Image: Jim Jubak

Jim Jubak

The financial markets' faith in the world's central banks would be touching if it weren't so scary.

In the late 1990s we had what was called the "Greenspan put." In the dark days when the collapse of a hedge-fund portfolio at Long-Term Capital Management threatened global financial markets, then-Federal Reserve Chairman Alan Greenspan led a massive intervention to stabilize the markets. Investors studying Fed policy concluded that the Fed would intervene to prevent any future collapse in asset prices and that, therefore, piling on risk was a good investment strategy. We all know how well that ended.

What progress we've made! It looks as if we've replaced the Greenspan put with a global put, backed not just by the U.S. Federal Reserve but also by the central banks of the eurozone and the People's Bank of China.

You're entitled to worry about how this will end.

Betting on stimulus

Wonder why European stocks and sovereign bonds haven't collapsed, even though we're contemplating a Greek default (an official one this time), the wreck of the Spanish banking system and another downgrade of France's credit rating? Because of the belief that if worse comes to worst, the European Central Bank can print unlimited amounts of money.

Wonder why Chinese stocks -- and the emerging-country stock markets that rise and fall with China's prospects -- aren't in a panic as a result of the latest numbers showing slower-than-expected economic growth in China? Because of the almost-universal belief that every bit of worse-than-expected economic news brings us closer to the day when the People's Bank of China will ride to the rescue with a cut in interest rates.

Wonder why the Standard & Poor's 500Index ($INX), is stubbornly hanging around 1,340, even as worries mount about a slowdown in U.S. economic growth? Because of a conviction on Wall Street that if the recovery is in real danger of faltering, the Federal Reserve will launch a third program of quantitative easing that will pump money into the economy (and the financial markets).

Each of these three major pieces of the global put is constructed in a slightly different way. Understanding those different methods of construction can provide some indication of how and when this global put will be resolved.

The Fed's $2.9 trillion dilemma

It says a great deal about how risky the overall global put has become that the U.S. Federal Reserve is now the most conservative player. That's not so much a reflection of a policy bent at the Fed as it is an indication that the Fed got started earlier down this road. The Federal Reserve's balance sheet stood at $2.9 trillion as of the week ended May 9. That's essentially even with the balance sheet in March and only $300 billion above the balance sheet total in September 2011.

To find the big expansion in the Fed's balance sheet, you need to go back to before the September 2008 Lehman Brothers bankruptcy and the global financial crisis. In May 2008, it stood at just $900 billion. In May 2009, it was $2.1 trillion. In May 2010, the Federal Reserve's balance sheet showed $2.3 trillion.

Only when talking about the Federal Reserve (or the U.S. budget) does an increase from $2.1 trillion to $2.9 trillion count as not very much. But it does fall into that category when compared with the total jump of $2 trillion from May 2008 to May 2012.

And what is on the Fed's balance sheet now that wasn't on the balance sheet in May 2008? $1.7 trillion in U.S. Treasury securities, up from $540 billion in May 2008, and $850 billion in mortgage-backed securities, up from zero in May 2008. That increase from 2008 to 2012 is the result of the Federal Reserve's purchase of U.S. Treasurys and mortgage-backed securities after the onset of the global financial crisis. The Fed did this buying as part of its effort to drive down interest rates in order to increase growth in the U.S. economy.

The Federal Reserve paid for the assets now on its balance sheet by printing money (the mechanics are somewhat more complicated than that, but the description is essentially accurate).That expanded the U.S. money supply, lowered interest rates, increased the short-term stability of the U.S. financial system, added something to growth and propped up asset prices in the financial markets.

To the degree that the money the Fed has added to the money supply hasn't gone into investments in productive assets -- and with economic growth this slow, companies haven't been rushing to expand capacity -- it has gone into other assets. These include stocks (either through the direct purchase of stocks by investors or through corporate buybacks and acquisitions) and bonds (which is one reason that bond yields are so low).

The challenge for the Fed is how and when to unwind that $2 trillion addition to its balance sheet by selling the Treasurys and other securities it has bought. That would take money out of the money supply and the economy, which would slow growth. With the economy was growing at just a 2.2% annual rate in the first quarter, that's tricky, and it's made even trickier by the need to reduce the federal budget deficit, currently projected by the Office of Management and Budget at 8.5% of gross domestic product for fiscal 2012. (To put that into context, the deficit as a percentage of GDP is 2 percentage points higher than Spain's projected deficit.)

The alternative, however, is a permanent expansion of the Federal Reserve balance sheet, which would have the long-term effects of adding to inflation, weakening the credit rating of the United States, leading to the depreciation of the dollar and, perhaps most important, limiting the Fed's ability to intervene effectively in any future crisis. (And there are a few of them looming.)