Posted on 09/06/2009 8:25:36 PM PDT by politicket
In an effort to better understand the construction of the U.S. economy I created a scenario where the entire economy contains $1,000.
The Fed would have $1,000 of assets in the form of U.S. Teasury securities, and liabilities of $1,000 as a computer entry that the U.S. government owns
The U.S. government would have $1,000 of assets as a computer entry, and $1,000 of liabilities as U.S. Treasury securities.
Then I assumed that the U.S. government bought a plane from ACME Airplanes for $1,000.
The U.S. government would send ACME a check for $1,000 and would now have assets of an airplane and liabilities of $1,000 of securities.
ACME woud have assets of $1,000, liabilities of whatever their costs were, and capital("profit") of whatever remained after deducting costs.
ACME deposits the check into the only commercial bank around (and only Primary Dealer) in my fledgling economy. We'll name this "BANK".
BANK now has $1,000 of assets and $1,000 of liabilities (since ACME actually owns the money).
I'm getting close to my question. The U.S. government needs more money to operate, so they print up another $2,000 of Treasury securities.
The FED will hold a Treasury auction (since the FED is barred from purchasing securities directly). BANK is the only institution available in my economy to purchase the new securities, but they only have $1,000.
BANK makes a $900 loan to JOE, and JOE purchased something from DAVE. DAVE deposits the $900 in BANK.
BANK now has assets of $100 (cash reserve) + $900 loan (Joe) + $900 deposit from Dave, and liabilities of 1,000 to ACME and $900 to Dave.
BANK's assets are still only $1,900 - still not enough to purchase the Treasury seurities - so they make another loan for $810 to MARK, and MARK purchases something from ANDY. ANDY deposits the $810 into BANK.
BANK'S assets are $100 (ACME cash reserve) + $900 loan (Joe) + $90 (Dave cash reserve) + $810 loan (Mark) + $810 deposit (Andy) = $2,710. BANK's liabilities are $1,000 (ACME) + $900 (Dave) + $810 (Andy).
BANK now has enough assets to buy the $2,000 of Treasury securities from the U.S. Government.
My question is this: The bank still only has $1,000 of "money" assets - the rest of the assets are based on loans.
If the bank buys the U.S. Treasury securities for $2,000 then don't some of those loan assets transfer over to the Government? If so, wouldn't that mean that the Government is now the new loan servicer?
How does this work? After all, the bank using fractional reserve principles is the only way that the government can sell new debt in my sample economy.
What am I missing?
Thanks in advance....
The Fed can purchase Securities directly through Open Market Operations (FOMC IIRC)
Not to mention Buying the loan from the Broker-Dealer at the Discount window etx etx
That's true. But they can only purchase them from approved dealers, not the Federal government.
This means that the bank in my example would have to buy the Treasury securities first, so that the Fed could buy them through a Permanent Open Market Operation (POMO) - and then create Federal Reserve notes as liabilities against the securities.
How would the bank afford the $2,000 on new securities in my example, without using some of its loan papers as assets for the purchase?
If the Fed bought the loans from the Primary Dealer (bank in my example) then who would be responsible for servicing the loans?
Also, those loans would sit as assets on the Fed's balance sheet, which didn't really happen prior to 2008.
Right over the plate.
It's a piece of the banking puzzle that would be interesting to figure out.
I’d be interested in your thoughts...
TALF allowed them to do whatever they wanted.
And the Fed publishes it’s balance sheet weekly by zone? again IIRC
Are you forgetting that the entire system is based upon fractional-reserve banking?
Any “borrower” only needs to have 10% of actual reserves. They can borrow up to 90% against whatever they have.
When they do borrow, whatever they lend out, they consider that an “asset” which serves as security for future loans.
Yes, “debts” are assets in this scheme.
The hypothesis that the amount of money in the economy is fixed, despite the bank’s lending activity, seems to limit the possible outcomes. But this is others’ area of expertise, certainly not mine.
Missed your last lines.
As I said in my previous post, “debt” is considered an “asset” that can be borrowed against.
That is why there are so many banks out there that already walking dead. They just haven’t fallen over yet.
Look at the books on the banks that have been closed down. Colonial was declared healthy just a few months ago. When they were closed down, they were found 37% in the hole. They were allowed to continue borrowing based upon their outstanding loans, a large part of which was the mark-to-market “value” of the mortgages they had out there. When they were closed down and they actually investigated the real assets to trash and debt, that’s when they found the 37% figure.
If you read the first pages of G. Edward Griffin’s “The Creature from Jekyll Island,” he prints an excerpt from a British newspaper that explains how all this happens, and how, say $1 of money “magically” multiplies into $9 dollars through this re-definition of “debts” and “assets” and borrowing and lending upon each up-tick in newly invented value.
Debt is an asset to the creditor and a liability to the debtor.
Your transactions are a bit hard to follow in words. You might want to put them in T-account format as it’s easier to conceptualize.
One other thing you’re missing is that banks not only have loans and securities (assets) and deposits (liabilities) but common equity on the balance sheet (which would mean corresponding cash on hand as an asset). I’m not sure if this will make a noticeable difference in your analysis, however.
Anyways, in any regard, I’ll ping this out in just a sec.
Thanks for the replies. I appreciate them.
The Fed's weekly balance sheet (H.4.1 report) shows their assets, liabilities, and capital.
The TALF allows the Fed to purchase "questionable" paper, but that only started last year.
I'm looking at how the introduction of new funds into the economy works, and the role that banks play. From everything I can figure out it looks like the Primary Dealers buy Treasury securities with assets that include loan promissory notes.
That's very true. Loans are counted as assets on the bank's balance sheet.
So, in my example, the bank could buy $2,000 of Treasury securities by using Fractional Reserve banking to get the assets.
But those assets would include loans (which is fine, since they're assets). But if loans are used as assets then who becomes responsible for servicing those loans? The government?
“Debt is an asset to the creditor and a liability to the debtor.”
Not exactly.
A bank borrows money through the discount window from the Fed, say the $1000. That is a liability. They then turn around and lend that money out. They then consider that a $1000 asset. The way our screwed up banking system works, they don’t cancel each other out. They, 1. use fractional reserve lending so that if they only lend out a portion, they can borrow in multiples of 9 on what is left, and 2. they can use the $1000 lent out as an asset in and by itself to borrow against, regardless that they are on the hook for the first $1000 they borrowed. This is why so many banks in this country are about to implode.
The problem, as you imply, is the hypothetical example. The system is far more complex than how it is presented in the hypothetical. The complexity enables a shell game of “debt” and “asset” that empowers the banks to borrow and lend in an ever-increasingly risky ponzi scheme.
The bank that needs extra cash pays a fee to buy extra funds before it balances its books at end of days business and returns the funds the next morning.
Next day the same thing happens if the bank still needs the extra fund and the next and the next.
But paying fees eats into profits.
Flying these “funds” around the country was, years ago, FedEx’s main business. FedEx purchased a fleet of small jets and was able to keep the very schedules this paper shuffle required.
Thanks for the reply, and for the ping!
Banks would have capital("profit"), which would be generated on loan interest minus the cost of doing business.
But how would the $2,000 of Treasury securities be bought from the government without assets of loan promissory notes being part of the package. And if they are, then who services the loans after the transaction?
“But those assets would include loans (which is fine, since they’re assets). But if loans are used as assets then who becomes responsible for servicing those loans? The government?”
No one, until the system collapses. Borrowing and lending continues in a snowballing effect and is continually passed along in new credit and debt.
As long as the economy is relatively healthy, and as along as individuals borrow and spend within the means of their income and government agencies borrow and spend within a slim portion of GDP, the debt can be pushed out.
The problem occurs when the economy slows and people and governments run out of credit and the debt comes due. That’s where we find ourselves today.
This recession is different than all others since the Great Depression in that it is not an inventory recession (as all others have been). This is a credit recession. It was caused by this pyramid scheme of pulling credit forward and pushing debt out with new loans.
Well, the shi7 is about to hit the fan. And the real problem this time around is, 1. we no longer have the manufacturing capacity to “produce” our way out of this economic rut and 2. we have burned up (by the irresponsible spending and printing policies for the past 20 years or so) the faith of foreign governments to “lend” us out of this rut. The US dollar is about to implode. It could be this year, it could take 2 years. There are several factors that will determine when it dies. But it’s going to die.
I have my own theories about why this is happening and where it will probably lead, but that’s beyond what we’re discussing here.
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