Tags: Fed | bond | big | fail

Fed Proves 'Too Big to Fail' Is Economic Reality

Friday, 03 May 2013 07:36 AM

By Michael Carr

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In 2008, government officials around the world were forced to bail out the largest financial institutions because they were simply too big to fail. Allowing all of the struggling firms to suffer for their miscalculations would have led to chaos in the financial system.

Regulators finally understood that big businesses and small were dependent on credit from Wall Street.

Since the financial crisis, the Federal Reserve has been propping up the largest financial firms by buying bonds from them. At their latest meeting, Fed officials confirmed they would continue buying about $1 trillion a year in bonds, an amount that can increase or decrease based on their assessment of financial conditions.

By adding so many assets to its balance sheet, the Fed is now the ultimate example of too big to fail.

No one knows what the Fed will do with the $3.3 trillion in assets it holds. But we do know the Fed has the tools needed to guard against losses.

The Fed does not have to recognize declines in the value of its holdings when interest rates rise. That frees the regulators from market forces.

Even if the Fed were to lose hundreds of billions or even trillions of dollars, the losses would have no impact on its operations. Fed officials would be free to continue buying bonds or take any other action they decide is appropriate because the Fed is able to create the money it needs to do as it pleases.

While the Fed itself seems to be immune from the repercussions of its policies, consumers are not. If bond markets react to Fed problems by demanding higher interest rates on Treasury securities, like they have in Greece and other European countries, economic growth could drop and unemployment could rise.

The Fed is now too big to fail and since they set the rules, traditional consequences of failure are not an option. If the Fed is wrong, or if the policymakers make a serious mistake in the future, the United States could become Greece. This change could happen quickly, as it has in many other countries throughout history. Then, using hindsight, we will know with certainty that the Fed's policies were ill-advised.

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