Free Slides from Ed Dolan’s
Econ Bloghttp://dolanecon.blogspot.com/Could QE3 Cause the Fed To Go Broke? Post prepared September 19, 2012 Terms of Use: These slides are made available under Creative Commons License Attribution— Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.

Can Central Banks Go Broke?
The Federal Reserve System, universally known as “The Fed,” is the central bank of the United States Its most recent highly expansionary program of quantitative easing, QE3, raises an old question: The Federal Reserve Board Building in Can central banks go broke? Washington, DC. The “Fed” is the central bank of the United States Photo by Agnosticpreacherskid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve _Board_Building.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why Banks Need Capital A
bank’s capital is defined by the equation capital = assets – liabilities If the value of a bank’s assets decreases because of loan defaults or poor market conditions, its capital can become negative. This example shows the result of a loss of $1,500 on loans A bank with negative capital is said to be insolvent—in everyday language, it “goes broke.” Insolvent banks are normally required to cease operations For a more detailed discussion of bank capital and insolvency, see this earlier post on Ed Dolan’s Econ Blog September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

The Fed’s Balance Sheet in
Normal Times (2007) In normal times, the Fed’s assets have consisted largely of short- term Treasury securities Usually its major liability has been Federal Reserve Notes—the paper currency we use every day It also holds reserve deposits of commercial banks and a few other liabilities As of 2007, its capital was equal to 4.7% of total assets, which would be a little on the low side for a commercial bank, but not extremely low September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

The Fed’s Balance Sheet Today
(September 2012) Today the Fed’s balance sheet is very different from normal times Treasury securities are now only 58 percent of total assets Mortgage-backed securities and securities of other government agencies have grown greatly Reserve deposits are 75 times larger than in 2007 Total capital is slightly increased, but since total assets are larger, the capital ratio has fallen to less than 2% of total assets September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why The Fed Normally Needs
Little Capital The Fed can normally operate safely with very little capital because it does not face the same risks as commercial banks There is essentially zero risk of loss on short-term Treasury securities Currency is a nonredeemable liability, so there is zero risk of a “run” on the Fed September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why the Fed’s Balance Sheet
is Riskier Today Today the Fed’s balance sheet is riskier than in the past As part of QE3, the Fed is buying more mortgage-backed securities and long-term Treasuries, which face risk of loss of market value if interest rates rise Its capital cushion is thinner, so a loss of just 2% on its assets could, technically speaking, cause the Fed to become insolvent September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

What Would Happen if the
Fed’s Capital Dropped Below Zero? What would happen if a loss of, say, $80 billion on securities reduced the Fed’s capital to a negative value? The Fed would be insolvent in the balance sheet sense However, unlike a commercial bank, it would still be able to meet all of its financial obligations because its liabilities are not Two meanings of insolvency: redeemable. There could be no 1.Balance sheet insolvency: Liabilities exceed run on the Fed. It would still be assets, capital is negative 2.Equitable insolvency: A business is unable to meet solvent in what is called the its financial obligations in full as they become due equitable sense September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Who Could Recapitalize the Fed?
Although the Fed could technically operate with negative capital, it would be an embarrassing position to say the least. There would be pressure to recapitalize it The only entity that could afford to recapitalize the Fed would be the US Treasury The simplest way to carry out recapitalization would be for the Treasury to issue an appropriate quantity of bonds (say, $100 billion) and transfer them to the Fed as a grant, taking nothing in return. The Fed’s assets and capital would rise by Stature of Albert Gallatin at the same amount as the transfer the US Treasury Building Photo by Dan Vera http://upload.wikimedia.org/wikipedia/commons/6/6d/JEFraser_Gall atin.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Complication: The Fed’s Unusual Ownership
Structure The Fed: Myths and realities •The Fed is not a profit-making Recapitalization would be complicated by business. Its income normally exceeds the Fed’s unusual ownership structure its expenses, but the net income is In a functional sense, the Fed is fully a automatically turned over to the part of the federal government Treasury for use by the government •By law, the Fed’s stockholding Legally, however, the Fed is a member banks receive a token 6% stockholder-owned corporation. dividend on their stock. Changes in Stockholders are the private banks that Fed policy neither increase nor are members of the Federal Reserve decrease the dividend, so policy This unusual ownership structure, arising changes neither impoverish nor enrich from the Fed’s history, is the source of its private member banks many paranoid theories and bizarre myths •The Fed is NOT owned by the about the Fed Rothchilds, the Masons, or Swiss gnomes. Don’t believe everything you read on the internet! September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Reality: Recapitalizing the Fed would
be Difficult Paranoid myths to one side, recapitalization of the Fed by the Treasury would be difficult in the current US political climate It is unlikely that the Treasury could make a capital transfer of tens of billions of dollars to the Fed without an act of Congress Such a transfer would be perceived as another “bank bailout.” Who can guarantee that a majority of Congress would vote in favor? Even if such a bailout passed Congress, would the price tag be a limit on the Fed’s independence? Tea Party Protest, Hartford CT Photo by Sage Ross, http://commons.wikimedia.org/wiki/File:Tea_Party_Protest,_Hartford ,_Connecticut,_15_April_2009_-_036.jpg September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Bottom Line: Could the Fed
Go Broke? Because of radical changes in the Fed’s balance sheet resulting from quantitative easing, the Fed could, in fact, “go broke” in the sense of negative capital Technical balance sheet insolvency would not prevent the Fed from carrying out its monetary policy functions Insolvency would create political pressure to recapitalize the Fed. The process could easily be highly controversial, and could result in limits being placed on the Fed’s political independence September 19. 2012 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/