Why there is no Fiscal Case for the Fed's Large Balance Sheet

David Andolfatto, fiscal policy, normalization, balance sheet, preferred credit allocation
David Andolfatto giving a Federal Reserve Bank of St. Louis Lecture on Bitcoin. https://i.ytimg.com/vi/kmjuhrPuLSU/maxresdefault.jpg

It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.

Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed's balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.

Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.

Andolfatto writes that the Fed’s “rate of return has generally followed the path of market interest rates downward.” While that was true in 2007-08, it should be noted that the Fed’s rate of return largely stopped following the downward path of market interest after 2008. As market rates on five-year Treasuries fell closer to the administered interest rate on reserves after 2008, the Fed shifted from a portfolio maturity of 5 years to one of around 12 years, as if determined to keep its interest income large. This is shown in the following two figures from a 2016 Cato Journal article of mine.

Here is Andolfatto’s closing pitch for embracing the status quo: “Reducing the Fed's balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. … if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?” The Fed faces an “arbitrage opportunity.” Having the Fed hold Treasury debt, in place of the public holding it, yields a pure arbitrage profit, because the Fed can borrow to carry the debt at a rate lower than the rate at which the Treasury borrows.

Characterizing the situation this way, however, neglects the simple difference between borrowing short and borrowing long. When the Fed borrows short from the banks to lend long to the Treasury, it does not do so costlessly. Duration transformation carries a risk of capital loss, also known as duration risk. Suppose the yield curve shifts up, both short and long interest rates rising together. The Fed will experience a decline in present value of its assets that will swamp the smaller decline in the present value of its liabilities. Such an event is not unknown: in 1979-81 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits. In cash-flow terms, such an event would mean that the Fed would quickly have to start paying higher interest rates to borrow, while its asset portfolio continues to pay low yields and roll over much more slowly. The Fed’s annual net transfer to the Treasury might even go negative. Smaller or negative transfers from the Fed to the Treasury would mean a sudden jump in the present value of the public’s ordinary tax liabilities. Net interest income from playing the yield curve is not a free lunch.

The Fed has also been carrying significant default risk by holding $1.7 trillion of its portfolio not in Treasuries but in mortgage-backed securities. It was not so many years ago that MBS were trading well below par because of their default risk. Indeed it was to push their prices back towards par that the Fed purchased so many.

Responding to a commentator on his blog who pointed out the Fed’s duration risk, Andolfatto remarks: “the duration risk … could be mitigated considerably if the Fed restricted itself to short-duration assets.” He proposes that “If a one-year UST is yielding anything significantly higher than the interest on Fed liabilities, then the Fed can make a profit for the government.” But when we look at the actual numbers, we find that the yield on one-year UST is not significantly higher. The Fed could not in fact continue to make a profit for the government. One-year Treasuries are currently yielding just 82 basis points (0.82%), only 7 basis points more than the 75 basis points that the Fed pays on reserves. Multiplying 7 basis points by the Fed’s $4.45 trillion asset portfolio yields only $3.1 billion in net interest income, less than the Fed’s 2016 budget of $4.5 billion or its ex-post 2015 operating expenses of $4.2 billion. Mitigating the duration risk by going to a portfolio of one-year Treasuries would thus eliminate the Fed’s profit from borrowing from banks and relending to the Treasury.

The principal cases for normalizing the Fed’s balance sheet are (1) the Fed should not distort the allocation of credit by holding trillions in MBS, and (2) normalizing the size of the balance sheet would allow the Fed to normalize the conduct of monetary policy by making bank reserves scarce again. There is no fiscal-free-lunch case for holding off on normalization.

  • Walker Todd

    As one of the early drummers of this tocsin, I agree heartily with what Larry White wrote here. On the idea that the Fed helps the Treasury by holding such a large portfolio of long-term securities, yes it does, partially by holding them off-market. Worthies no less than Paul Volcker and Alan Greenspan on separate occasions in recent decades made public statements to the effect that the Fed should not attempt to spare the Treasury the necessity of submitting itself to the discipline of the marketplace. The Fed can help to make a market, but it should not be that market, which it too often has done in recent years. Those of us who remember how open markets in Treasury securities work and are supposed to work are getting rather old now. It is time to bring such markets back before the institutional memories on all sides are lost. — Walker Todd, Chagrin Falls, Ohio, and Middle Tennessee State University

  • Ditto Larry. As Bob Eisenbeis of Cumberland has noted rather eloquently, the Fed is an expense item for the Treasury, its alter ego. There is no fiscal argument to be made other than monetizing the federal debt at the expense of private investors. This is financial repression at its best.

    See our research note from yesterday, “For the Yellen FOMC, Duration Matters More Than Size”
    KBRA
    February 27, 2017

    https://www.krollbondratings.com/announcements/3398

    • So much for independence…

      • George Selgin

        There never was much. Just "independence within government."

    • Spencer Hall

      The problem with Fiscal policy was Jack Lew's disregard for the Federal Reserve's needs. And there's simply little reason for “failure-to-deliver” at settlement, and more “specials” for a particular CUSIP number, etc. Indeed, savers/investors sometimes pay premiums for “specials” just to acquire them (accepting negative rates of returns/interest). The Fed's unspoken mandate (supporting the government securities market), has been weakened. Treasury Secretary Jack Lew:

      (1) reaffirmed his stance Friday that a strong United States dollar being justified simply as a: "good thing."

      (2) “Treasury’s decisions about how to manage government debt are made independently of the Fed’s monetary policy choices, he said"

      Effective monetary management is impossible without the cooperation of the U.S. Treasury (aka, the 28 member countries of the EU). The open market operations of the Fed require
      a depth of market that will enable the Fed to buy or sell billions of dollars’ worth of treasury bills on any given day without deeply disturbing the bill rates.

      The Treasury, Jack Lew, could have exercised a segmented control of their sales, and the “desk” can buy “on-the-run” treasuries (the most recently issued U.S. Treasury bonds or notes of a particular maturity).

      The Fed didn’t collaborate with the Treasury on the type of debt to be issued. Not only may the Treasury exercise important monetary powers through the timing of their borrowing, but specific monetary objectives may be achieved through a choice of the types of issues to float. Within board limits the Treasury can plan on the types of securities to be sold and decide whether they should be short-term, long-term, marketable, or redeemable, eligible or ineligible for bank investment, etc. I.e., the Treasury can decide who will buy a given issue (targeting, RPDs, viz., the non-bank public).

      However, the Treasury intends to continue “gradually lengthening” the average maturity of its debt, Office of Debt Management Director Colin Kim" & “Treasury’s policy is to maintain regular and predictable issuance, while financing the government at the lowest cost over time,” Mr. Kim said in a statement, when asked about the strategy’s impact on Fed policy.

    • Spencer Hall

      KBR: "By purchasing longer dated Treasury and agency mortgage-backed securities (MBS), the duration of the Fed’s system open market account has grown from an average of less than two years when QE commenced to a duration over six years today."

      Surely they could still re-position and at the same time accommodate the whole-sale funding money market.

  • The government gain is at the expense of the citizens who are REQUIRED to hold at least some Fed funny money to transact business in their daily lives. For many Americans, who live paycheck to paycheck, ALL of their savings is in the form of bank deposits and it is them that are hurt the most by the Feds real mandates; maintaining or inflating financial asset prices, maintaining bank liquidity and solvency and ensuring the federal government has a cheap source of financing no matter how irresponsible they are. Mr. Andolfotto's remarks and suggestions completely ignore, or worse, the American chump who is stuck with their monopoly money.

    • Spencer Hall

      "ALL of their savings is in the form of bank deposits"

      As Anderson says: Reserves are driven by payments".

  • Spencer Hall

    "Such an event is not unknown: in 1979-81 it rendered insolvent about
    two-thirds of US thrift institutions, who were financing 30-year
    fixed-rate mortgages with 1- and 2-year deposits"

    That was predicted in May 1980. The DIDMCA of March 31st 1980 laid the legal basis for the addition of 38,000 new commercial banks to the 14,000 that we already had. Thus, it was also predicted that Fannie and Freddie would assume their void. And eventually, the GR (which was accelerated after the BOG dropped legal reserves by 40% ->rendering RRs unconstrained).

  • Spencer Hall

    The Federal deficit is unsustainable. There's no reason to punish the public for Bankrupt u Bernanke's misdeeds.

  • Spencer Hall

    “neglects the simple difference between borrowing short and borrowing long”

    Neither the Reserve, nor the commercial banks, are financial intermediaries.

    The remuneration of IBDDs will cause a protracted economic depression. The contractionary policy exacerbates the impoundment and ensconcing of voluntary savings within the confines of the commercial banking system (the origin of both stagflation and secular strangulation). It destroys savings velocity as reflected endogenously, inside NZM deposit velocity (i.e., fundamentally, debits against deposit accounts).

    Never are the DFIs intermediaries (conduits between savers and borrowers), in the savings-investment process. Contrary to the ABA, and Dr. R. Alton Gilbert, deposits are the result of lending – not the other way around.

    In the flow of funds analysis, all monetary savings (funds held beyond the income period in which received), originate within the CB system. And unless voluntary savings are expeditiously activated (and put back to work), through non-bank conduits (either directly or indirectly by their owners, saver-holders), thereby completing the circuit income and transactions velocity of funds (redistributing income), a deceleration in N-gDp is precipitated. Thus, there is a decline in the purchase of durable consumer goods, followed by diminished business investment in productive capital goods (just as Dr. Leland J. Pritchard, Ph.D., [Chicago School, Viner’s and Mints’ classes], 1933 predicted in the late 1950’s).

    • Spencer Hall

      Keynesian economists have finally achieved their objective, that there is no difference between money and liquid assets ("We are all Keyneisan's now").

      No the error, as demonstrated in the New York Times, by sobriquet, the “Three-Card Maestro’s”, like all other Keynesian economists, is the macro-economic persuasion that maintains a commercial bank is a financial intermediary (matching savings with investment):

      To wit, Greenspan: “Much later came the evolution of finance, an increasingly sophisticated system that enabled savers to hold liquid claims (deposits) with banks and other financial intermediaries. Those claims could be invested by banks in in financial instruments that, in turn, represented the net claims against the productivity enhancing tools of a complex economy. Financial intermediation was born” [sic]

      Or Ben Bernanke in his book “The Courage to Act”: “Money is fungible. One dollar is like any other”.

      “I adapted this general idea to show how, by affecting banks' loanable funds, monetary policy could influence the supply of intermediated credit" (Bernanke and Blinder, 1988).”

      For example, although banks and other intermediaries no longer depend exclusively on insured deposits for funding, non-deposit sources of funding are likely to be relatively more expensive than deposits”

      The first channel worked through the banking system…By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop "informational capital."

      “that the failure of financial institutions in the Great Depression increased the cost of financial intermediation and thus hurt borrowers” (Bernanke [1983b]).

      In "The General Theory of Employment, Interest and Money", John Maynard Keynes’ opus ", pg. 81 (New York: Harcourt, Brace and Co.), gives the impression that a commercial bank is an intermediary type of financial institution (non-bank), serving to join the saver with the borrower when he states that:

      it is an “optical illusion” to assume that “a depositor & his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

      In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term non-bank in order to make his statement correct.

  • "The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves." Strikes me the Fed does not borrow reserves in the sense that if the Fed paid no IOR, where would the reserves go? They've got nowhere to go. IOR is a GIFT made by the Fed to commercial banks for reasons that elude me.

    • George Selgin

      You're quite wrong here, Ralph. The (excess) reserves would "go," through bank asset purchases and loans, to expand the broader money stock. In real terms, the Fed would get less, other borrowers more. It is necessary to think of the alternative real equilibria, and not simply at what happens to the total nominal stock of bank reserves.

      • I'm baffled. First, if you Google the phrase "banks don't lend out reserves" you'll find numerous articles explaining why that is the case. Are they all wrong?

        If a commercial bank lends $X, yes, the "broader money stock" rises. As the saying goes: "loans create deposits". Chances are that $X will be deposited at other banks. The latter will demand $X of reserves from the lending bank so as to settle up. But the TOTAL STOCK of reserves stays the same.

        There are a limited number of ways total reserves can be reduced. One is to reverse QE. Now what have I missed?

        • Hu McCulloch

          Bank lending does not change the total quantity of base money, and until there are currency outflows, does not change the total quantity of reserves. However, since borrowers want to spend the money they borrow and won't just keep their loans on deposit with their bank for the full term of the loan, the bank who made the loan can count on losing the reserves to other banks, unless it is the only bank in the economy.

          As long as there is a penalty for not meeting reserve requirements (even if only having to borrow from the Fed at a penalty Discount Rate), banks will only make loans out of excess reserves, or if they can borrow excess reserves from other banks through the Federal Funds market.

        • George Selgin

          "First, if you Google the phrase "banks don't lend out
          reserves" you'll find numerous articles explaining why that is the case. Are they all wrong?"

          Yes. I have written on this matter in several places, including https://www.alt-m.org/2016/01/05/interest-reserves-part-ii/

          Here is an excerpt: "Banks do, in effect, lend "reserves" to customers no less than to other banks. The lending of "reserves" is more apparent in the overnight market simply because it is reserves per se that borrowers in the market are after, for they need extra reserves to avoid shortfalls that would otherwise subject them to penalties, or to what amounts to the same thing: a visit to the Fed's discount window.

          "If, on the other hand, a businessman borrows $500,000 from a bank, it isn't cash itself that the businessman wants, but other things that can be got for the cash. But as soon as the proceeds of the loan, originally received as a deposit balance, are drawn upon for the sake of
          acquiring these other things, the withdrawals, whether by check or draft, lead quickly to redeposits in other banks, and thence to a $500,000 adjustment to the pattern of interbank clearings and settlements at the expense of the lending bank and in favor of rival institutions compared to what would have been the case had the loan not been made."

          There are, of course, many fallacies that would have to be regarded as indisputable truths were their frequent appearance on the internet considered definitive proof.

          • Spencer Hall

            Selgin's right, but it all depends upon perspective. Commercial banks need clearing and correspondent, “pass-thru”, balances to lend (from an individual bank’s perspective), but these “reserves” are either re-deposited within the same institution, or endogenously shifted to (clear thru) one of the other 5,083 CBs (reflecting the distribution of District Reserve balances from the system’s perspective). I.e., they are either derivative or primary inter-bank demand deposits (IBDDs) to member banks, but just a change in the composition of (IBDDs) for the system.

            Even with CB credit expansion, total reserves remain the same, but their form
            may change if excess “or precautionary?” reserves need to be converted to
            legally “required” reserves (though for the CB system, reserves are no longer binding c. 1995, as 85% of required reserves are satisfied using CB’s applied vault cash).

            Thus IBDDs are indeed "lent" from the standpoint of an individual bank (have reserve velocity) but are not destroyed from a system's perspective (unless Federal Reserve Bank credit on the BOG’s balance sheet changes).

            And net changes in Reserve Bank Credit, since the Treasury Reserve Accord of 1951, are determined by monetary policy decisions. Excess reserves may be depleted (if not offset by the “trading desk”), as “factors that affect reserve balances change” (as currency is issued or as System Open Market Account securities are sold or “run off”, etc).

            So an individual bank is limited in the volume of deposits it can create by an amount up to approximately equal to its excess reserve position. .But any and all such individual bank inflows involve a decrease in the lending capacity of other CBs; unless inflows result from the return of currency to the banking system; or is a consequence of an expansion of Reserve Bank credit. Money creation is a function of the circular velocity of deposits (not their volume).

            I.e., as Izabella Kaminska says: “Base money is what’s left over after all assets & liabilities cancel out. It is, in other words, the system’s tangible equity. Or the equity of the system”

          • Spencer Hall

            The complete deregulation of interest rates for the commercial banks, indeed sponsored by the most dominant economic predator, the oligarch: the ABA, is vitiated on largely false premises on which deregulation is based, viz., that demand deposits in commercial banks constitute the “savings’ of the depositors, that these are “lent” to the banks, and that the commercial banks are only a “medium” through which this end is affected.

            The remuneration of IBDDs is an extension of this perverse fallacy. It will create an economic depression.

          • You got me baffled.

          • Spencer Hall

            100 percent of all economists are "baffled". I am the Alpha and the Omega. I just nailed this interest rate move. The BEA's 4th qtr. R-gDp figure was obviously "leaked".

          • On re-reading this discussion, we've actually got side-tracked. My fault, perhaps. I accept that extra reserves result in more lending. But my original point was that I objected to the idea that somehow or other the Fed "borrows" reserves from someone. It doesn't: it can create reserves at will, surely, just like a backstreet counterfeiter can produce $100 bills at will.

            The Fed has chosen to pay interest to commercial banks holding reserves, but there is absolutely no way the Fed needs to do that. The Fed is not in the same position as someone with a mortgage who absolutely must pay interest, else the mortgagor's house gets re-possessed.

          • George Selgin

            The Fed must reward banks to hold EXCESS reserves, which they are otherwise inclined to dispose of. It doesn't have to reward them for holding required reserves, because in that case it punishes them for failing to hold them instead. In paying banks to hold excess reserves, the Fed is essentially paying the to supply funds to it rather than to those whose assets it might otherwise purchase.

            Here as elsewhere the distinction between excess and required reserves is absolutely essential; all discussions that ignore it risk getting things wrong.

          • "..which they are otherwise inclined to dispose of." I don't see how the commercial bank system as a whole can actually dispose of reserves. Only the Fed can cut the total amount of reserves, e.g. by selling government debt, surely?

          • George Selgin

            Ralph, so long as you write "reserves" rather than "excess reserves," you will not "get" it. Yet I have insisted very clearly on the difference. I've said it too many times already, banks eliminate excess reserves by a process of lending and multiple deposit creation. Hence the "multiplier," presently low owing largely to IOER, but capable of being much higher. As D multiplies, a larger share of R becomes required, and a smaller "excess' remains. Every money and banking textbook explains the process, or used to.

  • Hu McCulloch

    It sounds like Andolfatto is confusing arbitrage with speculation. Riding the yield curve is profitable on average because of the empirical term premium (see my vintage 1975 JPE article), but nevertheless is risky. The risk of maturity transformation increases with the difference in duration between assets and liabilities. A few months of maturity transformation is manageable for a well-capitalized firm, but years or even decades of maturity transformation, as practiced by the now largely defunct S&L industry and at present by the Fed, is prohibitive without subsidized insurance from FSLIC (in the case of the S&L's) or the taxpayers (in the case of the Fed). See my 1985 J. of Banking and Finance paper, "Interest Rate Risk and Bank Capital Adequacy."

    The term premium presumably compensates investors for intertemporal risks, much as the stock equity premium compensates for market risk. If an investor were to borrow on thin margin to invest in the stock market, we would call this speculation, not arbitrage, even if the expected return on the stocks exceeded the investor's cost of borrowing. Investors tried this in the late 1920s, since stocks seemed to go nowhere but up. But then they started jumping out of windows when the market turned down for a while.

    • Hu McCulloch

      I embedded a hot link to my paper on "Interest Rate Risk" in its title, but this doesn't show up as a distinctive font. Did I do something wrong, or doesn't this work in the comments section? Larry's link to Andolfatto's blog shows up in bold blue.

      • George Selgin

        Embedded links work in the main text, but not the comments, where links must be inserted whole.

    • Lawrence White

      Exactly. Thanks, Hu.

  • Spencer Hall

    There is no "duration or default risk" on the Fed's balance sheet.

    • Spencer Hall

      Dr. Lawrence H. White writes about duration risk in the borrow short to lend-longer, savings-investment paradigm: “in 1979-1981 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits”.

      How do you defend this? Funny how professional economists talk about dis-intermediation for the non-banks, but not for the commercial banks. But this is correct. The DFIs, via various Depression Era regulatory modifications, are now backstopped. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

      However, dis-intermediation for financial intermediaries (non-banks), was predicated on their loan inventory (& thus was induced by the rates paid by the commercial banks); earning assets (e.g., mortgages), with formally, historically longer term structures & lower net interest rate margins/spreads (as the remuneration of IBDDs also proved).

      In other words, competition among commercial banks for TDs: 1) increased the costs & diminished the profits of commercial banks; 2) induced dis-intermediation among the "thrifts" with devastating effects on housing & other areas of the economy; & 3) forced individual bankers to pay higher & higher rates to acquire, or hold, funds.

      All economists are STUPID.

      • George Selgin

        You forgot to add that they are all crazy.

        • Spencer Hall

          (1) the day stocks topped:
          ·
          "the stock market should be topping & in the process of a downtrend (i.e., without further stimulus)."
          ·
          « Last Edit: Jul 21, 2011, 8:32pm by flow5 »

          (2) Or maybe how I denigrated Nassim Nicholas Taleb's "Black Swan" theory 6 months in advance and within one day:

          To: anderson@stls.frb.org
          Subject: As the economy will shortly change, I wanted to show this to you again – forecast:
          Date: Wed, 24 Mar 2010 17:22:50 -0500
          Dr. Anderson:

          It's my discovery. Contrary to economic theory and Nobel Laureate Milton
          Friedman, monetary lags are not "long & variable". The lags for
          monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2)
          inflation indices, are historically, always, fixed in length.

          Assuming no quick countervailing stimulus:
          2010
          jan….. 0.54…. 0.25 top
          feb….. 0.50…. 0.10
          mar…. 0.54…. 0.08
          apr….. 0.46…. 0.09 top
          may…. 0.41…. 0.01 stocks fall

          Should see shortly. Stock market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from Apr to May. Recent history indicates
          that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down.

          And:
          flow5 Message #10 – 05/03/10 07:30 PM

          The markets usually turn (pivot) on May 5th (+ or – 1 day).

          I.e., the May 6th “flash crash”, viz., the second-largest intraday point swing (difference between intraday high and intraday low) up to that point, at 1,010.14 points.

          (3) Like the Treasuries' conclusion:
          "Diminishing market depth and a surge in volatility were both on display Oct. 15, when Treasuries experienced the biggest yield fluctuations in a quarter century in the absence of any concrete news. The swings were so unusual that officials from the New York Fed met the next day to TRY AND FIGURE OUT WHAT ACTUALLY HAPPENED"

          From:Spencer
          Hall (caps_on_now@hotmail.com)
          Sent:Thu 9/18/14 12:42 PM
          To:FRBoard-publicaffairs@frb.gov (frboard-publicaffairs@frb.gov)

          Dr. Yellen:

          Rates-of-change (roc's) in money flows (our "means-of-payment" money times its transactions rate-of-turnover) approximate roc's in gDp (proxy for all transactions in Irving Fisher's "equation of exchange").

          The roc in M*Vt (proxy for real-output), falls 8 percentage points in 2 weeks. This is set up exactly like the 5/6/2010 flash crash (which I predicted 6 months in advance and within 1 day).

      • Lawrence White

        You write as though the typical S&L merely lost some customers rather than became insolvent due to portfolio losses. See the work of Ed Kane on the S&L crisis.

        • Spencer Hall

          How so? I said that the S&Ls and all other intermediaries, NBFIs, suffered dis-intermediation ("with devastating effects on housing & other areas of the economy"), but not the DFIs.

  • wfoster

    For the high IQ monetary types, here is a stupid question, with glancing reference to "a sudden jump in the present value of the public’s ordinary tax liabilities" – which I take "ordinary" to refer to writing checks to the IRS in contrast to the inflation tax from money debasement.

    Question: If the US treasury/Fed complex is issuing debt in a fiat currency, soberly but continually debased, and if foreign central banks continue their own competitive debasement, so accumulating forex US$ parked in US treasuries, THEN why should the nominal federal debt ever decline or the Fed's balance sheet ever shrink? Isn't this system just a way of sharing across the globe the burden of running the US government? Not via ordinary taxes, but via an inflation tax spread thin across users of dollars and other currencies kept in a rough BrettonWoods-like peg?

    I look at the time graphs of foreign exchange accumulation by many central banks and they appear to be step functions, popping up after Fed balance sheet expansions, and remaining, popping up then remaining, etc. Here in Chile, for example, the central bank holds on the order of US$2000 per capita in US treasuries, and it looks unlikely to liquidate and return those potential resources to domestic consumers. Isn't this near-global inflation-tax routine interpretable as a system of foreigners paying tribute to the hegemon?

  • Mattyoung

    How much buffer should the central banker keep?
    Prices vary by about 3% over the year, and assume something else handles seasonal adjustment, then the central bank out to keep about 3-5% of GDP on hand to handle price variations. Otherwise the rates will not reflect goods allocation over the economy.