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Source link: http://archive.mises.org/14783/can-the-fed-become-insolvent/

Can the Fed Become Insolvent?

November 29, 2010 by

Many academic economists are beginning to worry: Could the Federal Reserve itself become insolvent? In this article I’ll explain these fears and I’ll argue that the Fed, with its printing press, cannot really go bankrupt the way other corporations can. FULL ARTICLE by Robert P. Murphy

{ 41 comments }

Deefburger November 29, 2010 at 10:36 am

Fundamentally, any fractional reserve bank is broke right out of the gate. The moment the “fraction” is “created” the bank is in debt for that amount minus the reserve. It’s not a question of whether the bank will go broke, but when it will become evident.

Whether or not you believe in the banks assets will determine whether or not you can see its insolvency. The banks “power” of money creation is a belief in the power of money creation. Continued belief in un-natural power will result in a continuation to see evidence of money and value. When the market opens its eyes and sees the fraction for what it is, a belief in value, then the insolvency will be apparent and the banks estimated value in the market will collapse.

A super-suit only works as long as people believe it does. A run of luck at the casino only lasts as long as you believe it is there. Hitting the ATM to keep the run going is a fool’s errand. $600B in stimulus is just another ATM withdrawal in an attempt to make it to the next run of luck. Investment in belief of value is a loss in the long run.

Ohhh Henry November 29, 2010 at 10:46 am

economists and other analysts are slowly realizing that Bernanke’s “exit strategy” could collapse if and when interest rates rise sharply.

Is there really any exit strategy? Or are statements claiming that an exit strategy exists merely a propaganda exercise meant to disguise the most heinous, opportunistic, short-term looting of USD-holders’ wealth?

I imagine that what’s going on is that The Bernank is under orders to please shovel money out the door and “stall them” for as long as possible with the fictitious claim that, don’t worry, the attempt to right the ship by opening the seacocks is going well and “real soon now” the holes can be plugged up again. Meanwhile, the savvy few (foreign governments, big bankers and gold bugs) must be buying up hard assets like crazy knowing that the USD ship is close to the final plunge. Remember the story of the Japanese men caught smuggling billions in US treasuries into Switzerland? Looks like Japan was trying to do in secret what it can’t do in public because of its official position as Asian Puppet #1 of Washington DC. Evidently someone decided to tell them, “not so fast!” and arranged for them to be caught. The BRIC of course are less restrained politically and only have to figure out how to jump from the ship without suddenly upsetting it and losing half their assets before they can be offloaded.

I see rats leaving a sinking ship, while The Bernank is on the quarterdeck spouting malarkey to the crew to get them to stay on duty until all the boats and valuable cargo have left. After that, who cares what happens to US housing prices or Social Security? Nobody who matters.

As for the European situation, this guy summarizes it much better than I could.

… if you rob people of their identity, if you rob them of their democracy, then all they are left with is nationalism and violence. I can only hope and pray that the Euro project is destroyed by the markets before that really happens …

Richard Marmorstein November 29, 2010 at 10:54 am

There’s an error in the final table. The total on the bottom right is the same as the total on the bottom left when it should not be. It’s a little confusing.

Dunno if anybody reading this can do anything about it, but figured I’d comment.

J. Murray November 29, 2010 at 12:47 pm

That’s an artifact of rounding errors.

Mike Sproul November 29, 2010 at 11:00 am

It’s actually the Fed’s decision to make its dollars inconvertible into gold that makes it immune to insolvency. This makes the dollar like a share of corporate stock. Since the stock, like the dollar, can rise and fall in reflection of the assets backing it, the issuer has no fixed claims against it and can’t go bankrupt.

Phinn November 29, 2010 at 11:10 am

If the Fed’s notes are shares in corporate stock, then what business is the corporation in?

And which entity is the stock-issuing corporation? Do you mean the business of the US government? If so, then we already know the answer — it’s in the taxation business.

If what you say is true, then every note issued by the Fed is a corporate share issued against what the corporation can take from us, i.e., our productivity. It’s much like issuing shares against the productivity of livestock, or other farm products.

eric November 29, 2010 at 2:59 pm

The corporation Mike speaks of is in the business of legal tender. They have a government monopoly on legal tender. They give no dividends, like many corporations or etf’s on the market. They are more liquid than any stock, however.

Unless you are willing to barter, and never use the government court systems (who make awards or punishments in fed dollars) then you are forced to convert what stuff you do have into fed dollars at some point in time. The utility of money over barter is such that a corporation who can dilute it’s stock at will is not going out of business over night. Your shares in this corporation are very liquid, as liquid as money, since these shares are, in fact, money.

So, unless there’s something I missed, Mike’s analogy of a stock holding seems pretty good. They are only convertible, as Murphy says, into other denominations of fed dollars. But they can also be deposited into demand accounts and debit card accounts.

A Liberal In Lakeview November 29, 2010 at 11:47 am

Q: If “the dollar [is] like a share of corporate stock”, then what is “quantitative easing”?

A: A euphemism for ‘dilution’.

J. Murray November 29, 2010 at 12:48 pm

Precisely. Except when the Fed does it, there isn’t widespread anger amongst existing shareholders.

Phinn November 29, 2010 at 1:05 pm

And don’t forget the whole “immunity from lawsuits for diluting the shares of minority shareholders” privilege that the Fed enjoys, which ordinary corporations do not.

Mike Sproul November 29, 2010 at 2:11 pm

Stock dilution happens when the firm’s assets don’t rise in step with the shares issued. But if assets do rise in step with shares, then the shares hold their value. So if the fed issues $100, but gets $100 worth of bonds as new assets, the dollar holds its value.

J. Murray November 29, 2010 at 2:25 pm

Wow Mike, wow. You really need to learn how to bullshit effectively.

http://www.merriam-webster.com/dictionary/dilute

Definition 4: to decrease the per share value of (common stock) by increasing the total number of shares

Dilution deals EXCLUSIVELY with the raw volume of shares outstanding, not the day-to-day fluctuation in value of the stock on the open market and certainly has nothing to do with the number of assets on the books (asset values and market capitalization never line up). Dilution is addition of new shares, nothing more. The company can add new assets equal to the outstanding share value and keep them constant and still dilute the per-share value because the reported value of the assets on the books is irrelevant in stock valuation. For instance, Apple has a market cap value of $287 billion yet their total assets are only $75 billion.

The Fed cannot create a new Dollar without diluting the Dollar because dilution is defined as adding more into a system.

greg November 29, 2010 at 2:49 pm

This is true if the company’s profits are static. But if a company is growing and the price of the stock is growing, it makes sense at times to split the stock. A 2 for 1 split results in double the amount of shares and the price of the stock is cut in half. In most cases, the company’s decision to split the stock is based on profit growth and the attraction of the lower priced stock to the investors, the end result is the stock price moves higher creating more wealth.

The same applies to the money supply, if our economy was static, then your example holds true. But if you substitute productivity gains for corporate profits, the economy can absorb changes in the money supply with gains in productivity. I have used this example before that I got off the History Channel, since 1900 productivity in the US has increased over 1000 times while a dollar today is worth 5 cents in 1900. This is why we are much better off today than our great grandparents were in 1900.

The economy and markets are much more dynamic than your examples.

Phinn November 29, 2010 at 5:01 pm

Stock dilution is a wholly different kind of transaction than stock splits. Splitting is merely a change in unitization, and is done for accounting convenience and marketing purposes. The percentage of interest in the corporation owned by each shareholder does not change.

Issuing new stock, in contrast, reduces the percentage of the corporation that is owned by the each of the pre-dilution shareholders.

J. Murray November 29, 2010 at 5:11 pm

Exactly. The Fed isn’t splitting our currency, they’re diluting it by issuing new currency unevenly over current “shareholder”.

eric November 29, 2010 at 3:44 pm

The problem with the FED’s holdings are they usually buy stuff that’s not worth what they pay for it. For example, they bought a bunch of toxic debt.

And when they buy government bonds, those IOUs are never paid back, since they always borrow more when the time comes to redeem existing bonds. This makes the bonds worth less at the time of redemption.

It is in essence a ponzi scheme.

However, unlike a ponzi scheme, the fed can always find more investors, to pay off the old investors (who get no interest). It does this by creating more dollars backed by more debt. Normally in a ponzi scheme, investors buy in because the returns are high. In the FED note ponzi scheme, investors buy in because they must have fed dollars to engage in trade. If they attempt to trade in anything else, they are subject to confiscation and time in prison. Later, when they want to redeem their fed dollars, they find that there are so many more of them, that nobody is willing to trade as much for them.

So much for the theory of fed dollar backing.

Phinn November 29, 2010 at 2:29 pm

>>>if assets do rise in step with shares, then the shares hold their value. So if the fed issues $100, but gets $100 worth of bonds as new assets, the dollar holds its value.

Words can’t express just how wrong you are. You are mis-measuring the effect of the dilution.

Even if the post-dilution value-per-share is exactly equal, in nominal terms, to what it was prior to the new issuance, that value is still lower than what it would have been if it were not for the dilution. This means that the owners of the pre-dilution shares are deprived of the INCREASE in value that they would have otherwise experienced.

In other words, the only meaningful comparison is between the pre-dilution value and the NON-DILUTION value (what it would have been without the dilution), not between the pre-dilution value and the post-dilution value.

I’m still waiting for a comment about how the issuance of these quasi-shares (diluted or not) is made against the future productivity of us livestock, extracted by force.

Mike Sproul November 29, 2010 at 4:43 pm

If a firm’s assets are worth 100 oz. of silver, and there are 100 shares outstanding, then each share is worth 1 oz. If the firm then issues 100 new shares and sells them for assets worth 200 oz, then each share is still worth 1 oz, so there is no dilution of value. (There is dilution of voting rights though.) This result does not require future increases in productivity. Replace “firm” with “Fed” and “shares” with “dollars”, and you see how the dollar can hold its value even as more are issued.

Beefcake the Mighty November 29, 2010 at 4:55 pm

What do you mean when you say the assets are “worth” 100 oz of silver?

J. Murray November 29, 2010 at 4:58 pm

A firm’s shares are not worth 1 oz per share if 100 shares of stock are outstanding and the total assets are 100 oz of silver. A firm’s share value floats based on a market rate. The assets on a company’s portfolio has little to do with the stock valuation. Hence why the combined market value of any given company is somewhere around 4 times the total value of all assets currently on the books, on average 10 times the listed book value of owner’s equity, and on average 30 times the realistic liquidation revenue of the total on-hand assets.

You really don’t know how stock pricing works, do you? It’s pure supply-demand as stock ownership is not tied to any asset in the corporation it represents. Asset values are irrelevant and the fluctuation of the stock price is not remotely predictable should a company sell an additional 100 shares of common stock for 100 oz of silver. It may increase in price as a signal of future expansion or it may decrease in price as the outstanding shares are now diluted. Stock valuation is a future expectation, not a static math problem of assets/shares.

Mike Sproul November 29, 2010 at 5:36 pm

Correction: The 100 new shares (or dollars) are sold for assets worth 100 oz., not 200 oz.

eric November 29, 2010 at 6:29 pm

Mike:

But the fed doesn’t buy assets like oz of silver. It buys debt. There is no limit on the amount of debt they can buy. As the amount of debt increases, it’s value (relative to other goods) goes down – simple supply, demand, and prices.

If they bought silver instead, and then someone found a treasure sitting on an island that overnight doubled the amount of silver in the world, then the backing of the fed’s notes would still be an oz of silver, but then the silver would be worth half as much, and so the fed notes would also be worth half as much – relative to other goods.

It’s because the amount of debt that backs the fed notes is virtually unlimited, that the value of the fed notes keeps dropping. There’s a lot more fed notes backed by a lot more debt today than 90 years ago. That’s why the dollar today will trade for only 1/20th of what it would 90 years ago – in goods that have not changed in value, such as gold.

Beefcake the Mighty November 29, 2010 at 8:04 pm

@Mike Sproul:

I guess you didn’t see my question, which I’ll repeat:

What do you mean when you say the assets are “worth” 100 oz of silver?

Phinn November 29, 2010 at 11:27 pm

>>>What do you mean when you say the assets are “worth” 100 oz of silver?

He means IOUs with a nominal value of 100 oz of silver.

It’s part of his life-long habit of failing to appreciate the difference between a bedrock form of hard currency and “assets” that consist of a nearly-endless pyramiding of commercial paper on top of commercial paper. He seems to think that as long as the balance sheets are balanced, things that are deemed by bean counters to be equal are, in reality, equal.

As though accounting is reality, and debt is money.

Beefcake the Mighty November 30, 2010 at 9:29 am

“He means IOUs with a nominal value of 100 oz of silver.”

By this I assume you mean face value of 100 oz? If so, then yes, you’re right, he repeatedly makes this error. I was just trying to get him to admit it, which is likely why he won’t respond.

Phinn November 30, 2010 at 10:59 am

>>>By this I assume you mean face value of 100 oz?

After coin itself, that’s the best-case scenario — an IOU of some sort that theoretically provides for actual payment in actual coin. In Sproul-land, this IOU is an asset “worth” whatever somebody says it is, and VOILA! — the ledger is thus balanced, and all is right in the world. Accounting is reality.

But there are other possibilities, each further removed from both coin, or even notes for coin, such as notes for notes, or notes for shares in some other company that holds “assets” that may be … whatever accountants and Mike Sproul say they are “worth.” And so on.

But, hey, so long as the balance sheets balance, there’s no inflation caused by the creation of this endless trail of paper, right?

Mike Sproul November 30, 2010 at 4:00 pm

Eric:

“But the fed doesn’t buy assets like oz of silver. It buys debt. There is no limit on the amount of debt they can buy.”

You’re ignoring the law of reflux. If each dollar is backed by assets (like silver, bonds, land, etc) that are worth 1 oz. of silver, then each dollar is worth 1 oz. The Fed will only issue new dollars to people who want the dollar badly enough to hand over 1 oz. worth of assets, so the Fed can only issue as many dollars as people want. The only way for the fed to issue more than this is for the Fed to accept assets worth less than 1 oz. for each dollar. But then the fed is not getting adequate asssets and the dollar would lose value from the loss of backing.

“then the silver would be worth half as much, and so the fed notes would also be worth half as much”

Of course.

“That’s why the dollar today will trade for only 1/20th of what it would 90 years ago ”

That’s because each dollar has 1/20 of the backing it had 90 years ago.

Beefcake the Mighty November 30, 2010 at 9:45 pm

C’mon Mike, answer the question. What do you mean for something to be worth 1oz of something else? Please, amuse me.

Jeff November 29, 2010 at 11:15 am

Hi Bob, nice article. One point confused me; “Suppose that price inflation begins rising in our hypothetical world, so that one-year interest rates rise to 1 percent, while ten-year yields jump to 8 percent.” How does price inflation directly lead to rising rates? What if price inflation goes unnoticed by Fed such that they continue printing money, buying treasuries and, therefore, keep interest rates synthetically low (like now)? Thank you for your help.

Mary Lee Harsha November 29, 2010 at 11:43 am

I noticed the error on the 2nd table as well. A confusing double entry of $250 and $850 on the third cell down and no total for the assets column. It would be helpful if the confusions could be cleared up and the article reposted.

Matthew November 29, 2010 at 12:00 pm

It seems to me that if there is such thing as the Fed’s “solvency” it’s not any sort of traditional definition as addressed in the article, but rather its ability to continue functioning within its mandate of price stability. Obviously, the Fed has unlimited potential to create additional money, but it is fundamentally limited in the opposite direction. It can only remove money from the economy if it has valuable assets on its balance sheet to sell.

Every loss the Fed realizes from defaulting/impaired assets puts a floor in on the amount of base money in the economy. If those losses ever got way out of hand (e.g. it keeps buying more and more toxic paper from bailout recipients or Treasury yields go through the roof and the bonds the Fed holds plummet in value), the Fed would no longer have any assets to sell to remove money from the economy.

In a runaway inflation scenario, the Fed would then require a bailout from another institution that’s willing to give up valuable assets so that the Fed could sell them, thereby reducing the money supply and combating infation.

The notion of “insolvency” above is the relevant one when discussing whether or not the Fed realistically has an “exit strategy” for all the printing it has been doing (which I acknowledge wasn’t the subject of RPM’s article).

Rick Ackerman November 29, 2010 at 12:37 pm

No one “owns” the Fed, since there is no Fed common or preferred stock that confers ownership equity. This point was stressed by C.V. Myers in “The Coming Deflation” and “World Rollover”.

agdrummer November 29, 2010 at 1:15 pm

Rick, do You believe that the “crash” in (MUB) is an( unintented) conciquence of QE2 or a”reaction” as with sept. 2008 ?

billwald November 29, 2010 at 2:00 pm

The Fed is “owned” by the member banks in the sense that they have a controlling interest if not an actuarial interest, same as so-called “non-profit” corporations.

gene November 29, 2010 at 2:32 pm

good article!

it would be my understanding that the fed can only “go under” if the dollar loses it hegemony as the world currency. when that occurs, printing to pay off debt will have the effect of compounding the debt by lowering the value of our currency in relation to the currency of the specific debt {increasing rather than decreasing the total debt in proportion to our worth}.

as it stands with the dollar as world currency, printing for the most part has the effect of lowering the value of ALL currency {even though a country may get more dollars after printing occurs, they end up with lower buying power with translates to their own currency} and actually liquidating our debt, which is why every other country gets pissy about it.

Vincent Cook November 29, 2010 at 3:01 pm

If you go to the Fed’s and scroll down about 2/3rds of the way, you can find the current consolidated balance sheet for the whole system (there are actually twelve separate corporations that own the Fed’s assets and are liable for the Fed’s notes and accounts; a table with balance sheets for each individual Federal Reserve Bank is a little further down).

Looking at the Fed’s assets, it is noteworthy that not only have short term T-bills been replaced with longer term T-notes and bonds, but also that over half of the Fed’s assets now consist of mortgage-backed securities (over $1 trillion of these), Fannie & Freddie bonds, and equity stakes in failed investment bank asset pools. Where did the banks get the money to pay back the TARP bailouts? Now you know.

The danger to the Fed’s balance sheet is not just the risk of an interest rate spike (which would reduce the market value of the T-bonds), but also that roughly half of its assets are essentially unmarketable and worth only pennies on the dollar. The only reason why the Fed’s balance sheet isn’t currently in a negative equity position is that it isn’t required to use “mark to market” accounting. As long as the Fed doesn’t sell its sub-junk portfolio, it can carry it on the books indefinitely at its current gross overvaluation.

As a practical matter, the Fed won’t have to be “seized” because it will never have to recognize its losses (unless Ron Paul gets to audit them, that is). However, there is a danger that when inflation starts raging out of control, the Open Market Committee won’t be able to do much about it. The marketable assets they have left to sell are both vulnerable to interest rate spikes and insufficient for soaking up the enormous hoard of newly-created bank reserves that are now hanging over the economy like Damocles’ sword.

While there are other things that could be done to deal with this problem, none of the alternatives are particularly attractive from the Establishment-point-of-view. Any overt acknowledgment of the Open Market Committee’s incapacity would in itself be a serious and possibly fatal blow to the dollar.

Vincent Cook November 29, 2010 at 3:05 pm

If you go to the Fed’s H.4.1 release and scroll down about 2/3rds of the way, you can find the current consolidated balance sheet for the whole system (there are actually twelve separate corporations that own the Fed’s assets and are liable for the Fed’s notes and accounts; a table with balance sheets for each individual Federal Reserve Bank is a little further down).

Looking at the Fed’s assets, it is noteworthy that not only have short term T-bills been replaced with longer term T-notes and bonds, but also that over half of the Fed’s assets now consist of mortgage-backed securities (over $1 trillion of these), Fannie & Freddie bonds, and equity stakes in failed investment bank asset pools. Where did the banks get the money to pay back the TARP bailouts? Now you know.

The danger to the Fed’s balance sheet is not just the risk of an interest rate spike (which would reduce the market value of the T-bonds), but also that roughly half of its assets are essentially unmarketable and worth only pennies on the dollar. The only reason why the Fed’s balance sheet isn’t currently in a negative equity position is that it isn’t required to use “mark to market” accounting. As long as the Fed doesn’t sell its sub-junk portfolio, it can carry it on the books indefinitely at its current gross overvaluation.

As a practical matter, the Fed won’t have to be “seized” because it will never have to recognize its losses (unless Ron Paul gets to audit them, that is). However, there is a danger that when inflation starts raging out of control, the Open Market Committee won’t be able to do much about it. The marketable assets they have left to sell are both vulnerable to interest rate spikes and insufficient for soaking up the enormous hoard of newly-created bank reserves that are now hanging over the economy like Damocles’ sword.

While there are other things that could be done to deal with this problem, none of the alternatives are particularly attractive from the Establishment-point-of-view. Any overt acknowledgment of the Open Market Committee’s incapacity would in itself be a serious and possibly fatal blow to the dollar.

gene November 29, 2010 at 7:36 pm

which seems to reiterate that it is not exactly what the fed does or what its balance sheet says, but the position of the dollar that determines its “solvency”. in other words, the fed in a sense, is the dollar.

bionic mosquito November 30, 2010 at 1:32 am

Not that it would make any difference (because the FED will never go bankrupt in any sense recognizable to normal human beings operating in the real world), but the FED will never take a write-down of its assets as described in the final table. I believe the FED already holds assets at face value if they intend to keep them to maturity (regardless of market value). They will certainly do this with government notes/bonds, and they will MOST certainly do this to keep a pretty face on the balance sheet.

Therefore, this will only matter upon default of an underlying bond. Even then, the accounting and legal games that can be played will be played. The charade will end only via hyper-inflation or an end to the government deficit game. It will not end via some “default” in any traditional, corporate sense.

Jim Brooks November 30, 2010 at 3:53 pm

Mr. Murry, negative net worth does not necessarily mean that an entity (whether it be an individual, partnership, corporation or a central bank) is insolvent. “Insolvent” means the entity can’t pay its bills or honor its obligations. I’ve seen many “entities” over the years that have negative net worth (net negative capital) with cash on the balance sheet and a continuing ability to honor obligations. In the final analysis, it’s a liquidity crises that will bring down an entity and that includes those with positive net worth or capital.

Jim Brooks November 30, 2010 at 4:05 pm

I addressed my comment to Mr. Murry, it should have been Mr. Murphy.

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