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Fed Balance Sheet 1996
April 18, 2010 Money

Yesterday, without examination, we posted a look at what the Fed’s balance sheet looks like today. Here is what the Fed’s Balance Sheet looked like in the summer of 1996 (click it to enlarge).

Not too much “fishy” stuff – this was at the tail end of the Latin American debt crisis, the S&L Crisis had largely passed and the trouble in Asia had yet to start brewing. My only few comments for the benefit of the readers are these:

  1. Notice how much larger the Fed’s balance sheet is today than it was 15 years ago. The size of the Fed’s balance sheet is a proximate picture of how much high powered money is floating around out there.
  2. How does it get so large? Well, the Fed simply creates short-term liabilities out of thin air. Whereas a private bank would only be able to create deposits (or back in the State Banking era print banknotes) if it received assets or gold from its customers, the Fed in fact prints the FRN or creates deposits on its member bank balance sheets out of thin air.
  3. Why all the weird stuff on the current balance sheet? In fact, much of this was because the Fed was unwilling (because it might exacerbate a panic) or unable (by law) to use its discount window to help out troubled firms. The classical lender of last resort role for a central bank, and one justification for the existence of the Fed was to make emergency liquidity available to solvent banks via discount window loans at penalty (e.e. above market) rates. This would prevent otherwise healthy firms from using the window as a low cost way of borrowing (like the Fed allowed banks to do to fuel the inflation of the late 19-teens and the 1920s via “rediscounting of commercial paper” and would be a way to ensure that healthy banks would pay back the emergency loans quickly when the panic passed. So, all of those bizarre facilities it set up were either (1) ways to legally get around the fact that some firms are not permitted by law to make use of the discount window or (2) prevent firms from having to use the discount window for fear that it would signal to investors and customers that the bank is, in fact, in trouble. All I will say about point (2) would be that by not allowing discount window use by anyone, the Fed in fact exacerbates the information problem and leaves investors and customers guessing that all firms must be in trouble (perhaps we can write down a model to show this in a future post). And as a way to prevent this information problem from causing an even worse panic, the government actually mandated that certain firms have to take part in these liquidity auctions.

Anyway, I hope you enjoy comparing the two. My fear used to be that today’s balance sheet would have lots of poorly performing assets on it so that the taxpayers would have to bail out the Fed … now it is … I am worried that these things will turn out to be good investments. And before you know it, the Fed will turn into nothing different than a giant hedge fund – the very thing it is supposed to (at least in the new la la legislation world) be monitoring, not engaging in.

Why? Because the profits of the Fed are plowed right back into the Treasury. Thankfully, we spend so much freakin’ money as a Congress that even if the Fed generates $50 billion per year in “profits” (from its monopoly position) that is a little more than 1% of the $4 trillion that the accountants in DC spend each and every year. Countries that rely on central bank profits for a larger portion of their fiscal spending (I hope this puts aside the notion that the Fed is an independent branch of government) are at a much larger risk of severe inflations than we are.

"1" Comment
  1. Milton Friedman thought a computer could do a far better job than the Fed, which has the primary role of preserving the value of our money.

    I used to keep a book by my bed when I was in my twenties entitled “The Federal Reserve System.” Written by a committee of economists to promote the Fed, half a chapter was enough to assure a sound sleep, but I got through the thing.

    Tomorrow, I will re-read your excellent post to your blog, and I will not lose too much sleep thinking about the wizards who have run the Fed.

    Imagine a billion sheep leaping over a low border fence all together, one coordinated jump every five seconds. Twelve billion sheep a minute, 720 billion sheep an hour, 17 trillion sheep a day. That would take a lot of sheep.

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