While I do have some philosophical disagreements with Milton Friedman on economics (ie: the free market and privatization of all regulation, business and services would protect individuals from harm much more effectively than any system of government or government taxation/theft scheme), this interview is great at destroying many of the statist economic myths we all hear everyday.
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From The Mises Institute
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By Paul Cwik
Oh joy, oh joy! It has finally arrived! You wouldn’t believe how excited I was to receive a letter from the Social Security Administration. In the letter, they dutifully showed me how much taxable income I have ever made. (Is it me, or is there something really creepy about that?) They showed me how much I have paid in taxes and how much my employer also “paid.” Then they showed me how much my payment would be if I retire at full retirement (67 years old — not 62 or 65 like you may have heard) and if I delay “collecting” until I turn 70.
It is no secret that I turn 40 this year. That means I have another 30 years of work in front of me. I have (for fun) just taken an online life-expectancy survey, and it says that I will live until the age of 86. So let’s assume that these numbers are correct. I will work for another 30 years and then have 16 years to spend it all.
According to the Social Security Administration, I will receive $2,522 a month during those 16 years. The value of that money when I turn 70 is a present-annuity-value calculation. For the purpose of this example, let’s pick an easy interest rate of 5% per year. So the value of the Social Security payments (compounded monthly) for 16 years at annual rate of 5% is $335,444.57. In other words, for me to privately do the same as Social Security, I will need to have $335,444.57 in cash when I turn 70 and deposit it in a security that has a 5% annual return.
To take this example a step further, how much money would I have to set aside each year at an annual compounded rate of 5% to hit this target? Using some “quick math,” we see that I would have to set $5,048.91 aside each year. Well, this does not seem too unreasonable. One might think that this is equivalent to putting away the maximum of $5,000/year in an IRA, and one would not be wrong for thinking that way.
Unfortunately, there is a larger point that has been missed. I have already been taxed for all of the previous years that I have worked. The Social Security Administration informs me that I have currently sunk a little more than $80,000 into this governmental pyramid scheme. Setting aside any interest I could have received over the past 21+ years, let’s assume that they give me a lump sum payment today of $80,000.
Suppose that I take that $80,000 and put it into a security that gives me an annual return of 5% and I do not add another single cent. How much would I have when I turn 70? $345,752.00! I have already exceeded the target needed for the Social Security Administration to fulfill its “promise” to me.
Alas, I do not think that it will do me any good to write a letter to the Social Security Administration explaining that I have reached my target and that they no longer need to tax me. In fact, the letter states, quite explicitly, that I must maintain my current earning rate to collect the stated numbers. So at this point any additional taxes that come from me are just wealth extractions with no benefit to me.
You may think that this is a bad deal for me, and it is, but it is going to be much worse for those who are younger than I. At least I am still making a positive rate of return, somewhere between 2% and 2.5%.
A person born in 1988 making $30,000/year can expect to receive $1,539/month in the year 2058. The Social Security Administration says that he is expected to live until the ripe old age of 87. So that’s another 17 years after retiring at the age of 70. The annuity present value of $1,539/month for 17 years at an annual rate of 5% is $212,938.88. In order to hit that target, he would have to set aside $1,132.50/year in a 5% security. This amount is only 3.775% of his $30,000 annual income.
Social Security and Medicare taxes are 15.3% of his income. If he invested that 15.3% of his income instead, he would be investing $4,590. Supposing that this annual contribution was invested each year for the next 48 years and the principal was collecting 5% interest, instead of the Social Security value of $212,938.88, he would have $863,036.55! That’s a little more than four times the return that Social Security is “promising.”
Or, to drive the nail home, he is paying $4,590 a year and is getting a future value of only $212,938.88. If he simply took that money and buried it in the dirt, he would have, after 48 years, $220,320! The bottom line is that, for today’s 21-year-old, Social Security is a negative return.
From Townhall.com
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By Walter E. Williams
Because of failure to heed the limitations of the U.S. Constitution, which has produced runaway federal spending, our nation sits on the precipice of disaster. Former Senator Alan Simpson of Wyoming and Erskine Bowles, White House chief of staff under President Bill Clinton, co-chairmen of President Obama’s debt and deficit commission, in a Washington Post article “Obama’s Debt Commission Warns of Fiscal ‘Cancer’” (July 12, 2010) said that “(A)t present, federal revenue is fully consumed by three programs: Social Security, Medicare and Medicaid. The rest of the federal government, including fighting two wars, homeland security, education, art, culture, you name it, veterans — the whole rest of the discretionary budget is being financed by China and other countries.”
The commission added the current budget trend is a disaster “that will destroy the country from within” unless checked by tough action in Washington. The tough action required is spending cuts in programs, including the so-called nondiscretionary, eating most of the federal revenues.
According to the Census, around 80 percent of Americans 65 and older own their own homes compared to 43 percent under 35. Twenty-three million households, or 37 percent of all homeowners, own their homes free and clear, and most of these are seniors aged 65 and older. According to the Federal Reserve Board’s 2007 “Survey of Consumer Finances,” the median net worth of people 65 and over is $232,000, those under 35 years have a net worth of $12,000 and for those 35-44, it’s $87,000.
For good reason, older people have accumulated more wealth than younger people; the primary reason is that they’ve had more time to do it. There is no logical case that can be made for using the tax system to force Americans with less wealth to subsidize those with more wealth. But it’s not clear who is subsidizing whom. Consider an elderly widow, say 70 years old, with a modest retirement income of $18,000 living in a $300,000 house that’s fully paid for. She might receive local property tax forgiveness, medical and prescription drug subsidies and other federal, state and local subsidies based upon her age and income.
When subsidies are provided for this lady, whom are we truly benefiting? It’s not the lady but her heirs. Conceivably, the lady could make a deal with a financial institution to pay her property taxes, allow her to live in the house for the rest of her life and give her a lump sum cash settlement so that she can live without the handouts. Upon her death, the house becomes the property of the financial institution, not her heirs. Giving the widow handouts allows her to bequeath to her heirs her assets, a $300,000 house. If her children want to inherit the house, they, rather than taxpayers, ought to take care of their mother.
We can start getting the federal spending under control by ending subsidies to people with high net worth that can be ready turned into cash such as a home or business. While seniors might say that they support reduced government spending, they, like other handout recipients, believe they have a right, through government, to live at the expense of others. What’s more, they have considerable clout — they vote in large numbers. Only 50 percent of young people vote, but up to 70 percent of seniors vote.
Political guts have always been in short supply and politicians fear senior retaliation at the polls. Moreover, it’s a practical matter for seniors and politicians. The true economic calamity won’t hit the country until 2030 or 2040. By that time, both today’s politicians and seniors will be dead so why should they make sacrifices now to prevent an economic calamity decades off into the future? Seniors might protest my cynicism but they can easily prove me wrong by waging an effective campaign to end handouts based on superannuation.
From Bloomberg
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Let’s get real. The U.S. is bankrupt. Neither spending more nor taxing less will help the country pay its bills.
What it can and must do is radically simplify its tax, health-care, retirement and financial systems, each of which is a complete mess. But this is the good news. It means they can each be redesigned to achieve their legitimate purposes at much lower cost and, in the process, revitalize the economy.
Last month, the International Monetary Fund released its annual review of U.S. economic policy. Its summary contained these bland words about U.S. fiscal policy: “Directors welcomed the authorities’ commitment to fiscal stabilization, but noted that a larger than budgeted adjustment would be required to stabilize debt-to-GDP.”
But delve deeper, and you will find that the IMF has effectively pronounced the U.S. bankrupt. Section 6 of the July 2010 Selected Issues Paper says: “The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates.” It adds that “closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”
The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years.
Double Our Taxes
To put 14 percent of gross domestic product in perspective, current federal revenue totals 14.9 percent of GDP. So the IMF is saying that closing the U.S. fiscal gap, from the revenue side, requires, roughly speaking, an immediate and permanent doubling of our personal-income, corporate and federal taxes as well as the payroll levy set down in the Federal Insurance Contribution Act.
Such a tax hike would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit. So the IMF is really saying the U.S. needs to run a huge surplus now and for many years to come to pay for the spending that is scheduled. It’s also saying the longer the country waits to make tough fiscal adjustments, the more painful they will be.
Is the IMF bonkers?
No. It has done its homework. So has the Congressional Budget Office whose Long-Term Budget Outlook, released in June, shows an even larger problem.
‘Unofficial’ Liabilities
Based on the CBO’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt. This gargantuan discrepancy between our “official” debt and our actual net indebtedness isn’t surprising. It reflects what economists call the labeling problem. Congress has been very careful over the years to label most of its liabilities “unofficial” to keep them off the books and far in the future.
For example, our Social Security FICA contributions are called taxes and our future Social Security benefits are called transfer payments. The government could equally well have labeled our contributions “loans” and called our future benefits “repayment of these loans less an old age tax,” with the old age tax making up for any difference between the benefits promised and principal plus interest on the contributions.
The fiscal gap isn’t affected by fiscal labeling. It’s the only theoretically correct measure of our long-run fiscal condition because it considers all spending, no matter how labeled, and incorporates long-term and short-term policy.
$4 Trillion Bill
How can the fiscal gap be so enormous?
Simple. We have 78 million baby boomers who, when fully retired, will collect benefits from Social Security, Medicare, and Medicaid that, on average, exceed per-capita GDP. The annual costs of these entitlements will total about $4 trillion in today’s dollars. Yes, our economy will be bigger in 20 years, but not big enough to handle this size load year after year.
This is what happens when you run a massive Ponzi scheme for six decades straight, taking ever larger resources from the young and giving them to the old while promising the young their eventual turn at passing the generational buck.
Herb Stein, chairman of the Council of Economic Advisers under U.S. President Richard Nixon, coined an oft-repeated phrase: “Something that can’t go on, will stop.” True enough. Uncle Sam’s Ponzi scheme will stop. But it will stop too late.
And it will stop in a very nasty manner. The first possibility is massive benefit cuts visited on the baby boomers in retirement. The second is astronomical tax increases that leave the young with little incentive to work and save. And the third is the government simply printing vast quantities of money to cover its bills.
Worse Than Greece
Most likely we will see a combination of all three responses with dramatic increases in poverty, tax, interest rates and consumer prices. This is an awful, downhill road to follow, but it’s the one we are on. And bond traders will kick us miles down our road once they wake up and realize the U.S. is in worse fiscal shape than Greece.
Some doctrinaire Keynesian economists would say any stimulus over the next few years won’t affect our ability to deal with deficits in the long run.
This is wrong as a simple matter of arithmetic. The fiscal gap is the government’s credit-card bill and each year’s 14 percent of GDP is the interest on that bill. If it doesn’t pay this year’s interest, it will be added to the balance.
Demand-siders say forgoing this year’s 14 percent fiscal tightening, and spending even more, will pay for itself, in present value, by expanding the economy and tax revenue.
My reaction? Get real, or go hang out with equally deluded supply-siders. Our country is broke and can no longer afford no- pain, all-gain “solutions.”
From Fr33 Agents
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Well, at least some of them. I read an article lately in which some economics Ph.D. tried to convince me (and anyone else who reading his essay) that economics was really, really complicated. A gentleman named Kartik Athreya penned an essay entitled “Economics is Hard. Don’t Let Bloggers Tell You Otherwise.” Of course, bloggers should also ignore the fact that he works for the Federal Reserve system. I’m sure this hasn’t affected his objectivity in any way, shape or form. After all, he does state that the views expressed in his essay are his own and do not reflect the views of the Federal Reserve. We should just believe that, right? We can trust him because he has a Ph.D.
So, Mr. Athreya opines, though not in so many words, that there are lots of people buying lots of things in lots of ways, and that’s what makes macroeconomics so complicated. Hmm. Of course, I paraphrase to try to simplify so we less than intelligent beings can comprehend. Isn’t that what we bloggers, or at least some of us, are best at, simplifying? Perhaps Mr. Athreya has not considered that maybe macroeconomics appears to be so complicated because that is what those with Ph.D.s in economics are paid to do, to make things seem complicated. That is how they justify their existence. Of course, I could be wrong. After all, I
am just a lowly blogger.
Let’s examine a little more closely what it means to have a Ph.D. Now, I don’t mean to sound like someone who comes down on all Ph.D.s; indeed, I know some who are not only very intelligent but very nice and personable. But the tone this particular one took sticks in my craw. And it’s not just him, but there are quite a few of his ilk who seem to have come to the conclusion that those of us who don’t hold the vaunted Ph.D. simply do not know enough to run our lives, or to form our own opinions, or to add any kind of insight into any conversation or debate, or to do anything about anything we haven’t been formally educated in. They hold themselves superior to the uneducated not taking into account another’s life experiences or his ability to reason. They carry no respect for us poor, stupid common folk. It’s academic chauvinism.
That aside, the quality of one’s formal education is only as good as the quality of one’s teachers. The quality of those teachers can only be as good as what will be allowed by the formal educational system itself. In this case, the Ph.D.s that have been developed over the past several decades have come out of a system that is not so much an educational system as it is an indoctrination system. The public schools of this country have become a bastion of propaganda and socialism, teaching children more about political and social correctness than about critical thinking. Many economists that have earned Ph.D.s have likely learned much about the Keynesian economic system but not much about the Austrian system. Either that, or the Keynesian system has likely been praised by their professors while the Austrian system has likely been demonized.
It doesn’t take much to discover, when one takes a close and objective look at things, that the Keynesian system of economics leads to more power, control and money in the hands of an elite few, mostly central bankers and central planners, while the Austrian system leads to more power, control and money in the hands of the common folk who can then vote with their dollars in terms of who survives in the marketplace and who fails. Is it any wonder someone with a Ph.D. in economics would defend the current Keynesian system of central banking? Especially if he works within that same system. Is it any wonder that when one is confronted with a thoughtful, honest, objective presentation in favor of fewer regulations and a more free market they might become defensive and start attacking the messenger?
The truth can hurt. As I see it, the truth is that the Ph.D.s and Keynesian economists haven’t prevented our nation, and in fact the world, from falling into depression. They haven’t prevented massive unemployment. They haven’t prevented the boom/bust cycle from taking place. They haven’t stabilized the economy as they were supposed to. Indeed, they have caused these things. They have created the conditions that have made these things possible. They can point fingers all they want and make the claim that the economy is just too darn complicated, but that’s because they don’t want to look at themselves in the mirror
and admit they were wrong.
It seems inevitable that one of them would come out and tell you to ignore the bloggers. They simply don’t want everyone blaming them. They don’t want everyone blaming the system itself and attempting to dismantle the monopoly that has treated them so well for so long in favor of a system that will make them less influential and relevant. They want you to forget that the Federal Reserve system was sold to the American people on the promise that it would end the boom/bust cycle, depressions, massive unemployment and stabilize the economy. We haven’t forgotten, at least I haven’t, history hasn’t forgotten, and the Federal Reserve system has failed. It needs to be held accountable, no matter how many Ph.D.s say otherwise.
The idea should be to keep the economy as stable as possible. The idea shouldn’t be to try to grow the economy so much. It seems to me that if the economy grows too much, it is inevitable that it is going to shrink. It seems that the system favors those who have the most money and the most influence over our government.
The economy is about trading goods and services. There should be no “too big to fail” corporations. If a corporation is failing in the marketplace it is because either people don’t want to use their goods or services, or bad business decisions were made. In either case, those corporations should have to pay the price and either adapt, or go out of business. That’s what would happen in a free market, Austrian type economic system. It is the Keynesians and their central banking, central planning schemes that allow for government to have the means to bail out failing enterprises. They have convoluted and obfuscated in order to make economics, and specifically macroeconomics, seem too complicated to understand so that they could continue their schemes and market manipulations, so that they can continue to benefit, and to try to keep the rest of us, we under educated common folk, from figuring out what’s really going on.
The common folk need to start ignoring the corporate Ph.D.s and the Keynesian economists. They have done nothing but lead us down the path of economic destruction. They have done so for decades. They promote systems that have proven to fail again and again. They do so in order to benefit themselves and become part of the elite class. Economics is not so much a natural science as it is a pseudoscience like psychology. It is not based so much on natural law as it is on manmade law. It does not study nature’s processes so much as it studies human interactions. One does not need a degree of any kind in the subject in order to understand it, or even to understand macroeconomics, one just needs to be a little more involved and observant.
When push comes to shove, it seems to me that those involved in the system give advice to help maintain the power of the system. Their decisions are based more on political realities rather than scientific fact. Competition and the free market are the natural enemies of monopolies, whether business or government, central banking and central planning. It is natural for authoritarians, control freaks and those who wish to gain power to demonize free markets, sound money and anything else that might challenge their establishment. It is natural for those involved to delude themselves into thinking they are actually doing good and to adapt an elitist, snobbish attitude to justify their obviously harmful actions. After all, they are only human, like everyone else. They simply wish to be more relevant than anyone else, which is their nature I suppose.
From Bloomberg
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Federal Reserve officials decided to reinvest principal payments on mortgage holdings into long-term Treasury securities, making their first attempt to bolster growth since March 2009 to keep the slowing U.S. economy from relapsing into recession.
“The pace of economic recovery is likely to be more modest in the near term than had been anticipated,” the Federal Open Market Committee said in a statement in Washington. “To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level.” The Fed retained a commitment to keep its benchmark interest rate close to zero for an “extended period.”
With growth weakening in the second quarter and company job gains in July falling short of estimates, today’s step signals that risks of a downturn have increased enough for the Fed to delay its exit from unprecedented stimulus. Chairman Ben S. Bernanke told Congress last month that the Fed was “prepared to take further policy actions as needed.”
The Fed said it will “continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.” The reinvestment policy applies to agency debt and agency mortgage- backed securities held by the central bank.
The central bank left the overnight interbank lending rate target unchanged in a range of zero to 0.25 percent, where it’s been since December 2008. High unemployment, low inflation and stable price expectations “are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” the Fed said, repeating language from every policy meeting since March 2009.
“The pace of recovery in output and employment has slowed in recent months,” the FOMC said. The Fed will “continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.”
U.S. central bankers repeated that inflation is “likely to be subdued for some time.” Prices in June rose 1.4 percent from a year earlier, the third straight month of slowing gains under the Fed’s preferred index, which excludes food and energy costs.
Kansas City Fed President Thomas Hoenig dissented from the decision for the fifth straight meeting.
Fed policy makers, at their last meeting in June, judged that the central bank “would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably,” according to minutes of the session. Records of today’s meeting will be released Aug. 31.
Bernanke said in an Aug. 2 speech that “we have a considerable way to go to achieve a full recovery in our economy.” Still, he avoided signaling that the central bank would reverse months of reductions in record stimulus and liquidity programs, including the end to $1.7 trillion in purchases of housing debt and Treasuries.
St. Louis Fed President James Bullard said July 29 that while he expects a continued recovery, policy makers should be ready to buy Treasuries if the economy slows further.
The Fed’s last move in favor of easier policy came in March 2009, when policy makers agreed to buy $300 billion of Treasuries and more than double planned mortgage-debt purchases to $1.45 trillion while starting a pledge to keep the benchmark rate close to zero for an “extended period.”
This year the central bank stopped buying assets, raised the rate on direct loans to banks and shut emergency-lending programs for corporations, bond dealers and money-market mutual funds. It’s also developed tools for raising rates with a near- record $2.3 trillion balance sheet.
Today’s decision defied easy prediction after a report Aug. 6 showed U.S. private employers added 71,000 jobs in July, below the 90,000 median estimate of economists surveyed by Bloomberg News. The unemployment rate was unchanged at 9.5 percent. Including government workers, the U.S. lost 131,000 jobs in July, compared with the median estimate of 65,000.
The weak job market has inhibited growth in consumer spending, which accounts for about 70 percent of the economy. Such expenditures rose at a 1.6 percent pace last quarter, down from a 1.9 percent rate in the previous three months that was smaller than previously estimated.
“They’re supposed to keep inflation under control, but they’re also supposed to promote full employment,” Christopher Low, chief economist at FTN Financial in New York, said in a Bloomberg Television interview before the announcement. “The Fed is starting to worry about hitting that full-employment goal any time in the next three or four years.”
Aeropostale Inc., a retailer to teenagers whose sales rose in July at one-seventh the pace analysts predicted, said changing consumer preferences and a “challenging” retail environment hampered spending. Sales at J.C. Penney Co., a department-store chain, fell 0.6 percent last month.
Still, Bernanke and other officials in recent weeks had maintained their outlook for a pickup in the economy over the next year. Corporate spending on equipment and software jumped at a 22 percent annual rate last quarter.
While weakness in housing and commercial real estate will restrain the recovery, and the job market’s “slow recovery” weighs on consumers, “rising demand from households and businesses should help sustain growth,” Bernanke said in a speech last week in Charleston, South Carolina.
United Parcel Service Inc., the world’s largest package- delivery company, raised its annual profit forecast last month and posted second-quarter earnings that climbed more than analysts estimated on increased demand overseas.
The S&P 500 Index has rebounded 12 percent as of yesterday from its low this year on July 1.
Investors don’t expect the Fed to raise the federal funds rate until late 2011, based on futures contracts on the Chicago Board of Trade.
The housing market has faltered since a federal tax incentive for first-time homebuyers expired in April. Sales of previously owned homes fell 5.1 percent in June from May, housing starts slid to the lowest level in eight months and the 330,000 annual pace of new-home sales was the second-lowest in data going back to 1963 after May’s 267,000 rate.
The National Bureau of Economic Research, an academic group with a committee that marks the start and end of recessions, has yet to announce a date for the end of the downturn that started in December 2007, even after four straight quarters of growth. Some panel members including Stanford University’s Robert Hall and Jeffrey Frankel of Harvard University have said it’s clear the contraction has probably ended.
To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.
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Abstract: This paper is a presentation and an interpretation of Murray Rothbard’s views on the relation between the fiscal necessities brought by war and interventionism in Money and Banking as read from his book A History of Money and Banking in the United States.
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This short video explains one of the most persistent economic fallacies of our day.
From The Mises Institute
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The Federal Reserve Bank of Minneapolis recently interviewed macroeconomist Robert Hall for the June issue of its quarterly magazine, The Region.
His words on the Federal Reserve’s ability to enact an exit strategy to unwind its unconventional policies were clear and sure: “There are two branches to the exit strategy: There’s paying interest on reserves, and there’s reducing reserves back to normal levels. They’re both completely safe, so it’s a nonissue.”
Before addressing the question of whether the exit strategy is really “completely safe” or a “nonissue”, we must first address the specifics of these two components.
In the wake of the credit crisis of late 2008, the Federal Reserve flooded the banking sector with liquidity. The Fed purchased troubled assets in exchange for base money. Since the banking system was not prepared to immediately loan this new base money, the system’s reserves increased dramatically. The Fed concomitantly commenced paying interest on these reserves to remove the incentive for them to be fully used. In theory, by removing the incentive to loan out reserves, price inflation would be minimized: banks would not be constrained by their troubled loans and bad assets, and the Fed would retain credibility as an “inflation fighter.”
The result was immediate and effective. As bad assets were removed from their balance sheets, banks were not forced into fire-sale situations by selling their assets to maintain regulatory capital levels. At the same time the Fed was able to save the banking sector via an increase in available credit without causing inflationary pressures to build.
While the short-term effects were seemingly beneficial and controlled, the long-term outlook is much less certain.
The Fed’s liquidity injection was made by issuing credit to banks and simultaneously buying back troubled (i.e., subprime) banking sector assets. While the banking sector’s balance sheet ballooned with cash and cash equivalents, the Fed’s own balance sheet witnessed a sharp rise in the very troubled assets it was removing from the banking system. As Philipp Bagus recently noted, the Fed had become exactly the type of “bad bank” it had tried to rescue.
The figure below outlines the growth in the Fed’s balance-sheet policies during the crisis.
Some of the enacted programs were self-liquidating, and now pose minimal danger to the financial system (central-bank liquidity swaps spring to mind, as does the money-market mutual-fund liquidity provision). Other programs have continued growing and cannot be so easily phased out. Over $1.1 trillion of mortgage-backed securities have been purchased since March 1, 2009. These assets, typically rated subprime, are of questionable quality (with total assets of almost $2.4 trillion as of July 1, 2010, nearly half of the Fed’s total assets are subprime). More troubling is that these mortgages cannot be properly valued until they are sold to a willing buyer — buyers who are increasingly in short supply.
This “qualitative easing” — the purchasing of low-quality assets from the banking sector in exchange for high-quality assets from the central bank — persisted until central banks lacked adequate high-quality assets to continue the policy. It was only at this point that the more obvious policy of “quantitative easing” was pursued.
Philipp Bagus and I have been among a minority of economists who have signaled the occurrence of this policy (both by the Fed and the European Central Bank), and, more importantly, its detrimental ramifications. The long-term implications of this policy are now becoming evident.
As the Fed withdrew these troubled assets from the banking system, they were offset by issuing increasing amounts of Federal Reserve liabilities — cash. By offering an interest payment on reserve holdings, banks were incentivized to hold on to this newfound liquidity, thus nullifying any inflationary effects the policy could immediately cause. And as Robert Hall correctly notes, one exit strategy the Fed now has is the continual payment of interest on these reserves. As long as banks can profitably hold the 1.1 trillion extra dollars of monetary base that the Fed has created since August 2008, no inflationary pressures will build.
The reality may be very different from what Hall’s theory suggests. As the figure below shows, the banking system now receives around $230 million each and every month for doing nothing other than holding on to the assets they passively received in exchange for their low-quality mortgage-backed securities.
Three billion dollars a year in interest payments is a large portion of the Fed’s annual operating profits. The recipients — America’s large and not-so-large banking establishments — are now much less hindered by subprime loans than they were two years ago. How much longer the Fed can give the banking sector billions of dollars to hold on to these reserves is questionable. Politically, it seems unlikely that Americans will continue to support these payments. Economically, the Fed is losing a large portion of its operating profits to these payments.
Despite these troubling aspects, the banking system’s subprime situation is being alleviated. The Fed continues its policy of buying these mortgage-backed securities from the banking sector in order to maintain stability. This is a show of force, an attempt to demonstrate that the Fed is in full control of the situation.
Full control, however, is exactly what the Fed does not have. The alternative exit strategy, if financial stability is to be maintained without runaway inflation, is for the Fed to simply swap the “bad” assets on its own balance sheet for the “good” assets of the banking system.
Herein lies the rub. Inflationary pressures could be neutralized if the aggregate value of the assets originally purchased by the Fed is equivalent to the aggregate value of the assets now being returned. We should take comfort in knowing that at least one of these numbers is known with some degree of exactness. The cash now resting as reserves, and more importantly excess reserves, on the banking system’s balance sheet can be valued at par: more or less, there are $1.1 trillion waiting on the sidelines for the Fed to reabsorb.
The value of the mortgage-backed securities that the Fed holds is far less certain. While the reported value on its balance sheet is $1.1 trillion, we should note that the Fed is balancing its books based on the current face values of these securities. These trillion odd dollars represent the outstanding principle on this debt, which is guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. While these assets may have been purchased originally by the Fed for this recorded amount, the maintenance of this value is questionable.
At what discount are securities backed by and comprised of Las Vegas gambling parlors and Miami vacation rentals selling today? We don’t know for certain, and more troubling, we won’t know what discount a trillion dollars worth of these securities will sell at until the market finds buyers for them. Presumably, the Fed purchased the lowest-quality assets that the banking system held: removing the most “toxic” assets to aid bank capitalization levels. Knowing that the Fed now holds the most toxic of the subprime assets the banking system could create during the roaring 2000s should leave us with some concern.
What then of the Fed’s exit strategy? Ben Bernanke and Robert Hall, along with a multitude of fellow central bankers and economists, have stressed that there is no technical problem in exiting these positions. This is theoretically true — until reality sets in.
Any Fed-enacted swap of its subprime assets for the excess reserves of the banking system will result in some degree of inflation if the two values do not coincide. An upper and lower bound for future price inflation can be approximated from this differential.
At the upper bound, as several commentators such as Robert Murphy have warned, is the outcome where the Fed does nothing to reign in excess reserves. In this case, the Fed will have created $1.1 trillion worth of inflation.
More importantly, we can estimate the lower bound for the Fed-created inflation. The value differential between the excess reserves in the banking system and the subprime assets held by the Fed will remain in the banking sector indefinitely. As the Fed can only purchase back from the banking system reserves of equal value to its available assets, any drop in the value of its own assets will result in excess reserves remaining in the hands of the banking sector — waiting to manifest as price inflation when finally utilized.
Neither bound, upper nor lower, seems particularly attractive.
The silver lining in all this may be that any inflationary pressures will have to wait for another day. The Fed will not enact either exit strategy until the banking sector is back on firm footing, lest a tenuous situation worsen. With several banks entering insolvency weekly, the Fed is in no position to start unwinding any of its balance-sheet policies designed to aid the struggling sector.
Until the day comes when the Fed deems the banking sector able to stand on its own two feet — either with its subprime mortgages back, or without the interest payment on its reserve holdings — inflationary pressure on prices will remain low. But until the Fed finally decides to unwind its subprime balance-sheet positions, entrepreneurs will have to function in an era of uncertainty as to what price inflation lies ahead.
