There used to be a time when the mass media covered the Federal Reserve as if it was Hollywood or a professional sports league. Whenever the Fed acted or the Fed chairman made a statement, it was big news. That has not been the case for a long time, mostly due to the mortgage meltdown. Worshiping the money men was no longer good copy after they came close to blowing up the world. Halfway through the Trump tenure, the media barely mentions the Fed or Fed policy.
Still, the central banks remain the most important government institutions on earth and this is particularly true of the Federal Reserve. They control the global economy, because they control the supply of money and credit. This is why the massive intervention into the credit markets by the Federal Reserve recently should be front page news. Something very big is happening and no one seems to know why, but the Fed is responding to it with $500 billion in new money.
Now, they are not just printing up cash and throwing it out the window. Instead, they are intervening in the repo market to head-off a market crash. For those who don’t know, the repo market is not where repossessed items are sold. The word “repo” is slang for repurchase agreement¹. A repurchase agreement is a short-term funding mechanism where one party needing cash, sells an asset to a party for cash, with an agreement to repurchase the asset at an agreed upon price.
A repurchase agreement functions in effect as a short-term, collateral-backed, interest-bearing loan. Much of what happens in the world of investment banks is reliant on the repo market. In order for these entitles to function, there has to be enough cash available in the system for these transactions to occur. Otherwise, borrowing rates go up, which means the cost of doing business goes up. Taken to the extreme, no cash available means the credit markets lock up.
Since the financial system is like a watch with gears interlocking with gears, one gear seizing up has the potential to seize up all the other gears. A frozen repo market could result in a cash crunch for banks, which locks up business and retail lending. That locks up the Main Street economy and we’re looking at bread lines. The economy, as we understand it, relies on a steady supply of money and credit freely flowing through the system according to the rules established by central banks.
As an aside, if the repo market probably sounds a lot like a pawnshop to you. A pawn shop offers short-term, collateral based loans. You take the family silver into the pawnshop and they give you cash. You agree to come back with the cash, plus interest, to get the family silver out of hock. If you blow the cash on a sure thing and are unable to pay the pawnshop, they take ownership of your item and sell it for cash. So yes, the financial system is built on the logic of the pawnshop.
Now, this move by the Fed is very curious. Clearly, something has caused this problem in the repo market, but no one seems to know the cause. It’s serious enough that the Fed’s balance sheet, currently at $4.1 trillion, will surpass its all-time high of $4.5 trillion. For several years now the Fed has made clear its intent to shrink its balance sheet. Therefore, this problem is serious enough to cause the Federal Reserve to change course and blow up its balance sheet.
The question is, what’s going on?
One possible answer is bad rule making over the last decade that has rewarded banks for hoarding cash. Instead of lending to one another, they are sitting on cash reserves. The risk-reward is better than short term lending. This could be due to a combination of market factors created by Fed policy and regulations on banks regarding their cash reserves. In other words, the government has created a distorted short-term lending market, through regulation and Fed policy that discourages short-term lending.
Another, more worrisome cause is that central banks have built a low-interest rate trap for themselves that they cannot escape. In lowering rates and intervening so aggressively in the market to stave off collapse a decade ago, they have created a system that cannot exist without low rates and aggressive intervention. Efforts to restore rates to historic norms or attempts to shrink the balance sheets of central banks threatens the very existence of the global financial system.
In such a scenario, the system controlled by the central banks becomes increasing complex with every intervention. Currently, the Fed does not know why the repo market is broken. They are simply reacting to the short-term effects. Their actions, however, will be part of the problem to be solved, a problem they don’t fully grasp. By the time they do understand the issue, they may have been forced to make additional interventions that further change the complexity of the problem.
Of course, a world of permanently low interest rates and unlimited intervention by the central bank is not a world controlled by the central bank. Rather, the central bank is now controlled by the system it created. The main weapons the central bank has used in the past to address systemic failure are no longer available. Taken to its logical conclusion, the financial system is a run-a-way train. The Feds do what they can to keep it on the tracks, but eventually, the inevitable happens.
In the long run, the story of credit money may be that it is simply a complex way to pull forward the benefits of economic activity, for the benefit of a few. Eventually, all of the pain avoidance with low interest rates and central bank intervention consume all of the economy to pull forward. Those accrued costs are reversed out all at once and system collapse in the result. The resulting political fallout then topples over the liberal democratic order and we enter an entirely new age.
That may sound overly apocalyptic, but consider how political institutions must weather a crisis. The people must not only want to preserve those institutions, they must trust the people running them. A great systemic collapse of the economic order would need a lot of trust in the political order to avoid revolts. At no time in the West has the current political order be less trusted. It needs the good economy to survive. That sound a lot like a house of cards waiting for the wrong decision.
¹Short primer on repurchase agreements.
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