Exit Strategy, or New Normal


War Reparations, or Prosperity

In September 2008, when the Fed first began to expand its balance sheet while the U.S. Congress dithered over TARP, I likened what was happening to war finance.

In World War I, and then even more in World War II, the Fed served as dealer of last resort for U.S. government debt, creating money as needed to meet the exigencies of war spending. In September 2008, the Fed used the same powerful emergency mechanism to support collapsing private debt markets; the current swollen balance sheet is the result.

After World War I, the world embarked for a while on a fantasy voyage, imagining that defeated Germany would somehow pay reparations to its European opponents sufficient to allow them to repay massive war debts to the United States. That ship soon enough hit the rocks; the result was world depression and a second world war.

As the second world war came to an end, that reality voyage was in everyone’s mind as a paradigmatic example of what not to do. In the event, the Marshall Plan for reconstruction of Europe came first, and the Treasury-Fed Accord of 1951 came second. First we dealt with the debt mess, and only then did we deal with the money mess.

That historical experience has lessons for us today.

It is clear that we are nowhere near having dealt with the debt mess. In the U.S., we have moved a good chunk of private debt onto the public balance sheet, and urged “extend and pretend” for the rest, but that is all. In the Eurozone, the absence of a Europe-wide public balance sheet has meant that the debt mess is playing out differently from the U.S. But who doubts that, if there were a Euro-bond, the S&P would be issuing a negative outlook for it just as much as for U.S. debt?

I draw the conclusion that, much as I sympathize with the Fed’s anxiety over its current exposures, any talk of imminent exit is highly premature, bordering on fantasy. Nevertheless threats of exit may serve a useful political purpose, insofar as they draw attention to the unfinished business surrounding the debt mess.

Here are the concrete dimensions of the current exit fantasy, according to the FT:

“Most officials still endorse the basic sequence discussed last year: first, scrap the promise of ultra-low rates for an “extended period”, then drain reserves out of the banking system, raise short-term rates and only after that begin sales from the asset portfolio. Mr Kocherlakota argues that tightening policy will happen via interest rates and shrinking the balance sheet can be kept separate.”

Let’s consider what this means, as applied to the current balance sheet of the Fed, reconfigured as in my previous post as a set of three different risk exposures. Each of these exposures can be thought of as a swap, initially zero net value but potentially in-the money to the benefit either of the Fed or of its private counterparties.

Raising short term interest rates would likely increase the Fed’s net payout commitment on its various swap positions. Thus there would be capital losses, although the accounting would probably not show it since the Fed need not mark to market. Because the Fed can hold its positions to maturity—no survival constraint—over time these losses would be offset by the Fed’s usual carry profits from borrowing short and lending long.

On the other hand, “draining reserves” and “sales from the asset portfolio” would mean closing out some of the implicit derivative positions before maturity, and that would mean realizing capital losses (and capital gains for the Fed’s counterparties). That is not necessarily a bad thing—the whole point of a central bank is to focus attention on the needs of the system, not on its own profitability.

From a money view perspective, instead of focusing on short rates and asset sales, it is more natural to consider the underlying risk exposures directly. One piece of that is what I am calling the money market swap, the standard instrument for Fed operations before the crisis, now swollen by about three times, from about .8 trillion to 2.3 trillion. The other pieces are new, 1.0 trillion of what I am calling credit default swaps (arising from QE1), and 2.3 trillion of interest rate swaps (arising from QE2 but also earlier interventions).

This way of thinking makes clear that the usual talk about exit strategy is underspecified. Which of the risk exposures are we supposed to be imagining is no longer required? Which of the risk exposures is it proposed to liquidate first? And how would we know what is the right thing to do?

In this respect it is helpful to think of the Fed as dealer of last resort, stepping in to absorb temporary imbalances in supply and demand for various risk exposures. The Fed acquired all these exposures by selling insurance when everyone else wanted to buy. It will be able to liquidate these exposures when the private sector is once again eager to sell.

Meanwhile, the debt mess remains. We are sailing in uncharted waters.

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