Courtesy of Sandeep Jaitly @ Fekete Research.com:
What we are currently witnessing with the various ‘quantitative easing’ procedures across the world is the culmination of a process that began many decades ago in the 1920s shortly after the establishment of the Federal Reserve System.
The Federal Reserve System was set up in 1914 to run in a similar fashion to the London gold bill market. The charter informs us that the purpose of the System is to:
“…furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes…”
At its founding, the assets of the system were limited to commercial paper, i.e. self- liquidating gold bills and gold, to the strict exclusion of government securities – i.e. government bonds redeemable in gold (via the fiat ‘dollar’ name intermediary.) This was thrown to the wind during World War I. The ‘Liberty Bond’ series was initiated in April 1917 with a $5bn issue, followed by a $3bn issue in October. In 1918, April and September saw $3bn and $6bn issues respectively. The first four ‘Liberty Bond’ issue amounted to $17bn (approximately 25,000 tonnes gold.) When the repayment of these bonds within the given schedules looked more unlikely, they started appearing on the System’s balance sheet and were thus ‘accommodated.’
Bills being discounted from the Member banks started to dry up in the early 1920s reducing the Reserve banks’ revenue, as the ‘Liberty Bonds’ were rolling off. So in the first half of 1922, they purchased government securities from the open market. This didn’t have the intended effect – as soon as government securities were purchased, any commercial bank paid off their loans to the Reserve banks further – increasing the Reserve banks’ income. But, the commercial banks were in a theoretically more advantageous situation for lending on.
Thus, overtly to stem slack revenue for the Reserve banks, the purchase of government bonds from the open market was deemed to have potentially beneficial effects. Reserve banks would purchase government securities from commercial banks in exchange for Federal Reserve credit, which could be lent on for the needs of commerce in times of stress – so the theory went.
The government securities acquired would then be exchanged back for the credit originally granted once the economy started to improve thus reigning in any excesses…so the theory went.
When government bonds first started to appear on the Reserve bank balance sheets in 1916, they never occupied a significant portion of total resources; this only started to occur after the repayment of the World War I ‘Liberty Bonds’ within the stated schedule was looking questionable. When those bonds started to roll off the Reserve banks’ balance sheets, the process of buying Treasury bonds was repeated but this time in the open market.
From 1923 to 1928, with no overt government financing as required during World War I, the percentage share of the Federal Reserve Bank of New York’s balance sheet in government debt advanced from 14% to 24%. This would have undoubtedly depressed the market rate of interest below what it naturally would have been. By 1933, the year before Roosevelt’s gold confiscation, the share had reached a record 41%. The sharp drop in the government’s share of the balance sheet is the result of the stolen gold being accounted for.
From there on, it’s a one way progression higher with a few dips for diversion. Numerous wars pepper this progression until nigh on 100% of total resources being represented by the government bonds just after the first war in Iraq. The actions of the London gold pool in attempting to maintain the gold ‘fix’ and the closing of the gold window are put into their correct context of the Federal Reserve System’s balance sheet growing exponentially in illiquidity. The bill of exchange was to be found only in text books by the 1960s.
There’s no way of calculating what interest rates would have been had the System not purchased government bonds, but the chart to the right shows a distinct negative correlation between rising government shares of the Fed’s balance sheet and falling interest rates (see within yellow circle.)
This grossly destabilising effect on interest rates and the broader economy cannot be underestimated. When interest rates were meant to be higher, they were not and when they were meant to be lower they were lower than they would have been. Such an action induces the business cycle; nothing more than the equivalent in economics of the observation in physics. The unadulterated gold coin standard that has never existed in history should not be confused for any so-called gold standard prior to the Bretton Woods system and certainly not the Bretton Woods system itself.
The depth of the data given in the annual reports from 1915 onwards varied, as the System’s holding of government securities increased. Occasionally, the split between government bills and bonds was given, as was the case from 1933 to 1950. From 1971 onwards, repurchase agreements (loans of fiat to the banking system against fiat government bonds as collateral) are split out.
Every economic downturn has been attended by colossal increases in repurchase agreements. During the Asian financial crisis in 1998, repurchase agreements reached a staggering 40% of total resources.
The split by maturity of the government securities held in the System wasn’t widely available until the Great Financial Crisis started in 2008; when the requirement to display such metrics couldn’t be brushed under the carpet.
What were originally meant to be short term securities gradually changed into longer term securities, until from 2008 where the whole spectrum of government and private debt was on the cards for re-monetisation. As of March 2014, the total holdings of government and mortgage securities in the System account for 15% of all government and mortgage debt combined.
When open operations were first conducted they were overtly limited to short term government securities. The System managers cared not about the maturity of the pool of government securities from which they were purchasing, as the amounts of purchases relative to the size of the pool were comparatively small. This is no longer the case.
The managers of the first open market operations were not worried about the maturity of the securities they needed to purchase because they could always find securities of the maturity required. Looking at the difference between the maturity of the government securities in the System and outside of the System was of no concern. This is no longer the case.
The weighted average maturity of the $2.3 trillion of government securities held in the System is 112 months. This is down from the peak of 118 months reached in December 2012.
The average maturity of government securities outside of the System is 67 months. This problem was pushed back by ‘operation twist’ in 2011, whereby shorter dated securities were exchanged for longer ones, thereby creating another problem: the number of government securities with a maturity greater than the average in the System has plunged to only 25% from over 70% of all marketable debt.
With that, the length of time for which the system can continue to accumulate government securities of the right maturities has been brought much closer to the present. A similar calculation with the Bank’s holdings of gilts presents a similar picture, but the difference between the maturity of gilts held by the Bank (145 months) and those held elsewhere (114 months) is diminishing at a faster rate than the system’s.
When the difference between the maturity of what has been re- monetized versus what can be re-monetized has reached zero, whatever game this is being played will be over.
The Use of Open Market Operations in Federal Reserve Policy 1927-1936, by Mary Barnes Johnson, University of Atlanta, June, 1938.
Federal Reserve Bank of New York. Annual Reports; 1915-2007.
Bank of England ‘Asset Purchase Facility’ schedules.