The Federal Reserve And Evaporating Money

It seems like it is never going to end, doesn’t it?  It is getting to be ‘Kind of a Drag’, as the Buckinghams used to sing.

There are lots of reasons why this recession is taking so long to break out of. We happen to think that the Obama White House and Congress have played two very wrong cards in their efforts to turn around the economy: 1) excessive direct federal spending when a good jolt of business-targeted tax cuts would have jump-started the economy and 2) laying down a never-ending list of new humongous federal programs that will have to be paid one day with higher taxes on business, frustrating new investment and subsequent job creation.

But a friend of ours who worked in Washington for years in Congress and at OMB as an analyst pointed out a very important dynamic that many of us do not know about, which is why guys like him are now known as ‘experts’, because they worked inside the belly of the beast for so long.

His explanation helps explain clearly ‘why’ this recession is stretching into multiple years instead of being just a brief 6-12 months setback as in past recessions for most people.

It all has to do with the Federal Reserve’s balance sheet, which we first raised to your attention earlier this year.

Oddly enough, this gentleman told us the following story on the same day that another friend called to say:

“I am finally retiring from the Fed after decades of public service this year.  God Bless America!”  And he was the one who told us about how the balance sheet will be reduced like just so many digits on a computer game screen that all the younger people can do blindfolded several months ago.

Anyway, here is what is ‘really’ going on about why this recession is lingering on, and on, and on according to both of these guys:

There is very little, in fact, scant discussion being given to the now $2 trillion-plus Federal Reserve balance sheet.

While real estate and commercial property assets put on the Fed books were a ‘boost’ to the economy when bought during the meltdown of 2008-09, because that injection of money at least arrested the rapid rate of decline in real estate values, we are now faced with the “drag” of those very same toxic assets being paid down by borrowers.

When the Fed bought mortgages from the collapsing banks, they put $1.5 trillion (created out of thin air) into the economy which was paid to bondholders, developers, realtors, closing attorneys, appraisers and so on and then this money was reused to pay grocers, department stores, buy cars etc. by these same people.

The good old ‘multiplier’ effect and ‘velocity of money’ phenomenon.  All the things we should have learned in high school economics classes. Money invested into something gets used to pay people who use that money to buy other things.  The very life-blood of a healthy, vigorous economy based on private sector investment and activity.

Back in the ‘good old days’, this is what happened when people took a loan out from their ‘friendly neighborhood bank’ (remember them?), bought a house and furniture and appliances and all that money got circulated throughout the local economy and kept people employed for decades at a time.

Today, things are much different. An owner of a mortgage now owned by the Federal Reserve earns a living (hopefully he/she is still gainfully employed), and makes a $2,000 per month mortgage payment. Of that, say $400 goes to taxes. The remaining $1,600 goes to pay principal and interest, both of which now go to the Federal Reserve who holds their mortgage, NOT the local bank.

The “drag” on the economy happens after the employer pays salary to the same employee who then uses $2000 per month to pay for the house mortgage; $400 to taxes, $1600 to principal and interest.  Instead of being “multiplied” in the economy by 2:1, 3:1, or 4:1 by going to the local bank, re-lent, spent at a grocery store or used at a local department store by others, that $1,600 now goes into the abyss at the US Federal Reserve as loans are paid down to zero.

‘And this money is never to be seen again.’

The Fed is not a commercial lending institution. Its primary function in life is to provide a solid and sound currency for the US economy and grow the money supply in a responsible manner to account for a growing population base and (hopefully!) a growing economy again one day.

The money now paid to the Fed ‘evaporates’ as the Federal Reserve sheet declines in balances. As these loans are paid down, they are not recycled through the economy in the form of new loans. They are deleted like so many digits in a computer video game once again!

Who says ‘video games are stupid and a waste of time and talent?”  You might be able to get a high-paying job at the Fed pushing buttons all day long deleting these assets it seems to us.  It might be a lifetime job, sad to say, based on the enormous amount of personal and commercial real estate mortgages that need to be cleaned up nowadays.

Some experts now expect that reducing the Federal Reserve balance sheet of mortgages will slow the economy by perhaps 1% of GDP (from where it would have been otherwise) while they are paying it down over the next what? 3 years? 5?  Please don’t say 10.

With a GDP still over $14 trillion in value, still larger than China with its billion+ people by a factor of 3, that ‘drag’ on the economy represents job loss and production/service value loss of close to $140 billion per year in 2010, 2011 and beyond. If we had that sort of extra growth in the economy instead of ‘wasting’ it paying down problem loans, a lot of people would be able to get back on their feet and keep more businesses from going under.

It is also quite clear to see why the Fed is reluctant to sell the mortgages they now own  into the current depressed real estate market. Such a glut of new assets on the market would drive an already depressed real estate market down even further and faster. It would cause even a larger abyss of economic activity lost.

Fortunes delayed; jobs not created.

So there really is no silver bullet or magic carpet ride to get us out of this current situation, ladies and gentlemen. We are just going to have to hold tight and let the Fed work off its inventory of excessive assets before things will get better.

In the meantime, you college grads, you might want to apply for a job at the Fed and use your video games skills to delete all these loans when paid.  They might be able to use your services tapping away at these digits on a screen for years.

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Frank Hill writes at TelemachusLeaps.com

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