I thought a little more about the Treasury’s Supplementary Financing account. The Fed traditionally has 2 ways of obtaining new financing, and thus add new items on the right hand side of its balance sheet:
- Physically print dollars and buy debt securities
- Create computer entries in dollars in member bank accounts against debt securities
- That the monetary base was soaring, setting the stage for a massive price inflation
- That further purchases of bad debt instruments were pushing the overnight rate below the 1% that the Fed is currently pledging to maintain
Thus the Fed resorted to the Supplementary Financing Program, a 3rd, nontraditional, way of obtaining financing. The precise characterization of this move has to be nothing but this: That the Treasury borrowed very short term money on the open market, thus withdrawing it, and then invested this money in the Fed, similar to someone investing in stocks of a business. The Fed does not necessarily have to pay off the people the money was borrowed from. The Treasury owes that money, and the taxpayer will directly foot the bill (rather than through inflation). (It is, however, conceivable that Fed and Treasury agreed that over time the Fed would reduce the Supplementary Financing Account by selling assets once the market recovers and forward the proceeds to the Treasury.)
The Fed then had to immediately turn around and purchase the troubled assets with this money, since it cannot maintain any cash on the left hand side of its balance sheet.
Apparently the idea was to temporarily create an adverse tendency against the two effects above, inflation and interbank interest rates below 1%.
Inflation would not increase as much as it would, had the money been printed, because some money is withdrawn through the Treasury sales, and the interest rate target would be supported because more Treasuries pushed onto the market would create a downward pressure upon Treasury prices and thus an upward tendency for interest rates, thus keeping the rate at 1%, rather than dropping below it.
At the same time, the Fed gets to purchase more troubled assets which in this case are financed via money withdrawn from the open market directly, rather than via inflation.
The only reasoning, if we want to call it that, that I see behind this is that Ben Bernanke and Hank Paulson and their blind followers believed that somehow, like through magic, the bailout would quickly fix the miserable situation that the markets are in, the worthless assets would go up in value and could be sold at a profit, and the money could swiftly returned to the Treasury, while during this whole operation inflation and rates could be held in check.
This rationale is so utterly absurd that anyone should balk at it. However, I wouldn’t put anything past these terribly incompetent people who are running the show right now. Obviously the measure will not work. The economic situation will continue to deteriorate, the worthless assets will remain worthless.
The fact that the Treasury Department had to virtually bail out the nation’s Federal Reserve Bank only reconfirms how bad the situation really is and how much worse it will get.
According to current news reports, the next step will be for the Fed to issue its own bonds outright, with no help from the Treasury. The same reasoning above would apply. But in addition I suspect that the motivation behind such a move would be to create a shadow extension of the Department of Treasury that would have the ability to borrow money with no or limited constitutional constraints.