"Every economy rests on a credit system, which means it rests on the erroneous assumption, that the other will pay back the borrowed money. If he does not do so, a so called support operation is initiated, through which all, except the state, profit well. Such a bust can be recognized from the fact that the population is asked to have trust. By then it likely has nothing else left."
Kurt Tucholsky: Short Abstract on the National Economy (Kurzer Abriss der Nationalökonomie), 1931, (my translation)
The Paulson plan, aka TARP or the bailout, may well get through the House today. Paulson will then have loads of money to spend until January 20, 2009. We can only hope that the satirist Tucholsky is wrong and Paulson will work for the benefit of all and not only a few.
What has been little noticed is that the action the Paulson plan prescribes is already happening by abusing the Fed balance sheet.
A friend asked me to deliver a simple short talk today about the recent Fed action and the Paulson plan. I came up with a few simplified charts to explain what is going on. They concentrate on what changed within the system.
The usual monetary flow looks somewhat like this:
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Banks buy treasuries (debt notes) from the U.S. Treasury. The banks
give those treasuries to the Fed as reserves holding and in return for
cash. They now have money to lend to the economy. In a fractional reserve banking system, the banks can lend out some 10 times their reserves. They do so against some collateral from the borrowers.
The Fed’s balance sheet holds mostly treasuries, bills and notes, as
assets and the dollars it handed out as liabilities. Such was still the
case in January. $850 billion of sound stuff on each side.
Now some of Tucholsky’s ‘others’ decided not to pay back the money they borrowed from
the banks and it turns out that the collateral the banks received has
less value than assumed. A bank in total may have lend out ten times as
much as it has as reserves. A loss of ten percent of all loans it made
would eat all of its reserves and it would have to shut down its
business. It needs to get rid of the bad collateral and/or find fresh
reserve capital to continue to lend.
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When this happened earlier this year, the Fed stepped in and offered to
take Mortgage Backed Securities and other dubious collateral for
renewed cash lines. It did not print more money, which would have been
inflationary, but exchanged half of its valuable treasuries for "bad"
assets of dubious value. One can see this in its September balance sheets as ‘term auction credit’ and ‘other Federal Reserve assets’.
It soon turned out that this was not enough and that the banks needed
to get rid of much more dubious ‘assets’. The banks stopped lending to
the real economy. They simply had not enough untainted money left.
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Here Paulson stepped in. He wrote additional federal debt notes and
sold those to China. The Treasury then lend the money to the Fed which
used it do buy "other assets" from the big banks and broker/dealers.
Within a month the Feds balance sheet expanded by an unprecedented $650 billion dollar.
But such a balance sheet expansion can not go on indefinitely. As the Economist explains
further expanding the Fed balance sheet may eventually push the fed
fund rate to zero. It would essentially make the Fed impotent of
setting and keeping inflation targets. A problem Japan fought for over
an decade.
To not further damage the Fed, Paulson came up with the TARP plan.
He wants the authority to continue directly what over the last weeks
has been done through the balance sheet of the Federal Reserve.
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Paulson will lend money form China and use this to buy whatever he
likes to prices only he may determine from any financial institution
he thinks deserves that gift. (The Fed, by law, is restricted in that and had to buy the "other assets" at
somewhat realistic prices from well know folks.)
The not very hidden real Treasury intend is to buy "other assets"
for too high prices and to thereby re-capitalize the banking system.
The amount which Paulson will be able to spend is only limited by the
current legal debt ceiling. That gives him some $1.5 trillion for now. What
happens after that is gone down the drain is the problem of a different
administration.
Eventually the Fed will have to get rid of the "other assets" too
and will have to transfer them to Treasury to pay for the loan it got.
Will the TARP plan work? It will take some bad assets off the books of
the banks. But it will also have some terrible unintended consequences,
most of them inflationary. An outright nationalization of the banks,
like Sweden did a while ago, would likely have been much more
effective. Direct lending to Main Street could help a lot more. Maybe the next ‘support operation’, which certainly needs to and will
come and be even bigger, will go into those directions.
Within the international view I see two issues. The lenders Paulson needs for his plan, China, the Gulf and others, will have political conditions for such a huge endeavor. China will ask for a free hand on Taiwan, but what will the Sheiks ask for?
The Fed has done the above in cooperation with other central banks
and set up hundreds of billions in swap lines with these. This has
some interesting currency effects. The Euro dropped pretty hard. I have
yet to understand by what chain of effects it did so. Any idea?
(Bret Setser’s blog Follow The Money
is the usual place to go to learn about the international money flows,
but even as he calls this a ‘currency crisis’ he has not yet explained
why.*)
* Update: See Bret’s comment here
