Tag Archives: fed

$7.8 Trillion and Counting

The New York Times has an arresting chart on the government’s new financial commitments made during the financial crisis. According to the Times, the government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender. Wow, you may think, that’s a lot of money. US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range. But wait, there’s more: the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet (although they were always implicitly there).

All that said, though, there’s a big difference between these “commitments” and ordinary government spending. Ordinary government spending simply evaporates into the economy: for example, Medicare expenses go to pay for people’s health care, and the government will never get them back. Making financial commitments is what banks and other financial institutions do, and they do it because they expect to get their money back. What we are seeing is the growth of a massive financial institution within the government. This one’s primary goal is the public interest – in this case, the health of the economy – rather than getting its money back. But still, it should get most of the money back.

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Federal Reserve for Beginners

We had a comment last week asking for an explanation of, roughly, what it is that the Federal Reserve does, so I thought that would be a good topic for a Beginners post. (For a complete list, go here.) This would have been a relatively easy question to answer a year ago, but since then it’s gotten considerably more complicated. Like all Beginners articles, I’m going to make a number of simplifications, for example generally treating the Federal Reserve as one big bank (it’s really twelve different banks). I’m also going to ignore many of the Fed’s functions; for example, the Federal Reserve is itself a bank regulator, but I’m not going to discuss that.

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Federal Reserve Invokes Emergency Powers?

As has been widely reported, the Federal Reserve announced today that it will start buying commercial paper directly from issuing companies. (Commercial paper, as expertly explained in last weekend’s episode of This American Life, is a short-term IOU that companies issue when they need to smooth out the short-term fluctuations in their bank balances; the issuer promises to pay $1 million in 7 days’ time and, for example, gets $999,000 from the lender immediately.) Highly experienced journalists have described this action as using the Fed’s “emergency powers,” although the Fed was itself careful not to use the word “emergency” in its press release. Rather, the terms and conditions released this morning cite the authorization of Section 13(3) of the Federal Reserve Act. That section reads as follows (bold emphasis added; you don’t need to read it carefully, there won’t be a quiz):

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

(“Discounting” just means that the Fed can loan the holder or issuer of the commercial paper a little less than the face value of the paper.)

So while the phrase “emergency powers” can be frightening, this doesn’t mean that martial law has been declared, or its financial equivalent; just that the Fed identified an “unusual and exigent circumstance” in the market. By this action, the Fed is intervening in the short-term credit market for ordinary companies directly; previously, its actions had been devoted to encouraging banks to provide short-term credit to those companies. We can infer from this that the Fed has decided that the previous strategy wasn’t working, at least not well enough. Because it bypasses the banking sector altogether to provide credit to the real economy, this should reduce borrowing costs for companies, which is a good thing. (The downside is that theoretically it creates exposure for the government, and hence the taxpayer, if any issuers default on their commercial paper.)

Still, though, this latest Fed action points out two concerns. First, the Fed still appears to be reacting to events as they arise rather than plotting a strategy to get ahead of the crisis and stop it in its tracks. (A set of steps that might stop a crisis of confidence, if announced in one fell swoop, could fail to have that effect if spread out over several weeks or months.) Second, there is no Congress in session, and there won’t be until after the election at the earliest. The election is only four weeks away, but as we have seen markets can shift significantly from one day to the next. Today’s action can be seen as a signal that the Fed will do whatever it takes to keep credit flowing until Congress can reconvene and develop a more fundamental set of solutions. Which is a good thing, assuming that Bernanke doesn’t run out of tools in his magic toolbox.