Friday, 7 November 2008

The Fed doubles its balance sheet - above $2 trillion in just 5 weeks

Think about that. If any commercial or investment bank had been seen to do that, it would become an instant leper in the credit markets. It is a truism that banks go bust by writing business that wiser banks rejected, and so grow their balance sheets faster. As a young bank supervisor I was told that the surest way to spot a potential bank failure was to look for outliers in asset growth.

Had anyone at the Fed or FSA been brought up in the old school, they would have seen Countrywide and Northern Rock coming a mile off. Perhaps they did, but in the new Friedmanite culture of forbearance and free markets, and Basle II risk models, they decided to let capitalism run its disastrous course rather than take unpopular decisions about constraining the prerogatives of over-compensated executives and shareholders.

And now we have the Fed doubling its balance sheet in just five weeks. It is exactly by taking on the assets of the banking sector that are otherwise unmarketable that the Fed has grown its balance sheet. And it is by doing this while indulging the banks in continued oversized dividends and executive bonuses that leads me to believe the policy must ultimately fail to either correct the problems in the US banking sector or sustain the credibility of the Federal Reseve as a prudential supervisor and lender of last resort.

Dallas Fed President Richard W. Fisher has speculated that the balance sheet could expand to $3 trillion by January:

“You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in our balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today, our assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year.”

At the same time the Fed has equalised the interest it pays on reserves deposited in the Fed and the Fed Funds target rate. That undermines any incentive to interbank lending, virtually ensuring that banks will prefer to hold their cash as reserves at the Fed rather than as lending exposures to one another. On the other hand, according to a Fed research note from August, it allows the Fed to supply greater liquidity for market needs without the risk of pushing lending rates below target rates.
In contemplating the anomalies of this policy, it occurred to me that it might be aimed at reinforcing the dollar by drawing reserve balances to the Fed in preference to other central banks as they follow the Fed by cutting rates this week. Perhaps the Fed is pre-emptively combating dollar capital flight, or perhaps it is a further extension of the "ring fence" tactic of drawing assets to the US in contemplation of future insolvencies to secure advantage for US creditors over global peers.

As Sam Jones at FTAlphaVille commented yesterday:

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

This is uncharted territory for a central bank of a reserve currency. I suspect, however, that these moves play into the strategy of the Paulson Plan survivor bias. As someone reminded me recently, Mr Paulson's primary objective at Goldman Sachs was to outperform peers in both good times and bad times. If profits were to be made, he wanted Goldman to have more of them. If losses must be booked, he wanted Goldman to have less of them. He seems to have taken the peer outperformance strategy global with the Paulson Plan.

Hat tip to FTAlphaVille for posting relevant Fed insights yesterday and today:

The mother of all balance sheets

Fed capitulates: the central bank is broken


yoyomo said...

Like any imperial power, the US is trying to extract tribute from its vassal states by selling them shiny trinkets that turn out to be worthless. No other country could get away with it; compare the way the UK handled its little disagreement with Iceland.

Knute Rife said...

The problem is never really that the balance sheet expands rapidly but rather that the rapid expansion is effected by rampant book-cooking, i.e that the added assets are worth nowhere near what they're booked for. The Fed is eating toxic waste and pretending it's Cordon Bleu. That means the balance sheets are a massive lie and will implode.

As for interest on reserves, even if Bernanke is doing it to defend the dollar, how long do you think it will take the other central banks to figure out he's gaming them and then make it all backfire in his face?

Anonymous said...


thanks for this update. This has been driving me nuts for the past weeks, trying to understand this.

When USD started gaining strength against EUR/YEN, I wondered why.

The standard econ-explanations thrown around didn't make sense.

When I learned about the deposit rates FED offers to banks to park their money, a warning sounded off inside my minuscule brain.

Let's assume for the sage of discussion, that this move is done on purpose. That begs the question: why?

I think I understood the gist of your argument, but how about foreign debt handling - after the domestic creditors get the best from the top?

Isn't US (near) insolvent because of foreign debt? How does playing in favor of domestic creditors solve this? Perhaps it may help the domestic creditors, but does it help the US government?

Is there an upside to be realised in this regarding treasury sales? Something else?

Even to me US looks insolvent, if not now, then in fairly near future.

I know the rest of the world is between a rock and a hard place: can't dump those assets, but rather not load up on a lot more.

But what other choices are there?

If there a haircut in the future for US debt? Or will the debt be settled via financial trickery, using USD world reserve currency role and existing foreign treasury holdings as a reverse weapon? Or will they resort to the more traditional type of weapons in order to settle the debt?

The mind boggles.

Antti K

PS On a related note, I was just as surprised as anyone by the BoE 1.5% rate cut, but even more baffled bye the mere 0.5% BoE deposit rate cut. Doesn't this stink the same that FED has been doing? When will ECB do the same? Who then picks up the tab? Ah, so confusing... I lost my half-broken decoder ring way back in September and haven't been able to find a working replacement since.

Anonymous said...

Since the Federal Reserve has no reserves and isnot a government agency but a private bank cartel and creates money out of nothing the conversion of worthless debt for another debt instrument isnot a problem for them. When will the public and the so called experts wakeup to this clever scheme?

gordon said...

A belated response to your last posting. I too was delighted with Obama's win, and just as quickly disillusioned by his first appointment (and the likelihood of more poor choices to follow). But when you consider that he spent almost a billion dollars for his campaign, and where most of that money came from, then it becomes clearer. He was selected, but not by the people: their choice was limited to two.

When I used to sit on selection committees I quickly discovered that obtaining the candidate of choice was not achieved by stacking the final committee (where oversight was clearly exercised) but by fixing the shortlisting (where there is little oversight) to ensure that your chosen candidate stands out as the best. Among Democrats much of this selection process (determined by funding) would have been organized and orchestrated by Emanuel.

From many blog readings it looks clear that aspects of the subprime fiasco were heading towards social unrest, particularly among poor black people. For the wealth transfer and looting by the banksters and military industrialists to continue, it became necessary to take a different tack, to assuage this people in some way. What better than Obama ! Obama ! Brilliant.

In retrospect I think it would have been better if McCain/Palin had won, the quicker to bring this putrid political system to a head to have it finally lanced.

Knute Rife said...

The US isn't insolvent, it's just reached the point where it can no longer throw paper at its problems and must bring hard assets (painful hard assets) to the table in order to proceed.

There has been a great deal of noise about the planet being barely solvent. The figures I've seen, though, compare debt to GDP, which isn't a solvency comparison but a carrying capacity comparison. The US has exceeded its carrying capacity, and its debt is far more than the assets currently securing it, so creditors are now wanting hard assets to pay current accounts, pay down principal, and extend additional financing. If the US refuses, expect those areas of the world with solvent spot balance sheets to start carving themselves away from the US (and Western Europe for that matter). Then the fun begins in earnest.

Electing McCain would no more have brought it to a head than electing McKinley brought it to a head in 1896. Contrary to "good old days" mythology, politics in the US has been a "follow the money" game for as long as we've had politics in the US. This has ebbed and flowed a bit over time, but it has always been there.

Further, we are nowhere near even the kind of rage in the streets we had in the late 60s, let alone the kind that would fundamentally overhaul the political system and require the Ueberklass to gin up a canned candidate. 35% of the masses still think Bush is a good idea. 46+% voted for McCain, even though he really promised nothing but more of the same. And if there had been massive fraud and McCain had been elected, what percentage of Obama supporters would have taken to the streets? Miniscule. There simply isn't the desperation or the commitment to change needed for a revolution, such as we saw with the Russian population in August 1991.

Colin said...

In retrospect I think it would have been better if McCain/Palin had won, the quicker to bring this putrid political system to a head to have it finally lanced.

In some ways, I too think it might have been beter if a member of Bush's own party had to clean up the mess he leaves behind. There will of course be a nasty backlash in several years, when it appears that Obama is unable and/or unwilling to deliver the goods. It will not be a pretty sight; I predict all kinds of extremist behavior on the part of the fairly desperate electorate.

samantha said...

Would you please refrain from associating "free markets" with this fiasco? We haven't seen anything remotely like a free market in the US since at least the Great Depression and arguably not since the inauguration of the Federal Reserve. The current crisis was almost totally the doing of the government and the Central Bank Cartel that the Fed in actuality is. That some scoundrels made a fortune off the rape of capitalism aka free markets does not mean the fact they could do so and were in the "private" domain means their actions or winnings had anything to do with a free market or capitalism. Stop labeling this government atrocity as if it was the fault of its primary mostly absent victim.

Anonymous said...

Revolutions aren’t televised, elections are. Why are we surprised that Obama hardly represents a significant change?

In some ways Obama represents a triumph of superstition (also known as “hope”) over reason and of ethnocentricity and racism over nationalism and unity. Why the latter? Because it never occurred to anyone and Obama never pointed it himself that he is “black” only by the “one-drop rule” (even one distant black ancestor makes the person automatically black), a racist division of people legally established in many states in the US in 1900-1930 for the purposes of racial segregation, and now informally culturally reemphasized, reinforced and accepted through this election. Obama is really a mulatto, or mixed ancestry if you don’t like the word “mulatto”, but mulatto is a word absent from the American vocabulary. For contrast, Tiger Woods politely declined the moniker “black” and embraced his multi-ethnic identity.

Funny, Biden condescendingly called Obama a “clean minority” and Obama then selected Biden as his VP.

As to “real free markets”, “real free markets” exist and can only exist in the heads of economists and the thick books that they have written. Don Quixote is probably the best literary treatment of the difference between the noble and honorable adventure that life is portrayed in the books and the messy cesspool out there.

Anonymous said...


We haven't seen anything resembling free markets since Alexander Hamilton's bank plan and Thomas Jefferson's Louisiana Purchase. Free markets are archetypes. They don't exist in reality, only in the mythic "golden ages" we construct from historical memory.

Anonymous said...

thing there
is in the American
soul that soars with
kites that soar! Some-
thing alive with the roar
of the wind lifting the kite
that soars above rooftops, tree-
tops, and awestruck heads! And yet—
Something there is not in the
American soul to adore the
kite that fails to soar.
I've seen it, I've
feared it, and
so have you.

The kite whose tail
is tattered in the
TV antenna.
The kite that rises
at dawn
then crashes
at your feet.

in a

Joyce Carol Oates
kiting is an amazing experience.


dearieme said...

Bugger me. The USA is going to default, isn't it? The UK too, perhaps? Bugger, bugger, bugger.

acrumb said...
Mikhail Khazin: U.S. will soon face second "Great Depression"

Renowned economist Khazin predicted U.S. financial crisis in 2000

Readers might this item of interest...

acrumb said...

You might want to read this article by Michael Lewis if you haven't: