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    Ed Dolan’s Econ Blog
http://dolanecon.blogspot.com/

Could QE3 Cause the Fed
     To Go Broke?
    Post prepared September 19, 2012




    Terms of Use: These slides are made available under Creative Commons License Attribution—
       Share Alike 3.0 . You are free to use these slides as a resource for your economics classes
    together with whatever textbook you are using. If you like the slides, you may also want to take a
                 look at my textbook, Introduction to Economics, from BVT Publishers.
Can Central Banks Go Broke?




 The Federal Reserve System,
  universally known as “The Fed,” is the
  central bank of the United States
 Its most recent highly expansionary
  program of quantitative easing, QE3,
  raises an old question:
                                                    The Federal Reserve Board Building in
 Can central banks go broke?                       Washington, DC. The “Fed” is the
                                                    central bank of the United States
                                                    Photo by Agnosticpreacherskid,
                                                    http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve
                                                    _Board_Building.jpg




          September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Why Banks Need Capital


 A bank’s capital is defined by the equation
  capital = assets – liabilities
 If the value of a bank’s assets decreases
  because of loan defaults or poor market
  conditions, its capital can become
  negative. This example shows the result
  of a loss of $1,500 on loans
 A bank with negative capital is said to be
  insolvent—in everyday language, it “goes
  broke.”
 Insolvent banks are normally required to
  cease operations                                     For a more detailed discussion of bank
                                                       capital and insolvency, see this earlier post
                                                       on Ed Dolan’s Econ Blog
            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Fed’s Balance Sheet in Normal Times (2007)

 In normal times, the Fed’s assets
  have consisted largely of short-
  term Treasury securities
 Usually its major liability has been
  Federal Reserve Notes—the
  paper currency we use every day
 It also holds reserve deposits of
  commercial banks and a few
  other liabilities
 As of 2007, its capital was equal
  to 4.7% of total assets, which
  would be a little on the low side
  for a commercial bank, but not
  extremely low
            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Fed’s Balance Sheet Today (September 2012)

 Today the Fed’s balance sheet is
  very different from normal times
 Treasury securities are now only
  58 percent of total assets
 Mortgage-backed securities and
  securities of other government
  agencies have grown greatly
 Reserve deposits are 75 times
  larger than in 2007
 Total capital is slightly increased,
  but since total assets are larger,
  the capital ratio has fallen to less
  than 2% of total assets

            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Why The Fed Normally Needs Little Capital



 The Fed can normally operate
  safely with very little capital
  because it does not face the
  same risks as commercial banks
 There is essentially zero risk of
  loss on short-term Treasury
  securities
 Currency is a nonredeemable
  liability, so there is zero risk of a
  “run” on the Fed



            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Why the Fed’s Balance Sheet is Riskier Today


 Today the Fed’s balance sheet is
  riskier than in the past
 As part of QE3, the Fed is buying
  more mortgage-backed securities
  and long-term Treasuries, which
  face risk of loss of market value if
  interest rates rise
 Its capital cushion is thinner, so a
  loss of just 2% on its assets
  could, technically speaking,
  cause the Fed to become
  insolvent


            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
What Would Happen if the Fed’s Capital Dropped Below Zero?

 What would happen if a loss of,
  say, $80 billion on securities
  reduced the Fed’s capital to a
  negative value?
 The Fed would be insolvent in the
  balance sheet sense
 However, unlike a commercial
  bank, it would still be able to meet
  all of its financial obligations
  because its liabilities are not            Two meanings of insolvency:
  redeemable. There could be no              1.Balance sheet insolvency: Liabilities exceed
  run on the Fed. It would still be          assets, capital is negative
                                             2.Equitable insolvency: A business is unable to meet
  solvent in what is called the
                                             its financial obligations in full as they become due
  equitable sense

            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Who Could Recapitalize the Fed?

 Although the Fed could technically operate
  with negative capital, it would be an
  embarrassing position to say the least.
  There would be pressure to recapitalize it
 The only entity that could afford to
  recapitalize the Fed would be the US
  Treasury
 The simplest way to carry out
  recapitalization would be for the Treasury to
  issue an appropriate quantity of bonds (say,
  $100 billion) and transfer them to the Fed as
  a grant, taking nothing in return.
 The Fed’s assets and capital would rise by                 Stature of Albert Gallatin at
  the same amount as the transfer                            the US Treasury Building
                                                             Photo by Dan Vera
                                                             http://upload.wikimedia.org/wikipedia/commons/6/6d/JEFraser_Gall
                                                             atin.jpg
            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Complication: The Fed’s Unusual Ownership Structure
                                                     The Fed: Myths and realities
                                                     •The Fed is not a profit-making
 Recapitalization would be complicated by
                                                     business. Its income normally exceeds
  the Fed’s unusual ownership structure              its expenses, but the net income is
 In a functional sense, the Fed is fully a          automatically turned over to the
  part of the federal government                     Treasury for use by the government
                                                     •By law, the Fed’s stockholding
 Legally, however, the Fed is a
                                                     member banks receive a token 6%
  stockholder-owned corporation.                     dividend on their stock. Changes in
  Stockholders are the private banks that            Fed policy neither increase nor
  are members of the Federal Reserve                 decrease the dividend, so policy
 This unusual ownership structure, arising          changes neither impoverish nor enrich
  from the Fed’s history, is the source of           its private member banks
  many paranoid theories and bizarre myths           •The Fed is NOT owned by the
  about the Fed                                      Rothchilds, the Masons, or Swiss
                                                     gnomes. Don’t believe everything you
                                                     read on the internet!
           September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Reality: Recapitalizing the Fed would be Difficult


 Paranoid myths to one side, recapitalization of
  the Fed by the Treasury would be difficult in
  the current US political climate
 It is unlikely that the Treasury could make a
  capital transfer of tens of billions of dollars to
  the Fed without an act of Congress
 Such a transfer would be perceived as another
  “bank bailout.” Who can guarantee that a
  majority of Congress would vote in favor?
 Even if such a bailout passed Congress, would
  the price tag be a limit on the Fed’s
  independence?                                               Tea Party Protest, Hartford
                                                              CT
                                                              Photo by Sage Ross,
                                                              http://commons.wikimedia.org/wiki/File:Tea_Party_Protest,_Hartford
                                                              ,_Connecticut,_15_April_2009_-_036.jpg
             September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Bottom Line: Could the Fed Go Broke?


 Because of radical changes in the Fed’s
  balance sheet resulting from quantitative
  easing, the Fed could, in fact, “go broke” in
  the sense of negative capital
 Technical balance sheet insolvency would
  not prevent the Fed from carrying out its
  monetary policy functions
 Insolvency would create political pressure
  to recapitalize the Fed. The process could
  easily be highly controversial, and could
  result in limits being placed on the Fed’s
  political independence


            September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

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Could QE3 Cause the Fed to Go Broke?

  • 1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Could QE3 Cause the Fed To Go Broke? Post prepared September 19, 2012 Terms of Use: These slides are made available under Creative Commons License Attribution— Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.
  • 2. Can Central Banks Go Broke?  The Federal Reserve System, universally known as “The Fed,” is the central bank of the United States  Its most recent highly expansionary program of quantitative easing, QE3, raises an old question: The Federal Reserve Board Building in  Can central banks go broke? Washington, DC. The “Fed” is the central bank of the United States Photo by Agnosticpreacherskid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve _Board_Building.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 3. Why Banks Need Capital  A bank’s capital is defined by the equation capital = assets – liabilities  If the value of a bank’s assets decreases because of loan defaults or poor market conditions, its capital can become negative. This example shows the result of a loss of $1,500 on loans  A bank with negative capital is said to be insolvent—in everyday language, it “goes broke.”  Insolvent banks are normally required to cease operations For a more detailed discussion of bank capital and insolvency, see this earlier post on Ed Dolan’s Econ Blog September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 4. The Fed’s Balance Sheet in Normal Times (2007)  In normal times, the Fed’s assets have consisted largely of short- term Treasury securities  Usually its major liability has been Federal Reserve Notes—the paper currency we use every day  It also holds reserve deposits of commercial banks and a few other liabilities  As of 2007, its capital was equal to 4.7% of total assets, which would be a little on the low side for a commercial bank, but not extremely low September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 5. The Fed’s Balance Sheet Today (September 2012)  Today the Fed’s balance sheet is very different from normal times  Treasury securities are now only 58 percent of total assets  Mortgage-backed securities and securities of other government agencies have grown greatly  Reserve deposits are 75 times larger than in 2007  Total capital is slightly increased, but since total assets are larger, the capital ratio has fallen to less than 2% of total assets September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 6. Why The Fed Normally Needs Little Capital  The Fed can normally operate safely with very little capital because it does not face the same risks as commercial banks  There is essentially zero risk of loss on short-term Treasury securities  Currency is a nonredeemable liability, so there is zero risk of a “run” on the Fed September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 7. Why the Fed’s Balance Sheet is Riskier Today  Today the Fed’s balance sheet is riskier than in the past  As part of QE3, the Fed is buying more mortgage-backed securities and long-term Treasuries, which face risk of loss of market value if interest rates rise  Its capital cushion is thinner, so a loss of just 2% on its assets could, technically speaking, cause the Fed to become insolvent September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 8. What Would Happen if the Fed’s Capital Dropped Below Zero?  What would happen if a loss of, say, $80 billion on securities reduced the Fed’s capital to a negative value?  The Fed would be insolvent in the balance sheet sense  However, unlike a commercial bank, it would still be able to meet all of its financial obligations because its liabilities are not Two meanings of insolvency: redeemable. There could be no 1.Balance sheet insolvency: Liabilities exceed run on the Fed. It would still be assets, capital is negative 2.Equitable insolvency: A business is unable to meet solvent in what is called the its financial obligations in full as they become due equitable sense September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 9. Who Could Recapitalize the Fed?  Although the Fed could technically operate with negative capital, it would be an embarrassing position to say the least. There would be pressure to recapitalize it  The only entity that could afford to recapitalize the Fed would be the US Treasury  The simplest way to carry out recapitalization would be for the Treasury to issue an appropriate quantity of bonds (say, $100 billion) and transfer them to the Fed as a grant, taking nothing in return.  The Fed’s assets and capital would rise by Stature of Albert Gallatin at the same amount as the transfer the US Treasury Building Photo by Dan Vera http://upload.wikimedia.org/wikipedia/commons/6/6d/JEFraser_Gall atin.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 10. Complication: The Fed’s Unusual Ownership Structure The Fed: Myths and realities •The Fed is not a profit-making  Recapitalization would be complicated by business. Its income normally exceeds the Fed’s unusual ownership structure its expenses, but the net income is  In a functional sense, the Fed is fully a automatically turned over to the part of the federal government Treasury for use by the government •By law, the Fed’s stockholding  Legally, however, the Fed is a member banks receive a token 6% stockholder-owned corporation. dividend on their stock. Changes in Stockholders are the private banks that Fed policy neither increase nor are members of the Federal Reserve decrease the dividend, so policy  This unusual ownership structure, arising changes neither impoverish nor enrich from the Fed’s history, is the source of its private member banks many paranoid theories and bizarre myths •The Fed is NOT owned by the about the Fed Rothchilds, the Masons, or Swiss gnomes. Don’t believe everything you read on the internet! September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 11. Reality: Recapitalizing the Fed would be Difficult  Paranoid myths to one side, recapitalization of the Fed by the Treasury would be difficult in the current US political climate  It is unlikely that the Treasury could make a capital transfer of tens of billions of dollars to the Fed without an act of Congress  Such a transfer would be perceived as another “bank bailout.” Who can guarantee that a majority of Congress would vote in favor?  Even if such a bailout passed Congress, would the price tag be a limit on the Fed’s independence? Tea Party Protest, Hartford CT Photo by Sage Ross, http://commons.wikimedia.org/wiki/File:Tea_Party_Protest,_Hartford ,_Connecticut,_15_April_2009_-_036.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 12. Bottom Line: Could the Fed Go Broke?  Because of radical changes in the Fed’s balance sheet resulting from quantitative easing, the Fed could, in fact, “go broke” in the sense of negative capital  Technical balance sheet insolvency would not prevent the Fed from carrying out its monetary policy functions  Insolvency would create political pressure to recapitalize the Fed. The process could easily be highly controversial, and could result in limits being placed on the Fed’s political independence September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/