Fed Going Bankrupt?
Entry posted by Lord GVChamp
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Confession: I peruse the economics subReddit on occasion. Most of the time, the experience leaves me wanting to pull my hair out. But today I ran across something that may be of interest to you.
The topic is what is says on the tin: is the Federal Reserve about to go bankrupt?
I read the article expecting some whack-job nonsense. Bankruptcy is a legal condition where companies unable to pay their debts are either restructured or liquidated. The Federal Reserve probably cannot go bankrupt in this fashion, since they can simply print up more money.
Thank the lord, that is NOT the point of the article. While the Fed won't go bankrupt, per se, they can sorta become insolvent, because the Federal Reserve has a balance sheet like other companies. And while they won't "go out of business" like other companies, going insolvent can be very bad for the US economy because the Fed will have to let inflation rise. That's the point of the article. And that probably makes absolutely no sense to you, so let me explain some more.
All companies have something called a balance sheet, which is a snapshot of a company's finances at a particular point. It's based on the fundamental accounting equation:
Assets = Liabilities + Capital
Basically your company is worth X (your assets), you owe Y dollars (your liabilities), and the difference between the two is Z(your capital). If we have $10 in our business, owe people $9, then we have capital of $1, and if we disbanded today we'd get $1 back. That "capital" number is EXTREMELY important for companies, especially banks. If capital is negative, it means the company is worth LESS than what it owes. And that's when bad stuff happens. Companies that owe more than their company are called balance-sheet insolvent.
The Federal Reserve has a balance sheet, too, but it operates differently than most companies. The Fed does not necessarily borrow money from people. They print money and give it out to people, namely the American people. The money counts as a liability, though, because the Fed is using it to buy assets.
Example:
Ben Bernanke wants to add $100 billion to the economy. How does he do this? Have you ever seen a Federal Reserve agent on the street corner, handing out money? Doesn't happen. Instead, Ben Bernanke goes to the banks and says "I will give you guys $100 billion in exchange for 100 million houses." The banks agree. Now the banks have $100 billion extra, which gets pumped into the economy, while the Federal Reserve now owns $100 billion worth of houses. Those houses are their assets, which they bought by issuing $100 billion in money, which are their "liabilities."
Though they have "liablities" of $100 billion, they owe nothing . They can technically go insolvent if the houses drop in value, because the assets are worth less than their liabilities, but there is no conceivable way that the Federal Reserve can go bankrupt in this scenario. They don't owe any money to any one. You'd think everything would be fine.
But, you'd be wrong. The Federal Reserve has to manage inflation, which means sometimes they have to take money OUT of the economy. Have you ever wondered how they do THAT? Has Ben Bernanke ever mugged you in a dark alley? Doesn't happen. The Federal Reserve takes out money in the exact opposite way they add money, by selling assets.
This is where insolvency takes its toll. Say housing prices dropped 50%, so Ben's houses are now only worth $50 billion. Ben Bernanke wants to take $80 million out of the economy, so he heads back to the banks and asks for the money back. The banks laugh at him, because who the hell would give away money for nothing? Ben says, okay, I'll sell the houses I have, reaches into his bag and finds out...he can only get $50 billion back because that's how much the houses are worth. The Fed can't take the money out of the economy and inflation results.
Right now, we're going through a similar situation with the Federal Reserve. The Fed dumped a TON of money into the economy back when the markets collapsed, mainly by buying treasury bonds and mortgages. Right now, banks are sitting on that money, but when the economy picks up, banks will pump it back into the economy, causing inflation. Lots of inflation. The Fed may need to buy that back, but it might not be able to do that if the value of its assets fluctuate too much. Inflation becomes unavoidable in this scenario.
So while the Federal Reserve cannot go bankrupt, it certainly can find itself in a tough spot. Assets purchases have been the primary method of adding and subtracting money from the economy for a long time. If the Fed ends up insolvent, it will have to rely on other, less traditional means of adjusting the money supply. And that'll be interesting.
Note: I am not 100% certain on all of this, but this is my best understanding. Anyone with more information is more than welcome to critique and add in their two cents.
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