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You’ve seen the proof in real time.
Once-dominant industrial companies, e.g., General Motors, can run out of
money. The biggest banks, e.g., Bank of America, can run out of money. Even
sovereign governments, e.g., Greece, can run out of money. Yes, all those
organizations are still limping along, but only after being rescued by other
giant institutions, such as the U.S. government, the less unhealthy European
governments, the European Central Bank, and the International Monetary Fund.
So far, it’s been easy to get rescued. The people who run giant
institutions seem to shudder at the thought of other giant institutions being
shown up as anything less than indestructible. Of course, the rescues weaken
the rescuers and push them toward the day when they, too, may join the ranks
of the desperate.
By now it’s clear that neither big, Bigger, nor
BIGGEST implies unlimited resources. But how about central banks? In a
world of fiat money, a central bank can always print more of its own
currency. So unless it takes on debt or other obligations denominated in
something other than its own currency, it’s impossible for a central
bank to become formally insolvent. Nonetheless, it can become functionally
insolvent, void of any ability to command resources or influence markets.
That’s what happened in Zimbabwe, with a hyperinflation.
As of today, we’re nowhere near such a
catastrophe. But there is another way, long before hyperinflation destroys
its currency, for a central bank to become functionally insolvent. It’s
a trap into which our own Federal Reserve System has already stuck its foot
and now seems to be getting ready to stick its neck.
The Federal Reserve has come a long way since it was conjured by Congress in
1913. From the beginning, it was authorized to issue Federal Reserve notes
with the status of legal tender and to issue demand deposits, redeemable in
Federal Reserve notes or other “lawful money,” to member banks.
But there were constraints. Among them was a requirement for the Federal
Reserve to hold a gold reserve equal to 35% of the deposits it owed to member
banks plus 40% of the total Federal Reserve notes outstanding. In addition,
being legal tender, Federal Reserve notes were redeemable in gold. Those
restraining factors didn't last.
The 1933 prohibition on gold ownership by U.S. citizens weakened the
constraint of gold redeemability, but not by much,
since foreigners (whom governments normally treat better than their own
citizens) could still redeem dollars for gold. Next, in 1944, in conjunction
with the Bretton Woods agreement, the gold reserve
requirements were lowered to 25%. In the late 1960s, through a series of
steps, the requirements for a gold reserve were eliminated altogether.
Then, in 1971, the U.S. government told all foreigners, "If you haven't
redeemed your dollars for gold already, it's too late, ha-ha-ha." The
era of Central Bankers Gone Wild had arrived.
The Federal Reserve was not long in using its new license. In the 37 years
that followed the abandonment of the last tie to gold, successive waves of
printing reduced the dollar's purchasing power by 81%. That was mischief
enough, but nothing like the danger the Fed embraced in the fall of 2008. Determined to rescue the country's largest
banks from their subprime lending and derivative investing blunders, the
Federal Reserve in effect swapped more than $1 trillion in newly created cash
for the low-quality loans and debt securities that commercial banks wanted
badly to be rid of.
For the banks, the swap was like waking up on Christmas morning and finding
that Santa had taken out the trash and left a big sack of money in its place.
But the exchange gave the Fed a new problem – how to keep all the new
cash that banks were sitting on from fueling a doubling in the public's money
supply (M1) and the unprecedented rates of price inflation that such a
doubling would cause. The solution was to give commercial banks an incentive
to keep sitting on the excess reserves rather than lending or investing them.
The incentive the Fed offered was to pay interest on the reserve that
commercial banks keep on deposit at Federal Reserve banks, so that the money
would stay there.
The Federal Reserve is now paying interest on nearly $1 trillion in deposited
reserves. The interest rate is only 0.25% per year, but with open market
interest rates so low, it's more than banks can earn elsewhere, so it's
enough to keep the excess reserves sequestered. And at that low interest
rate, the expense is easy for the Fed to manage, only about $2.5 billion per
year.
But what happens when interest rates start rising from today's abnormally and
artificially low levels? To prevent an explosion, roughly a doubling, in the
M1 money supply, the Fed will need to raise the rate it pays banks on their
deposits, so the Fed's interest expense will start growing.
Could it grow into a problem?
Below is a summary of the asset side of the Federal Reserve's balance sheet.
Those are the assets that generate income for the Fed, income that currently
runs about $65 billion per year. Most of the income-earning assets –
chiefly the Treasury securities, agency securities, and mortgage-backed
securities – have long maturities (short-term T-bills make up only a
small portion of the total).
Given the composition of the Fed's assets, when interest rates start rising,
the immediate effect on the Fed's income will be negligible. But the Fed's
interest expense will respond immediately, because the interest it is paying
is interest on deposits that commercial banks are free to withdraw without
notice. That's not a healthy combination. Short-term rates would only need to
rise above 6.5% for the cost of keeping the $1 trillion sequestered to exceed
all of the Fed's income. The Federal Reserve would be operating at a loss.
A rate of 6.5% is higher than the historical average for short-term rates,
but it's not extraordinary. The fed funds rate was higher than that for most
of the 20 years from 1969 to 1989. (It peaked at 19% in 1981.) And it will
move back up to the 6.5% neighborhood when, as I expect, the rate of price
inflation picks up substantially.
And the crossover rate, at which the Federal Reserve starts losing money, may
be about to come down. The Fed is about to begin round 2 of
"quantitative easing," in which it creates still more reserves to
buy still more long-term Treasury bonds. Suppose that QE2, regardless of what
details are initially announced, adds up to a
purchase of another $1 trillion of 30-year T-bonds, at the current yield of
3.9%. That will add $39 billion per year to the Fed's income. But it will double the effect that any rise in short-term rates
has on the Fed's interest expense. The net effect would be to lower the
crossover fed funds rate, at which the Federal Reserve starts operating at a
loss, to 5.3%.
When the Fed does start operating at a loss, it won't be broke, but its hands
will be tied. It won't have the latitude to influence markets that it had
just a few years ago. Its choices for covering its operating loss will be:
- Sell assets to
cover the loss. It has plenty of assets to sell, but selling them would
put upward pressure on interest rates.
- Print the money to
cover the loss but continue to pay interest at a sufficiently high rate
to keep the new reserves sequestered. That, of course, would add to the
rate at which the Fed would be losing money.
- Print the money to
cover the loss and simply let the new reserves have their inflationary
effect. But that, too, would add to future operating losses, since
higher inflation means higher interest rates, which means higher
interest expense for the Fed.
If short-term rates bob up to the 5% to 7% neighborhood and stay there, all
this will happen in slow motion. Mr. Bernanke and company can still hope to
find a way out. But the higher rates go, the less real hope there will be.
Even without QE2, if the fed funds rate returns to its historic peak of 19%
(price inflation running at a similar rate would get it there), the Federal
Reserve will be losing $125 billion per year. In that case, things would move
rapidly. Then we would find out what happens when the last lifeguard has swum
out so far that he hasn't the strength to get back to shore.
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[Every month, the editors of The Casey Report analyze big-picture
trends to find the best crisis investment opportunities for subscribers. And
one of their current favorites is betting on rising interest rates – a
no-brainer for savvy investors. Read more here.]
Terry Coxon
The Casey Report
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