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Source link: http://archive.mises.org/10794/the-feds-dilemma/

The Fed’s Dilemma

October 8, 2009 by

If the central bank does not increase the money supply enough, bad assets will remain bad, leading to insolvency. If the central bank increases the money supply too much, a hyperinflation will become probable. FULL ARTICLE by Phillipp Bagus


Patrick Barron October 8, 2009 at 9:18 am

“Bad loans and assets would be returned to banks’ balance sheets.” How would this happen? Would the Fed just demand its money back and return the assets?

Michael Orlowski October 8, 2009 at 9:26 am


I’m assuming yes, the government can always be the enforcer.

Christopher October 8, 2009 at 10:27 am

Did this article just sugges the only viable solution was to continue throwing more money at the problem?

I feel both completely helpless and furious.

Ohhh Henry October 8, 2009 at 10:35 am

… The problem can only be solved by acknowledging it. Turning bank creditors into equity holders would fix the banks’ solvency problems and would increase confidence in the financial sector, thus also improving the liquidity situation.

If this is done, the balance-sheet policies of quantitative and qualitative easing can be reversed by selling the bad assets, buying back the good assets, and refusing to roll over emergency loans. Otherwise, the policies cannot be undone without instigating the breakdown of the financial system or risking hyperinflation.

I don’t think this will be considered a viable option, at least not yet. The new owners of the banks would insist on all kinds of changes like firing the management who wrecked the banks, canceling golden parachutes (or making the recipients get in line with the rest of the creditors), foreclosing on mortgages offered under the Community Reinvestment Act, and killing all kinds of sacred cows.

My impression is that there are many historical examples of nationalization and hyperinflation but few if any examples of a government allowing all of the largest banks in its jurisdiction to be taken over by creditors.

Dick Fox October 8, 2009 at 11:36 am

What is missing in this report is what has happened to banks since the FED bought their distressed assets. Consider, the banks now have more healthy balance sheets while the FED has a weaker balance sheet. This actually allows the banks to engage in more questionable lending and since the government has not changed their policies and procedures and Fannie and Freddie are still in business will the bank balance sheets get better or worse?

So let’s say that the FED forces the banks to buy back the assets. Are the banks balance sheets more stronger or weaker than when the FED bought the assets from the banks?

In fact not only are the banks balance sheets weaker than when the assets were purchased by the FED but these assets have probably declined in value since purchased by the FED.

So not only has the FED actions not changed anything it has actually made things worse so that when the final unravelling takes place it will be worse than if it had been allowed to happen in the first place.

Mushindo October 8, 2009 at 11:53 am

Theres no such thing as a bad asset – just a badly priced asset.

All of the hysterical policy attempts to ‘rescue’ the world economy over the last couple of years have one thing in common: They are all ultimately attempts to prevent assets from honestly repricing. And when nobody knows what an asset is really worth, the works get gummed up and people sit on their hands instead of trading. Thats actually how a recession is prolonged.

Michael October 8, 2009 at 3:35 pm

Leaving the level of theory (and its practical implications) for a moment… can anyone recommend a truly Austrian principled broker or investment advisor, who has a good performance track record?

Or, is there any mutual fund that exists that is strongly influenced by someone who understands Austrian principles?

John Galt October 8, 2009 at 3:49 pm

Michael, check out Peter Schiff’s firm Euro Pacific Capital.

Michael Covel October 8, 2009 at 9:18 pm

“The insolvency of a large part of the banking system would only acknowledge a fact that has been concealed, and whose consequences have been delayed, causing important moral hazards. The alternative is to continue the existing policies, with the danger of an enduring recession not unlike the one in Japan.”

Well stated.

P.M.Lawrence October 8, 2009 at 9:53 pm

Mushindo wrote “Theres [sic] no such thing as a bad asset – just a badly priced asset”.

Oh? What about shares that aren’t fully paid up and have an outstanding amount greater than their yields can justify? Or Glebe land with an encumbrance that falls due, as happened at Aston Cantlow?

Andrew Jackson October 8, 2009 at 10:25 pm

“A strong central-bank balance sheet is essential for the quality of a currency and the stability of a financial system.”

Are you kidding?

Glenzo October 8, 2009 at 10:35 pm

In addition, one of the time tested methodology to recapitalize banks is ‘time’. By qualitative and quantitative easing, bank’s balance sheets are repaired through a steeper yield curve and the spread between the cost of funds and the earnings of good assets. Prior to the problems, Citicorp was earning around $20 billion a year.These earnings are now being used to mark down assets. The question is how long will this to take?

George October 8, 2009 at 11:12 pm

I saw this a long time ago:

imho, the Fed is walking a balancing act between keeping the dollar afloat by raising rates, and keeping the economy going by not raising rates.

And parallel lines never meet — what makes everyone assume these lines are parallel? I keep feeling that somewhere in the future we will all find out that they cross…

Walt D. October 9, 2009 at 12:23 am

The Fed can not create wealth. It can buy bad assets at par and buy US Treasury obligations, but it is doing it with money created out of thin air. This is why all hell may break loose if Congress ever gets to audit the Fed.
BTW everybody is acting as if the Fed action has been successful. But as the song says “the best is yet to come – you ain’t seen nothing yet”, only in this case its the worst!

Ralph H October 9, 2009 at 9:53 am

Well said Walt D. Fed action interferes with the natural order of things(the market) which can only result in a less desirable result.

Gerry Flaychy October 9, 2009 at 5:56 pm

To Philipp Bagus.

How the “Public Private Partnership Investment Program” fits in your “Fed’s Dilemma” ?

Will it help to solve “the looming insolvency problem of banks”?

Patrick Barron October 9, 2009 at 7:50 pm

If the Fed sold its distressed assets in the open market at the market price, it would show huge losses. Right? But, the Fed carries gold on its books at a price well below market. Right? If the Fed liquidated, it might break even or come close to it. We have an opportunity to allow the market to take over the banking system and reprice all assets at their market value. Then we could get on with life. What do any of you think of this option?

Walt D. October 9, 2009 at 11:23 pm

Another 6 cents worth. The Fed has been keeping interest rates close to zero and bailing out insolvent financial institutions. Austrian theory predicts that this will result in mal-investment and bubbles. Has anyone noticed that the S&P500 is trading at a 122 P/E ratio? Before this took crisis took place, the previous high was 46. Historically, the S&P500 P/E is in the low teens. The run up in the S&P500 has been super-exponential, indicating a bubble, according to Didier Sornette’s model. Should we expect some correction on October 18th or 21st?

Gerry Flaychy October 10, 2009 at 10:40 am
Patrick Barron wrote:“If the Fed sold its distressed assets in the open market at the market price, it would show huge losses. Right?”

1- I would be very surprised if the Fed was holding distressed assets.
2- In the event that is the case for some of the assets and the Fed sell them with losses, it doesn’t mean that it will be the Fed who will take the losses. If the Fed has taken a good guarantor for those assets, it will be this guarantor who wil take the losses, usually meaning us !
3- Even if the Fed make some losses at the end, those losses will diminish the profit that the Fed give back to the Treasury each year. So no loss for the Fed! Only for … (you know who).

4- Concerning the “opportunity to allow the market to take over the banking system and reprice all assets at their market value” , it is already begun as you can see here: http://www.wealth.bloomberg.com/apps/news?pid=20601110&sid=aXkEBE3AQFpw

See also this one: http://www.treas.gov/press/releases/tg65.htm

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