Gyroscopic Investing

stone wrote: HB reader, am I understanding you rightly that the US fiat system is set up such that the commercial banking system has unlimited capacity to create money without ever being at risk of systemic default but that the USG only has as much deficit spending ability as the Fed and the commercial banking system chooses to grant it? The example of the Fed setting up a line of credit to AIG in 2008 shows that the Fed has unlimited ability to create money to bail out financial institutions. BUT the USG unlike AIG etc can not legally get overdrawn with the Fed. If primary dealers and the Fed were to choose not to buy USG bonds or the debt ceiling were not raised, then the USG would just have to lump it or change the law (or use the trillion dollar platinum coin trick???). On a wider level it seems interesting that the USG chose to enact laws in such a way as to give pre-eminance to the commercial banks. Are commercial banks really such trustworthy guardians of the interests of US citizen's?

jmourik's observation of the legal loophole for making platinum coins with unlimited face value does look like a get out of jail free card for the USG if the Fed has a legal obligation to give the USG the same value of bank reserves as the face value the USG engraves on the platinum coin. Is this a widely known loophole?

Stone -- I'm not sure I fully understand your question, but I will make some comments.  I'm not an expert on Treasury/Federal Reserve operations, but I know enough about the basic process to see there is a lot of misundertanding and fuzzy thinking about the topic on this forum.

Despite what you often see written the Federal Reserve (the FED) does not really have the "unlimited ability to create money to bail out financial institutions."  Totally aside from the possible inflationary or interest rate effects on the broad economy, every new dollar the FED creates, unless it is directly offset by the corresponding purchase of an asset, reduces their own capital by a dollar.  I don't have the figures in front of me, but I know that their balance sheet is already leveraged something like 45 or 50 to one now so there is definitely an operational limit on their capacity to simply print money and use it willy-nilly to bail out financial institutions.  The last thing in the world the FED wants to do is destroy their credibility worldwide by becoming insolvent. 

What the FED can do virtually without limit is purchase (and thereby monetize) debt, because that expands both sides of their balance sheet equally.  For a whole variety of reasons they prefer to have mostly high grade US Government debt (although they can and do buy some other debt on occasion, like the MBS purchased during QE1) as assets on their balance sheet.  In fact, this has been their primary monetary policy tool in recent years.  Just like with excessive leverage, a large amount of low quality debt on the asset side of their balance sheet would raise questions about their solvency. 

Without getting into the details, the FED and primary dealers can't simply refuse to participate in Treasury debt auctions.  A primary dealer that refuses to place a market-related bid in the Treasury debt market will be dropped from the primary dealers list.  The FED always has to participate in some manner because it acts as fical agent for the Treasury.  Whether it is a net buyer or seller of Treasuries depends almost entirely on the FED's current monetary policy goals. 

So, no, the system is not set up to somehow favor the commercial banking system over the USG.  If one wants to view it in terms of who it favors, it is probably more accurate (in my view) to say that it favors both of those sectors equally over everyone else in the US economy.

       

jmourik wrote:

HB Reader wrote:So the Secretary can create a platinum coin of any denomination he desires.  That doesn't change anything.

Unless the coin can be circulated in the commercial banking system (i.e., shipped to and then distributed by the Federal Reserve to a member bank) at a face value higher than it costs to produce it, or sold directly to the public for more than it costs to produce it, the USG will receive no net benefit.

So you are saying that the Federal reserve can refuse to accept coins that have legal tender face value?

§ 5103. Legal tender

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.

No, what I am saying is that the Bureau of the Mint can only produce legal tender coins for use as circulating coinage, or for sale directly to the public.

The legal tender provision you are quoting doesn't apply.  So, yes, the FED can "refuse to accept coins" from the Mint and the Treasury will simply be stuck with coins they can't use.  It is happening right now with hundreds of millions of $1 dollar coins.  

Congress controls the purse strings.  They always have.  No amount of amateur creative lawyering on our part is going to change that.  

HB reader, thanks for the clarification. So when the Fed "extended a line of credit" to AIG in 2008 it was doing something that it only has limited capacity to do? I don't follow how the increased leverage ratio of the Fed actually plays out into halting what they can do. Accepting that it does pose a constraint, from what I understood the Fed already gets interest from the treasury bonds they hold from QE (most of that interest gets sent to the treasury but the Fed keeps back what it needs). Doesn't that in its self give them a lot of scope for doing bank bail outs on a huge scale?

stone wrote: HB reader, thanks for the clarification. So when the Fed "extended a line of credit" to AIG in 2008 it was doing something that it only has limited capacity to do? I don't follow how the increased leverage ratio of the Fed actually plays out into halting what they can do. Accepting that it does pose a constraint, from what I understood the Fed already gets interest from the treasury bonds they hold from QE (most of that interest gets sent to the treasury but the Fed keeps back what it needs). Doesn't that in its self give them a lot of scope for doing bank bail outs on a huge scale?

Stone -- Not exactly.  I didn't mean the FED doesn't have a lot of capacity to bail out firms, I meant that is not unlimited.  The extent to which to the bailout or money creation is not backed by assets acquired by the FED they risk directly devouring their own capital.  I don't remember exactly, but in the case of AIG there was collateral (equity warrants or something of similar value) posted.  So the FED can certainly still throw money around, but they can't prop up complete deadbeats forever and the more they throw around and lose, the more they limit their flexibility in the future.  They are already leveraged more than most (or maybe all) of the big banks they oversee. 

It is also important to remember that AIG probably didn't really need (or draw on, I think) the full amount of the line of credit.  They had substantial assets, but there was a system-wide liquidity squeeze so they couldn't sell certain assets at that particular moment to raise funds.  What gets reported sensationally in the press as a $85 (or was it $185?) billion "bailout" by the "money-printing" FED doesn't neccessarily mean anywhere near that much money was ultimately needed or created.     

It is true the FED gets some interest from the Treasury bills, notes and bonds they hold, but bond holdings are a double-edged sword for them.  Short-term Treasuries (where they traditionally concentrate their purchases) yield virtually nothing now.  Long-term notes and bonds yield more, but just like any other long bond holder, they will get hammered big time if they decide to raise rates (say to fight inflation or "take away the punch bowl").  The declining value of the bond holdings would greatly exacerbate the leverage problem on their balance sheet. 

The (almost) unlimited power of the FED to monetize debt by purchasing Treasury securities actually also increases the leverage problem, but not by directly eating into FED capital.  It does this by increasing the ratio of liabilities to capital on the right hand side of their balance sheet.    There are a few more wringles to all of this, but they don't really change the basics here.

The FED's leverage and how it limits their ability to maneuver gives me greater concern now than many other issues from a systemic perspective.  I believe we are already pushing the limits of monetary policy.  There was a pretty good discussion of this in January and early April by Hussman on the Hussman Funds website.  I don't care much for their funds, but their commentaries are often very good. 

   

HB Reader,

Since it's short-rates that they're surpressing and that are so low right now, if they DO decide to raise them, and given the strain that will put on businesses, do you really think that will raise long-term rates much?

moda, in principle could they try and raise long term rates directly by offloading the longer term debt that they hold (if they do hold enough to do that)? I hadn't appreciated before what hbreader said about the Fed mainly holding shorter term debt.

HBreader, I also like the Hussman commentary but I hadn't understood what he meant by Fed insolvency. I guess I just had doubts about the validity of viewing the Fed using the kind of terms of reference that are used for viewing entities that don't "conjure up the money" themselves.  I also don't get it when Hussman says that a rise in interest rates would create inflation. I totally agree with you that the Hussman fund is a great example of how bad market timing strategies are even when a massive effort is put into them.

moda0306 wrote: HB Reader,

Since it's short-rates that they're surpressing and that are so low right now, if they DO decide to raise them, and given the strain that will put on businesses, do you really think that will raise long-term rates much?

I don't think they want to.  The problem will come if they feel they need to.  Also, I think long term rates are a little harder for them to control as precisely as short term rates. 

That is one of the problems with pushing monetary policy to the limit.  To some degree, they are painting themselves into a corner and limiting their flexibility.  I'm sure they have far better minds than mine looking at these problems and that they have options that I've never contemplated.  But I highly suspect that all the options are becoming higher risk and more problematic.       

stone wrote: moda, in principle could they try and raise long term rates directly by offloading the longer term debt that they hold (if they do hold enough to do that)? I hadn't appreciated before what hbreader said about the Fed mainly holding shorter term debt.

HBreader, I also like the Hussman commentary but I hadn't understood what he meant by Fed insolvency. I guess I just had doubts about the validity of viewing the Fed using the kind of terms of reference that are used for viewing entities that don't "conjure up the money" themselves.  I also don't get it when Hussman says that a rise in interest rates would create inflation. I totally agree with you that the Hussman fund is a great example of how bad market timing strategies are even when a massive effort is put into them.

I think by insolvency he simply means that the FED's liabilities exceed its assets.  The FED's capital is then wiped out and any attempt to simply "conjure up" any new money only highlights the FED's increasingly insolvent status and brings into question the FED's liabilities, i.e., the dollar.  Again, there are a few more wrinkles to all of this (including, strangely, how this might affect the federal deficit) but they don't really change the basic storyline, only the timeline.

This is why some (myself included) fear that we have a "morphing" crisis here.  First, a private debt crisis morphes (spelling?) through QEs and bailouts, into 2) a public debt crisis through increased Treasury and Federal Reserve debt or liabilities issuance, into 3) a currency crisis for the dollar.  Of course, other countries are doing something similar, so we end up with a sort of a race to the bottom without any real timetable.  

Maybe it will happen quickly, maybe it will happen slowly.  But it sure looks to me like this is happening.  This is one of the reasons I'm still pretty bullish on gold for the next few years, maybe longer.

With respect to Hussman's discussion of the interest rates/inflation problem, I don't have time to get into it now other than to say I think he may be overstating it somewhat, but even if he is partially right it provides a good example of how we have pushed monetary policies to dangerous limits.

Then again, I could be completely wrong about all of this.  How's that for uncertainty?  

More importantly, my wife wants me to mow the lawn now so I'm signing off.

       

HB Reader wrote:The extent to which to the bailout or money creation is not backed by assets acquired by the FED they risk directly devouring their own capital.

This part I don't understand. When the Fed "acquire assets" they can create the money for it I thought. And likewise destroy money:

Fed Purposes and Functions wrote:Purchasing securities or arranging a repurchase agreement increases the quantity of balances because the Federal Reserve creates balances when it credits the account of the seller’s depository institution at the Federal Reserve for the amount of the transaction; there is no corresponding offset in another institution’s account. Conversely, selling securities or conducting a reverse repurchase agreement decreases the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve; there is no corresponding increase in another institution’s account.

HB Reader wrote:No, what I am saying is that the Bureau of the Mint can only produce legal tender coins for use as circulating coinage, or for sale directly to the public.

Hmm, OK. Where exactly does the law state that?

Also, I guess what they're saying is the Treasury would deposit the $2T coin into the Mint Public Enterprise Fund, as per § 5136. United States Mint Public Enterprise Fund. After which they "shall be available without fiscal year limitations".

HB Reader wrote:The legal tender provision you are quoting doesn't apply.  So, yes, the FED can "refuse to accept coins" from the Mint and the Treasury will simply be stuck with coins they can't use.  It is happening right now with hundreds of millions of $1 dollar coins.

What??? You haven't ordered your roll of 250 coins yet, here?

jmourik wrote:

HB Reader wrote:No, what I am saying is that the Bureau of the Mint can only produce legal tender coins for use as circulating coinage, or for sale directly to the public.

Hmm, OK. Where exactly does the law state that?

Also, I guess what they're saying is the Treasury would deposit the $2T coin into the Mint Public Enterprise Fund, as per § 5136. United States Mint Public Enterprise Fund. After which they "shall be available without fiscal year limitations".

HB Reader wrote:The legal tender provision you are quoting doesn't apply.  So, yes, the FED can "refuse to accept coins" from the Mint and the Treasury will simply be stuck with coins they can't use.  It is happening right now with hundreds of millions of $1 dollar coins.

What??? You haven't ordered your roll of 250 coins yet, here?

The law doesn't state it that way anywhere, it's just that those two uses (circulating coinage and public coin sales) are the only uses for legal tender coinage consistent with all the provisions of Title 31, Chapter 51.  Congress could probably write a clearer law, but they could also raise the debt ceiling.

The United States Mint Enteprise Fund is the operating fund set up to hold receipts from the Mint's programs and operations.  The "shall be available without fiscal year limitations" language applies to amounts needed to fund Mint programs and operations.

Yeah, the sale of the $1 coins is a good example of what the Treasury would have to do with any legal tender coins they have produced that can't be shipped to the Federal Reserve for circulation.  They can be sold directly to the public for face or bullion value.  They can't spend them or use them for government operations.

jmourik wrote:

HB Reader wrote:The extent to which to the bailout or money creation is not backed by assets acquired by the FED they risk directly devouring their own capital.

This part I don't understand. When the Fed "acquire assets" they can create the money for it I thought. And likewise destroy money:

Fed Purposes and Functions wrote:Purchasing securities or arranging a repurchase agreement increases the quantity of balances because the Federal Reserve creates balances when it credits the account of the seller’s depository institution at the Federal Reserve for the amount of the transaction; there is no corresponding offset in another institution’s account. Conversely, selling securities or conducting a reverse repurchase agreement decreases the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve; there is no corresponding increase in another institution’s account.

Yes, that is correct.  When the FED buys assets (like Treasury securities) they create new money (i.e, FED liabilities) for it.