Econ Questions Inside - Liberty.me

Econ Questions Inside

Tags: Economics federal reserve

Concerned Kiwi January 24, 2015 at 4:44 pm

I would really appreciate some advice on the Federal Reserve “Assets” and terminology.

What happens if the Fed lets its “Loans”(?) mature and not “roll them over”? Does the Fed then have to print money to pay for them? If it does then that money goes to the holders of the “Loans”, the creditors, and is now out in the market, so to speak. What’s the downside to letting the “loans” mature from an Austrian point of view?

If it continues to roll over the “loans”, how does that happen and what’s the potential downside?

The Fed considers these “Loans” to be Assets. Correct? And that they can sell these “Assets” later on. Are they worth the value they’re on the books for?

I understand they’re in a Catch 22 situation. I gather it’s because if they raise interest rates it will cause jitters in the market, and interest rates will increase and the deficit will go through the roof. And if they don’t raise interest rates, and they print more money QE, they will likely have to buy their own debt (monetise it) because no one else will likely want to lend America any money. So, either way the U.S. is stuffed. Correct?

You can see I’m a clutz when it comes to this sort of thing, but I’d really appreciate a layman’s guide if anyone would care to take the time in simple terms to explain.

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Youliy Ninov January 25, 2015 at 10:04 am

Let me try to explain to you how I understand the situation.

In order to give a loan FED does not need to have the money for the loan at the first place. It just prints it and gives it to the big financial players (banks, etc.). Since these are loans they are given for some period of time, and after this period has ended they “mature” and must be paid back. So, when they are paid back the money which has been printed goes back to its source, the FED and when it gets there you can consider it gone, vanished.

So: when FED gives loans FED increases the money in circulation but when these loans mature the money in circulation decrease. But a decrease of the money in circulation is exactly what FED does not want, because this would either lead to low inflation or outright deflation. So, FED does its utmost to keep the loans stable (rolls them over) or increases them.

So far the US government has sold much debt in order to cover its deficits. What would happen if the interest rates rise is the following: it would cost much more to get and service new debt, read more taxes. Moreover if the interest rates start rising many of the holders of the old debt would be willing to sell it because its value would go down in price (this is how it functions) and it would be very hard to find buyers for the new issued debt.

Basically the US government and FED are interested in keeping the interest rates down while the real inflation is rising but the official/perceived inflation figures are low. In this way the investors lose money without understanding it and it is easier for the US government to finance its debt and continuing deficits.

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Concerned Kiwi January 25, 2015 at 4:09 pm

Excellent explanation for me to understand. Thank you.

> and it would be very hard to find buyers for the new issued debt.

Which would mean that the Fed would have to resume QE in order to keep rolling over those loans because no one else is willing to buy that debt. Correct? Who would buy that debt? The Treasury?

What’s twisting my mind is the concept of “Buying” the Debt.

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Youliy Ninov January 26, 2015 at 2:10 pm

Note that I am not aware of the particular way in which the system in the US works (I am a European). I am explaining the stuff from a theoretical point of view.

So: the US governments needs to finance itself. Since it runs permanent deficits (which means that it spends more than it gets from taxes, etc.) it has to issue promises to pay (bonds) and sell them on the open market. This is the government’s debt. On the market there are several groups of investors. For instance: independent buyers (like you for instance), banks (from the USA and abroad) and the FED itself. They together buy the US debt. However the only one who is really independent is the independent buyers. The US banks get their money from FED indirectly. FED buys from them old government bonds with newly printed money (open market operations) increasing the money supply and the banks buy new government debt with the newly obtained money. The money which FED prints and gives the banks is normally (when it is not crisis-time) multiplied many times so that the banks can buy with 1 newly printed dollar from the FED 10 times (for instance) more government debt. It is worth noting that the US debt is bought not only from US banks but from outside banks, even governments too.

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Concerned Kiwi January 26, 2015 at 3:26 pm

Wonderful. Thank you so much.

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Nick Newell January 26, 2015 at 11:05 pm

The way debt is created in the U.S. is that the government issues bonds (read “debt securities”), which are then directly sold to and bought by the Federal Reserve. The Fed exchanges newly created money to the government, which then puts it into circulation. This is called inflation, increasing the monetary base. The majority of this is done electronically (only 3% of the money stock actually physically exists). Money in reality is a promissory note issued by the Federal Reserve, which is “backed” by a promissory note from the federal government. A promissory note is simply an IOU, a promise to pay the holder of the note at some time in the future. Money (“Federal Reserve Notes”) are debt intruments that all holders of dollars hold, interest-free. On top of that, inflation robs the holders of money of their purchasing power.

Then we get to the issue of fractional reserve banking. Once newly created money is given to the government, it goes to the banks. Then we get to what is an inverse-pyramid structure, with the Fed at the bottom, then banks, then more banks. For example, suppose $1 million is created and given to banks. Fractional reserve banking means that banks only have to hold a certain percentage of cash deposits in their vaults. For this $1 million created, only $100,000 is held on reserve to to honor redemptions of demand deposits. The bank takes the remaining $900,000 and lends it out. Now the monetary base has increased from $1 million to $1.9 million. Individuals and businesses that receive these new loans are then likely to deposit part of the loan into a bank. Just assuming that 50% of the loan taken out is deposited with another bank, the monetary base again expands to $1 million + $900,000 + 0.5($900,000) = $2.35 million. This is how the inverse pyramid works: $1 million is the base, then it expands to $1.9 million (as $900,000 is added), then its expands to $2.35, etc. Banks pyramid debt like this because although they only actually have $1 million in money, they can lend out and collect interest on $2.35 million.

If the Fed lets the federal bonds it holds as assets mature i.e. stop accepting government bonds to roll over the debt, then the government would be forced to pay the Fed in money. The only way to do this is by taking the money from the taxpayers. I’m not sure what you mean by the Fed allow its loans to mature; it’s only loaned out debt instruments are Federal Reserve Notes which have no maturity date. The reason interest rates are kept so low is because the federal government would be unable to service its existing debt. If interest rates shot up to just 3%, just the interest on the debt the federal government has to pay would change from 0.5%(17) = $85 billion to 3%(17) = $510 billion.

You are correct in that it is a Catch 22. Lower interest rates and inflation cause their own catastrophes in the economy. But on the other hand, raising rates will only tap the taxpayers for more money to service the debt. Once people realize how the monetary system functions, they will be skeptical of holding American dollars, much less any dollar-denominated instruments. The only reason the dollar still exists is because the world, for some odd reason, still hold faith in our currency, and is willing to accept being a creditor of dollars. Most of the world also inflates even more than we do, so dollars are “sound” relatively speaking. There are several options instead of holding dollars to avoid losing your purchasing power by holding them. One obvious option is to purchase real goods (or at least a redeemable claim to a real good aka “warehouse receipt”). Another option is to hold currencies that are sounder than dollars. The easiest way to find sound currencies is to look at the Economic Freedom Index, which has a specific category ranking currencies based on their soundness. The trick is to find securities that are not denominated or tied directly to the dollar.

This video should help, though it’s a bit dramatic at points.

https://www.youtube.com/watch?v=8Fm5NSeVPog

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  Nick Newell January 26, 2015 at 11:10 pm
  
  I just realized I made a slight mistake. The government issues bonds but it does not directly sell them to the Fed. Bonds are issued and are first sold to banks. The government receives the money and spends it. The banks then take those bonds and sell them to the Fed, who give them new money in exchange. New money is introduced once the banks lend out the newly-received money.
  
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  Youliy Ninov January 27, 2015 at 11:35 am
  
  Nick,
  
  I have several comments and hope that you will not take them personally 🙂
  
  “For this $1 million created, only $100,000 is held on reserve to to honor redemptions of demand deposits. The bank takes the remaining $900,000 and lends it out. Now the monetary base has increased from $1 million to $1.9 million. ”
  
  The monetary base (M0) consists of cash, coins and the money of the banks at the FED (equivalent to cash). In your example above , since 1 million worth of new money has been created, the monetary base increases with 1 million. The next monetary aggregate (M1) however increases with 1.9 million.
  
  “The reason interest rates are kept so low is because the federal government would be unable to service its existing debt.”
  
  This is a common statement which I have heard many times and I have always doubted its validity. Here is what I think.
  
  When the government issues a bond this bond is fixed, i.e. the interest on it is fixed too. So, if a bond is worth 100 USD and the interest is 5 USD (5%) then the government will have to pay the investor every year 5 USD. However: It does not matter how high the interest rates are, the interest on the bond is fixed. So, even if the interest rates rise the government will not pay more to the investor. It will pay the same amount. So: the government will be able to service its old debt (excluding TIPS which are supposed to be inflation corrected). It is just the new debt which would be very difficult to issue and service.
  
  Actually what will happen in case of inflation rise is the following: So far the inflation has been 2% (for instance). The investor gets 5% on his bond and is 3% ahead of inflation (according to him). However inflation rises to 6%. The investor is stuck with a negative real interest bearing bond (-1%) in this case and would try to get rid of it immediately. The result would be that the bond price would go down, since it value and interest received from the government are fixed. A new investor would buy the bond for 96 USD, so that he gets 5+4 USD , i.e. around 9% interest. With 6% inflation this would mean that he would be 3% ahead of inflation. So, if inflation rises the interest rate on bonds would rise too, but their price would go down. Still the government would pay the same amount (excluding the inflation protected securities).
  
  Actually, if the inflation picks up there would be an avalanche of bond selling and the newly issued debt would have to bear a very high interest (paid by taxes) if the government wants somebody to buy it.
  
  About FED not buying bonds directly from the government: Most likely you are right, I do not know for sure. To the best of my knowledge this is a “forbidden” operation which is typically easily circumvented by buying debt from the banks which buy it from the state on their part. Just an intermediately is introduced and everything is “OK”.
  
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    Nick Newell January 27, 2015 at 3:37 pm
    
    Youliy,
    
    You are correct on M0, M1, etc. I did not make that distinction as I was trying to keep the explanation in plainer terms for those not familiar with all the banking terminology. The inverse pyramid would then begin at M0 -> M1-> M2 -> M3 -> M4, increasing each time as each successive M includes the sum of the previous M’s plus further pyramiding at each successive level.
    
    As for interest rates, newly-issued bonds would bear a higher rate if they rose. Older, cheaper debt would have to be paid off by newer, more expensive debt. This is the process of rolling over debt. But the government doesn’t want to do that because it wants to spend money on other things that earn them votes.
    
    I know for certain that the U.S. government issues bonds, they are sold to the banks, who turn around and sell them to the Fed. This supposedly circumvents “government funding itself” and allowing the Fed to maintain “independence”. The ECB I know is slightly different though the effect is the same. The only difference is ECB doesn’t collect interest while the Fed does collect the interest on government debt. I think that’s how the ECB works. You can correct me if I’m wrong, but I remember the primary difference being interest is collected by banks instead of the ECB.
    
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    - Youliy Ninov January 28, 2015 at 10:33 am
      
      I can not correct you since you seem to know more regarding this topic 🙂
      
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    - Nick Newell January 28, 2015 at 10:32 pm
      
      Can you explain how the ECB works?
      
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    - Youliy Ninov January 29, 2015 at 11:03 am
      
      Sorry! I wish I could!
      
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    - Nick Newell January 30, 2015 at 4:41 pm
      
      I think I will write a few articles explaining the Federal Reserve System, why is was created, how it functions, and how it can manipulate the money supply and lower interest rates. Any other questions you want answered?
      
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    - Concerned Kiwi January 30, 2015 at 7:16 pm
      
      If this post is meant for me, then no. I have to digest all this. I’m really happy with all the responses. Thank you.
      
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    - Nick Newell January 30, 2015 at 8:40 pm
      
      No, it’s not for you, it’s for the community.
      
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Concerned Kiwi January 28, 2015 at 2:08 am

Woah. The more I read, the more confused I get.

So what happens please if, or when, the U.S. gets to the point where nobody else wishes to buy U.S. Debt?

I have a friend who thinks that this would be a good thing as the U.S. would then own its own debt, and could then just write it off.

What’s the worst case scenario?

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  Nick Newell January 28, 2015 at 10:17 am
  
  Then the U.S. could not roll over its current obligations.
  
  They would either have to:
  
  1. Cut spending
  
  2. Raise taxes
  
  3. Print money (tax through inflation)
  
  4. Default on their obligations, that is, simply refuse to pay them
  
  So probably 2 and 3. It’s important to understand that the process of rolling over debt is an intertemporal Ponzi scheme, which means that current obligations are financed by incurring more debt to be paid later in the future. Bernie Madoff himself has said that U.S. debt is a Ponzi scheme, and if anyone recognizes a Ponzi scheme, it’s him. It can be a painful mixed bag that will be contingent on government spending. If no one accepts U.S. debt, it will resort to taxation and higher taxes or inflation in order to service current obligations as they arise. The government could default on its debt and simply tell creditors it won’t pay. But if the people can somehow get the government to cut spending, it will be beneficial in the long-run. Ending a Ponzi scheme is going to be painful, and there will be some big losers, but the only other option is to kick the can down the road and instill a greater obligation on future generations that they will have to pay off. Someone will have to bite the bullet. There will be pain no matter what.
  
  The worse case is that no one will want to hold the dollar anymore, and the dollars that have been accumulated abroad will start finding their way back to the U.S. For example, last year we imported about $450 billion more than we exported. This means that foreigners have to accept money in dollars or credit in dollars in the amount of $450 billion. Once American dollars abroad start coming back to the U.S., that’s when the real inflation will start. You will see hyperinflation and the flight to real goods.
  
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Concerned Kiwi January 29, 2015 at 3:11 am

Loving it. Thank you.

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