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Given last week's dramatic events — the bankruptcy of Lehman Brothers, the end of Merrill Lynch's independence, and an $85 billion US-government bailout of insurer AIG — most financial institutions are likely to become more sensitive to the state of their net worth.

For instance, all it takes for a financial institution that has a net worth of $30 billion and assets of $600 billion to go under is for the value of assets to fall by 5%. In the current financial climate, it can easily happen; hence, most financial institutions are not immune from the potential threat of going belly up.

One of the major reasons why the Fed rescued AIG was to prevent a fall in the value of bank assets, a fall that would in turn expose their true net worth and cause (it is generally believed) a run on banks that would decimate the entire banking system. As long as the AIG can keep paying the banks' losses for their suspect (but insured) investments, those banks don't need to reappraise their true values.

But there is always the lingering fear that at some stage banks will be forced to disclose market-related valuations and that this could set in motion a financial tsunami.

Mortgage-linked assets are regarded as being at the root of the present credit crisis — the worst since the Great Depression. To eliminate a potential threat from devalued mortgage-linked assets, US Treasury Secretary Paulson and Fed Chairman Bernanke are planning to move these assets from the balance sheets of financial companies into a new institution. The Bush administration is asking Congress to let the government buy $700 billion in bad mortgages as part of the largest financial bailout since the Great Depression.

The plan would give the government broad power to buy the bad debt of any US financial institutions for the next two years. It would also raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion.

But how is the transfer of bad paper assets to some new institution and their replacement with a better quality of assets — with Treasuries, let us say — going to fix the economy? How can it reverse the present slump in the housing market?

The Treasury and the Fed believe that allowing financial institutions to get rid of bad assets will remove the threat of banks' having to assign correct values to their suspect assets. It is held this will bring things back to normal, that the banks will start expanding mortgage loans and revive the housing market and in turn the economy.

But allowing banks to get rid of bad assets doesn't imply that they will be keen to expand mortgage lending, thereby accumulating new potentially bad assets.

At present, for most US banks, the major concern is improving their net worth, i.e., strengthening their solvency. This means that banks are likely to slow the pace of expansion of their assets, and the volume of lending is likely to come under pressure. In the week ending September 10, commercial banks' total assets fell by $33.9 billion. The yearly rate of growth of total assets fell to 4.9% from 6.7% in August and 12.7% in March.

According to the Federal Deposit Insurance Corporation (FDIC), commercial banks and savings institutions' net worth fell by $10 billion from Q1 to Q2. This was the first decline since the data was made available in Q2 2000.

At the root of the problem are not mortgage-backed assets as such but the Fed's boom-bust policies. It is the extremely loose monetary policy between January 2001 and June 2004 that set in motion the massive housing bubble (the federal-funds-rate target was lowered from 6% to 1%). It is the tighter stance between June 2004 and September 2007 that burst the housing bubble (the federal-funds-rate target was lifted from 1% to 5.25%).

The tighter monetary stance put a brake on the diversion of real savings toward bubble activities. Now the effect of a change in monetary policy operates with a time lag. We suggest that the tighter interest stance of the Fed between June 2004 and September 2007 has so far only hit the real-estate market and financial institutions.

Various bubble activities that sprang up on the back of loose monetary policy between January 2001 and June 2004 are not only in the real-estate and financial sectors; they are also in the other parts of the economy.

Consequently, there is a growing likelihood that these activities will come under pressure. Since they are the product of loose monetary policy, obviously the banks that supported them are going to incur more bad assets, which will put more pressure on banks' net worth.

The US Congress May Help Bernanke to Increase Monetary Expansion

The rescue package is a combined act by the US Treasury and the Fed and is seen by experts as a comprehensive approach since it also addresses the issue of liquidity. The chairman of the Fed, who is fearful that the American economy could plunge into depression, holds that the only way to prevent this is through massive monetary pumping.

We suspect that Bernanke is of the view that he hasn't been allowed to operate "properly" to prevent the current upheavals in financial markets because he wasn't free to pump money at liberty.

In the present setup of interest targeting, the Fed cannot simply pump money unhindered into the economy and boost monetary liquidity. Monetary pumping, while the federal-funds rate is at its target, will push the rate below the target. To bring the federal-funds rate back to the target the Fed is obliged to sell assets such as Treasuries to absorb money from the federal-funds market.

All this means that if there is no upward pressure on the federal-funds rate, the Fed cannot pump money without pushing the rate below the target. For instance, if the Fed increases lending to a financial institution, the new money that will enter the financial market will put downward pressure on the federal-funds rate.

To eliminate this downward pressure, the Fed will be obliged to sell Treasury securities. By selling these securities, the Fed takes money from the market. In this way the US central bank offsets the downward pressure on the federal-funds rate brought about by the increase in lending to financial institutions. Note that the holdings of Treasuries by the Fed play an important role in the process that we have described.

As a result of all the actions to boost liquidity taken by the Fed since August 10, 2007, the US central bank holdings of US Treasury securities has dwindled. Just a year ago, the Fed held $780 billion in Treasuries; by September 17, 2008, this has fallen to $480 billion. Year-on-year Treasury securities holdings by the Fed fell by 38.8% in August after falling by 39.4% the month before. This was the tenth consecutive month of yearly decline.

So far in September, the yearly rate of growth has stood at negative 38.5%. If we allow for the $200 billion that the Fed pledged to the Term Securities Lending Facility and the $85 billion loan to AIG then the amount falls to $195 billion.

If more institutions are on the brink of bankruptcy, and the Fed decides to provide support to them, it would have difficulty in doing so without a sufficient inventory of Treasuries. Again, if the Fed were to run out of Treasuries, then any lending by the Fed would lead the federal-funds rate to fall below the target.

To help out the Fed, last Wednesday, the US Treasury announced that it would auction $100 billion in debt in order to offset the monetary pumping by the Fed.

Observe again that the Fed has officially been engaged in actions to boost liquidity since August 10, 2007. All this means that the Fed might appear to be loose, but in reality, the overall pumping by the Fed, as depicted by its balance sheet so far, has been moderate.

The yearly rate of growth of the Fed's assets stood at 4% in August against 3.8% in July. Note that since November 2004, the growth momentum of the Fed's assets has been in a downtrend (the yearly rate of growth in November 2004 stood at 7.1%).

How Can the Fed Boost the Money Supply?

So how can the Fed boost the money supply without pushing the federal-funds rate to below the target? One way of achieving this is by asking the Treasury to issue more debt. Once the Treasury sells more debt to the public, this absorbs money from the federal-funds market. As a result the federal-funds rate will be pushed above the target. Once this happens, the Fed will step in by buying the Treasuries from the public.

Remember that, by buying Treasuries the Fed injects money into the federal-funds market. The new money in turn pushes the federal-funds rate back towards the target. The final outcome of all this is that the money supply has increased and the Fed now has more Treasuries, i.e., its balance sheet has increased.

Now this way of boosting money supply and monetary liquidity is somewhat cumbersome. It also raises the level of the Treasury debt and pushes long-term yields and hence mortgage interest rates higher than they would have been.

The better way, according to Bernanke and US central bank officials, is to pump money any time they think it is necessary. Not only will this boost monetary liquidity but it will also boost the Treasuries holdings by the Fed. (Remember: to pump money, the Fed buys Treasuries.)

But how can this be done, given the fact that to keep the federal-funds rate at the target prevents the Fed from pumping money at liberty?

A solution is on its way — to pay interest on bank deposits held at the Fed. By paying banks an interest rate, which corresponds to the target rate, the Fed removes from banks the incentive to lend surplus cash to each other. As a result, the federal-funds rate will not fall below the target in response to the Fed's monetary pumping.

(Remember: when more money is pumped, banks' surplus cash increases. To get rid of the greater surplus, they will agree to lend at a lower interest rate than before.)

When every bank is guaranteed interest on its deposit with the Fed, banks will not lend to each other — why bother to lend and incur risk if a bank will be paid interest by just keeping the money at the Fed? Consequently, the interest rate will not decline in response to the increase in the Fed's pumping. With this setup, the Fed could pump money at liberty without pushing the federal-funds rate to below the target.

We suspect that against the background of last week's events and the emerging view that something drastic must be done to prevent a calamity, there is a high likelihood that the Congress is going to approve the Fed's (i.e., Bernanke's) request for paying interest to banks very soon. Once the Congress gives the green light, Bernanke will start pushing a massive amount of money to soften the crisis in the credit markets.

The idea is that this should boost bank lending, which in turn will kick-start the economy. Some experts are arguing that the Fed needs to pump over $1 trillion to make things work.

Can More Money Fix the Current Economic Crisis?

But why should pumping more money do the trick? It seems that, for most experts, money is an agent for economic growth. Money however is just a medium of exchange and cannot create real wealth as such. On the contrary, monetary expansion results in the squandering of real wealth and economic impoverishment (look at Zimbabwe). If the pool of real savings is declining, then real economic growth will follow suit regardless of how much money the Fed is going to pump.

Declining household net worth raises the likelihood that the pool of real savings could be in trouble. According to the Federal Reserve flow-of-funds data, the net wealth of households fell 0.8% in Q2 as both home values and financial-asset values fell.

This was the third consecutive quarterly decline. In its press release, the Fed said it has never before recorded three consecutive quarters of declining household wealth since it began tracking quarterly changes in 1951. Year-on-year net wealth fell by 3.5% in Q2 after falling by 0.7% in Q1.

Conclusions

The Bush administration is asking Congress to let the government buy $700 billion in bad mortgages as part of the largest financial bailout since the Great Depression. The plan would give the government broad power to buy the bad debt of any US financial institutions for the next two years. It would also raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion.

At the root of the problem are not mortgage-backed assets as such but the Fed's boom-bust policies. It is the extremely loose monetary policy between January 2001 and June 2004 that set in motion the massive housing bubble (the federal-funds-rate target was lowered from 6% to 1%). It is the tighter stance between June 2004 and September 2007 that burst the housing bubble (the federal-funds-rate target was lifted from 1% to 5.25%).

Can the "rescue plan" fix the US economy, or will it plunge us into the mother of all recessions?

On account of the time lag, we suggest that the tighter interest stance of the Fed between June 2004 and September 2007 has so far only hit the real-estate market and financial institutions.

Various bubble activities that sprang up on the back of loose monetary policy between January 2001 and June 2004 are not only in the real-estate and financial sectors; they are also in the other parts of the economy.

Consequently, there is a growing likelihood that these activities will come under pressure in the month ahead regardless of the rescue package. Since these activities are the product of loose monetary policy, obviously the banks that supported them are going to incur more bad assets, which will put more pressure on banks' net worth.

Contrary to popular belief, the rescue package cannot help the economy; it will only severely weaken wealth generators. (The larger the package, the more misery it will inflict.) Hence, once the massive rescue plan is implemented, it will not prevent an economic slump but, rather, runs the risk of plunging the economy into the mother of all recessions.