Sunday, January 12, 2014

Luck Is The Residue of Good Design: Reserve Bank Transfers to the Treasury For 2013

"The Federal Reserve Board on Friday announced preliminary unaudited results indicating that the Reserve Banks provided for payments of approximately $77.7 billion of their estimated 2013 net income to the U.S. Treasury."
Src: Fed Press Release, January 10, 2014
One has to wonder how much of the national debt the federal reserve should buy up. Since operating costs are fixed, essentially if The Fed bought 100% of Treasury debt it would essentially be an interest free loan since the "surplus" of all that debt payment would just go back to the Treasury.

If that statement isn't intuitive, here's the math:
  • Pretend "total cost of servicing the U.S. Treasury debt" was $453.3 billion.
  • Pretend 100% of that debt servicing payments went to The Fed.
  • Pretend The Fed needs "$20 billion for operations" (see the press release difference between what they recently earned and what they just returned)

If they owned all the debt, the cost of servicing the national debt would be 20 billion, not 453.3.
  • 453.3 - 20 = 433.3
  • "total cost of servicing the U.S. Treasury debt" minus "$20 billion for operations" = "surplus to return to the treasury"
  • 453.3 - 433.3 = 20
  • "total cost of servicing the U.S. Treasury debt" minus "surplus returned to the treasury" = "the net cost of servicing the national debt paid out from tax revenues"

Here's a common everyday scenario of how that works.
Son: Dad, this car must be worth a million bucks! It's a classic!
Dad: No son, no one will believe you unless you could get someone to pay you that much.
Son to his rich Uncle: Will you buy this for me for $1 million if I pay you a kickback? I need to recover my 10 grand I put into it.
Uncle: Sure, here's $1 million.
Son to Uncle: Thanks here's your receipt for $1 million.
Son to Dad: Look dad, I sold it for $1 million!
Dad: Wow, that's awesome. Sorry I doubted you.
Son to Uncle: Here's $999,990,000 back. I really only needed $10,000.
Test question: What was the 'true' cost of the car the uncle bought?

So the argument against fear that China will dump all our Treasuries is silly. In a crisis, The Fed simply agrees to buy it and store it for safekeeping until such time as a market buyer can be found to pay a reasonable price. That's exactly what they did in the bank run. When the world was about to come to an end (circa 2008) everyone (virtually, not literally) sucked up Treasury debt in a panic as the asset of last resort on earth. Naturally, most of those people calm down and eventually decide to go buy something better like stocks, bonds at rates above 2%, houses, etc., etc. Meanwhile, the Federal government started dumping new Treasuries on the market to cover the cost of all the unemployed.

Net Result: Massive flood of Treasuries coming to a market near you!

Reaction: The Fed simply agrees to buy it and store it for safekeeping until such time as a market buyer can be found to pay a reasonable price. We now know, also, that this safekeeping time frame is about 5-6 years. Like a storm water retention pool, they open the door and "collect" the "flood waters" in a safe storage facility until such time as they can trickle it out into the streams without washing away all the neighborhood homes and cars (pun intended).

One might argue, with a flood of new money to China (i.e. printing press operations to buy it all up) the value of the dollar would collapse.

Fantastic! Two great things to come out of that:
  1. All the friggin' money Microsoft, Apple, Intel, and whomever that is locked up offshore because they don't want to pay tax on it would be going down the toilet unless they cash it in and bring it back home. The risk management dealers in their internal Treasuries would quickly do the math and realize paying tax is cheaper than loosing purchasing power. Not only that, making products offshore would price them out of the domestic market bringing those products back to America's friggin' huge economy. Bringing back the money instead would allow them to build factories to build domestically for less money.
  2. The prices of American goods and services (and labor) would become "dirt cheap" just like China. So all the companies in all the nations on the planet would suddenly be looking for ways to hire Americans to produce their goods and services. And American businesses who are paying dirt-cheap labor in China and India would be paying through the nose because of their more expensive currencies. Those televisions, iPods, phones, clothes, etc., etc., would be cheaper to make here than there. American cars would be a fraction of the cost of foreign cars, and the auto industry is a HUGE part of our economy.
China knows this. China knows they can barely care for their billions of humans even in a weak global economy with America on the edge. China knows their political systems would collapse if their unemployment rates started climbing like America's from Americans shutting down manufacturing in China. China knows a population addicted to government stability would never support their totalitarian regime if they were starving. China doesn't have America over a barrel, America has them over a barrel. Or maybe the better analogy is the good-guy bad-guy movie scene where each is pointing a Glock 37 at the other's face. It's left as an exercise for the reader to assign good and bad labels on the player's in this scenario.

While we prefer sound money over fiat money, we have to say, the QE policy by the fed not only was a shrewd solution to a global run on the bank, it was a shrewd political statement to China (whether intentional or by unintended consequence) that the U.S. will do anything it takes to secure the value of U.S. Treasury debt.

Just another fantastic real-world example of the Navy SEAL's training motto:
“Luck is the residue of good design."