Monday, December 29, 2008

Uncorking The Fire Hydrant

There is an interesting development happening right now in the banking system around the world. As discussed in length here, the Fed has spent the last twelve months removing as much of the toxic debt on the bank's balance sheets as possible and replacing that debt with cash. (Up until about mid October they were also mixing in treasury bonds, which I will get to in a minute.)

When banks receive cash from the Federal Reserve it then gives them money to lend out into the open market. This is how banks make money, on the interest on the money they lend out. However, due to the recent collapse of the American economy the banks have been too frightened to lend to anyone. They are just sitting on the cash.

A fractional reserve banking system means that when banks take in a dollar of cash, either given to them by the Federal Reserve or deposited by a citizen or company, they can then lend ten dollars out in new loans. This means they only need to keep 10% of the money they lend out on reserves at the bank. (Thus the term fractional reserve banking) This is the system currently used around the world.

This system, as you can see, allows the money supply to grow exponentially. The Fed's goal in replacing the toxic debt with cash was to have the banks then lend this out money out to help increase the money supply to offset the deflationary impact of the loans currently going bad around the world. (Money disappearing)

This failure to lend is what has now led to the Fed bypassing the banking system altogether to inject money directly into the economy. They will do this through purchases of mortgage securities from Fannie and Freddie, corporate debt, credit card debt, and even treasuries.

At some point during this process the banks will come out from under their shell and begin to lend. This means at the same time the Fed is injecting money directly into the system and continuing to remove the bad debt from the banks, the banks will start to lend out the money given to them by the Fed at the 10 to 1 ratio. This means every dollar swapped with the banks for the bad debt will become 10 dollars. (As mentioned above, the Fed until about mid October was mixing in treasury bonds with the cash to try and slow the money supply growth, but when they realized that no one would lend the money it became all cash exchanges)

When the banks begin lending again, it will be like uncorking a fire hydrant. So what happens next? Hypothetically, the Fed is then planning on trying to give the banks back all the toxic debt they took off their balance sheets. They are hoping to call them up and ask them if they mind taking all the losses back into their portfolio. Their goal at this point will be to try and slow down the money now entering the system.

Will they be able to do this? Of course not. The economy is going to be so much worse 12 months from now that they will not be able to raise interest rates or slow down the banking system which will still be in recovery.

A better question is, do they want to do this? Does the American government want a cheaper dollar? Of course they do. We owe about $57 Trillion right now. If that debt is worth less, it is much easier to pay it off. The trick is to convince the rest of the world (and the American public) that they want a strong dollar as it continues to depreciate. They are only trying to prevent a run to the exits.

The rest of the world right now is not sending us a loan, they are sending us a gift. The money will never be paid back, it will just be inflated away.

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