Could QE2 Cause the Fed to Go Broke?

Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Could QE2 Cause the Fed To Go Broke? Post prepared November 8, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.

Can Central Banks Go Broke? The Federal Reserve System, universally known as “The Fed,” is the central bank of the United States Its recent highly expansionary program of quantitative easing, QE2, raises an old question: Can central banks go broke? Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Federal Reserve Board Building in Washington, DC. The “Fed” is the central bank of the United States Photo by Agnosticpreacherskid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg

Why Banks Need Capital A bank’s capital is defined by the equation capital = assets – liabilities If the value of a bank’s assets decreases because of loan defaults or poor market conditions, its capital can become negative, as in this example A bank with negative capital is said to be insolvent — in everyday language, it “goes broke.” Insolvent banks are normally required to cease operations Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ For a more detailed discussion of bank capital and insolvency, see this earlier post on Ed Dolan’s Econ Blog

The Fed’s Balance Sheet in Normal Times (2007) In normal times, the Fed’s assets have consisted largely of short-term Treasury securities Usually its major liability has been Federal Reserve Notes—the paper currency we use every day It also holds reserve deposits of commercial banks and a few other liabilities As of 2007, its capital was equal to 4.7% of total assets, which would be a little on the low side for a commercial bank, but not extremely low Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

The Fed’s Balance Sheet Today (Nov 2010) Today the Fed’s balance sheet is very different from normal times Treasury securities are now less than half of total assets Mortgage-backed securities and securities of other government agencies have grown greatly Reserve deposits are almost 50 times larger than normal Total capital is slightly increased, but since total assets are larger, the capital ratio has fallen to about 2.5% of total assets Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why The Fed Normally Needs Little Capital The Fed can normally operate safely with very little capital because it does not face the same risks as commercial banks There is essentially zero risk of loss on short-term Treasury securities Currency is a nonredeemable liability, so there is zero risk of a “run” on the Fed Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why the Fed’s Balance Sheet is Riskier Today Today the Fed’s balance sheet is riskier than in the past As part of QE2, the Fed is buying more long-term Treasuries, which face risk of loss of market value if interest rates rise Its other assets, especially mortgage-backed securities, are far riskier than Treasuries Its capital cushion is thinner, so a loss of just 2.5% on its assets could, technically speaking, cause the Fed to become insolvent Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

What Would Happen if the Fed’s Capital Dropped Below Zero? What would happen if a loss of, say, $88 bln on securities reduced the Fed’s capital to a negative value? The Fed would be insolvent in the balance sheet sense However, unlike a commercial bank, it would still be able to meet all of its financial obligations because its liabilities are not redeemable. There could be no run on the Fed. It would still be solvent in what is called the equitable sense Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Two meanings of insolvency: Balance sheet insolvency: Liabilities exceed assets, capital is negative Equitable insolvency: A business is unable to meet its financial obligations in full as they become due

Who Could Recapitalize the Fed? Although the Fed could technically operate with negative capital, it would be an embarrassing position to say the least. There would be pressure to recapitalize it The only entity that could afford to recapitalize the Fed would be the US Treasury The simplest way to carry out recapitalization would be for the Treasury to issue an appropriate quantity of bonds (say, $100 billion) and transfer them to the Fed as a grant, taking nothing in return. The Fed’s assets and capital would rise by the same amount as the transfer Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Stature of Albert Gallatin at the US Treasury Building Photo by Dan Vera http://upload.wikimedia.org/wikipedia/commons/6/6d/JEFraser_Gallatin.jpg

Complication: The Fed’s Unusual Ownership Structure Recapitalization would be complicated by the Fed’s unusual ownership structure In a functional sense, the Fed is fully a part of the federal government Legally, however, the Fed is a stockholder-owned corporation. Stockholders are the private banks that are members of the Federal Reserve This unusual ownership structure, arising from the Fed’s history, is the source of many paranoid theories and bizarre myths about the Fed Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Fed: Myths and realities The Fed is not a profit-making business. Its income normally exceeds its expenses, but the net income is automatically turned over to the Treasury for use by the government By law, the Fed’s stockholding member banks receive a token 6% dividend on their stock. Changes in Fed policy neither increase nor decrease the dividend, so policy changes neither impoverish nor enrich its private member banks The Fed is NOT owned by the Rothchilds, the Masons, or Swiss gnomes. Don’t believe everything you read on the internet!

Reality: Recapitalizing the Fed would be Difficult Paranoid myths to one side, recapitalization of the Fed by the Treasury would be difficult in the current US political climate It is unlikely that the Treasury could make a capital transfer of tens of billions of dollars to the Fed without an act of Congress Such a transfer would be perceived as another “bank bailout.” Who can guarantee that a majority of Congress would vote in favor? Even if such a bailout passed Congress, would the price tag be a limit on the Fed’s independence? Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Tea Party Protest, Hartford CT Photo by Sage Ross, http://commons.wikimedia.org/wiki/File:Tea_Party_Protest,_Hartford,_Connecticut,_15_April_2009_-_036.jpg

Bottom Line: Could the Fed Go Broke? Because of radical changes in the Fed’s balance sheet resulting from quantitative easing, the Fed could, in fact, “go broke” in the sense of negative capital Technical balance sheet insolvency would not prevent the Fed from carrying out its monetary policy functions Insolvency would create political pressure to recapitalize the Fed. The process could easily be highly controversial, and could result in limits being placed on the Fed’s political independence Post P101108 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Could QE2 Cause the Fed to Go Broke?

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Could QE2 Cause the Fed to Go Broke?