The BS of the Fed – Where the Magic Happens

(updated 8/19/2020 3:30am PT)

How can we Structure the Financial System to be Compatible with a Shared Ownership Economy? (Part 4)

The balance sheet of the Fed will give you clues as to the health of the economy and of society as a whole.

In the prior post I mentioned the Great Decoupling – the decoupling of Financial Capitalism from the Capitalist economy. How is the Great Decoupling even possible? Or, in more mundane terms, how can the US stock market be at an all time high when the US economy is at the brink of implosion?

The answer is to be found in the BS of the Fed (BS here stands both for Bull S**t and Balance Sheet :-).

It might be helpful to step back and ask why was the Fed created and what was to be the primary use of its balance sheet. In a nutshell, the Fed was created to act as a backstop to the liquidity transformation operated by commercial banks.

Let me explain.

In the post on money and banking I mentioned that at the core of banking is a swap of IOUs. The borrower signs and IOU to the bank (let’s assume it is a 5-year commercial loan) and the bank creates the corresponding amount of electronic money in the borrower’s checking account. The money thus created is an IOU of the bank to the borrower promising to make payments on her behalf up to the amount borrowed. Through this transaction the bank has “liquified” the borrower’s promise to repay, its has turned into cash something that will convert into cash 5-years from now. This is the liquidity transformation operated by commercial banks.

Yet, in the prior post about the Federal Reserve, I showed you that if the borrower then spends the money with someone banking at a different bank, the lending bank will have to transfer federal funds deposits to the payee’s banks. Let’s look at the downside of the liquidity transformation described in the prior paragraph and how the Fed was created it to address it.

Balance sheet of Bank One before and after payment by borrower One

On the left panel of the picture above you see the balance sheet of Bank One. It created $1M of electronic money by making ten $100K loans to customers. Bank One meets the liquidity requirements to hold at least 10% of the value of the demand deposits (checking account balances) in reserves (federal funds deposits). Now assume borrower One writes a $100K check to someone banking with a different bank. Bank One has to transfer $100K of federal funds deposits to the payee’s bank. On the left hand side is the balance sheet of Bank One after the payment is made. Now Bank One is out of compliance with the 10% reserve requirement and if a customer where to write another check or withdraw cash from its checking account Bank One would not be able to honor the request. Bank One is now completely illiquid!

When banks create money by lending it into existence they engage in a bit of a sleight of hand. They are telling their customers they can come any time and get money out of their checking accounts yet if too many of them do so at the same time the bank is in trouble. That’s how runs on the banks would occur during financial crises.

The Federal Reserve was created to avoid runs on illiquid bank by “rediscounting” their commercial and farm loans (the Fed was created in 1913, a time when agriculture accounted for a large share of the economy in the US). Rediscounting means buying a loan at a small discount. So banks facing illiquidity could resell their loans to the Fed and effectively replace them with federal funds deposits. In other words, the balance sheet of the Fed was primarily intended to support banks’ lending to businesses and farming operations.

Alas, shortly after the creation of the Fed, the US found itself engaged in World War One and the Fed’s balance sheet was used to support the war effort by the Fed’s purchasing of “Liberty Bonds” issued by the US Treasury. And so it happened that rather than purchasing commercial loans from banks the Fed ended up primarily purchasing government debt…until the financial crisis of 2007-2008 when the Fed went off script. Here is what happened to the balance sheet of Fed:

Federal Reserve Assets 2007-2012
Federal Reserves liabilities – 2007-2012

The picture of the balance sheet of the Fed from 1913 to 2007 would have been a very boring one. The top picture (assets) would have shown a dark blue band getting almost imperceptively wider over time representing US Treasury bills (short-term obligations of the US Treasury) with a thin frosting of “other” on top. The bottom picture (liabilities) would have been similarly boring with a dark blue band getting imperceptively wider over time representing the paper money in circulation printed by the Fed (technically printed by the US Treasury on commission by the Fed, but that’s an another story) with a tiny sliver of tile in the last couple of decades representing foreign reverse repos (don’t ask) and an almost invisible line of brown representing the less than $50B in federal funds deposits used by the entire US banking sector to settle their own balances up to 2007.

Then, in the aftermath of the financial crisis of 2007-2008 the balance sheet of the Fed exploded through the so called QE (quantitative easing) program. For the first time since its founding almost a century before, the Fed started buying privately issued securities (MBS, or mortgage back securities and CDO, collateralized debt obligations) the very toxic stuff that created the real estate bubble in the US and the Jenga tower of derivatives that collapsed the financial system in 2007-2008.

A forensic accountant could look at the balance sheet of the Fed and deduct the state of the world and some of the key challenges ailing the US society. The yellow area in the asset side (central bank swaps) speaks to globalization and to the hegemonic role of the US dollar in the world. It represents Fed’s lending to other central banks around the world trying to backstop lending denominated in US$ outside the US. The tile area in the asset side speaks of the perpetuation of the real estate bubble inflated by the excessive lending by banks in the US under the enabling eye of the Fed failing to act as regulator of the banking system. The increase in the blue area in the asset side speaks to the transfer of indebtedness from the private sector to the public sector. The “dog that never barked” would be the very absence of the type of assets for which the Fed was created to hold – loans to commercial and farming enterprises purchased from the banks.

We thought the Fed was doing crazy stuff then, yet what is happening now is even more outlandish.

Federal Reserves Assets – 2004-2020

Now the size of the BS of the Fed has swollen to $7 trillion! I inserted the chart above into this picture to give you a sense of the magnitude of the recent jump in the size of the BS of the Fed now involved in pretty overt manipulation of financial markets.

Arianna Huffington, the founder of The Huffington Post put it very succinctly

America went from being a country that made things to a country that made things up

The balance sheet of the Fed tells a similar story – rather than building the real economy up the Fed’s superpowers have been used to prop up and enrich the financial system at the expense of the real economy.

Now we are ready to turn towards the solutions…

My prior posts:

Published by Marco Vangelisti

Marco Vangelisti is a 100% impact investors dedicated to shifting financial capital from Wall Street and the extractive economy towards building the world we want. He helps individual investors, family foundations and financial advisers move towards aware and no-harm investing.

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