Monday, September 17, 2007

The US Federal Reserve - more powerful than ever

The Mises blog has a scary and shocking article about the US Federal Reserve, the precarious state of the US economy and what could be a looming disaster. Most people I encounter give very little thought towards monetary policy and the role and powers of central banks around the world. But it seems everybody is out there complaining and feeling the effect of rising prices. Most people go on to blame phantom boogeymen, like the government or global warming, without looking at the role of the money supply and the central bank in all of this.

The scenario painted by the article is not a rosy one at all. Since 1999, the Federal Reserve has been allowed to accept all kinds of securities as collateral for loans, without matching the loans with a corresponding sale of US treasury securities. This has led to easy easy easy money and booming credit and lending by banks.

If sub-AAA MBS [mortgage backed securities] collateral pledged to the Fed were to fall in value while the Fed was holding them, the bank that deposited the MBS and took the loan would be required to deposit additional collateral or reduce its loan balance to an appropriate amount. In the case of securities with no market price, the need for additional topping up could be difficult to determine. In theory though, most of the risk associated with falling collateral values lies with the bank accepting the loan, not the Fed.

The main risk to the Fed would be if the borrowing bank were to go bankrupt during the course of the loan. Under such a scenario the Fed would take possession of the collateral and sell it in the open market to recuperate the funds it had lent the failed bank. If the market price for the collateral was significantly below the amount the Fed had originally lent out, the sale would not withdraw the total amount of dollars originally created by the loan. This is problematic because it would put the Fed in contravention of Section 16 of the act, specifying that all dollars must be properly collateralized. In other words, the Fed would have lent a certain quantity of new dollars into the economy, but with the sale of the collateral it would have withdrawn only a portion of this amount, leaving a large chunk circulating with no backing. In order to comply with Section 16, the Fed would be required to withdraw this amount of money from the financial system by selling a corresponding amount of treasuries from its surplus.

In a situation in which the Fed exposed itself to significant quantities of iffy collateral and multiple institutions refused to honor their obligations, the Fed would be required to sell massive amounts of treasures in order to withdraw unbacked cash from the financial system, in the process drastically reducing the money supply and making an already precarious situation worse.