Ed Dolan's Econ Blog

Could QE3 Cause the Fed to Go Broke?

Each time the Fed undertakes a new program of quantitative easing, questions arise about the possible impact on its solvency. I addressed that concern in November 2010, at the time QE2 was announced. Here is an updated version of that post that looks at the solvency issue in the context of QE3.

The Fed’s new program of quantitative easing, QE3, once again raises an old question: Can central banks go broke? Conventional analysis, aptly summarized by Willem Buiter in a 2008 report, says “Never–Well, hardly ever.” The Fed is most assuredly not going to suffer a run or become unable to meet its obligations, but under some scenarios, keeping it from going going broke could raise difficult political issues and perhaps even threaten its independence.

We can start by noting that the Fed, like most central central banks, is rather thinly capitalized. As of September 2012, it had capital of some $55 billion, about 1.9 percent of its assets of $2,825 billion. By comparison, the consolidated balance sheet for all commercial banks showed assets that exceeded liabilities by 11.5 percent. If the Fed were a commercial bank, it would not be insolvent, but it would be on the watch list.

Of course, the Fed is not a commercial bank. The unique nature of its assets and liabilities allows it to operate safely with just a sliver of capital. Normally, the Fed’s assets have consisted largely of short-term Treasury securities, which are as close to risk-free as you can get. As for liabilities, as recently as the end of 2007, 90% of them consisted of Federal Reserve currency. Currency is a truly marvelous kind of liability, , since it is neither interest-bearing nor redeemable. Together, those assets and liabilities generate a healthy net interest income, most of which it turns back to the Treasury. With a balance sheet like that, who needs capital?

Since 2008, however, things have changed a bit. First, the nature of its assets has changed. Treasury securities now account for only 58 percent of the Fed’s assets. As of September, it held some $843 billion in mortgage-backed securities (30 percent of assets), and it is committed to buying $40 billion more each month under QE3. Those securities are neither very liquid nor risk-free. In addition, under QE3, the Fed will continue to lengthen the maturity of its Treasury portfolio. On balance, these activities create a growing exposure to market risk in the event of a rise in interest rates.

On the liability side, nonredeemable monetary liabilities still predominate, but the composition of the monetary base has changed. More than half of the base (as opposed to less than 10% five years ago) now consists of reserve deposits of commercial banks. Reserves are no longer interest free. While the rate paid on reserve deposits is now just 0.25%, that could increase.

Under QE3, the Fed is committed to continue increasing the size of its balance sheet until the employment situation begins to improve. That is unlikely to happen while inflation remains below its 2 percent target, as it has recently, and the Fed has left open the possibility that inflation will be allowed to rise above the target temporarily. At that point, the Fed will begin to execute its “exit strategy” from its current highly accommodative policy. The exit strategy could very possibly put strains on its income statement and balance sheet.

One element of the exit strategy could be to raise the interest on reserve deposits in order to discourage banks from using those reserves as a basis for making new loans. Doing so would raise the Fed’s interest expense. At the same time, the Fed could begin selling off the securities it has acquired under successive waves of quantitative easing. If market interest rates are higher by then, as they very likely would be, the Fed would have to sell them at a loss compared to their purchase price. Under those circumstances, the Fed’s capital could rather rapidly fall toward zero. What then?

First, it should be made clear that even if the Fed slipped into balance-sheet insolvency (negative capital), that would not bring about equitable insolvency (inability to meet financial obligations as they fall due). Because of the nonredeemable character of its monetary liabilities, and because both its liabilities and assets are denominated in dollars, any kind of run on the Fed is absolutely impossible. The Fed’s net interest income is currently more than $50 billion per year. Even if that were much reduced, it would easily be able to meet its operating expenses many times over. Still, a position of negative capital would be uncomfortable even if the Fed were able to keep up with its current obligations. Recapitalization would clearly be desirable. But just how could it be accomplished?

Recapitalization would be complicated by the odd legal status of the 12 Federal Reserve Banks as joint-stock entities that are “owned” by private commercial banks, yet are in every functional sense a part of the federal government. The only conceivable entity that could recapitalize the Fed is the Treasury, but this would be no ordinary capital injection. For commercial banks, a capital injection means a swap of good assets for equity, but the Federal Reserve Banks could not just issue new common or preferred shares to the Treasury, at least not without a revision of their charters. Instead, a recapitalization would have to take the form of an outright grant, in which the Treasury transferred tens or hundreds of billions of dollars in newly issued bonds to the Fed completely gratis. It is hard to see how that could be done without an act of Congress–and would Congress in its current mood approve this mother of all bailouts?

Let me emphasize this: The Fed is NOT a private corporation in any ordinary sense of the word. If the Treasury were to gift the Fed with a $100 billion capital grant, that would NOT amount to putting it in the pockets of the Rothschilds, whatever you might read to the contrary on the internet. But who could guarantee that all those paranoid myths about the Fed would not be raised in Congressional debate or on talk radio? Who could guarantee quick passage of the Treasury Asset Recapitalization Package of 20**, or whatever they might call it. Whatever the name, it would be called TARP II and it would be controversial. It would be so controversial that in return for passage, Congress might insist on new audit or oversight authority, something already high on the agenda of certain members.

So, what is the bottom line? Could the Fed go broke if QE3 creates a bond bubble that suddenly bursts in a surge of inflationary expectations? Theoretically, yes, at least in the balance sheet sense. Presumably, it could not become insolvent in the equitable sense. In the end, no one can rule out the emergence of a situation from which the Fed could be extracted only at the cost of a high degree of political discomfort and perhaps a loss of independence.

Follow this linkĀ to view or download a slideshow version of this post that includes detailed balance sheets illustrating possible solvency problems raised by QE3.

34 Responses to “Could QE3 Cause the Fed to Go Broke?”

BurkSeptember 19th, 2012 at 11:41 am

I am afraid I don't understand this.. doesn't someone at some point create our money ex nihilo? Isn't that someone the Fed? Didn't Bernanke say that he just creates reserves at banks by pressing a few keystrokes? Likewise, wouldn't the Fed extinguish the money brought back in by bond sales? As you say, there must be some accounting going on for all this, but ultimately, someone makes the money, and that someone can't very well go bankrupt.

Ed Dolan EdDolanSeptember 19th, 2012 at 2:05 pm

Burk and Wilkins make the same point–but they confuse "money" with "capital." At the same time, they confuse balance sheet insolvency with equitable insolvency. Here is how I would explain it:

Balance sheet insolvency means negative capital, or negative net worth. That means an entity's liabilities exceed its assets. That could happen to the Fed if the market value of the mortgage-backed securities and long-term Treasuries it holds as asset fell sharply, as it would in some scenarios where there is a sudden uptick in inflation expectations. In that case, the value of assets would fall, but the value of liabilities, which consist largely of reserve deposits of banks and currency, would remain unchanged.

The ability of the Fed to create money would not help to correct its negative net worth. The processes by which the Fed creates money–primarily, open market purchases of bonds and also to some extent lending to banks–always increase assets and liabilities by an equal amount. No matter how much new money the Fed creates, its liabilities increase just as fast as its assets, so its capital does not change.

Part of the confusion may come from a tendency to think of "money" as an asset. Yes, money–currency and bank deposits–is an asset for us ordinary mortals. If I "created money" by successful counterfeiting, yes, my assets would increase without an increase in liabilities, and my net worth would go up. But "money" (more exactly: the monetary base or so-called "high-powered money," which consists of currency plus reserve deposits of banks) is a LIABILITY of the Fed, not an asset. Some people are surprised to hear that, but it is true. That is why the Fed can't recapitalize itself by creating more money.

After saying all that, though, Burk and Wilkins are right about one thing. Yes, if we shift our perspective from balance sheet insolvency to equitable insolvency (the ability to pay obligations on schedule), and from the Fed alone to the whole government, then it is true that "It is impossible for the United States to 'run out of the fiat money' it creates and impossible to go involuntarily bankrupt." In theory, the Treasury could go the Zimbabwe route and pay its obligations by selling bonds directly to the Fed in return for newly printed Federal Reserve notes, then use those notes to pay its civil servants, electric bills, and so on.

barfSeptember 22nd, 2012 at 3:23 pm

well obviously the dollar is an asset as the clowns in charge keep repeating "we have the world's reserve currency! we have the world's reserve currency!" as if somehow saying it makes it immutable….which in fact BY saying makes it less so. the fact of the matter is there is direct competition with the Fed in the form of the Bank of North Dakota…and whatever other banks the various States start to establish in order to get out from underneath the entire "debt=money supply" paradox that the Chairman finds himself in. The States have to pay the bills…they need growth. that means getting oil out the ground, producing products people will buy, creating consumer demand, etc…etc…in short…and economy. Small "Fed's" at the State level…if the State is wealthy enough of course…and most are not…is the way to go forward without this boondoggle. these clowns have already wiped out the State of Ohio for all intents and purposes…History will not judge them kindly for it.

John WilkinsSeptember 19th, 2012 at 11:56 am

This is nonsense. The US dollar is a fiat currency that only the United States government controls. the fed is part of the government. It is impossible for the United States to "run out of the fiat money" it creates and impossible to go involuntarily bankrupt. The Fed is engaged in QE3 by adding to reserves by computer keystrokes, like points in a basketball game.

benleetSeptember 19th, 2012 at 4:15 pm

"Money . . . is a liability of the Fed, not an asset." No wonder I'm confused. It is a difficult article for beginners. The Zimbabwe route didn't work for Zimbabwe but would work for a long while for the U.S.A. Aren't there over $47 trillion in private financial assets, and wouldn't creating keystroke money to pay Fed's or Treasury's liabilities just water down the net worth of those private financial assets? In 47 years all private financial assets would be worth half their current worth. And since the Fed is buying bad assets from banks and investors, the balance of wealth distribution wouldn't change. The Fed announced the purchase of $85 billion per month ($40 billion in CDOs), QE3, and that's $1 trillion per year. It reads like a bailout to banks to me. Did the Fed pay fair market value for the CDOs they purchased? Every month they purchase $40 billion of trash the banks can't sell and won't mark-to-market? Why buy these "negative frozen assets"? If QE1 and 2 did so little for unemployment why will it be different this time? Isn't QE3 just a move to boost financial asset price and value? Economist Jack Rasmus and Yves Smith make this argument. And you say that the 0.25% interest pay out to private banks with reserves at the Fed may increase. Isn't that also a bailout?

benleetSeptember 20th, 2012 at 4:59 pm

I read it, every slide. Thanks. I have many questions, of course, which I'll try to answer myself. I read a short essay by Herman Daly, Nationalize Money, Not Banks, July 30, 2012. See this —… — What do you think? And I have begun The End of Money and the future of Civilization, Thomas Greco. What do you think? Thanks again, I added a micro-bit to my knowledge. My miniature blog is, I don't like to think about your specialty, but maybe I should.

Ed Dolan EdDolanSeptember 21st, 2012 at 7:00 am

Thanks for the link. 100% reserve money is an old idea. I have never understood why people who consider themselves libertarians advocate it. It seems to me it would take very intrusive government intervention to keep people and businesses from using substitute liquid assets instead of the officially approved form of money (e.g., money market fund balances instead of bank balances, or even foreign currencies and bank balances). Also not clear why we would expect the Treasury to do a better job of inflation targeting than the Fed does, it is more politicized. Good read, though. Maybe I'll do a post on the concept.

barfSeptember 22nd, 2012 at 3:32 pm

there is no politicizing M2. the Government must stop paying interest on state bonds lest these states go bankrupt. In effect Illinois, California, New York and probably Florida will become "the next Fannie and Fred." investors are already bailing and getting into equities. the debt boondoggle has BURST.

barfSeptember 22nd, 2012 at 3:30 pm

we already have "nationalized money" so no…this won't work. CASH FLOW works however. so does gold money of course. "moves railroads" as they say. interestingly…this policy is moving railroads as well…something not easy to do under any financial scheme save gold. "contained hyperinflation" i guess. my personal view is that the entire edifice is built on war successes in the Middle East using the Internet as your "point" ala the Railroads and the telegraph during the Civil War. On that score this policy strikes me as HIGHLY dangerous not only because the internet only has the power to inflame but also because our Armies are not concentrated in a manner where "actual war aims" is manifest. indeed the media goes out of their way…and the crazy political people seem to agree…that Egypt is not in fact in a state of war with Israel and the United States. Simply false….

TomSeptember 19th, 2012 at 6:50 pm

The important topic here is the exit scenario. What you're really getting at is the fact that once a central bank creates large amounts of reserves it might be very difficult to remove them without wreaking general havoc including on its own balance sheet. That's a very complex topic worthy of more discussion. To the extent the Japan experience is relevant to the US, it indicates that the excess reserves are simply here to stay and we are more likely to be worrying about prolonged low growth and even deflation.

The Fed falling short of capital is an extreme scenario. If it happened the government would have to replenish the Fed's capital by collecting dollars through taxation or borrowing and contributing those dollars to the Fed's capital. Central bank operational losses ultimately belong to the government, just as operational gains (seignorage) belong to the government.

Ed Dolan EdDolanSeptember 20th, 2012 at 7:32 am

I agree with your point that it's all in the exit scenario, and also the point that the topic is a complex one. Here is a little slideshow with some added detail in the form of illustrative balance sheets that may help some readers:

I agree that CB operating losses belong to the government, but I still doubt that the Fed could recapitalize the Fed without an act of Congress. Maybe I'm wrong about that.

barfSeptember 22nd, 2012 at 3:41 pm

be interesting to see what the Federal Government would recapitalize it with. I've heard a single coin would suffice…

Matt DubuqueSeptember 19th, 2012 at 10:03 pm

The Fed does not exist in a vacuum.

Let's stipulate that a bond bubble bursts in a surge of inflationary expectations.

Do you really think the open market desk of the Fed will NOT be doing reverse repos and various calendar spreads to profit on such an event?

At any event, you miss the big picture.

It is in the narrow self interest of the Fed's portfolio to have modest deflation.

So they are NOT going to permit any other scenarios to develop.

What is the biggest component of the cost of a widget?

Unit labor costs. And the unions have been smashed.

The deflationary biases in the system are overwhelming.

Advantage Fed.

Rocket Science to the Americans.

Ed Dolan EdDolanSeptember 20th, 2012 at 7:13 am

It "owes" its liabilities to whoever holds them as assets. A liability is a promise to do something of value in the future. For example, my credit card balance is a liability that consists of my promise to pay my bank some value in the future. Here are some examples of what valuable things the Fed agrees to do when it issues liabilities.

First example: Reserve deposits are a liability of the Fed and an asset of the banks that hold them. They are of value because they can be used by the bank to settle accounts with other banks, meet certain regulatory requirements regarding minimum liability, or pay any taxes that the bank owes.

Second example: Fed's paper currency liabilities that I hold as assets. The Fed promises that if I deposit the currency in my bank, it will (1) count the currency as part of the bank's reserves, thereby satisfying the bank's need for liquidity; or (2) if the bank wants, convert the currency to a reserve deposit that it can use for the above currency.

Historically, the Fed allowed people to redeem notes in gold or silver. It no longer does that. They have value now only because banks accept them and the Treasury accepts them as payment of taxes.

barfSeptember 22nd, 2012 at 3:44 pm

with the one big hiccup being paying Government workers in IOU's. Amazingly California has tried this..but only for a couple of weeks before BofA won't accept it as money. With the Fed it would probably have to be YouOwesMe's….which is probably what the Chairman is getting at when he says "jobs, jobs, jobs." in other words…a friggin' economy.

SchofieldOctober 2nd, 2012 at 8:19 am

The Fed as "part" of government has a liability to use the currency. To take back as dollars what it gives out as dollars. The Fed also creates "money" without indebtedness but along with "elected" government has accountability for inflation. In this liability sense it promises to do something of value in the future, namely to help maintain the value of the currency in as much as it is able with population increase, etc. The financial sector through the activity of licensed banks creates "credit" with indebtedness but without accountability for inflation.

areopageticaSeptember 20th, 2012 at 8:28 am

Ed, I think you are badly over-complicating a simple topic, as can be seen in the comments. No, the Fed cannot go broke in any meaningful way. The balance sheet has little meaning, primarily because those currency liabilities are fiction. Balance sheet insolvency would mean nothing in reality. Fed critics and gold bugs exploit the public's ignorance about this and perpetuate the false comparison to a commercial bank. The task at hand is to educate the public that the Fed cannot go broke.

Matt DubuqueSeptember 20th, 2012 at 10:20 pm

Actually I think Ed is dramatically oversimplifying a very complex topic.

So much of this has to do with the collapsing income velocity of the various monetary aggregates caused by Reagan's banking deregulation, a folly that has changed central banking forever.

He seems completely unaware of the collapse of monetarism among the intellectual elites in the various Federal Reserve branches OTHER than the diehard monetarists still holed up at the St. Louis Fed branch.

He is dramatically oversimplifying and misapprehending the current intellectual frameworks driving Fed policy today.

Rajan knows what I'm talking about. University of Chicago.

barfSeptember 22nd, 2012 at 3:49 pm

currently Greece…which used to be a sovereign country…simply has no physical currency with which to pay it's government officials. to say "this reflects badly on the ECB" is an understatement. Greece in effect is being forced to "secede"…which it won't do because "the drachma is beneath her." think of it as the ultimate game of Liars Poker…where the country must decide…do i enslave my self or acknowledge i'm poor and cut loose and try and find a way? so far only Iceland has chosen the latter. But before the Fed fails the ECB will. That thing is a bomb waiting to explode. that's why when the euro rallies so does the entire commodity complex. all in Europe know the euro is DOOMED.

Matt DubuqueSeptember 23rd, 2012 at 11:51 am

They are certainly relevant in examining the systematic overweighting of inflation risks by Ed and the St. Louis Fed.

Mike SproulSeptember 20th, 2012 at 2:44 pm

"They have value now only because banks accept them and the Treasury accepts them as payment of taxes. "

If paper dollars are the liability of the Fed (and they are) then they have value because they are backed by the assets of the Fed (including potential bailouts of the Fed by the Treasury).

My favorite analogy: A landlord collects 50 oz. of silver per year as rent on his land. At R=5%, his land is worth 1000 oz. (=50/.05). The landlord then buys some groceries with his own 1-oz. IOU's, which he accepts as rent. His IOU's become used as money.

Those landlord IOU's are not physically convertible into silver, but they are still backed by the landlord's assets, one of which is the landlord's "rents receivable". By analogy, the fed's paper dollars are acceptable for taxes, but are backed not just by 'taxes receivable', but by all the government's assets, including land, buildings, etc.

steve from virginiaSeptember 20th, 2012 at 7:14 pm

Thank you for an informative article. How the central banks become insolvent — either directly or at a remove — is an important aspect of our onrushing crisis.

The components of central banks' balance sheets are important to the degree these effect the perception of the banks as effective lenders of last resort. If the market perceives the central bank to be insolvent there is no effective lender of last resort … whether the central bank is actually underwater or not does not matter.

The central banks' actions are not felt by the banks themselves, consequences fall upon their banker clients .. and the clients' customers. Without effective lenders of last resort there are no guarantors for deposits, the outcome is systemic bank runs.

"First, it should be made clear that even if the Fed slipped into balance-sheet insolvency (negative capital), that would not bring about equitable insolvency (inability to meet financial obligations as they fall due). Because of the nonredeemable character of its monetary liabilities, and because both its liabilities and assets are denominated in dollars, any kind of run on the Fed is absolutely impossible."

True enough, a run on the Fed itself is impossible but a devastating run against all of its clients is both possible and in fact underway. The only issue is whether the current rounds of concerted easing/credit availability on the part of the world's central bankers will accelerate the process. A discredited central bank may as well close its doors, it would lack the policy tools needed to prevent a systemic credit freeze from cascading out of control. The central bank would become a spectator.

In Europe there are runs against entire countries' bank systems and out of currency, not just flight from individual 'impaired'. These runs speak for themselves, they indicate the European Central Bank (ECB) is insolvent and there is no effective lender of last resort. As it turns out, the ECB has engaged in lending against dubious collateral created specifically for the purpose of gaining central bank credit. The ECB has offered unsecured loans and is no different from other EU banks that have done the same thing. The outcome is discredit of bank, calling into question the abilities of the bank's management.

This is an unpleasant position for the central bank to find itself in: for it: to lend without security is fatal, to not lend is also fatal.

Reserve- or central banks' balance sheets are not leveraged (which is a reason why they don't hold capital). However, the CB's commercial banking clients' balance sheets are leveraged to a very great degree. Entire banking systems are arguably insolvent. If the central bank takes on a critical mass of its clients' (bad) loans onto its own balance sheet it is perceived to be one with the other banks: that is, it is another leveraged bank and insolvent like the others.

At the same time, if central banks are perceived to be making unsecured (leveraged) loans on their own they are perceived as insolvent on account of that leverage.

Systemic runs are now underway in Europe, China and elsewhere, these indicate events are outrunning analysis.

barfSeptember 22nd, 2012 at 3:53 pm

uh, no. you can have a run on the dollar…and if that happens then the Fed…well, i'm not sure if it could declare bankruptcy. it's an interesting question. if that happens i'm not sure the Federal Government could reconstitute a new bank. It would need to in order to pay for its largesse however. The postal service would go bankrupt immediately for example. Social Security still pays for itself so that should be okay. Medical care at Federal expense would cease to exist…save for the VA which is financed through the war budget. the imagination wonders at it all actually….

ThomasGrennesSeptember 22nd, 2012 at 3:00 pm

The Fed is a government agency with an implicit asset that is a claim on the government's
ability and willingness to tax. It also has an implicit liability that requires the Fed to transfer
any net earnings to the Treasury. The Fed has made these "seigniorage" transfers regularly, and in 2011 they made record transfers. Earnings were large because of the
large increase in earning assets associated with earlier quantitative easing. If the Fed should suffer losses on some of their mortgage-backed securities, the first effect would be smaller seigniorage transfers to the Treasury.

Matt DubuqueSeptember 23rd, 2012 at 11:53 am

The Fed is not a government agency.

It is a hyrbrid.

It has public aspects (such as a dual mandate, Humphrey Hawkins obligations to Congress and appointment of various FOMC members) AND it has a private component as well, most definitively expressed in the makeup of the various Fed branches.

Asserting the Fed is ONLY a government agency or ONLY a private entity is simply false and leads to skewed extrapolations.

ThomasGrennesSeptember 23rd, 2012 at 4:02 pm

The Fed is a government agency in the sense that the Congress has as much control over Fed policy as it has over fiscal policy of the Treasury. All members of the Board of Governors are nominated by the President and confirmed by the Congress, and they comprise the majority of the Federal Open Market Committee. The regional banks have private, but regulated, ownership, but this private influence does not weaken government control in any significant way. The regional heads are not a homogeneous group. Currently the Presidents of the Chicago and Boston regional banks openly support Bernake's QE3, but the heads of the Richmond and Dallas banks have opposed QE3, The entire Federal Reserve System is subject to all the laws made by Congress from the dual mandate to the new rules included in the Dodd-Frank bill.

I would not object to calling the Fed a hybrid, but we should not waste time on strictly semantic differences. What "skewed extrapolations" result from treating the Fed as a de facto government agency? I don't know of any private firm that is required to give all its profits to the Treasury.

VermonterSeptember 25th, 2012 at 9:03 am

You write:

Instead, a recapitalization would have to take the form of an outright grant, in which the Fed transferred tens or hundreds of billions of dollars in newly issued bonds to the Fed completely gratis.

I think you mean ….in which the TREASURY transferred….

MarkMarch 16th, 2013 at 9:57 pm

Correct me if I am wrong but they are buying a whole smorgasbord of assets including currently depressed real estate which will rise substantially in an inflationary environment thus potentially offsetting any losses on the burst in the treasury bond bubble.

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