The Fed has been forced to seek risk while other central banks seek safety
A global slowdown — likely a severe global slowdown — is now underway. Last week’s data erased any real doubt. US retail sales are down. US real goods exports fell in September, and the October ports data (and woes with trade finance) suggest that hope isn’t on the way. The dollar’s rally also won’t help — but that will only hit with a lag. Europe is slowing. Britain is slowing far more. And China is too.
Wang Tao of UBS argues — I suspect correctly — that the weak data on industrial production stems more from a fall in domestic activity, especially a fall in construction that reduced demand for steel and cement, than from a fall in exports. But if the polls on Americans holiday purchasing plans are accurate, exports are going to fall sharply. And this time it won’t just be the garment and toy factories that feel the pain; some of China’s newer export sectors (the ones that have kept y/y nominal export growth at 20% … ) will slump too.
It isn’t a pretty picture. But if nothing else it clarifies the need for strong policy action to offset what now looks to be a sharp and quite sudden fall in private demand.
The Fed’s balance sheet isn’t any prettier. Week after week it continues to expand. As jck of Alea notes, the Fed’s leverage ratio puts Goldman Sachs and Morgan Stanley to shame. Of course, the Fed could always get more capital if it needed it. But the rise in the Fed’s leverage illustrates how it has facilitated the deleveraging of other parts of the financial sector. If it hadn’t acted, things could be worse. Really.
And for all the talk of how foreign central banks are intrinsically stabilizing forces in the market, the real heavy lifting has all been done by the Fed (with a bit of help from the Treasury). The world’s reserve managers may have been a stabilizing force in the currency markets in the third quarter — we will have to see what the IMF’s COFER data tells us (and read the tea leaves to guess what China has been doing; to stabilize the market it should be stepping up its purchases of euros, pounds and Australian dollars … ). But they clearly haven’t been a stabilizing force in the US credit market. In the first two weeks of November they added over $30 billion to their Treasury holdings at the New York Fed while continuing to scale back their Agency holdings. Paul Swartz of the Council’s Center for Geoeconomic Studies (check out its coverage of the Leaders 20) and I tried to illustrate how the Fed has been taking on credit risk even as other central banks have pulled back.
We plotted the y/y change in the Fed’s holdings of Treasuries (including Treasuries that have been lent out through the Fed’s securities lending facility) against the y/y change in foreign central banks holdings of Treasuries and Agencies. There is little doubt that Fed has been selling Treasuries — and other central banks have been big buyers.
It some sense, the Fed hasn’t just been facilitating the deleveraging of bank balance sheets. It also has facilitated a large and fairly sudden change in the composition of the balance sheets of foreign central banks, who have shifted out of Agencies toward Treasuries. Remember central banks were net sellers of reserves in October, so the recent shift toward Treasuries implies sales of other less secure assets.
Two additional points.
First, the New York Fed’s custodial holdings seem to capture about 90% of central banks holdings of Agencies, but more like 2/3s or 3/4s of central bank holdings of Treasuries — so total central bank purchases of Treasuries over the past year could be even higher than the now close to $400 billion increase implied by the Fed’s custodial accounts.
Second, we didn’t plot the surge in Treasury issuance associated with the supplementary financing account, i.e. the Treasury bills that have been sold to provide the Fed with additional funds to lend out to the financial sector. We just looked at what happened to the Treasuries that the Fed held a year ago as assets on its balance sheet. The amazing thing is that the Fed in effect needed to sell even more Treasuries that in held on its balance sheet (about $559 billion more) to finance its lending to the global financial system during this crisis.
Outstanding blog. I never leave comments because I can’t keep up with you. I understand what you report and find it fascinating. You are a wealth of knowledge -thanks for the great blog!
Brad,
If Bernanke pulls this off. He will turn out to be the greatest Federal Reserve Chairman in history. There will be several new Federal Reserve tools attributed to him. But if he fails, than the U.S. government will have to bail out the Fed, and he will be blamed.
Past Federal Reserve Chairman have been content to hold the safest of all possible investments, U.S. Treasury Bonds. The interest that they would earn on those bonds, would eventually get paid back into the U.S. Treasury.
Bernanke is basically swapping Treasury Bonds for much more risky bonds (including those of foreign governments and of the agencies) that pay much higher interest interest rates. He gets the advantage of higher interest payments and the disadvantage of higher risk of default.
If he makes money, the additional interest that he earns will help balance the U.S. budget. If he loses, he will add greatly to the Federal Debt, and the U.S. taxpayer will have to bail him out. Basically, he is gambling with taxpayer funds.
I think I see one problem with Bernanke’s strategy. He may be having the Fed take the risk should these assets go into default, without giving the Fed a chance to benefit from an upside should the value of these assets increase.
Take the currency swaps for example. He gives the foreign governments the option of trading back in the future at the original currency exchange rate. Thus he has no opportunity to make a profit should the foreign currencies rise against the dollar.
Am I understanding things correctly? Is the Fed putting the taxpayer at risk without giving the taxpayer much chance to profit if there is an upside?
Howard
http://www.tradeandtaxes.blogspot.com
Forced?
I do not think that word means what you think it means.
KnotRP – inconceivable!
Watch the announcement at 11am Monday re: the Supplementary Financing Bill. They let a $50bn bill roll off this week, and we’ll find out on Monday if they do the same with the $30bn bill coming due. I suspect they will also let this roll off, signaling that they are winding down the supplementary financing program.
This is key. The SFP has essentially “fiscalized” some $580bn of Fed lending. The Treasury borrows from party A, and gives the funds to the Fed, who lends to Party B. So, while the Fed’s balance sheet is expanding via this exercise, its not printing the money. There’s no net money creation.
Should they wind down the SFP, that changes. So on Monday i suspect they’re going to signal another half a Trillion Dollars of money-printing is in the pipeline.
Brad,
There s not much that can de done. The USD is above its FEER value against many currencies, but not against its main trading partners (given the strength of the JPY. I do not think that dramatically reducing Treasury issue (and resorting to overt money creation by the FED system) would have much of an effect, except distorting the yield curve and indirectly pushing up credit spreads further. The heart of the problem is the botched rescue of F&F. Guess the incoming administration is going to do something about that.
NIALL FERGUSON: Well, I can’t remember the last time I was present at a meeting where there were 20 people around the table and anything very constructive emerged, but that may just be academic life in action.
It’s certainly true that when, in 1944, a new financial architecture was created for the post-war world, the Bretton Woods system, it was the G-2, Britain and the United States. And I must say, today I think we could do with another G-2 to look really hard at the fundamental underlying relationship of the global economy, and that is now the relationship between China and America.
In “The Ascent of Money,” I talk about Chimerica, that one economy that’s right at the heart of the system. It’s the imbalance between China and the United States which is really the key to this crisis.
Let me put it this way. If China decides to switch its resources to a domestic stimulus program away from helping to finance the U.S. current account deficit, then we’re in big trouble, because the U.S. is looking to borrow more than $1 trillion from the international capital market to finance its bailout.
I suspect that we need to look much more closely at the China-America relationship and not really worry about the other members of the G-18, who, frankly, could wait on the sidelines while the big questions are hammered out between the big two.
[...]
The problem is that the host is President Lame W. Duck, and that really puts the mockers on the likelihood of this meeting delivering any very positive result, especially after President Bush’s I thought rather inflammatory speech yesterday.
I must say, when I hear President Bush defend anything, I have to question it. And when I hear him defend the free market, then even I, as a staunch free-marketeer, become a little bit nervous.
This doesn’t set things up well. We’ve got the Spanish representatives talking about coming to attack economic neoliberalism. I mean, this has the makings of a really pointless slanging match at this point.
And as I’ve said, I think it would be much better if the United States were to talk directly to one of its biggest creditors, if not its biggest creditor, China, and try to ask the question, how can we coordinate our stimulus packages? How can we coordinate our monetary policies so that our relationship doesn’t break down?
Because I think if that China-America relationship goes wrong in the year ahead, then the world comes significantly closer to a Great Depression rather than just the big recession that we currently face.
Brad,
It seems that there are now common interests among all concerned for the Chinese and Japanese to divert their reserves to buy government debts other than US treasuries.
For US, such purchases shall stop the appreciation of US dollar and support American export.
For the Chinese and Japanese, it means a more diversified portfolio and less risks in the unfortunate case of a run on US dollars.
For Europeans, it means more buyers for their government debts, at a moment when they need to borrow money to shore up their financial institutions.
For other emerging economies (Russia, Brazil), it means much needed infusion of fund to stabilize their currency.
Is there anyone in the G20 meeting to propose such purchases?
And money at the treasury doesn’t go elsewhere? C’mon, ultimately the $ goes where it’s deemed most needed… who does the “deeming” though is debatable
awesome! elizabeth c. economy
It is not the Fed that is taking the risk, it is the US taxpayer. The Fed is doing everything possible to enrich the crooked banks with money robbed from generations of US citizens. Proof, that the last thing the Fed and Treasury want are transparency and honesty, can be found in the extreme oppositon mounted against Bloomberg’s quest, through the Freedom of Information Act, to let the public get a glimpse of the collatereral the Fed has taken in against its $1.5 trillion in loans to those very banks, who refuse to mark to market their level 3 assets.
Obama has sent a very clear message to the G20, by sending James A. Leach as his senior advisor to the summit. That is the same Leach who authored the Gramm-Leach-Bliley Act that repealed the Glass-Steagall Act and vitiated any firewalls standing between depositors and the insurance and securities brokers. The Gramm-Leach-Bliley Act may well have been the genesis of our current worldwide banking crisis and oncoming US depression.
James A. Leach also sponsored the The Commodity Futures Modernization Act of 2000, also known as the “ENRON loophole”. Again, this is the man Obama picked as his senior advisor and sent to the G20 summit. How is this “hope” and “change”.
I see that dr. ferguson hasn’t been persuaded by my arguments that china’s stimulus will keep china’s purchases of us debt from going by offsetting a fall in domestic chinese demand rather than lead to a sudden fall in chinese purchases. the us incidentally won’t be borrowing $1 trillion from the world’s governments next year. it cannot when the world’s governments aren’t adding those kinds of sums to their reserves. global reserve growth was negative in october. moreover, the us current account deficit will fall — if only b/c of the fall in the price of oil. the fall in oil prices from $120 to $60 represents a roughly $300b improvement in the us trade balance (assuming no cuts in imports in the oil exporters, but even so, that would in the first instance impact others).
I don’t think people have internalized the fact that the recent fall in us consumption and likely fall in investment means a lot more savings in the us for the us government to borrow, so less financing from china isn’t as much of a problem. and if higher rates on treasuries start to be a drag on the us, the us can scale back …
conversely, i am worried that many in the us seem resistant to the notion of adjustment — and view any increase in chinese demand for goods as a threat to chinese demand for treasuries rather than as an opportunity for the US to sell more to china, or to sell more to others who are selling more to china.
davidHK — my sense is that reserve management is too sensitive a topic to be raised at the leaders level; it is central to folks sovereignty. but it certainly would be good time for china to reallocate its reserves toward other currencies — as yes, $ and rmb strength are a potential problem. of course europe is quite happy to see the euro fall and probably wouldn’t welcome any increase in chinese demand; note the EADS profit this quarter.
The G-20 summit was a failure because it failed to address mercantilism (the strategy of maximizing exports while minimizing imports). The emerging countries were growing rapidly through exports without buying a corresponding amount of imports. The result was that they eventually bankrupted the net importing countries, thus spoiling the market for their exports.
Howard Richman
http://www.tradeandtaxes.blogspot.com
Howard: Am I understanding things correctly?
It seems not. First, you make the (common) mistake that the Fed is swapping its treasuries for risky bonds. In fact, the Fed is mostly making – ie buying – loans to banks, with the role of the risky bonds being confined to that of collateral only. Only if its creditor goes bust does the Fed end up owning the risky bonds, and even then, given that the collateral was valued with a large haircut, the Fed probably gets them at a below market price. With a sufficiently large haircut, this could be even safer than holding treasuries. Incidentally, the fact that the Fed needlessly held so many treasuries before the bust is one reason why the US cannot blame China for low long term interest rates before the bust. If the bank repays the loan as planned, the Fed returns the risky bonds, and does not benefit from the high yield. To fund these loans, the Fed has sold some of its treasuries and lent out others.
Second, while no details of the terms of the foreign exchange swaps have been published as far as I am aware, I would expect that the currencies are re-exchanged at a fixed forward price (ie the swaps are like a loan of dollars from the Fed to foreign central banks against foreign currency collateral), and that the Fed is not giving the foreign central banks an option.
Brad: The rise in the Fed’s leverage illustrates how it has facilitated the deleveraging of other parts of the financial sector. If it hadn’t acted, things could be worse. Really.
DJC: Then why are Paulson and Bernanke in a legal lawsuit battle with Bloomberg over failing to disclose to the American people exactly what they are doing with taxpayer money. Trillions of dollars in taxpayer money has been transferred to politically-connected Wall Street banks without any transparency or regulatory oversight. Paulson is further suspending “mark to market accounting” to permit more Enron creative accounting. As the largest counterparty to AIG, Goldman Sachs is the primary beneficiary of the $150 billion taxpayer bailout of AIG. Where is it written in the US Constitution or Federal Reserve charter that the federal government will bailout non-bank “private” corporations?
Brad,
Excellent comment. You were exactly correct when you wrote:
However, I disagree with another part of your comment, the part in which you predicted that the current trend in global reserve growth would continue. You wrote:
I see the fall in foreign government reserves in October as simply a temporary trend, a result of their currencies weakening too rapidly vs. the dollar.
If you look at the history of foreign government reserve accumulations you will note that they were especially high, as a percentage of the U.S. trade deficit, in 2003-2004 and in 2006-2008, periods when the dollar was declining in currency markets.
Foreign governments appear target exchange rates. They want their currencies to be weak enoough so that their products can gain market share in world markets, but they don’t want their currencies to weaken so quickly that their businesses have trouble paying back dollar-denominated loans.
Right now we are going through a period where foreign private savings is flowing into U.S. Treasuries so rapidly that the dollar is strengthening too rapidly for these central banks. Their reserves will again resume their climb when the dollar stops strengthening on its own.
Howard Richman
http://www.tradeandtaxes.blogspot.com
The German 10-year bond auction failed last week. Does anyone really think this protends well for the Fed, that may be coming to the market next year having to borrow up to $1.75 trillion? Not even a US account surplus with change that, and there will be no US account surplus.
DJC, good comment on Bloomberg. How I’d love to see him as the next Treasury Secretary. That will probably happen right after Obama makes Spitzer Attorney General.
Brad, somebody. Help me understand why it does or doesn’t matter, in a fiat currency world, that the US Treasury, owning approx. 55,000 tons of the worlds 150,000 tons of gold and scores its gold at $42 an ounce and the EU Treasury (Germany) which owns another 55,000 tons and scores its gold to the market and the Chinese which owns most of the worlds silver. and scores it precious metals cash to who knows what.
Does the real wealth of ones treasury not matter in a global central banking fiat currency system……..? If it does matter and you are the reserve currency, wouldn’t scoring your treasury’s gold at $42 an ounce give you a lot of reserve monetary fire power (credere)- when the market price is actually $700+ higher than your score?
Isn’t this a form of risk management?
known knowns.
the statement coming out of the g20 meeting said nothing. so that’s a known unknown. we know that they are telling us nothing. only the fact that it was a g20 not a g7/g8 or whatever tells us that we are into a multilateral world – for richer or poorer.
as for obama’s observers – better that he send the old guard, and after popular reaction to the crashes to come, retire them in favour of new blood, than vice versa. not only is he not going to the ball, but he’s not risking anyone associated with new thinking, either.
and he’s not buying his kids’ new dog until bush’s dog is clear of the white house kennel, either . . .
i suggested a long time ago that oil would go to $40 / barrel, that china’s dollar reserves were not necessarily a mistake, that obama would win alaska (something very funny happened to the vote count there . . . ) and the leveraged debt would go out of fashion.
i accept that the future is ever uncertain and that history consists largely of things that were not meant to happen – until they did – but at the moment the global deflationary slump is winning hands down against the unilateral superpower hyperinflationary getaway helicopter.
we have moved gradually but inexorably from ‘recession’ talk to ‘biggest recession since . .’ talk to ‘is this a depression ?’ talk
does anyone else wonder if this is a really big turning point – end of the automobile age ? end of the expansion stage of the industrial revolution ? beginning of the contraction of civilisation ? these may seem a bit of a stab in the dark, but it is only afterwards that the number crunching experts get the numbers to crunch. prediction is always done in a fog.
Brad,
Doesn’t the US want a weaker dollar? How else will we restart exports, devalue debt and seek to rebuild to produce something of value other than financial paper?
Capital flows will be guaranteed to come in as others seek to devalue their currencies, no?
Isn’t the pain of some domestic inflation worth it? Wouldn’t they do some unsterilized debt monetization as several times before to bring this on?
If the numbers I found are correct the average household debt for just credit cards is $8,400. You suggest that the slowing of consumption will free money for Treasury bond investment through savings. Won’t this money first go to reducing household debt? This may help recapitalize banks and therefore reduce the need for further bail-out funds but won’t help in covering the money that has already been used and will be used in the short term future. Or am I missing something?
About twenty years ago, I was talking with a Polish academic about “the economy”, what is “good for the economy”, and what is “good for us”. My acquaintance was rather sarcastic regarding what he saw as American naiveté. He response revealed his cynicism: Who exactly is “Economy”? And, who exactly is “Us”? I do not know anyone by these names.
I am thinking of him when I read a response like “If China decides to switch its resources to a domestic stimulus program away from helping to finance the U.S. current account deficit, then we’re in big trouble, because the U.S. is looking to borrow more than $1 trillion from the international capital market to finance its bailout.” Glory may be totally right, or very wrong, depending on the definition of “we”. Joe likes to spend his summers at Cote d’Azur, so he would hate to see the dollar be devalued by 40%. Jane has a job that competes with exports, no savings, and lots of debt; so she would love to see the dollar be devalued to extinction.
Brad,
Here’s some statistical data to support my contention that Foreign Banks build up their dollar reserves fastest when the dollar is falling.
In 2001 and 2005, the dollar was up by 3.5% and 0.5% in foreign exchange markets (Federal Reserve’s Broad Index of the dollar). Those years, foreign central bank additions to their dollar reserves (extrapolation from COFER database) were 24% and 44% of the US Current Account Deficit.
On the other hand in 2003 and 2007 the dollar was down by 7.5% and 7.7% while foreign central bank additions to their dollar reserves accounted for 71% and 109% of the US Current Account Deficit.
In other words, the October fall in Central Bank Reserves could be a temporary fluke, the result of the dollar rising so rapidly in foreign exchange markets.
Howard
EconNovice,
You are missing something. Many American households have been saving right along. American savings used to be zero because for every household saving there was another going deeper into debt for consumption. Now, the savers won’t be offset as much by those who are expanding their debt.
Howard
brad — your post beautifully illustrates another one of the ramifications of having the USD be the de-facto world’s reserve currency, for better or for worse (or both).
knotRP — yes, force is a word with multiple connotations, both for the subject and the object of the verb.
urbanDigs — read your latest blogpost. nice interpretation of the self-delusion. this line particularly stuck out for me:
USA — Agriculture: 1.2% of GDP and 0.6% of jobs; Industry: 20% of GDP and 22% of jobs; Services: 79% of GDP and 77% of jobs.
i/o/w the US economy is invertedly proportioned to the basic survival needs of human beings. not too healthy considering LBnker’s latest.
glory: “the Bretton Woods system, it was the G-2, Britain and the United States”
the IMF published a paper in 2002 entitled ‘Why White, Not Keynes?’ that gives an excellent history of the G-2 battle at BW that explodes the popular myth that BW was Keynes’ baby…a great read:
http://tinyurl.com/5c67a3
p.s. EE’s article you referenced makes a nice point — “The best thing we can do for the world, so China’s leaders say, is to take care of things at home.” perhaps the best thing the US can do as well? (see urbandig paragraph above)
rebel: “I would expect that the currencies are re-exchanged at a fixed forward price and that the Fed is not giving the foreign central banks an option.”
aahaha, thanks for clarifying this. this would mean that these swaps are ‘pegged’ yes? if so, wouldn’t that be applying an implicit pressure on foreign CB’s to stabilize their FX rates within a reasonable range of that forward price?
novice: “Won’t this money first go to reducing household debt?”
i was thinking the same thing….maybe that’s why the FED raised their deposit rates?
consumer debt drawdown —> incr in bank cap —-> incr in bank deposit @ FED —-> FED can buy more treasuries (frac/res banking baby) —-> USG can issue more treasuries
private debt becomes public debt with no direct monetization (for the moment)
gillies: nice observation on mr. obama. in basketball parlance, it’s called the crossover dribble or how BO likes to call it — the okie-doke. the amazing thing about the crossover is that with a true court magician, even after you know he can do it, and you know he’s going to do it, you never know when until your back is on the court and the ball is in the hoop.
and yes i wonder the same thing as you all the time, but wonder if it’s necessarily has to be a bad thing this go around. with all the black swans flying about, one of them is bound to fall in love with a white swan and produce a mutt swan….and thus evolution continues….
lb,
Since the central banks involved fix the forward exchange rate (ie the terms at which the initial exchange of currency is reversed) at the time the swap is opened, exchange rate movements during the lifetime of the swap should not matter. In fact, such a foreign exchange swap is more of a punt on interest rates. Given the size of these swaps, we should be told more details of the terms involved (perhaps Bloomberg can ask?).
The FED is over-leveraged, as in beyond GS and LB.
Yet, the FED can always increase it’s capital base.
How, pray tell?
And how possibly, without accelerating the fall into the abyss?
And, from where does the FED obtain the $$ to pay the interest on all the “leverage”?
Approaching game over !
Approaching game over !
rebel, i know you explained this b4, thanks for repeating it again with the addition of the int.rate variable…i understand it better, but still something escapes me.
if the swap FFP is let’s say 1x=2y. at the end of the swap, the open mkt FX rate is 1x=2.2y, country X is getting back their x with more value to y in the open mkt than what they swapped it for (and vice versa to country Y).
i understand in the frac.res CB galaxy that doesn’t necessarily make much of a difference given that the banks can create & destroy money at will,
BUT it is being done in an environment where:
1) only one of those currencies is being lent out into the private sector to settle private obligations.
2) there is a large potential for those swaps to be rolled-over as the private sector is currently unable to repay their loans to the CB’s (as brad surmised).
3) a massive fiscal stimulus may be undertaken in multiple countries before the swaps are finally settled.
4) country X has swapped with 1/3 of the alphabet, including many of the countries who just so happen to be also major trading partners with country 贼德.
i can’t put my finger on it, but i’m still wondering if the FED is really taking all the risk it seems it is, or whether if there is a hidden quid pro quo for taking on that added risk (which is massive given the cumulative size of the swaps).
maybe i should call 311 and hope that mayor mike is manning the phones tonight…
thanks lb, i was peripherally aware thru keynes’ new school bio, but not to that level of detail. i kinda always wondered ‘what if bancor had been adopted?’, but doubt that it would have been adhered to and now, really, if it even matters…
i still think revitalising SDR is worth a try
altho predicated on a level of political coordination that the g20 has amply demonstrated is lacking!
lastly pinging around in the recesses of my brain lately i’ve been thinking whether marx was (or, charitably, may be) right via polanyi (and gellner – viz. danegeld cf. the ‘social bribery fund‘).
like social value wasn’t so much management ‘theft’ as payoff, but when you consider that ‘taxpayers’ are increasingly owning vast swaths of the means of production you have to at least entertain the thought that there might be something more to those reflexively making quips about socialism…
Brad and Howard,
Lower consumption is lower consumption is lower consumption; both former borrowers and former savers reduce consumption in a severe recessionary credit contraction.
We may all wish to believe that this will result in a net increase of domestic funds available to buy Treasuries (because “the savers won’t be offset as much by those who are expanding their debt”), but that is well, wishful thinking.
The credit contraction produces a business contraction (including loan defaults & higher unemployment), which in turn produces a net overall decrease in funds for savings available, including for Treasury purchases – at least until the cycle has bottomed and both credit and business activity start increasing again.
Or, put another way:
Contracting credit is contracting credit is contracting credit; Treasuries are a form of credit.
Relying upon the current panic psychology to go on and on in order to sustain (ever greater) Treasury purchases at close to 0% return in a deleveraging world, so that monetary and fiscal profligacy can be fully funded, is as risky and irresponsible as anything Wall Street and American homeowners have done during the last decade.
Brad, summing up your positions on various China Policy issues; you make the following points. Please correct me if this is not your position.
1) Fiscal Stimulus:
You seem to be in favor of fiscal stimulus in China and a gradual re focus on domestic rather than an export led growth for the Chinese economy.
2) US Deficit Reduction:
You would favor a reduction in the US deficit. You would like this reduction to happen through increased US exports to China rather than through reduced US imports. I remember one comment from you that much lower imports from China wouldn’t be good for anybody.
3) PBoC holdings of Agencies:
China has been selling Agencies and buying Treasuries instead. In an ideal world you would like China to buy Agencies again.
4) Export Subsidies:
China announced export subsidies and you were not in favor of China providing export subsidies.
Summary:
Overall, what you’re proposing during the crisis is that China will continue to maintain open market operations to strengthen the US dollar. PBoC will accumulate Agency bonds and provide much needed financing for the US real estate market. There will be a fiscal stimulus in China and this stimulus will lead to increased exports from the US to China, presumably exports of civilian aircraft and high-end construction equipment, etc.
Bretton Woods II:
Since 2004 you have been pointing out the risks associated with the global imbalance in trade flows, and more pointedly China’s mercantilist policy to keep the RMB weak. Specifically, you have been postulating that Bretton Woods II will suffer a hard landing before the end of 2010 if things continue in the same way.
My understanding is that this position has not changed, and what you’re trying to convince policy makers to achieve is a gradual re adjustment rather than a sudden shock, which you think has a very negative effect on both the US and the Chinese economies.
On each of these points above, it’s important to understand the viewpoint of the Chinese side:
1) Fiscal Stimulus:
The Chinese Government has already announced a huge stimulus package.
2) US Deficit reduction:
The US has always been free to export goods and services in industries where US firms have a competitive global advantage. However the effect of the current global crisis is to decrease demand for these exports rather than increase it. Expansion of US exports will largely depend on increased demand in foreign countries.
3) PBoC holdings of Agencies:
In case of the Fed and Treasury they have a clear political mandate to support the Agencies, to help their domestic economy. PBoC does not have such a mandate. The current crisis has clearly clarified the position of the F & F as being simply private US companies. PBoC officials are likely to face a great deal of censure if they were to buy Agency bonds and if the Agencies were to default later.
My guesstimate is that if the US were to convey an expectation to China to buy Agencies, they would in turn expect the US to provide a full guarantee to the Agencies rather than a conservator ship. The conservator ship’s Captain is sailing on heavy seas and he is on the way to handing over the ship’s command to some other new captain.
4) Export subsidies:
If China’s Govt. provides export subsidies, they are in effect subsidizing US consumers, since the local competition will likely ensure that the benefits are passed on. In any case getting cheap goods from China is very good for US consumption and in times of this crisis more people than ever before are relying on Wal Mart.
The discussion on China policy above should lead to a discussion on the creditworthiness of the Agencies, and the possibility of the US providing an FF (Full Faith) guarantee to F & F.
But such a discussion would not be complete without a clear understanding of the origin, causes and consequences of the current global crisis.
Something that needs to be understood is that there has been a fundamental change in the relationship between the Fed and the Treasury. It used to be that the Fed financed the Treasury. With the hollowing out of the Fed’s holdings of Treasuries and taking on of all sorts of dodgy assets, including through the swaps with European banks, the toxic waste left over from the collapse of the Europana SIVs, that the Treasury is now financing the Fed, which ultimately means US taxpayers, as has been pointed out above.
Flabbergasted,
Great post. Your Pole is on the right track. How did he do since then?
Finally!
I’ve managed to tally up a few numbers very approximately and I think I now have a better insight into the causes of the credit crisis than ever before. As well as the corresponding reasons to buy banking stocks now.
Mark to market losses on selected financial assets = reduced market value of homes with outstanding mortgages on them + reduced recoverable from auto loans + reduced recoverable from credit card loans.
‘Selected financial assets’ in the above equation include:
Home equity loan asset backed securities
Home equity loan abs collateralized debt obligations
Commercial mortgage backed securities
Collateralized loan obligations
Investment-grade corporate bonds
High-yield corporate bonds
The current valuation of securitized instruments indicates that the market is ignoring the creditworthiness of the borrower and assuming that all borrowers who can default will do so. Arguably, the market valued these same instruments higher earlier due to the higher market value of homes then, similarly ignoring the credit worthiness of the borrower then.
Despite all the complicated mathematical credit risk models!!!
The mark to market loss in ABS, ABS CDOs, etc (which might have been synthetically constructed from CDS, instead of SPVs) depicts the reduction in market price of these bonds, and this reduction agrees with the reduction in market price of homes and cars, etc.
This reduction would justify lower valuation of the financial institution’s assets and hence a lower stock price for them.
This loss should not be confused or compared against actual loss from actual defaults on mortgage loans, which are likely to be in the $100 b range.
Mark to market losses:
In the Bank of England’s latest Financial Stability Report (go to page 14 and see the table alongside the title ‘Losses on financial assets’) estimates mark to market losses in selected financial assets in the US to be around $1577.3 billion as of close of business hours on October 20, 2008.
Home prices:
I looked up the OFHEO data on home prices and noticed that median home prices have declined around 17% or so off their April 2007 peak in 2 states, California and Florida, whereas on a national basis the decline in median home price is around 7% (this was the latest available OFHEO data in October; you can go over these numbers again and also look up the Case Schiller and Association of Realtors’ price estimates, which are in a similar range for the purpose of our analysis).
So overall median home price in the United States has declined around 7% off the April 2007 peak till date.
It’s quite likely that if you can get hold of average home price data rather than median price data the decline will be a few hundred basis points higher because California and Florida are pretty huge states and home prices there are quite high as well.
Total outstanding mortgages:
The total value of outstanding mortgage loans in the United States is estimated to be around $ 11 trillion. (I’m not able to recollect where I read that)
Approximate Calculation:
The decrease in market value of all the ‘selected financial assets’ seems to correspond approximately with the decrease in market value of all the homes that have an outstanding mortgage on them, plus you have to make allowances for defaults in auto loans, credit card loans, etc.
If you assume around 10% decrease in market value of homes on an average basis you get a total reduction of around $1100 billion (i.e.10% of $ 1.1 t in outstanding mortgages). Similarly the market seems to be recognizing a reduction in marketable value of cars, etc, and recognizing the risk of default in credit card loans, on the assumption that there might be defaults in such loans. This should explain the remaining $400 b or so in the reduced market value of the selected financial assets.
Hmmm … in retrospect the Simple Example Approach seems to be much better than all this complicated stuff from various indices and reports so here goes …
Borrower J gets a home loan of $100,000 from Bank B. Bank B issues a securitized bond against the mortgage loan and Bank L buys the bond. Bank L’s asset is valued at $100,000 since the home was bought for $100,000.
Now the market price of the home falls to $80,000. Borrower J is struggling to make payments and receives a delinquency notice. The market panics and re values Bank L’s bond down to $80,000. This reduction collapses Bank L’s stock price accordingly.
The market ignores the creditworthniess of all borrowers and re values all such bonds held by all such Bank L’s down, to reflect the reduced price of homes.
Quite an incisive comment above by Barkley Rosser.
15 reasons the US economy will get worse: Link Here
Latest from Bill Fleckenstein,
http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/trillions-down-and-still-bailing.aspx
Unfortunately, despite some 12 financing facilities created by the Treasury and the Fed, massive interest rate cuts and various bailouts, the government has little to show for its attempts to dictate where markets should trade.
The Fed’s own balance sheet has exploded from roughly $900 billion worth of debt in August to around $2 trillion as of last week. Knowledgeable sources expect that to reach $3 trillion by the end of the year.
That means that it will have grown from approximately 6% of gross domestic product to more than 20% in the space of four months. I think it’s certainly dawning on folks that when the government “does something,” it often creates more problems than it solves. In this case, as it props up poorly managed companies, it may only be allowing them to rain further havoc on the better ones in their industry. American International Group (AIG, news, msgs) is an example of this, and I’m sure many other financial entities will turn out to be as well.
Though the government hasn’t admitted it yet, we are in a recession, and in this particular instance, it seems to me that creating jobs will be an unusually severe problem. That’s because the economic expansion we saw from 2002 to 2007 was essentially just a function of speculation (as I have stated often — and I explain in my book “Greenspan’s Bubbles”).
Owner Earnings:
Lower Wages: Yes, this is a separate independent problem.
Here’s my take on your laundry list of the 15 reasons why the US economy will get worse:
1) Unemployment: The high level of unemployment indicates that the economy will come up sooner rather than later. Looking for a new job is typically more than a full time job in itself. Sooner rather than later everybody who’s unemployed right now will get into new jobs. Meanwhile unemployed people will make choices like cooking at home rather than going out for dinner at the local restaurant; and that can’t be helped meanwhile.
2) Asset Declines: More specifically, you’re looking at the effect of reduced home and stock prices. You say people planning to retire based on their home price or stock price would have to postpone their retirement. This is actually good for the economy. Secondly you say that spending plans based on the stock and home prices will get affected. This could be true.
3) Tighter Credit: You’re right in saying that if the people formerly employed in providing more credit are unemployed now, that’s bad for the economy. But then we have to reject this reason as a separate reason. You already counted the unemployment reason in reason #1.
4) Higher Interest Rates: Interest rates are responding to the Fed’s rate cuts. The response hasn’t been good enough so far, so logically it has to get better and lead to interest rates getting lower than they are now. So this is again an indicator that things will get better sooner rather than later.
5) Global Recession: The global recession only affects the jobs of people who’re employed in export oriented businesses like assembling aircraft engines. And that doesn’t seem to have happened as yet. Credit availability from foreign countries is a problem but again this reason has to be rejected as double counting since you’ve already counted Tighter Credit in reason # 2 above.
6) Fear: As the Indian finance minister said, the only thing to fear is fear itself. There’re a lot of people monitoring the fear level and as it gets higher and higher these people are more and more motivated to go long.
7) Higher prices: Yes, this is a problem. But prices are likely to get lower because there’s a general decrease in consumption and that decrease is because of the reasons above. So reason # 7 will make things worse but reasons #1 to # 6 are working hectically meanwhile to do away with reason # 7.
9) Pessimistic mood: Rejected as being somewhat the same as reason # 6, fear.
10) Excess Supply: (of homes) The current inventory of homes is 11 months’ sales whereas it used to be around 5 months’ sales at the height of the boom. 6 months’ inventory of homes is getting dealt with. There’s a decrease in the rate of decrease of home prices. Secondly there’s a small increase in volume of sales. The housing market is starting to look up again. But reason # 1 poses a big threat to the recovery.
11) Lower Taxes: I’m not particularly great at this topic, but it looked to me that the plan is to lower taxes for 95% of Americans, which will definitely make things better for them.
12) Stronger currency: This is particularly a very good thing for the US economy.
A stronger dollar means continued availability of cheap imports which will have a positive effect on consumption. The effect of a stronger dollar on employment through weakened exports is a completely silly argument. (Note that I’m calling this particular argument silly, and not you).
The US doesn’t have a trade surplus with any of the top 30 trading partners, and demand for products like civilian aircraft, high end construction equipment; etc which are exported from the US so far hasn’t been affected much by the rally in dollar. On the other hand a weaker dollar will make millions of people unemployed around the world and the demand for these exports will disappear overnight.
13) No Savings: Yes this is a problem.
14) Tendency to Overspend: Well if they continue to spend that’s good for demand and so this reason should be rejected.
15) Inelastic demand: This is just pure conjecture rather than anything based in fact.
DJC: According to Census data there were 127 million housing units in the US to house a population of 300 million, with the average household size varying between 2.16 and 3 point something depending on the state. And you have this Bill Fleckenstein critcising this tremendous progress in housing as a ‘Greenspan Bubble’.
black swan: The Gramm-Leach-Bliley Act may well have been the genesis of our current worldwide banking crisis and oncoming US depression.
I’m not so sure. One of the provisions of GLBA was to put the mega-banks under the supervision and regulation of the Federal Reserve, and that probably kept things from being worse than they are.
You will note that the banks that have been having trouble are the standalone investment banks and not the mega-banks that GLBA created. The reason for this is that it ended up that the investment banks were unregulated, but the mega-banks were regulated by the Federal Reserve, which meant that there was actually quite a bit of indirect regulation of derivatives and hedge funds.
If you work in a mega-bank, you’ll find that there are lots of regulators from the Fed coming around and asking very tough questions about your risk exposures and derivative positions, whereas you see no one from the SEC asking those sorts of questions. (The SEC does ask lots of questions, but those are about things like inside trading controls.)
One should also point out that answering the Fed’s tough questions requires a lot of technology. When the Fed asks you what your risk exposures are, you make them feel a lot better if you can go to your computer and print out a report explaining how all of your positions will do if there is a market crash.
The fact that regulators saved the rear ends of the big banks by asking tough questions, is why I’m very highly “pro-regulation” and why I don’t think very highly of Phil Gramm’s deregulation philosophy.
Now, I’m sure that none of this regulation was intended by Gramm. But this explains why I don’t think that trying to classify people into “good” and “evil” is terribly useful.
chidam: The current valuation of securitized instruments indicates that the market is ignoring the creditworthiness of the borrower and assuming that all borrowers who can default will do so.
A lot depends on the type of securitized instrument, but for some types of instruments (CDO’s made up of RMBS from subprimes). This isn’t a bad assumption, because the borrower has no creditworthiness at all. Those loans were backed by the price of the house, and if the house goes underwater, you really have nothing.
Twofish:
The numbers put out by Dr. Nouriel Roubini on his RGE web site blog regarding home prices are inaccurate.
The OFHEO, Case Schiller and National Association of Realtors all provide the correct data on their web sites.
‘house goes underwater’ is also an inaccurate description.
The only accurate thing you can say about home prices is that the median home price peaked in April 2007 and is now around 7% below that level on a national basis.
Secondly, before the home price peaked OFHEO reported a decreased rate of increase, then gradually the price topped off and started falling.
The most recent data from OFHEO shows a decrease in the rate of decrease of home prices.
2fish: “Those loans were backed by the price of the house, and if the house goes underwater, you really have nothing.”
backed by the price of the house AND the land, no? so unless the land goes underwater (literally), it must be worth *something*.
Chidaram: The OFHEO, Case Schiller and National Association of Realtors all provide the correct data on their web sites.
And if you ask anyone in the real estate business, you’ll find that those numbers are probably quite a bit about market clearing prices. You can list a house for anything you want. The question is will anyone buy anything for that price, and people aren’t buying houses, because the listed prices are too high.
This matters for a bank because what matters to them is the cash money that they can get if they are forced to foreclose.
Chidam: The only accurate thing you can say about home prices is that the median home price peaked in April 2007 and is now around 7% below that level on a national basis.
If you look at the time it takes to sell a house at those prices, you can quickly see that those numbers are above market clearing prices. House prices take a *long* time (three to five years) to go down. One problem is that there is no mechanism for shorting real estate to force prices down.
Brad –
This is off topic, but Pettis suggested me to turn to you.
http://mpettis.com/2008/11/would-a-trade-war-help-solve-the-problem-of-excess-capacity/
I was suggesting to Pettis that with US need to sell close to $2T of treasury bonds US might not be able to impose trade restrictions, because then China would not buy as much treasury bonds and US will suffer more.
What Pettis says is that as long as US does not have trade deficit (by imposing trade restrictions) and as long as it does not want to build foreign reserve, it does not have to sell treasury bonds overseas. It can fund it domestically.
My questions are:
1) If a country has fiscal deficit but not trade deficit, can the really fund it domestically?
Let’s assume that US imposes trade restrictions and gets 0 trade deficit. It still has more $1T to finance in 2009 as a result of general fiscal deficit + bail out packages. Who in domestic will buy it?
US banks and citizens are quite out of shape, I don’t think they can buy.
In this case, will Fed buy it by printing money? Is it really better than selling it overseas?
2)If US has to pay higher interest rate to sell its bonds, what is the impact on Fed rate? I see that a big portion of Fed balance sheet is funded by money from treasury.
As money is lent from treasury to Fed to banks, if treasury pays higher interest to borrow, shouldn’t Fed rate increase as well?
Unless it prints money and thus stops getting funded by treasury.
Would greatly appreciate your thoughts.
Also about the Fed. One other (unintentional) think about GLBA is that by consolidating things into about a dozen mega-banks, you made it much easier to regulate since you can have people from the Fed get on the 6 train march into mega-bank corporate headquarters in midtown New York and demand numbers. Which they do.
The Fed has some authority to regulate mortgage brokers, but since you have thousands scattered all over the US, you couldn’t effectively regulate them without an massive increase in the number of regulators. A lot of those mortgage brokers were mom and pop shops which are harder to regulate in a lot of ways.
One thing that worries me is that if you have the Fed try to do too much, then it won’t have the people and the budget to do things well. One problem with the “save taxpayer money” ideology is that if you want a good regulatory system, you need to hire lots of regulators and pay them very good salaries. If you try to skimp on salaries, you may find that you’ll pay in other areas. People sometimes will take a small salaries in exchange for glory, but if you skimp on salaries and then bash government bureaucrats, you won’t get the people that you need.
One reason that the Fed is a particularly good regulatory agency is that because the Federal Reserve Bank of New York is semi-private, it can afford to pay people competitive salaries. A lot of the reason that the Fed has taken the led on a lot of this is that the Bush anti-bureaucracy mentality has just gutted Treasury.
The only people that you can find to work for Treasury are people like Paulson that have already made their mega-bucks, and that opens up a host of other problems and conflicts.
lb,
You raise exactly the issues about the central bank currency swaps that should be raised. If the swaps are priced at market, then the forward exchange rate essentially discounts the money market return available in each currency. As you say, however, it is doubtful that the Fed does place its foreign currency in the local money market, so I would guess that the forward exchange rate is calculated on the assumption that the Fed earns nothing on its foreign currency.
Actually, I would guess that the swap is just a way of formalising an arrangement which is essentially one where the foreign central banks lend dollars as local agents of the Fed, and effectively pass to the Fed any interest they receive. The foreign currency leg is really irrelevant, since foreign currency “collateral” is a liability of the foreign country anyway, which would hardly help the Fed if the foreign country failed to return its dollars.
I must say, though, that these details really should be published, because the potential gain or loss if the swaps are not arranged rationally is huge when the swaps are so large.
“Current downturn will be worse than the Great Depression” – Former Goldman Sachs CEO Bankster
http://www.globalresearch.ca/index.php?context=va&aid=10941
According to Reuters:
“The economy faces a slump deeper than the Great Depression and a growing deficit threatens the credit of the United States itself”, writes former Goldman Sachs chairman John Whitehead …
“I think it would be worse than the depression,” Whitehead said. “We’re talking about reducing the credit of the United States of America, which is the backbone of the economic system. … I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America. … I just want to get people thinking about this, and to realize this is a road to disaster. I’ve always been a positive person and optimistic, but I don’t see a solution here.”
“There is no solution”.
Saudis spurn chance to help IMF
By Abeer Allam in Riyadh, Daniel Dombey in Washington, and Carola Hoyos in London
Published: November 16 2008 19:52 | Last updated: November 16 2008 19:52
Saudi Arabia at the weekend resisted international pressure to copy Japan’s example and give the International Monetary Fund additional funds to bail out ailing economies. It has opted instead to focus on domestic expenditures amid complaints from Saudi commentators that the west was attempting to “steal” the oil exporter’s wealth.
http://www.ft.com/cms/s/0/34727284-b415-11dd-8e35-0000779fd18c.html
Twofish, I think we are debating a side issue when we debate about the home prices.
However I’d like you to actually visit these web sites and see the details for yourself before you come to conclusion.
The Agencies report their data to OFHEO. The Agency data is mostly prime mortgages, and it constitutes around 60% of all mortgage lending. OFHEO looks at the actual price of transactions and does comparisons only based on the sales prices of the same home. What this means is that they mine their data on addresses and report out comparisons as to the actual sales price at which the very same home was sold for a second time.
The association of realtors reports based on sales agreements, and this includes all the agreements, prime or otherwise. It’s possible that after entering into a sales agreement and registering it, some of the transactions may not actually happen; but this effect is quite small. And it’s definitely not a case of reporting based on a listing or advertisement.
The crucial insight is that the mortgage backed assets are traded in the market, and their market value has dropped to the approximately the same extent that the actual market value of homes has. So it’s not correct to look at data from actual defaults or foreclosures, or data from actual settlement of CDS contracts and compare those numbers with the mark to market loss number on the Bank of England’s financial stability report.
What this shows is that there has actually been no failure of the free market system.
On the other hand there has been a major disruption in global finance over the Agencies. The term Government Sponsored Enterprise must have earlier created various confusions, especially in countries like China, about the actual legal status of the Agencies.
Treasury offering to sail the Agencies on a conservator ship has made it absolutely clear to every regulator and investor around the world that these Agencies are private companies rather than the US government.
Now PBoC is simply not in a good state to buy more Agencies or even hold on to their earlier Agency issued assets. Before doing that they have to think about what will happen if the Agencies default. If the agencies default then there will be a number of comrades in various committees who will issue various criticisms about how a central bank can go and buy bonds issued by a private American company. Nor does the purchase directly help the domestic Chinese economy. The only way PBoC can continue to finance the GSE bonds is if Treasury issues a full faith and credit of the united states guarantee to their bonds.
Chidam: OFHEO looks at the actual price of transactions and does comparisons only based on the sales prices of the same home.
But if a house is listed but not sold, that’s doesn’t enter into the statistics. If the last sale was three months ago, and no new houses in the neighborhood have been sold at the listed price, then the stats don’t get updated.
This is important for a bank, because in a foreclosure you have a forced sale to raise cash. If you are a homeowner, you have the option of not selling. If you are a bank with a foreclosed house, you don’t really have those option since without a sale, the house will deteriorate.
You can’t look at just the statistics. You have to walk over and talk to the people that actually buy and sell houses to see what is going on. Once you talk to people, you find figure out that there are some other statistics that you need to look at, namely in this case the time it takes to sell a house and the inventory of unsold houses.
It’s terribly easy in finance to get disconnected from reality. One thing that is the situation is that financial models don’t take into account some details that become important.
For example, pizza delivery guy shows up at a $500,000 house. He will not deliver the pizza if you don’t have $20 in cash. You won’t pay him if he brought anchovy pizza rather than the pepperoni that you wanted. This is a real world situation that breaks a lot of the assumptions of economic models.
The anchovy pizza example is relevant to the mortgage security market. The economist would say that a person would by the anchovy pizza at a discount and resell it, but that doesn’t happen when pizza delivery people show up with the wrong pizza. Similarly, people just won’t buy some types of mortgage securities, even if they could theoretically be resold.
Chidam: What this shows is that there has actually been no failure of the free market system.
I think things have failed. The whole system didn’t collapse, but the fact that we got to a point where that was a possibility means that we have to step back and fix things.
(2) Bloomberg’s Request: “During the GD, the Speaker of the House of Representatives, John Nance Garner, ordered that the identity of the borrowing banks be made public. The publication of the identity of banks receiving RFC loans, which began in August 1932, reduced the effectiveness of RFC lending. Bankers became reluctant to borrow from the RFC, fearing that public revelation of a RFC loan would cause depositors to fear the bank was in danger of failing, and possibly start a panic.”
Finally, I think it is only a matter of time before gold and silver power ahead. Precious metals were hit hard by global deleveraging and they should shine again; thanks to the money-printing abilities of the establishment. These ridiculous government bail-outs are hugely inflationary and will further erode the purchasing power of paper currencies. I urge you not to be fooled by the recent strength in the US Dollar. This is nothing more than a short-covering rally and the American currency is likely to witness an epic crash in the future. There is no way you can have a strong currency when you are the greatest debtor nation in the world (debt of US$54 trillion). Furthermore, the Fed has recently expanded its balance sheet by US$1 trillion and in my view, the US has now embarked on a hyper-inflationary road to nowhere. As the jokers in Washington continue to ’save’ the US economy (i.e. bail-out their rich friends on Wall Street), the US Dollar will eventually become worthless or it may be replaced by another currency. So, I would suggest that you take advantage of the recent rout in the markets by converting more of your cash to hard assets. If you are fully invested, please do not buy into the deflation hoax and simply ride out this weakness which should prove to be temporary.
http://www.financialsense.com/editorials/saxena/2008/1114.html
BRIC Developing Nations decline to provide funding to IMF, the stooge of the US Treasury Department.
http://www.guardian.co.uk/business/feedarticle/8036227
In the first sign of how difficult it could be to update the global financial architecture to include fast-growing developing countries like India, China and Brazil, none of the emerging countries at the Group of 20 summit offered to kick in money for the IMF to fight financial contagion.
The Brazilians went further. Foreign minister Celso Amorim declared “the G20 has effectively replaced the G8″ and President Luiz Inacio Lula da Silva echoed years of blunt advice from the West, telling rich countries to “solve their own economic problems.”
China, with a pile of foreign reserves approaching $2 trillion — the largest in history — likewise did not respond to lobbying by British Prime Minister Gordon Brown for countries running huge surpluses to contribute.
“Steady and relatively fast growth in China is in itself an important contribution to international financial stability and world economic growth,” said President Hu Jintao, which announced a $586 billion domestic stimulus plan last week.
(supplementary financing account)
At the end of WWII, the Treasury’s balance in the General Fund Account was approximately 26 bill. 1 year later these balances had been drawn down 22.5 bill. But it merely involved cancelling out excess balances held by the federal Government in the banks, balances which had never been spent. That became the precedent for excluding the Treasury’s balances from the money stock measures.
The Treasury’s supplementary operation was accomplished by putting the proceeds from the Treasury’s auction into the Treasury’s General Fund Account held at the Federal Reserve Bank of New York (the same account used above during WWII, and the same account used to accumulate and transfer the proceeds from the Treasury’s Tax & Loan Accounts).
These inter-bank deposits drained commercial bank legal reserves and their volume was sufficient to offset or sterilize the expansion of the FED’s balance sheet, resulting from member bank borrowings.
rebel: “which would hardly help the Fed if the foreign country failed to return its dollars.”
that is unless, the USD depreciated below the value of the FFP, then holding the FX is more valuable to the FED than holding the corresponding amount of USD. but that will also create an incentive for the foreign country to reswap, but if they don’t have the dough they’ll have to create it in their own currency, thus inflating the supply of that currency to buy the dollars back to exchange. once the FED receives USD in return, it can destroy it.
presto, the globalization of inflation.
now, these are ’short-term’ arrangements, which will have to be rolled over until the foreign CB can cough up the USD to reswap, which will probably mean the FFP will be renegotiated at the end of every term. but isn’t that if not a hard ‘peg’ (given numerous other variables), then at least an implied pressure for foreign countries to stabilize their currencies around the various negotiated FFP’s, even if the FED decides to inflate the supply of USD?
p.s. there is some serious currency arbitrage that could be had, IF the FFP was known by the market. maybe that’s why details may not be forthcoming anytime soon?
Bank capital as a percentage of total liabilities has declined, irregularly, from c. 35% in 1875 to 4% in 1982. In “1981, the FDIC established a threshold capital-to-assets ratio of 6 percent and a minimum ratio of 5 percent”. Basel I was adopted in 88.
The ability of banks to (1) absorb losses and still maintain their solvency, along with (2) assuring the confidence of their customers & investors, should be more dependent upon qualitative evaluations.
(for a good summary) Basel and the Evolution of Capital Regulation: Moving Forward, Looking Back http://www.fdic.gov/bank/analytical/fyi/2003/011403fyi.html
The FED should have powers commensurate with it’s responsibilities, i.e, the regulatory and supervisory decision-making processes should lie entirely with the Board of Governors, and that the Board should be reconstituted to include the Secretary of the Treasury, the Comptroller of the Currency, the Chairman of the Federal Home Loan Bank Board, the Director of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration, the Securities Futures Commission, and the Chairman of the Securities and Exchange Commission.
During the Great Depression “eligible” commercial paper, principally TRADE and BANKER’s ACCEPTANCES didn’t have “haircuts”.
p.s. i do realize my above example simplifies the mechanisms of inflation quite a bit, perhaps erring too much on the side of oversimplification (equally dangerous). however, this quote from JK Galbraith remains never too far from my mind: “The study of ‘money’, above all other fields, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.”
with that said, that the FED has consolidated so much more of the economic activity under its guise onto its balance sheet may not be necessarily a bad thing for those seeking to discover what the *truth* really is.
balance is key here as always.
“Finally, I think it is only a matter of time before gold and silver power ahead.”
DJC : i have read the article quoted by you in full, and it sets out precisely the point of view that i have repeatedly disagreed with. the reasoning in it is simplistic. it ignores the last 30 years of the oil price graph which bears no relation to the total global oil reserves over that period. it assumes that reduced supply – of oil, food, whatever – equals skyrocketing price. what is the price of bottled water in the sahara ? what was the price of potatoes in the irish potato famine ?
it repeats the mistake of king midas – forgetting that if money is worthless and you turn all to gold, what then will you turn gold into ? worthless money once again ? at what point ?
about four years ago approaching christmas 2004 i think, we had a debate over the dollar collapsing. living in the euro zone i see that from a eurozone perspective. just for fun i bought $100 in my local bank. the dollar was at about $1.33 to the euro. now it is at about $1.27. i put the notes in a drawer and recently found them still there.
i suspect that forecasters treating the dollar as if it behaves according to the rules of small national currencies (argentina, iceland ?) always risk miscalculation.
study the chinese mind. is there any evidence there of red hot anxiety to spend their ‘worthless’ greenbacks before they melt away ? if there is, i cannot see it.
flow5: (2) Bloomberg’s Request: The publication of the identity of banks receiving RFC loans, which began in August 1932, reduced the effectiveness of RFC lending.
The exact same thing happened in Japan in the 1990’s. It also happens at personal level in which there are people who would rather starve than have the stigma associated with taking a “handout” from the government.
The way around this is to make sure that rich people get money from the government as much as poor people so there is no stigma attached. This is why social security and medicare is not means tested, and why Treasury did its recapitalization by giving a lump sum to all of the banks.
lb,
You are getting too hung up on the exchange rates. Given that both central banks are committed to the forward re-exchange, and default by either party would raise far more serious problems than merely financial ones, the exchange rates at the beginning and end of the swap are almost irrelevant. Only the difference between them matters. If you lend me $100 for a year at 2% against (the security of) a paper clip, then you could see yourself as getting a poor exchange rate at the start of the swap and a fantastic closing exchange rate ($102 per paper clip). But you are committed to the re-exchange, and if default is out of the question for either of us, the exchange rates hardly matter. I dare say that the only reason that the central banks go through the formality of the swap is that the Fed does not have the vires to lend unsecured to a foreign central bank.
RBG –
it is very possible to finance a large fiscal deficit domestically. Japan does it. So does Germany. Both have fiscal deficits and current account surpluses. It does tho require that a country’s private sector save more than it invests. And while the US isn’t known for its savings, i do expect savings to rise and investment to fall, effectively freeing up financing for the us government.
as for the impact of higher interest rates, tis true that if the treasury had to pay more on its short-term borrowing, it would increase the fed’s funding costs – and might require that the fed charge more.
on the other hand the fed is taking on more risk and likely making more (so long as it gets paid back), as it has replaced long-term treasury bonds with higher-yielding (one assumes) assets on its balance sheet. moreover, the fed intrinsically makes money as many of its liabilities (cash) do not pay any interest. so in effect the fed could cross subsidize the portion of its lending financed by short-term treasury sales with the profits on the portion of its lending that is financed by issuing cash.
bottom line — the real risk from higher interest rates comes elsewhere. it would increase the treasury’s borrowing cost — making it harder to finance a large fiscal deficit. and higher treasury rates mean higher mortgage rates and that won’t help housing recover.
flow5: The FED should have powers commensurate with it’s responsibilities, i.e, the regulatory and supervisory decision-making processes should lie entirely with the Board of Governors, and that the Board should be reconstituted to include the Secretary of the Treasury, the Comptroller of the Currency, the Chairman of the Federal Home Loan Bank Board, the Director of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration, the Securities Futures Commission, and the Chairman of the Securities and Exchange Commission.
This may not be such a good idea because 1) the Fed is in charge of monetary policy and 2) if you have all of these agencies involved, you run the very real chance that nothing will get done and 3) you are leaving out the state regulators.
My one feeling is that the Christopher Cox and the SEC seriously dropped the ball as far as financial regulation goes. If you had put Cox both in charge of the SEC and in charge of the Fed, then he could have paralyzed both the Fed and the SEC.
Bureaucratic trick #157: Getting people that you know don’t agree with each other and then putting them on a board in which they have to reach consensus is a sure way of making sure nothing gets done.
bsetser: higher treasury rates mean higher mortgage rates and that won’t help housing recover.
I don’t think that recovery is the key concept. Right now the key is damage mitigation and post-disaster cleanup.
DJC: This is nothing more than a short-covering rally and the American currency is likely to witness an epic crash in the future.
I don’t think so. People that have been betting on a dollar crash have lost their shirts over and over and over again.
DJC: There is no way you can have a strong currency when you are the greatest debtor nation in the world (debt of US$54 trillion).
Way. The problem is that when the US economy crashes everyone gets hit worse so a crisis in the US has the paradoxical and perverse affect of strengthening the dollar and making it easier for the US to borrow.
Anything bad that happens to the US economy does makes everyone else economy worse, even if that damage is self-inflicted.
It’s perverse, it’s probably unfair, but it is an accurate explanation of what is going on and has been going on for the last seven years.
please, don t forget the us-eu swaps, will you. add the borrowed treasuries and one l summers research paper.
‘ there s this
Federal Reserve Bank of Kansas City President Thomas Hoenig said the central bank has “done about as much as it can do” to revive the economy, which has worsened faster than he expected.
“The focus should be on protecting the intermediation process and payments mechanism,” Hoenig said today
Authorities need to impose leverage ratios for financial institutions, Hoenig said. Basel II, an international accord geared toward allocating capital on the basis of risk, is complex, easy to evade and “pro-cyclical,” he said.
Hoenig said he would support a rule linking the suspension of dividends to the loss of earnings.
+ more
you’re probably right, rebel. many thanks for indulging me though. sometimes it’s good to talk things through to achieve an understanding, especially when it’s so complicated & mysterious.
upon further thought, i can see how the interest rate punt you mentioned earlier is the key variable to consider with the swaps, especially when the FED doesn’t have much breathing room before it goes ZIRP.
cheers
p.s. perfect example of 2fish’s trick #157: this wkd w/the G20.
Thanks, Brad
lococo,
Hoenig’s comments are not based on rocket science. Most people familiar with Basle II’s volution have seen these arguments many times before. In defense of Basle II (which I clearly do not regard as an optimal piece of regultion) it should be noted that there is more than just models. There is also process and lots of scope for responsible national supervisors to be as tough as they want to be.
The trouble is that the Basle II process got hijacked in its early stages by lobbyists from ISDA (If ever an organization should be held responsible for the current crisis (not solely of course), it is this strange beast made up of overeducated and underexperienced science people plus rather unscrupulous financial entrepreneurs) plus misguided senior banking executives unhappy whith the nature of their business: that of a rather boring utility where cost is the main variable to be managed..
But Basle II is better that Basle I and also better than the traditional US capital ratios, which are clearly unsuitable for an era in which it is impossible to separate commercial and investment banking effectively. As to the end of Glass Stegall, I think that was unavoidable, but it should simply have led to bringing all large financial institutions under a single federal charter, a single set of accounting rules (specific to financial institutions and set by the federal gvt), a single set of approved quantitative models (let banks estimate their own default frequencies, but centralize correlations, key parameters for market risk and collateral vatuation, etc. It is ridiculous that under the current rules banks are largely free to write many of the rules that determine capital adequacy (of course the regultor can challenge, but not impose uniformity without breaching confidentiality). Finally, product innovation should simply be as slow as the regulators can approve the required risk management methodologies. As said, none of this is rocket science, anyone risking his own money (whilst not yet gambling for resurrection) would not even dream of allowing his (contingent) debtors so much slack.