Bloom of Doom VII: The Borrower of last Resort
Not so very long ago the idea had firmly taken root that the Fed was the “lender of the last resort”, meaning that if no one else would lend to banks, the Fed would, thus preventing bank runs. Now it always struck CrisisMaven as odd that banks under any circumstance should be so little creditworthy that they couldn’t get credit. After all, aren’t banks the “eponym” of creditworthy, so to speak? But that the Fed one day would need to borrow from these banks no one else would lend to is an irony of fate we need to chew on a little to fathom all its dire implications.
(Statistical resources in our References section!)
Former chairman Greenspan now has gotten the idea that the crisis was precipitated by too little regulation. Again this strikes CrisisMaven as a bit odd. Where on earth do you know of a profession that cannot get its act together unless closely supervised? During training and apprenticeship, yes, but in daily operations? Something’s amiss here. But if one Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco can maintain a straight face when arguing that the Fed’s economic forecasting abilities are “second to none” then probably tight regulation of the whole profession is expedient – maybe in some closed institution. There are board games where you can play with paper money as your whim takes you, including prison, boom and bust without the populace at large suffering.
There are various camps discussing hotly if we’ll get inflation, deflation, stagflation or one of these first, the other later and so on. CrisisMaven is in none of these camps. He can see the rationale of the deflationists arguing that credit will contract at a far faster pace than the Fed can inflate, he sees the inflationists’ position that the money supply has risen so tremendously that Zimbabwe style hyper-inflation is in the offing. All he has argued so far is that debt default per se does not cause deflation, as the credit that is not repaid is still circulating rather than being retired as in orderly repayments plus, if recapitalised e.g. by the Fed, the credit sum is effectively even doubled. CrisisMaven has not committed himself on the final outcome, however, he has argued, that the money supply surely has risen to epic and unprecedented proportions (no one in any camp denies that, not even the Fed, whose own figures we actually show).
However, most of that money is held in so-called excess reserves with the Fed, again a phenomenon that is unprecedented in history:
As you can see from the chart, banks never used to keep excess reserves but seek to lend whatever they can to generate interest income from lending. Inflationists argue they will, some argue, they must lend again eventually as the banks need to pay (far higher) interest on deposits and if they don’t earn more interest than they pay on deposits they will incur losses which is not sustainable for long.
The Fed and the stimulus politicians are of two minds here. On one hand they bemoan the “credit squeeze” which they blame for the slow (if any) economic recovery, on the other hand they fret that these reserves could be lent and, at 10% reserve requirements actually could trigger a nine-fold increase in credit volume and spending. No one in any camp would deny that if that happened considerable (some say: hyper-) inflation would soon follow.
So, second to none, the Fed’s Yellen and the other designers and schemers at the central bank have come up with a brilliant idea: why, banks only lend to other banks and the private sector to generate revenue from interest received. Right, we remember, wasn’t that chase after ever higher returns what led to the bubble and the financial crisis in the first place?
Now we have the Fed’s work cut out for us: the mistake was it’s role as lender of last resort – instead it should have been borrower of the last resort! Of course, how could we have been so blind for almost a hundred years! These excess reserves need to earn interest and, bingo, no need for the banks to turn to insecure borrowers that could default, just pay interest directly to the banks on the deposits they hold with the Fed!
On second thoughts though, why on earth do we then need the banks at all? If the banks need interest paid on their reserves in order to pay their employees and esp. pay interest to their depositors, then in actual fact the Fed pays Americans’ interest on their deposits … and pays (part) of the banks’ profits to boot – why not does the Fed directly pay everyone interest on their deposits and does away with private banks altogether?
Or why do banks still accept deposits with which they then have to share the hard-earned Fed interest on their Fed reserves?
But weren’t those reserves originally generated through bail-outs, stimulus and quantative easing to make up for defaults and shortfalls caused by these banks’ “normal” operations? So that they could resume those operations?
Maybe no one has yet thought the whole operation through because there’s more than first meets the eye:
This stands the Fed’s role on its head! From lender of last resort to borrower of last resort! Installing a money creation merry-go-round all for its own sake! Unbelievable! I’m sure when Bernanke would have had this in an exam from a student before he became chairman he would have let that student fail. But these are extraordinary times calling for extraordinary measures or are they?
Why the Fed can’t tie up excess reserves without creating even more (money) inflation
So, the theory (if we may call it that, coming from Yellen) is that those excess reserves, currently “parked” at the Federal Reserve can only cause inflation if they began (nine-fold at least) to circulate in the economy chasing goods and bidding up prices. Banks would be tempted if not forced to finally lend those holdings out in order to earn enough interest to pay their bills and pay their own creditors (the depositors).
So all the Fed has to do is make up for the shortfall by paying interest to those banks from its own coffers. Yellen be forgiven if she misses a finer point that we will not unduly trifle with, after all, she and her team are second to none: when you lend someone money you expect to eventually get it back. Some credit runs for thirty years like in real estate, normally not much longer, most credit far shorter; Fed reserves really even are call money. Anyway, after a credit matures it has to be paid back. Just think it through: the Fed borrows from its depositor banks and eventually pays them back … and then? Just think it through, maybe CrisisMaven has missed the rationale …
With this finer point out of the way let’s look at the practical implications:
Let’s say the excess reserves at the Fed stand at two trillion (US, yes, US, dollars). Interest is, say, 2% per year. So at the end of the year (if not daily, given the nature of central bank reserves) the Fed pays out this interest, what happens? With every interest payment inflation, understood as expansion of money supply, goes up, diluting the value of the very interest “payments” the Fed feigns to make, increasing demand for a (inflation) premium which further dilutes the money supply which in turn raises the premium and so forth. This “excess reserves at interest” policy is itself necessarily inflationary and certainly no way to get rid of, not even realistically contain, excess money supply. If anything, like with carry trades, where money is borrowed cheaply in one place and invested at high rates in another, this excess reserve tie-down policy is part of the greater problem, not a solution.
So at best the Fed can try to keep the genie in the bottle by continuously widening the bottle but it can’t shrink it back to its former size (a size which was inflationary already or we wouldn’t have had a dotcom followed by a real estate bubble – that money is still “out there somewhere”). From a cybernetician’s standpoint this looks terribly like another extra fountainhead of pent-up inflation.