Reader Requests: Is the Fed Really That Stupid?

In response to my op-ed on the Federal Reserve, a reader says: You claim that banks are not lending due to non-creditworthiness of potential customers. I say they don’t lend because they really don’t have to anymore because the Fed pays them interest on their reserves. That translates to unprecedented interest spreads on the loans that they do fund, as well as unreasonably low interest rates paid to depositors, many of whom are retired and rely upon bank interest for much of their income. In addition, these super-size banks are holding onto bad mortgages and not refinancing them as they are supposed to do. They would rather foreclose or wait until the market gets better so they can make more money on them. Also, what about TARP, which was supposed to get these bad properties off the banks’ books in order to strengthen their capital financial strength? The banks kept the bad assets, and the Treasury gave them money to boot.

The Fed pays 0.25% interest on reserves. In a healthy economy, banks should have no trouble finding borrowers who will generate a higher return than 0.25%. As you said, borrowing at 0.25% from the Fed “translates to unprecedented interest spreads on the loans that they do fund.” That’s an incentive to make more loans, not fewer. The problem is finding creditworthy borrowers. Remember, banks don’t need to lend the excess reserves from the Fed if they find creditworthy borrowers. They can find cash elsewhere. Interest on excess reserves isn’t holding them back.

I completely agree with your second point, re bad mortgages, refinancing, and TARP. However, most of these problems don’t fall under the Fed’s purview. TARP was a terrible deal for taxpayers, but it was administered by the Treasury, not the Fed. It also falls outside the purview of my op-ed, which was supposed to address actions taken during the recovery, not the recession.  

Another reader asks: You state that banks will eventually lend the $1.6 trillion. Then you state that the Fed pays interest on reserves. Why would they loan the money where there is risk?

Bernanke will only raise interest rates on reserves if inflation starts to rise above the Fed’s target rate. He’s hoping that banks will lend that $1.6 trillion in measured doses, boosting the recovery without generating inflation much higher than 2%. Also, that $1.6 trillion is serving as a buffer, in case asset prices decline again and banks need access to quick cash that they can’t find elsewhere. Finally, by lending so much excess to the banks, the Fed is hoping that they can signal to the market that they are committed to preventing deflation, thus assuaging our fears and prompting us to spend and invest again. Whether any of this is really helping the recovery is hard to say, but it’s certainly not hurting.

A third reader counters: I think you are ignoring the fact that the excess reserves didn’t start growing exponentially until the Fed started paying interest on these reserves. In no other recession did excess reserves grow so much. Banks are always finding ways to invest the money, and keeping it at the Fed is a very safe way.

Very safe, indeed. So safe that banks are willing to earn a pathetic 0.25% instead of lending those reserves to borrowers who can pay a decent rate. Such a “flight to safety” only occurs when banks don’t trust most borrowers. Hence, the problem really is borrower creditworthiness.

Your history lesson is incorrect. Excess reserves started growing exponentially in September 2008, when they jumped from $1.8 billion to $59.4 billion in one month! The Fed didn’t start paying interest on reserves until October 6, 2008. (The actual trigger for excess reserve growth isn’t hard to find: Lehman Brothers filed for bankruptcy on September 15, 2008.)