The Fed Becoming Insolvent: Things to Worry About After We're Dead

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Tuesday, 29 October 2013 15:29

If the economy were humming along at 3.0 percent growth and 4.0 percent unemployment it would be reasonable for economists and economics reporters to worry about strange and unlikely state of affairs with little consequence. But at a time when the economy is down almost 9 million jobs from its trend level, wages are going nowhere, and growth is not much above zero, worrying about the Fed losing money on its bond purchases is more than a bit bizarre. But apparently this is the concern that occupies the Los Angeles Times business section and apparently some members of Congress.

The basic idea is that if interest rates suddenly soar then the bonds held by the Fed will be worth less, so the Fed will take a loss on its bond holdings. If the losses are large enough and the Fed realizes its losses by selling its bonds, then it could actually be insolvent.

The idea that long-term bonds fall in value when interest rates rise is not exactly new. Some of us suggested taking advantage of this fact to get around the nutty debt cult that controls Washington these days.

But what would these mean for the Fed? First, we should ask under what circumstances would interest rates rise suddenly? Presumably this would be the result of a rapid recovery of the economy. If that happened, and we suddenly get back the 9 million jobs we lost, a shortfall at the Fed would be a pretty silly thing to worry about.

Alternatively, we get a sudden spike of interest rates because aliens dump their bonds in huge amounts, even though the economy is still weak. Guess what the Fed could do then? That's right, if the economy is still weak, it can buy up those bonds and keep interest rates low and bond prices high. Are you scared yet?

Alright, but one of these days the economy will recover and the Fed will want to take reserves out of the system to prevent inflation. If it felt it had to sell off its bonds quickly, and then take a loss, it could face insolvency.

There are two points on this one. First, this is pure and simply an accounting issue. Congress could change the law and allow the Fed to have a negative balance. The consequence for the government and the economy would be precisely zero. The other possibility, for those who find the first solution to be too simple, would be to have the Fed slow the economy by raising bank reserve requirements. This would accomplish the same result. It is also a simple and old-fashioned mechanism.

So put the insolvency of the Fed off the list of things to worry about in your lifetime. Unfortunately we do have real world problems to deal with.