What is the Fed doing?

Trying to keep track of all the shenanigans innovation going on at the Federal Reserve is difficult.  Econbrowser and Interfluidity among others have been trying to help…  but every time I read about how our money system works, I find my head spinning in incredulity.  And that’s just when I’m reading about how it’s “supposed” to work.  It’s been getting more confusing lately.

So far as I can tell, what’s happening is a massive transferrance of all things toxic and broken within the financial system to the Fed’s balance sheet.  Do you have something illiquid and unsaleable (MBS, corporate paper, etc)?  Give it here and we’ll swap it out for treasuries or cash.  Don’t want to lend out your own money because you don’t trust anyone to pay it back? Just put your reserves on deposit at the Fed and we’ll do the lending for you.  Nominally, this doesn’t amount to money creation, because as per the Fed’s normal operations, when they buy a financial asset with newly created money, that asset (which has historically almost always been some kind of US Treasury issued security) vanishes – or at least, it ceases to be a financial drain on the Treasury, because the Fed re-patriates all the interest payments that the Treasury has to make.  But with the Fed redistributing most of its Treasuries to make room for other more exotic fare, the Treasury is once again required to pay that interest, to whomever ends up with the securities.  At the same time, while on paper the Fed isn’t creating additional money by buying up all this crap that nobody else wants, if when it eventually turns out that all of those exotic illiquid securities are actually worth a lot less than the cash that was created to replace them in the financial system, we will have made permanent the apparent (and spurious) growth in the money supply implied by the bubble in housing and other asset values.  Instead of allowing the dollar values of those assets to drop, punishing those who speculated unwisely, we will be allowing the asset value of the dollar to drop, distributing the loss over all holders of our currency, foreign and domestic.

The loss has to be taken by somebody, but how do we do it?  Can we manage our own orderly bankruptcy, or will it be a catastrophic collapse?  Is it a small enough loss, in the grand context of all economic value we have, that socializing it isn’t such a catastrophe?  If that’s true, then why can’t we just let the speculators take the loss?  Can the Fed really take on all of the questionable assets, and then wipe the slate clean by fiat?  Would foreign holders of our national debt stand for that?  What would “not standing for that” actually mean?  And what effect does this transfer of risk have on the otherwise reasonably secure assets which have the misfortune to be denominated in dollars, in the lead up to the Big Wipe?  If something similar is happening in all major currencies, what happens?  At that point, I guess it just becomes a big wealth redistribution, from those who were prudent, to those who speculated, instead of a transfer between different currency domains.  But if you, as a central banker in whereverstan, can see that this is coming, don’t you have a large incentive (if you’re able) to avoid participating in the Big Wipe, and allowing your own currency to appreciate, relative to those involved in the redistribution?  Or is that a catastrophe for your economy, because it means nobody can buy the things you make?  Who out there would have both the ability and the incentive to avoid participating in a global currency revaluation?

It seems like the freak-out signal will be a loss in confidence in US/Euro debt securities.  When the flight to quality means something other than buying 0% interest bonds.  Gold?  And speaking of 0% interest bonds, how can we arrange to fund all these infrastructure investments we’re supposedly about to make with 0% loans?  Right now rates are spectacularly low on short term government debt, but it sounds like the Fed wants to engineer a shift in low interest rates out into the longer term bonds.  Can it do this by buying up Treasury bonds with new money?  If it does, that would boost the value of all the existing long-term debt that’s being held by China and Saudi Arabia and friends.

Bizarre.  It’s all bizarre.  I’m glad my science and technology education is indexed to inflation.

5 thoughts on “What is the Fed doing?”

  1. Great questions, Zane. I'll trade you beer for some of the information and knowledge you've obtained; I feel pretty clueless about the details of our money system. Ron Paul has a bill in Congress that would eliminate the Federal Reserve within one year of passage (you probably know about that). Do you think it would help?

    I think the big-picture cause of the mess you describe is pretty simple: people trying to make money without producing anything. Rand would call that immoral and call the individuals looters. Whatever you think about her philosophy, she is very insightful about human nature. If you read Atlas Shrugged, you will forever see events (whether personal or global) in a new light.

    1. The great irony with respect to Rand in all this, is that by-and-large it's her sacred self-interested actors that have set up the initial instability (which the Fed seems intent on amplifying). They've been able to get away with it because of lax oversight, and a lack of transparency in the financial markets. Voluntary opacity. Self-regulation. They are immoral, or at least, amoral, and we should acknowledge that in any effort to guide their actions.I think financial markets are inherently unstable – that is, they tend toward speculative booms, and pessimistic busts – which are pretty disruptive to society. I think there is a role for government (*gasp*) in damping the boom-bust cycle, but that it has to do with ensuring transparency, and setting ground rules (that is, what's legal, and what's not, based on the mores of society), and not the creation and destruction of money. Allowing financial interests to participate in the setting of those ground rules opens up the system to manipulation, to political lobbying for the purpose of business advantage, which actually has very little to do with legitimate business in any sense Rand (or any other self-respecting free marketeer) would recognize.I think money ought to behave a lot more like a physical quantity than a political football. Allowing its manipulation by a political entity will inevitably lead to abuse of the power. If everyone knows it cannot be created or destroyed, and that its supply is a fundamental constant of the economy, economic behavior will be very different than in a fiat currency environment. I don't think it's a coincidence that multiple ancient societies decided, after centuries of experimentation, to ban usury (the charging of interest). Our economy has evolved under the assumption that perpetual growth was both possible, and desirable. We haven't often asked what it was exactly that was growing, or been forced to consider whether, perhaps, there was something else shrinking to take up the slack. Perpetual exponential growth in material consumption is obviously not possible, and as long as that's the basis of economic growth, we're ultimately screwed. Exponential growth in “informational” wealth – knowledge, technology, information, skill, etc – on the other hand, can continue for a very, very long time, and if we want anything resembling perpetual economic growth, that will eventually have to become the basis of our economy, in the same way that it has been the basis for the growth in complexity and pervasiveness of biological systems for eons.Destroying the Fed? Sure. But I doubt whether we can really do that in isolation. As in so many things, we are now deeply entangled with the rest of the world. I think that's good ultimately. Good but complex. And eschewing the Fed alone, while still pursuing continuous exponential growth in material consumption won't do any good in the long run. But economically we aren't even capable of thinking about the long run! At a 10% discount rate, nothing is worth much for very long.

    2. The great irony with respect to Rand in all this, is that by-and-large it's her sacred self-interested actors that have set up the initial instability (which the Fed seems intent on amplifying). They've been able to get away with it because of lax oversight, and a lack of transparency in the financial markets. Voluntary opacity. Self-regulation. They are immoral, or at least, amoral, and we should acknowledge that in any effort to guide their actions.

      I think financial markets are inherently unstable – that is, they tend toward speculative booms, and pessimistic busts – which are pretty disruptive to society. I think there is a role for government (*gasp*) in damping the boom-bust cycle, but that it has to do with ensuring transparency, and setting ground rules (that is, what's legal, and what's not, based on the mores of society), and not the creation and destruction of money. Allowing financial interests to participate in the setting of those ground rules opens up the system to manipulation, to political lobbying for the purpose of business advantage, which actually has very little to do with legitimate business in any sense Rand (or any other self-respecting free marketeer) would recognize.

      I think money ought to behave a lot more like a physical quantity than a political football. Allowing its manipulation by a political entity will inevitably lead to abuse of the power. If everyone knows it cannot be created or destroyed, and that its supply is a fundamental constant of the economy, economic behavior will be very different than in a fiat currency environment. I don't think it's a coincidence that multiple ancient societies decided, after centuries of experimentation, to ban usury (the charging of interest). Our economy has evolved under the assumption that perpetual growth was both possible, and desirable. We haven't often asked what it was exactly that was growing, or been forced to consider whether, perhaps, there was something else shrinking to take up the slack. Perpetual exponential growth in material consumption is obviously not possible, and as long as that's the basis of economic growth, we're ultimately screwed. Exponential growth in "informational" wealth – knowledge, technology, information, skill, etc – on the other hand, can continue for a very, very long time, and if we want anything resembling perpetual economic growth, that will eventually have to become the basis of our economy, in the same way that it has been the basis for the growth in complexity and pervasiveness of biological systems for eons.

      Destroying the Fed? Sure. But I doubt whether we can really do that in isolation. As in so many things, we are now deeply entangled with the rest of the world. I think that's good ultimately. Good but complex. And eschewing the Fed alone, while still pursuing continuous exponential growth in material consumption won't do any good in the long run. But economically we aren't even capable of thinking about the long run! At a 10% discount rate, nothing is worth much for very long.

    3. I agree that some regulation of markets is necessary to ensure transparency and set ground rules, and I think the overall purpose of that regulation should be protect individuals and prevent abuse of the system (the same goal, really).

      There is no irony with respect to Rand here. Her "self-interested actors" condemn the kind of actions that have made the market unstable. They glorify productivity through application of the mind and count as looters those who attempt to profit from dishonesty, political influence, manipulation of the market, etc. I don't think you understand what Rand means by self-interested.

      1. Okay, I'm being a little bit facetious about the self interested actors. The problem is that there's no shortage of simply greedy people, who are happy to take advantage of the system (whatever system) unscrupulously, and corporations are constricted as legal entities so as to be incapable of distinguishing between honest and dishonest profits. If we provide the opportunity to make dishonest (unproductive) profits, they will be made. Additionally, no corporation really wants to participate in a truly competitive market, because the margins are (by definition) close to zero. Any market actor that has the means and opportunity to create an uncompetitive market in which they enjoy aprivilegedposition, whether it be through subsidy, disproportionately favorable regulation, price fixing, or other monopolistic behavior, will do so.So the onus is on us, through our participation in the markets (as investors and consumers), but also in our roles as citizens via the government, to create an environment that is conducive to diverse competition, and discouraging to the looters. We're failing in these aims on multiple levels. Corporate governance is lousy (read Warren Buffet's shareholder letters for more on that). We don't demand transparency in markets either as investors or consumers. We allow corporations to influence the political and regulatory environment.I don't know why anyone is surprised things are a mess.

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