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Source link: http://archive.mises.org/16012/three-flawed-fed-exit-options/

Three Flawed Fed Exit Options

March 14, 2011 by

Can the Fed gracefully exit from the huge hole it has dug for itself? Unfortunately my answer is no. FULL ARTICLE by Robert P. Murphy


fundamentalist March 14, 2011 at 9:40 am

Nice analysis! Keep in mind the lags between policy change and its effect, which can be as long as 4 years. The Fed only watches prices, but primarily it watches expectations. Expectations lag behind prices for a while. So by the time the Fed notices a problem, it has been going on for a while and will continue for a while. And the Fed’s initial response will be timid.

It’s going to be a wild ride!

Fed Fraud March 14, 2011 at 10:37 am

If the Fed’s actions were neutral it wouldn’t need to exist.

Eric March 14, 2011 at 12:12 pm

But this would hardly “solve” the problem of excess reserves. Rather than facing a $1.2 trillion problem, the next year the Fed would face a $1.21 trillion problem, and so on. The excess reserves would grow exponentially.

Lost me there prof. That don’t look exponentially to me!

Ken Zahringer March 14, 2011 at 12:37 pm

It’s a matter of compounding. The Fed is paying the bank to keep excess reserves. That means the interest payment will remain part of the reserves, and the next year’s interest would accrue on the increased reserve balance. Actually, Bob did make an arithmetic error. At 7.5%, the “next year problem” is really 1.29 trillion. The year after that, 1.39 trillion, and so on. The way he described it it’s still exponential, but his exponent is 1.67%.

Bob Murphy March 14, 2011 at 12:55 pm

In the example I was using, the Fed owes the banks $90 billion and has earnings of $80 billion. So on net the excess reserves go up by $10 billion.

Ken Zahringer March 14, 2011 at 1:02 pm

So they first wipe out their earnings, and then only have to outright create $10 billion. Got it.

Eric March 14, 2011 at 3:24 pm

An exponential function, such as y = 2^x would be one that at each step goes up pretty fast. 1.20 to 1.21 on the curve would be next to nothing – 1%. If it was exponential growth, we’d expect to see numbers much higher.

In casual English, exponential growth is a term reserved for say, hyperinflation. It just seemed a bit over the top for something that increased only 1 percent.

Colin Phillips March 14, 2011 at 4:10 pm

“pretty fast” is of course, relative to your time scale, if we were talking about hyperinflation then that specifically refers to exponential growth over exaggeratedly short timescales.

In casual English, exponential growth refers to anything that grows at a rate proportional to its current size, so a 1% rate is perfectly acceptable, because it grows a 1% of its new size the next year.

Eric March 14, 2011 at 3:32 pm

My algebra is a bit rough, but exponential functions are where the exponent is the variable. If the exponent is a constant, whether high or low, that’s still not exponential growth.


Colin Phillips March 14, 2011 at 4:06 pm


You’re thinking of continuous functions, while Bob was clearly speaking about Year-on-Year (discrete) time. So the size in year n is
Debt(n) = Debt(0)*(1+i)^n
So the exponent is not constant, it is a variable, it is the time.

Eric March 14, 2011 at 8:48 pm

Debt(n) = Debt(0)*(1+i)^n

That is simply compound interest. That function, continuous or not, depends mostly on the value of i. Most people when talking about exponential growth don’t use:

y = 1.005^x

which, while an exponential function, certainly doesn’t grow all that fast.

My “surprise” at the usage of the term exponential growth comes from what one would ordinarily think of that expression. Here’s what one on line dictionary says about it:

” In everyday speech, exponential growth means runaway expansion, such as in population growth. ” at http://dictionary.reference.com/browse/exponential+growth

Going from 1.20 to 1.21 is not what I would call runaway or exponential growth. A minor point, but it’s a bit like someone equating Obama with say, Hitler. It loses it’s credibility. It caused me to stop reading the article. And I’m a Murphy fan. I can imagine what what a Bernanke fan would do with that statement. I was just trying to point out what seemed like an obvious misuse of a phrase.

Bob Murphy March 14, 2011 at 9:55 pm

It’s going to kick up as the problem intensifies. If the situation unfolds as I fear it might, interest rates will keep rising, and so Bernanke will keep jacking up the interest he pays and hence the rate at which the excess reserves grow.

Also, even at a constant interest rate, technically it’s not 1%. Rather the absolute growth was 7.5% (or whatever number I used, I forget) times the excess reserves, minus the Fed’s earnings of $80 billion. So yeah the first year blip wasn’t enormous, just a “mere” $10 billion, but once it got going it would grow much more quickly.

Also, when Einstein (allegedly) said the most powerful force in the universe was compound interest, I don’t think he had in mind 1 billion % annual growth rates. I still stand behind my point: How in the world is it a solution to something, to make the problem grow by x% a year, even if x is in single digits?

Oderus Urungus March 14, 2011 at 10:02 pm

Bob Murphy is the intellectual equivalent of a dirty sanchez.

Seattle March 15, 2011 at 12:01 am

Of course the first step isn’t runaway. It’s takes a bit to pickup speed. The difference between step 10000 and step 10001 is about 2.28*10^19.

Chyd3nius March 14, 2011 at 1:24 pm

I don’t get Bernankes logic. Why did he print those 1.2 trillion if he’s just going to keem them laying on an excess reserves?

J. Murray March 14, 2011 at 1:32 pm

He currently can’t dictate what the money can be used for. The banks just took that money and decided to park it in their Federal Reserve accounts to get the safe and easy return while the lending market was in a state of uncertainty.

Patrick Barron March 14, 2011 at 1:41 pm

I believe that Professor George Reisman recommended a variation of your third alternative last fall at a Mises Circle in Southern California. He advocated that the Fed give the banks sufficient reserves so that it could then require 100% reserves. I believe he did this in order to stop the growth of the money supply and then develop plans to convert to a gold standard. Could you comment on Professor Reisman’s plan? Thanks

babybell March 14, 2011 at 10:35 pm

That sounds like another huge bailout to me. Someone please clarify.

Brett in Manhattan March 15, 2011 at 12:23 am

I’ve believed all along that the liquidity injections had nothing to do with “getting the banks to lend” and everything to do with getting the bad assets off the banks’ books and onto the Fed’s. When this task has been accomplished, the Fed will proceed to raise rates, lowering the value of its assets until they are at bargain prices, at that point they will be sold back to the banks.

In essence, the Fed is being the “Sucker of last resort,” a role generally reserved for the investor and taxpayer. Of course, this role isn’t so painful when you’re the fed and it’s not your money going down the toilet.

A. Viirlaid March 15, 2011 at 1:29 pm

Good point Brett in Manhattan!!!

this role isn’t so painful when you’re The FED and it’s not your money going down the toilet…

Of course, you are right — it is The People’s Money — it just happens to be created by The FED.

This is really just a FED-con game run by The Federal Reserve’s Ben Bernanke.

It’s too bad — The FED will not leave the Federal Government’s Treasury to the ‘mercy’ of borrowing from the marketplace, at normal market rates.
This would at least have the side-benefit of paying savers a decent return for their savings, and thus leave those American who actually save in a far better position to spend (and pay their taxes as well).

No, instead The FED creates a lot of net-new money which it lends to the banks (at close to zero percent interest rates) for those banks to buy Treasury Bonds with (at a riskless return of about 3.5 percent). The FED itself does the same — with some of the this new money it creates, The FED also buys Treasury Bonds ‘indirectly’ from the Government (via ‘agent’-banks to keep it all at ‘arms-length’ of course — which gives those agent-banks a nice commission, on more than a Trillion Dollars; nice scam if you could legally get in on it!!!).

The American People get fleeced, coming and going — they have to eventually pay the taxes to the Federal Treasury to pay off all the loans, principal and interest, that the Treasury is incurring.
They don’t get market-place rates of return on their own investments.
And The People’s existing money stock is being debased, day by day, as this evil process continues unabated.
And The FED gets a nice return on its ‘investments’ (purchased with printed money, which really belongs to The People).

It really amounts to a game where the too-big-to-fail banks are getting a subsidy directly from The People, and very few of The People are wise to this scam, although more are learning about it, day by day.

Great related post, by the way, by David Stockman at http://mises.org/daily/5113/The-End-of-Sound-Money-and-the-Triumph-of-Crony-Capitalism

the Fed is being the “Sucker of last resort,” a role generally reserved for the investor and taxpayer.

The FED is never the “Sucker” — THAT role is ALWAYS reserved for The People.

ITGF March 17, 2011 at 3:52 am

Can someone explain this to me?

“if Bernanke started selling off hundreds of billions worth of Fed assets (consisting of Treasury debt, Freddie and Fannie debt, and mortgage-backed securities), it would cause a sharp spike in interest rates…”

I’m assuming its because there would be a sudden reduction in the supply of money. Right?

Colin Phillips March 17, 2011 at 4:20 am

As I understand it, interest rate manipulations work as follows:
The Fed holds Treasury bills, which are promises from the treasury to pay, say $100, in one year’s time, to the bearer of the treasury bill.
When the Fed decides to sell these treasury bills in any significant amount, this will change the supply of treasury bills, but the demand for treasury bills from the rest of the market will be unchanged (per assumption). So the price of a treasury goes down, because supply outstrips demand.

So, assume the treasury bill was originally trading at $99 – you pay $99 now, and get $100 in a year’s time, so your effective interest rate earned on your investment is around 1%. If the price drops to $91, then you are earning $9 per year on a $91 investment, so your effective interest rate earned on investments is close to 10%.

When you have such a sharp disparity in interest rates, the financial system will make profit by reducing the spread between the two, so the rate will come down somewhat, but only because the interest rate on everything else will go up.

At least, this is how I understand it…

ITGF March 17, 2011 at 4:01 am

Another question.

Is it just me, or can anyone else see that the chart shows THREE not TWO quantitative easings?
1) Sep 08 to May 09
2) Sep 09 to Feb 10
3) Dec 10 to ….

Jimmy s March 19, 2011 at 9:40 pm

Nice analysis. a couple caveats 1) on the third solution “raising requirements” the fed doesn’t have to make drastic changes as to create the given scenario.2) Realistically couldn’t the Fed could use all three methods on a smaller scale in conjunction, to either sop it up or significantly slow its entry to the economy?

Kaylea April 12, 2011 at 5:26 pm

You’ve hit the ball out the park! Icndrebile!

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