not yet troubled by this new world, get a copy of The Fed Unbound.


This article was published by Law & Liberty and is reproduced with permission.

Fed’s QT Kicks Off: Total Assets Drop by $74 Billion from Peak, New Era Begins

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QE creates money. QT does the opposite: it destroys money.


Total assets on the Fed’s weekly balance sheet as of July 6, released this afternoon, fell by $22 billion from the prior week, and by $74 billion from the peak in April, to $8.89 trillion, the lowest since February 9, as the Fed’s quantitative tightening (QT) has kicked off. The zigzag pattern is due to the peculiar nature of Mortgage Backed Securities (MBS) that we’ll get to in a moment.

Treasury securities fell by $20 billion for the week, and by $27 billion from peak.

Run-offs: twice a month. Treasury notes and bonds mature mid-month and end of the month, which is when they come off the Fed’s balance sheet, which in June was June 15th and June 30th.

Tightening deniers. Last week’s balance sheet was as of June 29 and didn’t include the June 30th run-off. However, the army of tightening-deniers trolling the internet and social media doesn’t know that, and so a week ago, they fanned out and announced that the Fed had already ended QT, or was backtracking on it because Treasuries hadn’t dropped in two weeks, which was hilarious. Or more sinister: hedge funds manipulating markets through their minions.

Inflation compensation from TIPS adds to balance. Treasury Inflation-Protected Securities pay inflation compensation that is added to the face value of the TIPS (similar to the popular “I bonds”). So if you hold a fixed number of TIPS, their face value will rise with the amount of the inflation compensation. When they mature, you will receive the total amount of original face value plus inflation compensation.

The Fed holds $384 billion in TIPS at its original face value. It has received $92 billion of inflation compensation on those TIPS. This inflation compensation increased its holdings of TIPS to $476 billion.

Over the month of June, inflation compensation increased by $4 billion. In other words, until those TIPS mature and run off the balance sheet, the Fed’s holdings of TIPS will increase by the amount of inflation compensation – currently around $1-1.5 billion a week!

No TIPS matured in June. But next week, July 15, TIPS with an original face value of $9.6 billion-plus $2.5 billion in inflation compensation will mature, for a total of $12.1 billion, that the Fed will get paid. After that, the next maturity of TIPS on the Fed’s balance sheet is on January 15, 2023. And the TIPS balance will increase from July 15 through January 15 due to inflation compensation.

The thing to remember about the Fed’s TIPS is that the inflation compensation is added to the balance of TIPS and therefore to the balance of Treasury securities, at around $1-1.5 billion a week currently.

The balance of Treasury securities fell by $20 billion from the prior week and by $27 billion from the peak on June 8, to $5.74 trillion, the lowest since February 23:

  • Note the two run-offs on the balance sheets on June 16 and today.
  • Note the small steady increase of around $1-1.5 billion a week after QE had ended from mid-March into June, which is the inflation compensation from TIPS.

MBS fell by $31 billion from the peak.

Pass-through principal payments. Holders of MBS receive pass-through principal payments when the underlying mortgages are paid off after the home is sold or the mortgage is refinanced, and when mortgage payments are made. As a passthrough principal payment is made, the balance of the MBS shrinks by that amount. These pass-through principal payments are uneven and unpredictable.

Purchases in the TBA market and delayed settlement. During QE, and to a much lesser extent during the taper, and to a minuscule extent now, the Fed tries to keep the balance of MBS from shrinking too fast by buying MBS in the “To Be Announced” (TBA) market. But purchases in the TBA market take one to three months to settle. The Fed books its trades after they settle. So the purchases included in any balance sheet were made one to three months earlier.

This delay is why it takes months for MBS balance to reflect the Fed’s current purchases. The purchases we see show up on the balance sheet in June were made somewhere around March and April.

And these purchases are not aligned with the pass-through principal payments that the Fed receives. This misalignment creates the ups and downs of the MBS balance, that also carries through to the overall balance sheet.

In addition, MBS may also get called by the issuer (such as Fannie Mae) when the principal balance has shrunk so much that it’s not worth maintaining the MBS (the issuer then repackages the remaining underlying mortgages into new MBS).

Tightening deniers. So when the tightening-deniers – including a hedge-fund guy with a big Twitter following – trolled the internet and the social media about QT not happening because MBS balance ticked up by $1.2 billion on the June 23 balance sheet, they got tangled up in their own underwear. The following week, the MBS balance fell by $19.5 billion. That’s how MBS on the Fed’s balance sheet work. These folks just didn’t know, or more insidiously, tried to manipulate the markets…..


Continue reading this article at Wolf Street.