If you take a look at this page, you will see that the Federal Reserve has a total capital figure of $46 billion dollars, with $2.198 trillion in assets and $2.152 trillion in liabilities.
The Federal Reserve holds out the promise to the world’s markets that if price inflation takes off in the United States because of all the money printing it is doing, then it will sell its US Treasury bond assets to rein in the money supply, to then destroy the money used to purchase these bonds, and all the fractional reserves pyramided up on top of this money.
[For those interested in the mechanism of that, and much else besides, the best book on the subject is The Mystery of Banking, by Murray Rothbard.]In a King World News interview, Jim Rickards contends that if the Federal Reserve should need to do that, it will go bankrupt even according to its own rules, because it will lose more than $46 billion on the transaction. This is because if it should need to sell bonds this will be due to rampant price inflation. In those circumstances, three forces come together to send the Federal Reserve bankrupt on a sale of its bonds:
- In times of rampant inflation, interest rates will be spiking massively to control the inflation. Higher interest rates send the values of fixed-interest bonds down.
- The Fed is now holding onto much longer-term US Treasury bonds than it used to. These bonds are more volatile than short-term bonds, because changes in interest rates have more effect on long-term bonds than they do on short-term ones, due to a horrible subject called duration. (If you don’t know, then you don’t want to know.) This means that the Fed’s bond assets will be rocketing downwards in value just at the time that they need to sell them.
- Finally, because interest rates are at record lows, just tiny uplifts in interest rates have a disproportionately large downward effect on the values of bonds. This is due to an even more horrible subject called convexity. (And no, unless you really need to know, then you really don’t want to know.)
Essentially, if the Fed’s bond assets go down 3% in value for the reasons laid out above, in a time of rising price inflation, and if the Fed sells its bonds, then it will crystallise these losses and go bankrupt. The only way to avoid bankruptcy will be for it to hang onto its bonds till maturity, to collect the full principal of $100 dollars a bond, though this will be at the price of letting price inflation run rampant.
The Fed is thus nailed into a corner, claims Rickards. The one time it cannot sell its bonds is the one time that it needs to sell its bonds. Hoist on their own petard, they therefore have no viable exit strategy, says Rickards. In times of rampant price inflation they will hang onto their bonds, he says, to survive, and the devil of inflation can have its wicked way.
The full interview, which also begins with a discussion on the gold and silver markets, is well worth listening to:
There is also a related blog article.
[Personally, I think the Federal Reserve will just invent a new set of accounting rules for itself, to meet any eventuality, but it is all still very interesting nevertheless and not really something that they want anyone to know or think about. The other way out might be for them to revalue their gold assets. They currently hold these at the original value of $11 billion dollars, at $42 dollars an ounce, but could revise this upwards to the market value of this gold, which is currently $250 billion. Although it will still be fairly easy for the Fed to blow this extra money, I think it is ironic that if they do use this get-out-of-jail method, then they will have been saved by the very barbarous relic they usually deny has any place in any kind of monetary system. It will of course be interesting to see if $250 billion dollars worth of gold actually exists in Fort Knox and the Federal Reserve Bank of New York, which they will have to demonstrate if they raise this asset figure up from $11 billion dollars. I think Rickard’s idea also highlights the Golgafrincham madness of this entire fiat currency fractional reserve situation. If we were to send Gulliver to Lilliput and he were to find Lilliputian government men standing in tiny fields and printing zeroes on fancy bits of coloured paper to solve all of their economic problems, rather than working harder and consuming less, then we would rightly conclude that the reports that Gulliver brought us back of this strange behaviour were either fictional or that the Lilliputians were deranged mad men. Yet somehow, these same Keynesian myths live on in the minds of highly educated full-sized human economists. I sometimes wonder what future historians will make of us all when they find out that we tried a forty-year experiment in global fiat currencies and then wondered why it all went so horribly wrong? They must have all been mad, they surely will conclude. They will be right.]The Mystery of Banking, by Murray Rothbard
I am totally underwhelmed by Rickards’s analysis.
His basic claim is that if inflation gets serious, the value of Treasuries falls (in particular the value of Treasuries held by the Fed). This in turn allegedly means even if the Fed sells all its existing stock of Treasuries, it might not be able to withdraw enough money from the economy to control inflation.
Well the big flaw in that argument is that there is nothing in principle to stop the Fed creating government debt or “Fed debt” out of the blue, just as it creates dollars out of the blue. Put it another way, there is nothing to stop the Fed announcing that it is willing to borrow at above going rates of interest till enough money has been withdrawn from the economy to stem inflation. As to where to get the money to pay interest in this debt, that is easy: extra taxation.
Whether the above policy complies with the rules that currently govern the Fed, I’ve no idea. The important point is that there is no big problem in principle.
The above suggestion that government should go into debt NOT to fund itself, but purely so as to bring a deflationary effect will seem odd to some readers. However, this idea is “old hat” or second nature to advocates of Modern Monetary Theory. It is an idea that Keynes and Abba Lerner (a contemporary of Keynes’s) were familiar with. Abba Lerner is widely regarded as the founding father of Modern Monetary Theory.
In conclusion, I am not suggesting that QE or the above anti inflationary wheeze are a good “way to run a railroad”. The current situation where the Fed has to provide all stimulus because Congress refuses to is crazy. But if we are into crazy methods of stimulus (and crazy deflationary policies) then I’m happy to explain to the crazies in charge what their crazy options are.
Ralph, I’m sure Messrs King and Bernanke now have your number! :-)