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Source link: http://archive.mises.org/7137/dont-discount-the-fed-discount-window/

Don’t Discount the Fed Discount Window

September 13, 2007 by

Though many have dismissed the Federal Reserve’s decision to drop the discount rate from 6.25% to 5.75% as mere window dressing, there are reasons to think otherwise. Citigroup, JPMorgan Chase, Bank of America and Wachovia each borrowed $500 million from the Federal Reserve discount window last week. Average end-of-day Fed credit outstanding for the week ending September 5 measured $1.1 billion, the largest balance loaned out via the discount window since September 2001 and the most since the discount window was reformed in 2003.

Of interest too are the sorts of collateral the Fed accepts nowadays from banks in return for loans. The list reads like a Who’s Who of the investment world. The regulars turn up: US treasuries, government agency debt, and foreign government debt. But the Fed can accept far more than that. FULL ARTICLE

{ 8 comments }

DickF September 13, 2007 at 10:25 am

Great article, but alarming.

The farther we travel from the 1970s (and Volker in the 1980s) the more we empower the monetary authorities. The history of the French inflation of the late 1700s and how they very slowly slipped into hyper-inflation ending with Napoleon haunts me. I have friends who tell me that we know more now about monetary policy and so we will not go the same route, but we are. The members of the French government constantly said that the lesson of John Law would never let them drift into hyper-inflation, but it did.

Will we return to gold before we face such a situation? We must pray so.

Buster September 13, 2007 at 12:11 pm

Someone should make a version of Monopoly where the bank has to follow the same rules as the Fed. But I suppose after a couple of hours the players would be buried in mounds of cash and Baltic Ave. would trade for a Billion dollars. Or they could enforce price controls, and all the players would end up in jail.

Kevin B September 13, 2007 at 2:16 pm

Federal Reserve, the Board game.

Todd Marshall September 13, 2007 at 4:34 pm

Hi Paul,

Thanks for your essay. It comes the closest I’ve seen to understanding
the equation governing the management of a media of exchange:

DEFAULTS = INTEREST + INFLATION

You write:

The main risk to the Fed would be if the borrowing bank were to
go
bankrupt during the course of the loan… the
Fed would have lent a certain quantity of new dollars into the economy, it would have withdrawn only a
portion of this amount, leaving a large chunk circulating with no
backing.

This anticipates the INFLATION resulting from a failure to match
DEFAULTS with INTEREST.

What the media manager must really do is adjust INTEREST to match
DEFAULTS such that no INFLATION (nor DEFLATION) arises.

The fact that virtually no one gets this is evidenced by the lack of
monitoring and reporting of DEFAULTS. INTEREST and INFLATION rates are
widely monitored and reported. Without monitoring and reporting
DEFAULTS, how can they possibly know how to turn the knobs on the
printing press?

Regards,
Todd Marshall
Plantersville, TX

Fundamentalist September 13, 2007 at 6:18 pm

I don’t see how the Fed operates is different from the Real Bills Doctrine. The Fed’s goal is to monetize all debt that any business presents to it, which is essentially RBD.

But this also hilites the Fed’s inability to control the money supply. The money supply expands as businesses present banks, and ultimately the Fed, with requests for loans. To a large degree, that requires business confidence. All the Fed can do is hunt for the appropriate rate that will encourage businesses to begin borrowing. Recently, the Fed has had to hunt for the appropriate rate that will stop businesses from borrowing, but by the time it has found that rate the money supply has expanded beyond recognition. Now that businesses are going bankrupt because of the excessive expansion of the money supply, the money supply is contracting on its own. So the Fed has to fish lower for an interest rate that will keep the money supply from falling further. But if bankruptcies proceed at a fast enough rate, businessmen will be in no mood to borrow at any rate. Bernanke could find himself pushing on a string as Greenspan once commented.

It seems that the Fed has some control over the money supply, but the real economy has even more control.

DickF September 14, 2007 at 8:41 am

Fundamentalist,

Consider: when everyone is in charge, not one is in charge.

jp September 17, 2007 at 9:13 am

“In a situation in which the Fed exposed itself to significant quantities of iffy collateral and multiple institutions refused to honor their obligations, the Fed would be required to sell massive amounts of treasures in order to withdraw unbacked cash from the financial system, in the process drastically reducing the money supply and making an already precarious situation worse.”

This paragraph isn’t entirely right. Here is a better explanation:

Historically, the Fed has always been overcollateralized. It has held more assets: gold, SDRs, discount window collateral, foreign currency, and treasuries (acquired via permanent operations as well as temporary operations) than the amount of Federal reserve notes circulating in the economy for which it is liable.

Currently, the total collateral on the Fed balance sheet is $851 billion. Notes in circulation amount to $812 billion. So the Fed has about$39 billion of extra collateral.

Say the Fed were to make a $30 billion dollar loan, accepting $30 billion worth of bad collateral (say sub prime MBS). Fed collateral now amounts to $881 while notes in circulation come to $842 billion. The counterparty goes bankrupt, and the Fed is left with the collateral, which in the meantime has fallen to $0. The Fed now has assets of $851 billion but is liable for $843 of federal notes. The margin by which it is overcollateralized has narrowed, but it still satisfies the Section 16 requirement that all notes must be backed.

If the Fed were to accept too much bad collateral, and many banks were to go bankrupt, then the bank could move to a state of undercapitalization ie. it would not be backing all its notes. It could not simply sell treasuries from its holdings as previously stated to withdraw unbacked notes. These treasuries already back other notes.

The only way the Fed can withdraw unbacked notes is by increasing the statutory reserve requirements of depository institutions. These instititutions would be forced to call in loans (or refuse to roll loans over) and deposit the resulting cash with the Fed. This would rectify the situation because cash within the Federal bank system (held in depository institution vaults, reserve balances, or Federal Reserve inventories) does not need to be backed. Only circulating cash must be collateralized.

So accepting a lot of bad collateral from numerous institutions that go bankrupt can only be compensated by increasing reserve requirements. In other words, the Fed may increase the money supply for some lucky parties via loans but only at the expense of decreasing it for other unfortunate parties down the line.

Discounts Sydney December 30, 2010 at 10:36 am

I think this is great opportunity for all. Don’t miss it guy’s…

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