Remember this question: “Who guards the guardians?” I offer another: “Who lends to lender of last resort?”
This is not hypothetical. The Federal Reserve is called the lender of last resort. In theory, it can always escape an audit. It cannot be shut down. But this applies legally only to the Board of Governors, an agency of the U.S. government. Legally, however, the FED’s assets — including the gold — are on the books of the Federal Reserve Bank of New York, a private agency.
There are general accepted standards for accounting. If the New York FED suffers losses, it must cover them.
The FED is up to its eyeballs in long-term bonds: Treasury bonds (“operation twist”) and Fannie Mae and Freddie Mac bonds. Problem: if long-term interest rates rise, the market value of these bonds falls. Price inflation — caused by the FED (monetary base) and commercial banks (loans) — raises long-term rates.
The FED keeps these bonds on its books at face value. So, it will not suffer losses on paper. But there is a problem. If it sells these assets, it must take the loss. It must write down the asset. This is deflationary.
Why would it ecer sell? Because that is the only way it can exit from its huge build-up of debt, 2008 and 2011 (QE2). Bernanke keeps assuring Congress that it has a plan for exiting. But there is only one way: to sell assets. If it does, it must take the hit to its balance sheet. It can’t sell the bonds for what it paid. It will suffer losses — gigantic losses.
Who will pay for these losses? The U.S. government.
The FED pays back most of the interest income it receives from the government’s bonds. This amounts to $80 billion a year. But, earlier this year, the FED and the Treasury cut a deal. If the FED suffers losses, it will keep the money and write IOUs to the Treasury for the money it does not pay back.
But the Treasury can’t spend IOUs. It is running a $1.3 trillion annual deficit. So, where will it get the money? There are only three sources: from the FED (monetary inflation — no exit strategy), from taxpayers (no chance), and from lenders (more deficit).
There is no exit strategy. The FED will not reduce its balance sheet. It will sit there, like yeast, waiting for commercial banks to lend, thereby translating the existing hyperinflation in the monetary base into hyperinflation in prices. But will it dare to do that? If not, it must sell assets. Wham! There’s the crisis. The bonds will be sold at a loss.
Here’s how it works:
Now as losses on future bond sales arise, the Fed does not reduce capital, as would normally occur, instead they increase the amount of the IOU to the Treasury. In effect, the Fed is issuing private IOUs to the Treasury and using the cash to avoid appearing insolvent. As long as the Fed can keep issuing these IOUs, its capital will not be wiped out by losses on its bonds. Corporate executives who played these kinds of accounting games would be sent to jail. Americans might be outraged to know that the Treasury is a public institution while the Fed is privately owned by banks, so this accounting sham is another example of bilking the taxpayers to enrich the banks.
The United States now has a system in which the Treasury runs huge deficits and sells bonds to keep from going broke. The Fed prints money to buy those bonds and loses money owning them. Then the Treasury takes IOUs back from the Fed to keep the Fed from going broke. This arrangement resembles two drunks leaning on each other so neither one falls down. Today, with its 50-to-1 leverage and investment in volatile securities, the Fed looks more like a poorly run hedge fund than a central bank.
For a detailed study of the FED’s new program of transferring its future losses to the Treasury, click the link.