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—
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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/