Very short lesson on what might happen in a few hours in the US Treasury market if a debt deal is not made (or even if one IS made)...

The Federal government borrows money by issuing US Treasury notes/bills---basically IOU's. I am going to use a very simple example to show how the market for US Treasuries may be affected by the failure to raise the debt limit. Keep in mind these numbers are NOT reflective of true market prices. The math is easier for me that way...

If the govt wants to borrow money they issue one of these Treasury Notes/Bills.  Assume the face value of this Treasury is $1,000 and the current market price for this Treasury is $900 (remember, this does NOT reflect the REAL market AT ALL!).  You buy this bond for $900, so the government in essence has borrowed $900 to spend on whatever they want to spend it on. When you redeem it at maturity you earn $100 over what you paid for it.  Your effective interest rate then was 11.11% ($100/$900 x 100). 

Now, assume the debt limit is not raised and there is perception/eat that the US govt will default on its debt obligations. What is going to happen to the price of US Treasurys now and in the future? We should expect the price to DECREASE as the Demand for them DECREASES. 

Now, for the govt to attract borrowers they will have to LOWER the price of the Treasury to entice people to buy one.  Assume the price is now $800 for a $1,000 Treasury.  So, now the effective interest rate is 25% ($200/$800 X 100)!!

This is what it means when you hear that the borrowing costs for the US government might increase if a deal is not reached.  They will have to accept LESS for each bond issued and pay MORE when they are redeemed.

I hope this helps when the stuff hits the fan in a few hours. The first thing that will be affected will be the price of US Treasuries in the market. 

Note: The demand may fall as I described for US Treasuries BUT the Supply of Treasuries already in circulation could (will ) increase as investors dump them. If the supply increases it has the same effect as demand decreasing, hence the same downward pressure on the price and effect on borrowing costs...

Since 1985 there are 50% fewer banks in the US making 350% more in loans*...Nothing can go wrong there, right?

The first graph below shows the change in the number of commerical  banks in the US since the mid-1980's.  I was quite surprised by the rapid decline in a relatively short period of time. Roughly a 50% drop. The slope is pretty steep considering it only represents 25 years.  Another interesting thing is that it appears recessions did not hasten the decline, which you might expect as some banks would fail--the decline just slides through the recessions like they never happened (post-2009 migth be the exception).  


Source: The New Arthurian Economics

 This next graph shows the growth in loans in Commericial/Industrial Loans (Business Loans for expansion, Capital Purchases, Accounts Receivables, etc), Real Estate (residential and commercial properties)  Loans and Loans to Consumers (Cars, Credit Cards, Student Loans, etc). Prior to 1985 banks were balanced in there portfolios of loans to these three sectors.  After 1985, there was a dramatic shift towards Real Estate loans.  Starting in the mid to late 1990's the Real Estate loan line (Red) becomes VERY steep and banks portfolios become very unbalanced (numerically and perhaps psychologically, too-- :) ).  


Source: The New Arthurian Economics

  What happened during the period between 1985 and the late 1990's that set in motion (1) the  decline in the number of banks and (2) the rapid increase in the number/value of loans made? Hmm...fewer banks making more loans...nothing bad can happen there, right?? Yes, Art, you can play along too and correct me as needed :)

*rough, ballpark calculation just by eyeballing--- 1985 about $1.7T and in 2011 about $6T..$6T/$1.7T = 3.529 x 100 = 353%

Nice Article on the Federal Reserve Bond Buyers...Learned some things I did not know...A must read for an AP Macro Class or a Money and Banking Class in College.

NYTIMES: The Fed’s QE2 Traders, Buying Bonds by the Billions

The smallest miscalculation, a few one-hundredths of a percentage point here or there, could unsettle the markets and cost taxpayers dearly. It could also embolden critics at home and abroad who say QE2 represents a dangerous expansion of the Fed’s role in the markets.

In a spare, government-issue office in Lower Manhattan, behind a bank of cubicles and a scruffy copy machine, Josh Frost and a band of market specialists are making the Fed’s ultimate Wall Street trade. They are buying hundreds of billions of dollars of United States Treasury securities on the open market in a controversial attempt to keep interest rates low and, in the process, revive the economy.

To critics, it is a Hail Mary play — an admission that the economy’s persistent weakness has all but exhausted the central bank’s powers and tested the limits of its policy making. Around the world, some warn the unusual strategy will weaken the dollar and lead to crippling inflation.


But inside the Operations Room, on the ninth floor of the New York Fed’s fortresslike headquarters, there is no time for second-guessing. Here the second round of what is known as quantitative easing — QE2, as it is called on Wall Street — is being put into practice almost daily by the central bank’s powerful New York arm.

Each morning Mr. Frost and his team face a formidable task: they must try to buy Treasuries at the best possible price from the savviest bond traders in the business.

Validation of my rant in class about the Fed-to-Banks-to-US Treasury circular flow of money/circular flow of logic that reminds me of a hamster on a treadmill...

Last class period I explained one of the pieces of the puzzle as to why the banking system is not lending as much money as they could be. even though the Federal Reserve is/has been on a bond buying spree.  The short version---(1) Federal Reserve BUYS a $1,000 bond  from a bank--(2) Bank withholds more than is required (or another way of saying this, is they lend out less than they are able to) because they believe  it is too risky to lend to people/businesses right now--(3) Bank buys US Treasury Bonds/Notes as a way to earn interest on the money...Repeat steps 1 through 3...Some lending is occurring, but not on the level required to get the economy going.  Just so you can see that I am not making this up because it sounds so preposterous, here is a comment from today's NYTIMES:

""Here’s the way things are supposed to work and normally do: Banks take in deposits and then lend that money out.


And here’s what’s happening more frequently now: People are doing a better job of spending less than they earn, but any leftover money is going toward paying down debt, not taking on new debt.


So to the extent that banks have deposits, they can’t lend them out in the quantity they used to (or aren’t because of tightened credit policies). Instead, they buy Treasury bills, according to Bill Hampel, the chief economist for the Credit Union National Association. And those don’t pay as they once did because of the interest rate environment. Nor do they deliver the kind of returns the banks would get if they were lending the money under normal conditions. ""

Low returns from US Treasurys are, at best, better than taking chances with credit risks and, at worst, better than a sharp stick in the eye.  I suppose it falls somewhere inbetween...

The Reserve Requirement in action!! Hey, it is as rare as Haley's Comet...Let me enjoy the spectacle that is a Monetary Policy tool rarely employed by a Central Bank...

The reserve requirement is the Monetary Policy tool of last resort for the US Federal Reserve to employ to control the money creation process in the banking system, but it is used by other Central Banks around the world on occassion.  Click HERE for more detailed explanation of the Reserve Requirement and click HERE for my explanation of the Required Reserve and how it affects lending by the banking system.

From WSJ: Brazil Joins China in Push to Cool Overheating Economy

""Brazil's central bank rolled out a series of measures to tame rapid credit growth and prevent inflation pressures, joining other large expanding economies such as China that are trying to curb rising prices and fast moving capital inflows.

Brazil's Central Bank President Henrique Meirelles said the directives announced Friday, which aim to withdraw some 61 billion Brazilian reais ($35.88 billion) from the financial system, will have an impact on inflation and economic activity, and would also be felt in interest rates.


The Central Bank said it would raise reserve requirements on term deposits to 20% from 15%...

 "As we have seen during the past year, central banks have often been using reserve requirements as the first step down the tightening path, and such hikes have almost universally been followed by policy rate hikes as well,." said Win Thin, Global Head Of Emerging Markets Strategy at Brown Brothers Harriman in New York.""

The Reserve Requirement is in the news! The Reserve Requirement is in the news!

     Ok, not in the US, but in China. However, it is an important concept that applies to the US banking system, so here we go with a basic primer on it...
     One of the monetary policy tools the U.S. Federal Reserve has at its disposal to control the amount of money commercial banks can loan out is called the "Reserve Requirement Ratio". The Reserve Requirement Ratio (aka "RRR") is set by the Federal Reserve. When a bank receives a deposit, it is required to with-hold a percentage of that deposit in its Required Reserves account with the Federal Reserve. The rest of the deposit not subjected to the reserve requirement is then put in the banks "excess reserves" account and may be lent out by the bank in the form of a loan to a customer.
     Here is a simple example:  I deposit $1,000 into my checking account (aka "Demand Deposit" in banking parlance). Assume the Federal Reserve sets the RRR at 10%. The bank is required to with-hold $100 of my deposit in its Required Reserves account with the Federal Reserve and can deposit up to $900 in its "excess reserves" account. MY bank can then loan out up to $900 to a customer, who in turn, it is assumed, will purchase some new (or perhaps used) good and/or service with that money, hence increasing GDP.
     If the Federal Reserve wanted to INCREASE the amount of excess reserves my bank could loan out, then it would DECREASE the RRR.  If the RRR was lowered to 5%, then my bank would have to with-hold only $50 from the $1000 deposit and loan out $950, a larger amount than before. The assumption is that a borrower could now purchase $50 MORE in "stuff" than before the change in the RRR, hence a larger increase in GDP.  The Federal Reserve might employ this monetary policy tool if the economy were at less than full-employment or recession.  More excess reserves =more loans =lower interest rate on those loans= more purchase of GDP = increase in Aggregate Demand = closer to full-employment. 
    What works forward, also works in reverse. If the Federal Reserve wanted to DECREASE the amount of excess reserve my bank could loan out, it would INCREASE the RRR. If the RRR is increased to 20%, then my bank is required to with-hold $200 of the $1,000 demand deposit and can loan out, in excess reserves, a maximum of $800, which is $100 less than if the RRR were 10%.  Now LESS money is available to be loaned out and presumably LESS "stuff" will be purchased, hence GDP would decrease.  The Federal Reserve might employ this monetary policy tool if the economy were experiencing inflation.  Less excess reserves = fewer loans = higher interest rates on those loans = less purchase of GDP = decrease in Aggregate Demand = closer to full-employment (reducing price level/inflation). 
   I used the example of only one bank when the Federal Reserve utilizes the monetary policy tool of changing the RRR,  but it applies to all banks.  In general, what happens at one bank will happen at all banks (in a follow-up blog entry I will change this assumption).  So, if the Federal Reserve decreases the RRR all banks will be able to loan out more in excess reserves, which will tend to decrease interest rates as more excess reserves become available to be loaned out, which tends increase the number of loans, which tends to increase the purchase of consumer goods ("C") or investment goods ("I") which tends to increase GDP. I will ignore the effect this has on Net Exports in this example, but suffice it to say, it will also serve to increase GDP.  This will help solve recession.  I believe you can now follow the logic of what an increase in the RRR will have on the banking system to solve the problem of inflation. 
     All countries have some semblance of a Central Bank (we call ours "The Federal Reserve Bank of the US").  The Chinese Central Bank just increased its RRR for banks in China, so they have some concerns about inflation and are trying to reign in excess reserves.  Click HERE to read all about it. 
     It is a great time to teach an introductory college level class---MOST of textbook stuff is coming alive in the "real-world"! It is sad to say, but the crappy economy makes it easier to teach economics! (Should I have said that out loud???)