The Fed’s Exploding Balance Sheet: What It Means and Reviving the Revolution

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The Fed’s Exploding Balance Sheet: What It Means and Reviving the Revolution

by Michael S. Rozeff
by Michael S. Rozeff


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Bernanke and Company, who are running the U.S. central bank, the Federal Reserve (Fed), have been very busy in the past year or so. The size of the bank has more than doubled since August of 2007. Their assets, mainly loans and credits they extend, have exploded from $902.4 billion to $2.17 trillion as of December 3, 2008.

The main idea behind all this lending is to prevent some large banks (and other financial institutions) from failing, shrinking, or restructuring. Behind this is the goal of maintaining the existing structure of banking and central banking. And behind that is the goal of maintaining government power and the existing political structure intact.

Preventing economic collapse and maintaining the bank lending to the public are not the central goals of those who understand these matters. These are important to the knowledgeable authorities only insofar as they support the goal of maintaining the existing power structure. There are, of course, ignorant economists who think that without government intervention, the economic and financial system cannot survive and we will all be wandering around in bearskins with spears. However, if the financial and economic system were to collapse and if the government and Fed did not interfere, a free market revival would occur with amazing rapidity. After all, the people, the labor, the land, and the capital goods are still here, not bombed out. If Tokyo, Hiroshima, Nagasaki, Berlin, and Dresden could rapidly recover after World War II, so can a freed-up U.S. economy. From this perspective, keeping the economy going is not per se what is important to those in power, because the economy will always keep itself going without these authorities and do a better job of it at that without them. What is important to them is keeping the existing economy going in that it is tied in to the existing power structure.

The alternative course of events is anathema to the Fed and the government. That course is to change the financial system at its roots and let alternative means of finance and financial intermediation arise spontaneously in a free market. That would spell the end of the Fed’s monopoly over the forced currency in the U.S. If this were to happen, every country in the entire world would have to follow suit if their economies were to survive and prosper, and that would mean a large diminution in government power and a fundamentally changed role for governments everywhere.

The public has given a vote of no confidence in many of these banks (and other firms) by shifting its assets out of loans to them and instead going into Treasury bills. The Fed is thwarting the public (and any semblance of a free market) by making the loans that the public refuses to make. The Treasury is helping the Fed do this. After selling Treasury bills to the public to meet the increased demand, it is depositing huge amounts ($440–$500 billion) at the Fed. The Fed is using that money to make the loans that the public is refusing to make.

The battle here is between the public and the government. The battle is economic for the public, but for the government the battle is political; and it does not admit defeat in these battles. The government instituted and maintained the New Deal, despite its baleful economic effects. Although the New Deal measures never resolved the Great Depression and, in fact, extended its life, there was a countervailing and far more important political consideration for the government, which was that the depression was a golden opportunity to put in place measures and gain powers and controls over the economy that it wanted to.

The kinds of loans the Fed has made as compared with a year ago include the following. The Fed has exchanged $406.5 billion of Treasury securities for troubled bank loans (called the TAF or Term Auction Facility.) It has swapped $542.5 billion for foreign currencies. The AIG loan is about $56 billion. Another $52 billion is for asset-backed commercial paper associated with money market mutual funds and $57 billion has gone to primary government bond dealers. Then there is $297.8 for commercial paper loans. The Treasury’s Troubled Asset Relief Program ($700–800 billion) or TARP for short is a separate deal.

New kinds of loans, not yet on the books, but slated to appear include the following.

On November 25, 2008 the Fed announced $200 billion in loans for student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (called TALF for Term Asset-Backed Securities Loan Facility.)

On the same date, it announced that it will lend $100 billion directly to the government’s mortgage lending companies (Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.) It will also be buying $500 million of the mortgage-backed securities that they package up from the mortgage loans that they buy from banks and other institutions who originate mortgage loans. The idea is to keep these government operations going. Without this support and the other support the Treasury already has given, they’d fail. As a reminder, the government took over some $5 trillion of debts and guarantees of these government-sponsored enterprises.

The Fed announced on November 23, 2008 that it (along with the U.S. Treasury and the FDIC) will support $306 billion of loans that Citibank holds "against the possibility of unusually large losses." The Fed announced that it "stands ready to backstop residual risk" in this $306 billion pool of bad loans through a non-recourse loan. The idea is to keep Citibank in operation and prevent its failure.

On October 7, 2008 the Fed stepped up its Term Auction Facility (TAF) from $150 billion to $900 billion.

And even more is to follow. The press reports that the Fed is considering still more "unconventional steps." The Wall Street Journal writes of efforts to bring down interest rates on mortgages, consumer loans, and Treasury bonds. In other words, the Fed is preparing to monetize debts directly, something that is clearly inflationary and that it has been trying to avoid, despite its exploding balance sheet that has hyped up bank reserves enormously and already carries a huge inflation risk. The Treasury announced that it is considering a plan to subsidize mortgage interest rates at 4.5 percent.

Every new loan is a sign that the powers-that-be will not let up in their efforts to revive the economy on their terms. In order for them to keep and hold power within this system, which is their perspective, they see no other choice. The Federal government is preparing to spend far greater sums than now, in the process expanding its deficits to unimaginable heights. The Fed seems unworried by that and/or prepared dutifully to monetize a goodly share of those debts. The public is attempting to reduce debt and save, but the government is thwarting that by planning to increase its debt. High debt is the hallmark of the political economy of a strong national government.

In 2007 and 2008, the Fed is doing what the Reichsbank did in 1931. We can understand what is happening and what is going to happen by examining the Reichsbank case.

A 1934 article by Dr. Heinrich Rittershausen, available here, describes the actions of the German Reichsbank They provide a striking parallel to the actions of the Fed. All quotes are from his article.

Unlike our Fed, which has very broad and far-reaching powers, the Reichsbank was restricted by law to discount only good commercial bills. It could not legally discount other credits, called "financial" bills.

"Contrary to these provisions, the Reichsbank, since the credit crisis of 1931, discounted financial bills to the amount of 2,000 million marks...These financial bills were accepted in order to maintain the solvency of the illiquid credit banks which had gone too far with the deposit system. In this case the Reichsbank did not grant advances on the proceeds of sales, but took over the illiquid assets of the leading banks and of the savings banks, assets which do not liquidate themselves but require continuous prolongation...In addition, the Bank granted long-term credits to the amount of 1,300 million marks to municipalities and their savings banks...Moreover, the Bank neglected everything necessary for ensuring the disappearance of the illegal and dangerous financial bill money and re-establishing legal conditions."

The Fed has far greater legal powers than the Reichsbank had to accept the troubled assets of any company or financial institution. The point here is not the legality of the matter. It is the action of both banks in taking in large amounts of long-term illiquid paper of questionable value and providing good assets and/or central bank credits in return. The Fed’s TAF ($406 billions worth and slated to rise to $900 billion) is the name for the Fed’s counterpart of what the Reichsbank did. As in 1931, there is no plan in place to wind down these assets. They require "continuous prolongation."

Rittershausen writes: "The Reichsbank, temporarily the largest mortgage bank, for lack of a sound banking system, prevents the re-employment of the workless." The Fed’s $600 billion program to support the mortgage market probably makes it into the largest mortgage banker in the U.S. The main point, again, is that the Fed is doing what the Reichsbank did.

For Fannie Mae, Freddie Mac, and other insolvent banks with mortgage loans that have fallen from a price of 100 to a price of 80 or 70 or 50 or 30, the solution spurned has been bankruptcy and re-organization of the companies. Bankruptcy brings the actual market value of these mortgages to light. It allows re-organization, which then allows the market to resuscitate. The existing uncertainties fade away. A fair solution is to allow mortgagees to repurchase their mortgage at the (reduced) market prices. That requires that they re-finance their loans from new lenders. New and free market channels of financial intermediation are precisely what are needed. The Fed and the government do not want this, and with very little prodding they induce weak banks to join their relief programs. The managements of insolvent banks prefer to remain in place. They do not want to recognize losses and go out of business. They welcome the succor of the U.S. government and the Fed. Now joined by automakers, the parade will soon lengthen to include many other firms and municipalities.

"The Reichsbank thus came to the rescue of tottering banks, and this suggested that the State was behind them. This "quasi-State guarantee" led the population, when the crisis was at its height, to withdraw their balances from the sound banks..."

The withdrawal of the population’s balances from sound banks finds its parallel today in the withdrawal of money from money market funds, certificates of deposit, commercial paper, and municipal securities. Interbank lending declines. Much of this money then seeks the safe haven of U.S. Treasury securities, whose yields then fall even as the yields on debts with default risk rise.

According to Rittershausen, the Reichsbank and the Government "aided the unsound banks with approximately 2,000 million marks in subventions and tax money. In this way they offered a masked State guarantee to the unsound banks and indirectly deprived the sound banks of their customers. They declared that ‘Germany’s’ credit was at stake; that ‘Germany’ had contracted the debts; that a ‘run on Germany’ had broken out; whilst actually only the credit of a few ill-managed banks with bank debts abroad had been shaken... Thus thousands of banks and bank branches were sacrificed to save a few who were in the good books of the State...In fact, the three unsound banks were identified with the ‘German banking system.’"

The parallel actions today are that the Fed and the Government cry "systemic risk." They feed the public with exaggerated scenarios about credit default swaps bringing down the financial system. (A rational account of credit default swaps appears here.) They cry "too big to fail," and they argue that the health of the entire American system rests upon the failure of a few favored banks and insurance companies like AIG. They completely ignore freeing up the financial system to mobilize new methods of creating money and credit.

The government has thrown about $6 trillion into the stew. The Fed has thrown over $1 trillion into it. Instead of a short and sharp recession followed by a recovery, our central bank and deficit-spending political economy is giving us a prolonged and deep depression. Business is thrown into confusion and uncertainty. Investors run for safety. The bad loans remain hidden and submerged within banks and other institutions. This paralyzes lending. The weak companies and poor managements that should be quickly cleaned out instead are given taxpayer money. With public debt rising, the interest costs of the national debt rise. Capital that should be going to healthy enterprises is diverted to government and to zombie enterprises. Inefficient enterprises are subsidized. Serious inflation looms larger and larger as a long-term problem. The capital markets become dependent on Fed loans, and it is not clear how that dependence can be ended. The government takes ownership interests in the most major banks, inducing further inefficiency in these semi-nationalized firms and threatening control of the allocation of capital. In this regard, the government policies have already fostered an undue concentration of assets in large banks. The three largest banks in the U.S. now have 38% of all large bank assets as compared with 27% in 2003. Banks with over $300 million in assets grew by 64% in the last 5 years, which is a very high per annum number, but the three largest banks grew by a still higher 130%. In short, the actions of the government and the Fed are throwing a giant monkey wrench into the operations of banks and capital markets in intermediating capital from savers to businesses. The likely result is a prolonged slowdown in economic growth and more government control over the economy.

What needs to be done? The main thing is to end the reign of forced currency such as the Fed’s. This will ensure that inflation and deflation cannot ever occur because these are both results of a forced currency. With competition in money, any issuer that issues too much currency will suffer a loss in value of the currency. That will, however, be a local matter and not affect the entire economy as a forced currency does. Without central bank–engineered inflations and deflations, the large-scale and widespread business cycles will be greatly mitigated and may even disappear, although business fluctuations and failures will no doubt still occur. If there is too little currency, competition will ensure that more will be produced. We need not worry about the supply of money anymore than we worry about the supply of corn flakes. Money supply and credit are only problems when monopoly central banks attempt to control them, for they have no known ways of measuring what they are, how much is needed, where it is needed, or who should get it. These kinds of questions are always ideally solved by free markets.

There will always be a need for standards of value in which to express prices. Let the free market decide the matter by competition. Persons have a right to try out any standard of value they wish to. It is highly likely that gold will become a medium of account (a standard of value), which would mean that media of exchange would be quoted in terms of fixed amounts of gold. For example, the "dollar" might come to be standardized at 1.5 grains of gold. (The Constitution empowers the government to set such a standard of value.) With an end to a single Fed forced currency, there can be any number of media of exchange. Any person or persons has the right to issue currency. In a free market, every person has a right to conclude contracts with any medium of exchange that is agreeable to the parties to the contract. No one should be obligated to pay in gold involuntarily. Legal tender laws that force acceptance of payment in any medium should be repealed.

The harmful policies and actions of the central banks and the government in response to recessions, such as occurred in the 1930s and are occurring now, are, in a deep sense, not "policy errors" or "policy mistakes." That language suggests that there exists a set of correct policies under the existing political structure that will resolve economic problems. That is a misleading way to think about the issue. The policies that central banks and governments choose are nearly always what these institutions do by law, under the generally-held expectation that they will alleviate economic problems. Occasionally a wise and beneficent ruler comes along who, within the system, mitigates its evil actions. Usually, the really important and fundamental policy errors lie buried elsewhere. The deepest policy errors are lodged in the public’s expectation and belief that central banks and governments can alleviate recessions and in the public’s giving these organizations the legal power to do what they do (or tolerating their power grabs). Further errors lie in listening to mistaken experts who continue to justify these counterproductive methods and laws, and in failing to learn from experience that the policies that central banks and governments use to fight recessions make them worse and turn them into deeper recessions and depressions.

Within the current political setup, central bankers would have to stop being central bankers and legislators would have to stop being legislators in order to play a constructive role in recessions. (While this can happen and sometimes does happen for short periods, it is not the equilibrium outcome.) The public would have to stop believing in the magical powers of central bankers and legislators to get economies going, using their usual nostrums of borrowing, spending, subsidizing, taxing, and printing money. The public and government officials would have to stop listening to the many economic experts who are selling Keynesianism. Subsidizing mortgage rates at 4.5 percent so that more people can go into more debt to buy homes and hold up home prices would have to be laughed off the stage as the kind of bankrupt economic manipulation that got us into this mess in the first place. The public would have to stop running to government for its favors, and the politicians would have to lose the power to sell these favors.

But if all of this is to change, it means that the basic political arrangement has to change. To change matters fundamentally, various leopards have to change their spots. A revolution in ideas needs to occur. Government power has to be seen as inherently inimical to society, for it is the very existence of that power that ensures its attraction to the public and its use. The public has to stop looking for free lunches where there are none. It has to stop believing in government as the tooth fairy. The public has to stop believing in a government that, again and again, augments its own position and power while pretending to fight recessions with methods that make matters worse and lay the groundwork for more booms and busts. The public has to understand that its welfare is best assured by building upon the liberty-promoting ideas that circulated at the time of the American Revolution. That revolution was won on the battlefields and lost in the State House in Philadelphia in 1787 and thereafter. The public needs to understand what its rights are and that they are being immensely abridged by government. It needs to know that restoration and augmentation of these rights is the only proper course to take and the only course that promises a lasting and bountiful prosperity.

This is a tall order. The problem is educational in part. The problem is also a social coordination problem. If we all reject big government together, we all generally benefit while some interest groups lose their goodies; but no one knows how to coordinate this transition. It sometimes occurs, however, as when the U.S.S.R. fell. And sooner or later, American politics will come in for a radical restructuring. The outcomes of that will be better if we now converse and educate each other continually in these matters. We need to entertain concepts that seem radical today but were not radical to those who fought for and articulated the ideals of American independence. Better to consider these matters now than when the system is collapsing around our ears.

December 8, 2008

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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