Two More Years Of Backdoor Bank Bailouts

Source: Decline of the Empire

The Federal Reserve’s zero-interest rate policy (ZIRP) has been a resounding success. The economy is booming! Well, OK, it’s not booming. Actually, the economy doesn’t seem to be doing very well. In fact, the economy sucks. We appear to be on the verge of another recession. Nevertheless, the activist Fed must appear to be doing something. Yesterday the Fed governors voted (7-3) to hold short-term interest rates at their current very low levels for at least another two years, which takes us well into 2013.

Issuing a grim new assessment of the American economy, a divided Federal Reserve said it now expects to hold short-term interest rates near zero for at least two more years.

The central bank’s surprise announcement on rates helped fuel a dramatic turnaround in the stock market, as some investors took comfort in the prospect of more help from the Fed.

“Yes, it’s a dismal outlook,” said Diane Swonk, chief economist at Mesirow Financial in Chicago. But in a market teeming with fatigue and confusion, she said, investors apparently read the Fed statement as somewhat hopeful. “It’s still growth, it didn’t say double-dip [recession] and the Fed is going to fight it,” Swonk said.

Analysts said the battered market had been primed for a rebound and that investors may turn less enthusiastic as the Fed’s message on the struggling economy sinks in. But the Fed’s shift on rates could affect spending and investing decisions.

In theory, if businesses and investors believe that short-term rates won’t rise for at least two years, they would have more incentive to do something potentially more productive with their money than keep it in bank accounts earning next to nothing. That could include investing in longer-term Treasury, corporate and municipal bonds.

Yes, in theory something productive could be done with money borrowed at virtually no interest, but we should not be concerned about theory. We are more interested in what actually happens in the Real World.

You may recall the big debt graph I used in yesterday’s post How F**ked Are We? Pretty Darned… I have included a smaller version for your convenience (left, click to enlarge). The right column shows who holds government debt, and the top of that column shows that “The Public” owns $3.6 trillion worth of Treasury securities. “The Public” includes debt held by individuals, corporations, banks and insurance companies.

We are interested in debt held by commercial banks. Fred Hoenig, the president of the reserve bank of Kansas City, is more concerned with practical outcomes than what might happen in theory. Consider Bloomberg’s Hoenig Says Fed’s Low Interest-Rate Policy Subsidizes Wall Street Banks (July 26, 2011)—

The U.S. central bank’s policy of holding interest rates near zero is a subsidy for large banks and redistributes wealth from savers to debtors, said Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.

Banks can borrow at 0.25 percent and buy Treasury bonds that yield 3 percent, keeping the difference. “It provides them a means to generate earnings and restore capital, but it also reflects a subsidy to their operations,” he said to the House Subcommittee on Domestic Monetary Policy and Technology today in Washington.

[My note: Yesterday's 10-year yield on Treasuries was 2.2%. The 2-year was 0.19%.]

“It is not the Federal Reserve’s job to pave the yield curve with guaranteed returns for any sector of the economy, and we should not be guaranteeing a return for Wall Street or any special interest group,” he said.

The circled area shows the “extended period” of the Fed’s near-zero short-term interest rates. Source: FRED

You can see that about 46% of the federal debt held by “The Public” is in fact held by commercial banks like Citigroup, Bank of America, J.P. Morgan Chase, Goldman Sachs, Wells Fargo, and so on. As Hoenig says, these banks have access to nearly free money, and can profit on the spread between the miniscule interest rate they pay and various treasury yields. This arbitrage is referred to colloquially as a backdoor bailout for the Big Banks.

But this is just one half of the equation. Back in June, 2010, the Business Insider noted that Banks Are Lending Money Like Crazy To Single Borrower. Who is that borrower?

That would be Uncle Sam.

The latest [FRED] data, which just came out yesterday, confirms that while bank lending remains subdued, purchases of government securities continue to soar.

Why the thirst for government securities? Well, government has a big thirst for money, and in this environment, it’s nice to put money with an entity that you’re sure can pay you back.

Seriously, why would you bother lending to an actual job-creating small business?

Why indeed? And then there is this delicious irony: it’s nice to put money with an entity that you’re sure can pay you back. That was said in 2010, long before Standard & Poors downgraded the United States to AA+ with a negative outlook after the debt ceiling debacle. You gotta love it!

You might well ask yourself what any of this had to do with the so-called Real Economy where you and I reside. There is an indirect connection through the banks, who lend the government money. That borrowed money can be used to fund transfer payments (Medicare, unemployment compensation, food stamps, etc.) or other useful activities. It might also go to financing the war in Afghanistan. Some of it goes to pay salaries and benefits to Congressmen. You’ve got to take the bad with the good

Thus the Federal Reserve bankrolls the banks, who bankroll the government, and make a tidy profit on the side. None of this has anything to do with productive investment in the Real Economy which might create wealth, jobs, and so on. So the next time you hear that the Fed is keeping short-term interest rates low to help the economy, you might ask yourself which economy they are helping.

All this explains why I like reality better than fiction, which also explains why I’m not a novelist. The saying goes reality is stranger than fiction because you can’t make this stuff up.

Read more at Decline of the Empire