In Buiter's magnum opus on all the ways a central bank can stuff an economy to the gills with currency, he discusses the balance sheet of a central bank. Historically, the equity of the bank that issued the currency helped make the currency sound and valuable. This was once very important, and the US has had many different currencies over the years, sometimes many at once, all with colorful histories.
It had become almost a historical relic before the Fed's new high-wire act. Buiter details some of the risks the Fed is exposing itself to today, and mentions the need for the bank to recapitalize itself. He doesn't go deep into why this recapitalization is necessary and how it is important, so we will.
Inflation risk and credit risk are the two really important risks the Fed is facing.
Inflation risk decribes the likelihood that inflation will rise too far during the term of the loan, and is greater for longer loans. Should there be any resurgence of inflation over the next multiple years, the Fed will suffer at least a mark-to-market loss.
Credit risk describes the likelihood that the deadbeats will fail to pay you back. Should it turn out that the Fed bought some toxic paper(I know, right?), then the Fed will suffer a capital loss. More of this paper is likely to be bad if deflation persists.
A mark-to-market loss or a capital loss might seem like it doesn't really matter. But as Sims pointed out at the beginning of this fiasco, it can actually be quite a big deal. We will look at the Fed's three main tools for stopping inflation: open market operations, paying interest on excess reserves, and raising the required reserves ratio. Suffering a either loss limits its capacity for open market operations, which is why Buiter discusses recapitalization as required, but there are other creative approaches.
When the Fed wants to take dollars out of the system to curb inflation, it has to get its dollars back from people. It traditionally sold off some of the Treasury securities on its balance sheet in exchange for these dollars. This removed the dollars from circulation, hypothetically limiting the amount of credit that can be created, shadow banking system notwithstanding, controlling inflation.
But what happens if the assets it owns are no longer Treasury securities, but a hodgepodge of pier loans, bad credit card receivables, MBS IO strips, and more? It would have to resort to selling those, and it's quite probable that those would be bought by the private sector only at a significant discount. The Fed would be left with a negative equity position.
This negative equity position could be quite large, but only in severe inflation should it become a real problem: when the Fed needed to sell more assets than it actually had. That's only when recapitalization with quality assets through outright taxation would be explicitly necessary. If things didn't get that bad, the Fed might be able to simply sit there with the hole on its books, waiting eternally for seigniorage to fill its pockets once more. The Treasury loses the small revenue from seigniorage, and that's the end of that.
Interest on Excess Reserves
Some of the clever readers in the blogosphere have suggested an alternative solution. The Fed now pays interest on deposits. If the Fed were able to increase that interest rate arbitrarily, it would quickly become more appealing to deposit funds at the Fed than loan them out. This would give the Fed another way to effectively take dollars out of circulation and curb inflation.
A key problem with this idea is that the Fed's balance sheet grows gradually worse. Just like anyone's favorite Ponzi -- or Madoff -- scheme, the Fed would be paying out more in interest on its good liabilities than it takes in on its bum assets. It's fun to call the Fed a Ponzi scheme, but in this case it would actually be true: it would gradually grow more broke.
This might be a temporary state of affairs as it acquires more assets that yield more than it must pay out in the future, but that really depends on the state of the economy, and how much inflation it's willing to suffer.
Thus, even if the Fed ran out of assets to sell, it still isn't completely powerless. In fact, the things that normally cause a Ponzi scheme to fail, like excessive redemption requests, are by definition not at play here. Could it go on indefinitely?
Required Reserve Ratios
The Fed can also simply change by mandate how many dollars are deposited on its books by depository institutions. It increases the required reserve ratio, which should mean the bank can create fewer dollars. Unfortunately, banks are pretty talented at getting around regulations designed to limit their aggressive risk taking. The shadow banking system and other leveraging mechanisms would probably flourish.
The RRR is currently roughly 10%. It could easily be raised or lowered from there. It might not have much tangible impact, and it would crimp bank profitability. However, if enforced well, it would be a way to curb money creation with little risk to the Fed.
Even if the Fed is in the hole, there are still a lot of things the Fed can do. I don't think the Fed will run out of options for controlling inflation.
Are there lesser risks than hyperinflation or collapse of the currency?
If either of the first two options were used, there would be more dollars outstanding than there would naturally be, which would be somewhat more inflationary, and require somewhat higher interest rates to combat it. That's probably not a really big deal.
The one risk that I have sympathy for is a general loss of confidence in the currency. Holders may anticipate the need for the bank to recapitalize itself, through inflation or taxation of dollars, and desire to escape this. They may also not really enjoy Ponzi schemes. This loss of confidence should lead to an increase in the level of interest rates or the amount of inflation that would occur. It's a long-term drag either way.
The only way I could see a real hyperinflationary collapse happen is if the Fed were politically restricted from fighting aggressively, or there were simply a widespread collapse of confidence in the currency altogether.
Complex topic, and I'm sure I missed a lot of things. What are your thoughts?