With the Fed yet to announce a new round of quantitative easing, some economists are starting to offer their own opinion about what else the central bank can do to introduce more money into the American economy and spur growth. One of the proposals I have heard is for the Fed to eliminate its policy, instituted in October of 2008, of paying interest on reserves and excess reserves kept by banks at the Fed.
I believe that anyone advocating for this proposal either does not understand why the Fed is paying interest on reserves to begin with, or believes that there is somehow enough loan demand for profitable investments that the enormous mountain of reserves now sitting with the Fed won’t result in hyperinflation if it were actually drawn down.
Let’s start first with the reason why the Fed is paying interest on reserves, because this is something entirely new and was only instituted in 2008 as a result of the crisis in the credit markets. You will recall at the time that interbank lending had frozen up, as banks were afraid that they may not have enough cash on hand to meet their short-term obligations. There was not only uncertainty about the health of a given bank’s own balance sheet (the value of its own assets and quality of its own loans), but there was also massive uncertainty about the health of other banks’ balance sheets, which is why we heard so much at the time about “counterparty risk.” The demand for money was high relative to the supply (drop in bank lending = drop in supply of money and credit), and so interest rates began to spike, as was seen most prominently in the interbank lending market (the interest rate set by this market is known as LIBOR). This is the core component of what we think of as the money markets, and it was freezing up. A freeze in money markets means that everyone from Fortune 500 companies to small businesses can’t get the money they need to meet their short-term obligations, since so much of today’s business is conducted on credit. And since a failure to meet one’s financial obligations is the definition of insolvency, the chain of events taking place at the time would have resulted in the bankruptcy of an untold number of banks, corporations, and small businesses, and could very well have collapsed the American economy into a state far worse than what we saw after 1929.
So, in response to this freeze in credit markets, central banks around the world (the Federal Reserve playing leader of the pack) needed to find a way to prevent, first and foremost, a collapse of the banking system. During the great depression, approximately 1/3 of all banks went belly-up, and many economists, Ben Bernanke included, contributed this collapse of the banking sector as the prime cause of the depression. It was his intention, therefore, to make sure that the financial system would be propped up at all costs, even if it meant risking hyperinflation at some unforeseen date in the future. I say hyperinflation, because the only way for the Fed to keep the banking system from failing as a result of all the bad loans and onerous debt that it had created over the years was to expand the money supply. It did this using all those “loan-facilities” we have heard so much about, and which were exposed by the most recent Fed audit by the GAO. Since banks would not lend to each other, the Fed decided that it had to pick up the slack, and it did just that, pumping in trillions and trillions of dollars worth of credit into the financial markets in order to keep the system from falling apart.
Most of this money came in the form of loans meant to meet short-term liabilities, but clearly a great deal of the money the Fed has created has simply been used to monetize outstanding debt (Treasuries, GSE paper and certain financial derivatives like the credit default swaps issued by AIG). The monetization is evidenced by the extraordinary rise in the adjusted monetary base since 2008, which is widely regarded as “money.” (in a fiat money world, money is not easily definable, so there are various definitions for money including the widely cited M1). In turn, because banks were afraid to lend money out during the crisis, and because the Federal Reserve incentivized banks to keep an excess amount of money on reserve by paying interest on overnight balances at the Fed, much of this newly created money began to accumulate as excess reserves on the balance sheets of the nation’s largest banks as can be seen here. And of course, with interest from the Fed being the equivalent of risk-free money, excess reserves held at the Fed can only grow the money supply over time, creating inflationary pressures that will eventually have to be released (the mechanism by which such a release could theoretically occur is something that we can speak about another time, but I have my doubts about how effective it will be).
[*Note: I find it interesting and noteworthy that, for the first time to my knowledge at least, the nominal supply of base money in the economy is greater than M1, which actually includes demand deposits. This may very well be the result of the perverse incentives now operating in the marketplace that reward banks for not lending money out, thus preventing base money from turning, through the multiplier effect of fractional reserve lending, into demand deposits. Hence the term "Zombie Banks"]
So, taking into account the fact that we may be headed back into recession (by official standards at least), banks may still be unwilling to lend out the reserves they have on hand, and the Fed unwilling to promote such action, for fear that further write downs on overvalued assets and non-performing loans will force banks to draw down their reserves anyway. The larger-than-required reserves being held by the banking system, therefore, may be all too justified given the continued uncertainty about the health of global balance sheets. However, even if banks were willing to lend the money out, there is good reason that the Fed should be extremely skeptical about allowing for such a prospect, and the reason why is because it could cause run-away inflation or even hyperinflation.
I have talked before, both on this blog, as well as in interviews, about how the money multiplier is broken in the banking system. The money multiplier is just another name for the fractional reverse lending process by which base money is converted into demand deposits. It is the process by which a bank takes X amount of money, and pyramids on top of it fresh loans that show up as deposits in other banks within the system. Here, the bank is functioning with the expectation that, at no given moment in time will the demand for bank capital (basically, depositors withdrawing their money from the bank) outstrip the amount of money that the bank has on reserve. In this sense, any bank engaged in fractional reserve banking is inherently and theoretically bankrupt, but in practice it usually does not have to acknowledge this fact since the amount of money it keeps on reserve is enough to cover its expected short-term obligations. In the even that depositors’ demand for their money exceeds the amount of capital that a bank has on hand, the bank goes from being theoretically bankrupt, to functionally bankrupt. When this occurs, it is usually referred to as a “run on the bank,” but unlike banks in the 1930′s which instructed tellers to slowly count the cash leaving depositors hands from the front as money was being rushed in through the back, today’s banks have been able to rely on a much more powerful, and institutionally rested Federal Reserve System to keep them from sinking into the bankruptcy abyss.
Once you understand how money is pyramided in a fractional reserve system, then you can understand how even a modest increase in base money (or actual money lets say) can quickly expand by at least 10 times that amount through the multiplier effect. Therefore, not only would Bernanke and the Fed have to worry about the inflationary effects of adding an extra 2 trillion or so dollars into circulation by emptying out excess bank reserves (prior to the onset of the financial crisis, excess reserves were roughly $1.5 billion, whereas now they are right around $1.7 trillion!) they would also need to be concerned about the multiplier effect that this money would have on demand deposits in the economy. In essence, the alarming amount of money now sitting in reserve at the nation’s largest banks has the potential, if lent out, to create runaway or hyperinflation. If this were to occur, arresting the process would prove extraordinarily difficult for the Fed, as it would have to raise interest rates dramatically by selling assets from its portfolio in exchange for trillions of dollars in federal reserve notes that it created in the past 3 years. Such an action would collapse the US economy, and this is why I said earlier that I do not believe the Fed will be able to stop inflation if it gets started this time around in the way that the Volker Fed did during the 1980′s. In any case, the rate of interest on deposits would have to go much higher than the 20% reached by Paul Volcker during his inflation fighting, because the potential for the problem today is much greater, so it’s really a practical impossibility. Let’s not even pretend like the Fed could stop the inflation, because it can’t. Sorry.
So, if the Fed can’t afford to allow banks to lend the money that they have accumulated on reserve, then how exactly is “credit supposed to start flowing again?” It isn’t, and that’s the point. The banks, having recklessly inflated the largest credit bubble in history, have now decided that the option that best benefits them is to allow the economy to slowly roast under decades of zero or negative growth as the economy dips in and out of recession and deflation as far as the eye can see. As long as the banks can remain afloat, they will continue to generate risk-free revenue through Fed subsidies of various sorts (the interest paid on reserves is just one form that these subsidies take) as the economy is allowed to collapse all around them. So long as social unrest does not become unmanageable, the cumulative effect of such a policy over time is to grossly accumulate a disproportionate amount of the world’s wealth on the balance sheet of financial institutions with a lifeline to the central banks. Bank executives become the new global landlords, and we rapidly move from what was once a relatively free-market capitalist economy into a neofeudal state where banks and multi-national corporations own the bulk of the world’s assets and charge onerous rents, payment for which is made by issuance of more loans by the largest banks, for the most basic type of accommodations. It will be subsistence farming on a global, technocratic scale, and this is again, why you hear me say that I will alway choose a system reset over what we have today, because the only thing that the current system is leading us towards is global serfdom.