Risk and Return

The Federal Reserve has for a long time eschewed increasing the money supply directly, and instead has manipulated credit to affect the economy and control inflation. This has led to three important things which are in my opinion at the root of this crisis.

• Asset price inflation (at least initially) as opposed to broader price inflation.
• A massive increase in leverage (debt to magnify returns) throughout the financial system and our economy.
• A massive increase in the size of the financial sector relative to the rest of the economy. Since it is built on leverage, financial sector compensation has soared and led to concentration of wealth in financial hands.

The last fascinates me, as a sector which should be a relatively small part of the economy functioning as intermediaries has through leverage achieved profits (a redistribution of wealth from the rest of our citizenry) far from the size their intermediary function can possibly justify. These intermediaries for example accounted for about a third of the market capitalization of the S&P 500 before they crashed and burned. How do the intermediaries deserve a market cap that amounts to around half of those for whom they intermediate?

The answer is increased leverage. I’ll address this in more detail later, but the Federal Reserve has finally decided to expand the monetary base, which has consistently grown at a very slow, or non existent rate. From David Merkel:

Check out the very far left side of the graph and look at the vertical takeoff.

David fills us in on the details:

Look at the H.4.1 report.  We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.  They are pumping the “high-powered” money into loans:

• $20 billion for Primary credit
• $80 billion for Primary dealer and other broker-dealer credit
• $70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
• $40 billion for Other credit extensions
• $80 billion for Other Federal Reserve assets
• -$20 billion netting out other entries

Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.  Astounding.

In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.  Now, I’ve written about this before, but it bears repeating.  What happens if the Fed takes losses on lending programs.  It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.  The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.  It’s balance sheet is tied to the US Treasury.

Yves Smith at Naked Capitalism is correct.  The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.  I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.  The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.  What will they offer them? The national parks?

True, all true, but possibly if they are going to provide monetary stimulus this might be a better way than cutting rates, now and in the future.

Technorati Tags debt crisis, Federal Reserve, leverage, monetray policy, Treasury

Tags: debt crisis, Federal Reserve, leverage, monetray policy, Treasury

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