The Other $800 Billion Giveaway

With the release of the latest Federal Reserve balance sheet on Dec. 29, we learn that the member banks have multiplied reserves to $815 billion, a 50-fold increase compared to this time last year. So how did they come by these reserves in these harsh economic times? After all, it’s reasonable that banks would try to sure up their holdings in a time of uncertainty.

I guess I should be grateful that the money has not started circulating and feeding the inflation monster. But with Ben Bernanke’s decision this year to pay the near risk-free yield on these reserves, these banks could theoretically walk away with over $800 billion in free money. If you pay the near risk-free interest rate in perpetuity, which is roughly the rate on three-month T-bills, the present value of those payments is equal to the original principal.

Banks would argue they are forced to pay a hidden tax by having to hold at least 10 percent of their deposits in at Fed regional banks. Yet it was the Fed that literally gave away these reserves at no cost to the banks in order to prop up the economy. The eternally wise chairman is only paying on these reserves as a backhanded way to keep them out of circulation.

At least with the $700 billion TARP plan, there are some strings attached so that there is a sliver of hope the money will be paid back. No, this here is a straight giveaway. It’s a proper assumption that the Fed is going to want banks keep the reserves sitting tight, so it will have to continue paying interest for as long as the eye can see.

If this doesn’t quite do it, the Fed could begin issuing bonds in exchange for the cancerous assets on banker’s books. Michael Rozeff says we could have more to fear from a bond-issuing Fed.

Now we must consider another feature of this scenario, which, unlike the one discussed above, is inflationary. Suppose that the Fed issues bonds and manages to sterilize bank reserves. It then decides that it has more room to expand its balance sheet even further! It goes through another round of vastly increasing bank reserves while buying up troubled securities. The currency depreciation possibility mounts up still further! The Fed then requires another round of bond issuance. And if the Fed, for political reasons, buys up mortgages from Fannie and Freddie and overpays for them as it expands its balance sheet, then this causes a direct depreciation of the currency (the dollar).

The Fed then, while still a central bank, becomes also a troubled-loan mutual fund. It becomes a kind of junk bond fund. The value of the currency and of the bonds it issues will move up and down with the value of the loans that it holds. Since the bonds have priority as to interest payments, the currency becomes a junior and levered paper that has much greater risk than at present. The country’s currency becomes even more unstable than at present.

The chairman is in it deep now. Expect him to take riskier and riskier gambles. And why shouldn’t he? It’s not his money on the line.