Tuesday, December 9, 2008

"Paper" money and the financial games governments play

An interesting thing happened today: short-term Treasuries sold with negative returns (link). This means that you get less money back at maturity for them than you pay today; ie: worse than holding cash. "How can this happen?", you might be inclined to wonder. Therein lies a very interesting context and back-story...

See, in my mind it starts with the fractional reserve banking system and the Fed. The banking system is what allows currency in circulation to multiply, as banks loan out money based on fractional deposits. This allows the amount of loans outstanding (and consequently the amount of money outstanding) to be significantly larger than the actual sum of deposited "hard" money held by the banks as reserves on the loans. The mathematical maximum in additional money is 9x the "real" deposited money; in practice it's typically closer to 2x.

As an aside, derivatives also add "fake" money to the financial system. These are conditional debt instruments, where someone promises to pay someone else if something happens. Financial companies held these as assets, against liabilities they had incurred (borrowed money, other derivatives, etc.), which added to the total "fake" money in the system. This has disastrous effect if/when it comes to pay off all these debts and some player in the middle in insolvent, and the "unwinding" process makes everyone else also insolvent (eg: the financial meltdown in the US), but is tangential to the whole money game discussion.

Now enter the Fed. They print "real" money, in the form of federal reserve notes (aka US currency), which are one thing the banks are allowed to hold as "real" deposits. This is also what's used to "purchase" Treasury notes, which is what the government sells to finance its debt. So at long as the currency supply is relatively constant, it has meaning, and the financial system can function.

Only, recently, the Fed has been doing interesting things. For example, they have been making massive "loans" to undisclosed people/companies/nations for undisclosed terms and accepting undisclosed collateral, on the order of trillions of dollars. The money given out for these loans (from the Fed) is "real" money, US currency, accepted for banking reserves and able to be subsequently borrowed against. Also, the Fed isn't disclosing the interest rate it's charging, but the Fed officials have said they are expressly trying to "recapitalize" banks, so you can bet the rate is close to zero.

Now say you were an enterprising bank, with access to the secret backdoor Fed lending programs, and wanted to "recapitalize" yourself (ie: make more money to pay yourself with). You could borrow from the Fed, then buy US Treasuries! Whatever you make on the Treasuries is profit, with no risk. It's even better than that, though: you get to show the Fed's money on your balance sheet instead of whatever worthless collateral the Fed is [temporarily] laundering for you, and you can also borrow against that "real" money to buy more leveraged investments! Might as well, right... it's not like there's not more bailout money where that came from if it doesn't work out.

Which leads us to an interesting question: who exactly is funding our massive debt spending handout wealth-redistribution programs? Let's see: the Treasuries are being purchased by banks, who are borrowing the money from other banks, who are lending on the basis of fractional reserves of federal reserve notes, which are loans based on junk collateral held by the Fed. So in essence, the Fed, in coordination with the "paper" monetary expansion allowed by fractional reserve banking, is funding the massive national borrow and spend binge. Huh... interesting.

When does this end? When the Fed calls due the loans, which causes the same unwinding process which created the financial crisis in the first place; that is, never. So who's financing the debt? Nobody is; it's all "paper" money created by fractional reserve banking and loans of "real" money from the Fed. So can we continue to borrow/print money forever? Well, I think, technically yes, until the currency ceases to have any value at all. Cool, huh?

2 comments:

  1. I think I don't understand the fractional reserve thing. I thought the Federl Reserve Bank had a certain amount of assets, mostly Treasuries. Now they've exchanged much of their Treasuries for these troubled debt instruments. It seems like they've lent out their money, and they don't have any more to lend. I know the fractional thing lets them print money, but what are the restrictions on that? Why do they bother doing open market operations with Treasuries to expand the money supply if they can simply print money?

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  2. That's what's "awesome" about it: they have no real restrictions or limit. For example, although they nominally have only one trillion in Treasuries in deposit, they have already loaned out over two trillion (in federal reserve notes, aka US currency), and have pledged over 8.7 trillion in total obligations and guarantees.

    Moreover, as I pointed out, the money they "lend" out (for worthless junk collateral they don't disclose) can be used a reserves for fractional lending, as it is "base" currency. Alternatively, the banks can deposit it back at the Fed (as their reserve deposits), for which the Fed pays them 1.5% interest now. The banks which can get interest from the Fed are doing so; the rest of the investment managers are buying the next best investment, which is Treasuries earning 0%.

    I think the Fed does open market operations in "normal" times so as not to appear to be manipulating the market. In today's times, though, pretty much everyone in government has given up on not manipulating the market, much less not appearing to manipulate the market, and moved on to "who gets the wealth redistribution".

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