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.