The economy seems to be recovering. Housing appears to have found a bottom. Unemployment is gradually improving. And America seems impervious to the trials and tribulations dogging the rest of the world. The Federal Reserve, with its policy of extremely easy money, would seem to have administered exactly the right tonic at the right time. Or has it?
A closer look at the reality of our economy tells a slightly different story. While the economy as a whole has improved, 2 percent GDP growth is well below what is needed to right the ship. More importantly, certain sectors have not been as resilient.
The automobile industry is still trying to get its groove back. Manufacturing, while improved from the lows of 2009, is well below its pre-crisis levels. Retail of all kinds continues to suffer as more and more Americans leave the workforce. And the one sector that is having one of its best years, finance, is seeing shrinking hours, lower pay, less benefits and more part-time workers.
Everyone is worried about their future. Even government employees can’t be sure they’ll have a job tomorrow. So what’s happened to all the money the Federal Reserve printed?
Quantitative easing is a fancy way of saying “putting money into the banking system.” To understand why it is not working, you have to understand what QE is supposed to do. The Federal Reserve Bank was created by Congress and charged with maintaining price stability and full employment via a number of available tools. The tool most often used is the Fed Funds rate, the rate banks charge each other to lend overnight to offset any deficit they may have in capital.
Here’s how it works: Bank A lends out too much money or has a few-too-many withdrawals on a given day. When it calculates its reserves, it realizes it’s a little short. Bank A can then go borrow money from Bank B, who had excess reserves to meet the shortfall. The rate at which loan is made is the Fed Funds rate.
As this terribly over-simplified example makes clear, if borrowing rates are very low, as they are now, banks should be borrowing lots from each other and using it to make loans. Unfortunately, that’s not the case. Remember, Bank B needs excess reserves to lend for the rate to matter. The crisis of 2008 was all about the banks not having enough to lend anyone. That’s why they had to be bailed out.
Lower rates also have an effect on consumers, who are encouraged to borrow money by the Fed’s effectively zero-interest rates. Again, things aren’t working out quite the way Chairman Ben S. Bernanke had hoped. A large number of consumers are either unqualified to borrow or have no desire to take on any more debt. The result is that the conditions necessary for an economy to run under its own steam are not present.
The U.S. Treasury issues bonds to pay the nation’s bills. Currently, the Treasury sells about $80 billion a month to fund our never-ending feeding frenzy. The mortgage companies, Fannie Mae and Freddie Mac, also sell bonds to raise money to buy mortgages from the banks that originate them. These are the bonds the Fed buys.
The Fed does not, however, buy them directly from the Treasury or the agencies themselves. Instead, the Fed buys them from the big banks. How? The banks buy the bonds, and then the banks sell the bonds to the Fed. What if the banks don’t have the money to buy the bonds? They can borrow it from the Fed at negative real rates, or from each other for that matter. And where does the Fed get its money? It prints it or, more accurately, presses a button and credits the banks’ reserve account at the Federal Reserve itself.
Some $2 trillion in bank reserves have been created in this manner and the Fed is buying $85 billion in bonds every month. With so much money in the system, you’d think our economy would be on fire. The problem is that it’s not in the system; it’s on deposit at the Fed earning 0.25 percent. Why hasn’t the Fed taken more aggressive action to force the banks to lend the money into the economy?
There are two answers, one worse than the other. The least bad is that the Fed’s own assessment of bank capital ratios and the nation’s current economic outlook warrants high levels of reserve capital.
However, the real reason for the program of never-ending quantitative easing is to fund our nation’s deficit without overtly monetizing the country’s debt. Ensuring that the Treasury can pay its bills extends the countdown in the hopes that Washington will come up with a solution to the country’s ills.
The shell game being played with our monetary system is going to end badly. The longer Congress and the central bank fail to address the underlying problems of excess capacity and too much spending, the worse the reckoning is going to be. •
David F. Brochu is the president and CEO of Kleossum Advisers.
