The Next Bank Bailout, And Why It's (Sort of) Different This Time

There are some words and phrases you should never say when talking about the economy. "Certain," "impossible," and "always," come to mind. The most famous of the unutterables is "This time is different."

But for those wondering why five years of unprecedented money printing hasn't led to runaway inflation, I'd offer that it kind of is different this time. The laws that guide the effects of central bank intervention changed in 2008. It's possible that the new laws will prevent massive money printing from turning into massive inflation. What they will very likely do is set up the next big bank bailout.

Why hasn't several trillion dollars of money printing led to runaway inflation? To conduct quantitative easing, the Fed buys Treasuries and mortgage-backed securities from banks, exchanging newly printed cash for bonds. But rather than lending that new cash out to businesses and consumers, banks have kept it parked at the Fed in the form of excess reserves. The Fed prints money and gives it to banks, and banks effectively hand it right back to the Fed. That's an oversimplification, but it explains why inflation has been tame.

The fear is that banks will increase lending once the economy picks up. That means reserves held at the Fed will fall, and the mountains of cash printed in recent years will flow into the economy, sparking high inflation.

But cognizant of this risk, the Fed lobbied Congress five years ago to let it pay interest on bank reserves. It worked, and in October, 2008, the Fed announced that, for the first time, it will pay banks a set interest rate on reserves they hold at the Fed.

This is hugely important, because it lets the Fed stem a possible drawdown of bank reserves that would push mountains of cash into the economy, igniting inflation. Say a bank has an opportunity to make a loan to a business at an interest rate of 4%. If the bank can alternatively earn a 4% yield keeping cash parked at the Fed, which option do you think it's going to take? At an equal interest rate, any sober banker would choose to keep money at the Fed rather than lend to a business or consumer, since the Fed has no default risk. So, if worried about high inflation, the Fed can raise the interest rate it pays on reserves, shooing banks away from the prospect of flooding the economy with new cash. That hasn't been the case in the past. It really is different this time.

That's the theory, anyway. In practice it will be much messier, if only because paying a high interest rate on reserves will serve as one of the biggest bailouts in banking history. Wells Fargo (NYSE: WFC  ) and JPMorgan Chase (NYSE: JPM  ) alone have more than $185 billion parked in reserves at the Fed. Banks currently earn 0.25% on reserves, and industrywide excess reserves (the amount above what is required by law) total $1.5 trillion, generating close to $4 billion a year in risk-free profits. If interest rates return to normal levels, that figure will balloon into a bonanza. James Bullard, president of the St. Louis Fed, told the Financial Times this week (emphasis mine): "If you're going to talk about paying them something of the order of $50 billion -- well that's more than the entire profits of the largest banks."

Will the public put up with that? Will Congress? I don't know, nor does anyone else. Paying interest on reserves is discrete and doesn't require a press release, so the bonanza might go largely unnoticed. And banks have never had a hard time extracting what they want from Washington. But the general consensus is that the public has exactly zero tolerance for more bank bailouts. If the protests are loud enough, the Fed could very well be persuaded to scale back the amount it pays banks for doing nothing. If that's the case, the inflation-fighting potential of paying interest on reserves could be less than is currently envisioned.

Maybe the wisdom is correct -- it's never different this time.

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  • Report this Comment On February 19, 2013, at 8:03 PM, sciencedave wrote:

    "Will the public put up with that?"

    They may never know.... Really, does the public even know what's going on right now? Hardly. Yours is the only article I have read in the last year talking about this potential problem. Lets keep this quiet says the government. Quantitative easing should never have been started.

    Should we all invest in banking stocks knowing they will be bailed out again thus profiting from this activity?

  • Report this Comment On February 20, 2013, at 10:05 AM, astuber9 wrote:

    Good article. This is the politics/crony capitalism stuff that should make everyone angry. Can we all agree that big banks need to be broken up?

  • Report this Comment On February 20, 2013, at 11:06 AM, slpmn wrote:

    Good to see someone writing about the topic. That's why I read your stuff, you cover a lot of interesting things I don't see discussed elsewhere. This is the first I've heard that the reason the fed is paying interest is to pull cash out of the system to manage inflation. I'm not entirely convinced that's the root reason they decided to do it, but it makes some sense. The reason I don't think it was the original intention is that in October 2008, in the middle of a catestrophic liquidity crunch, and staring into the gaping maw of impending depression, no central banker would have been worried about inflation. The concern would have been a deflationary spiral.

    Regarding what happens when rates rise, the figure to look at is the spread between the Fed rate (0.25%) and loan rates. When the Fed raises that rate, banks will immediately raise whatever index they use to price loans by a comparable amount. So if the going prime lending rate is, say, 3.75% right now, and the Fed raises its rate 50bp, then banks will raise their lending rate to 4.25%. At least that's how it would normally work. It's highly unlikely you would ever have a situation where the Fed rate would approach the lending rate. There is always a spread that makes lending more attractive than a Fed account.

    That said, I do think it's sort of a bailout that the Fed pays interest. I think they need to stop it and encourage banks to do something better with the money, like buying bonds or making loans.

  • Report this Comment On February 20, 2013, at 11:33 AM, SkepikI wrote:

    Morgan- an excellent dose of arcane fact plus useful logic, with a touch of new implications to consider, at least for me. I've watched this dangerous combination for more than a few months, becoming more concerned with the passage of time because it seemed everyone else was not.....concerned that is. I don't think this is the complete story, but it is enough to explain not only the lack of inflation, but also the pitiful capital investment in a record low cost of capital environment, as well as how its possible to have banks with "tight money" behavior in what would have been a loose money scenario just a few years ago.

    The other cards drawn to this inside straight are low demand from consumers (now reversing? ), fear or reluctance from businesses to borrow while they reinforce balance sheets, and fear of what new expenses the government imposes rather than becoming more frugal and efficient. They all make loans tough to get and borrowers reluctant to work hard to get them. Toss in the easy riskless road to profit, and is it any wonder there are few loans being made.

    That all seems to be in the mix of change right now... more equipment being ordered, more loans closed...I wonder what would happen if the Fed cut the interest rates to banks on reserves? Conventional wisdom is that the Fed has no more room to move to goose the economy, but maybe that is the one way they can...flood gates open for capital? Maybe the midnight express to inflation....

  • Report this Comment On February 20, 2013, at 12:58 PM, whereaminow wrote:

    The inflation has already been created. Inflation is the act of debasing the currency. Price inflation (what happens after you debase a currency) is just now starting to tick up. Home prices are skyrocketing (+23% yoy in Cali for example). Stock prices are at all time highs. Food and gas prices continue to skyrocket.

    And that's without even much leakage from the excess reserves.

    Quick question, where does the money come from to pay the interest on the excess reserves?

    Second question, how big was your raise this year? Because if you didn't get at least 5%, you're losing you'll easily see a decline in your standard of living in 2013.

    David in Liberty

  • Report this Comment On February 20, 2013, at 1:44 PM, TMFCrocoStimpy wrote:

    Perhaps this falls into the easier said than done category, but couldn't the Fed effectively achieve this type of inflation control by simply linking the level of required reserves to inflation? If inflation goes up, so do the required reserves, thus keeping the money from flooding the market. This may have some naive unintended consequences that I'm not thinking of right now, but on the surface it seems like a fairly simple negative feedback control.

    -Xander (TMFCrocoStimpy)

  • Report this Comment On February 20, 2013, at 3:17 PM, slpmn wrote:

    ^ Required reserves are based on the level of deposits at a bank, so as deposits grow, the amount the bank needs to keep at the Fed grows. The issue here, though, is the excess funds banks keep at the Fed, beyond what is required. Ordinarily, banks would not keep anymore at the Fed than they need to, but now that the Fed pays interest, it's an easy place to keep the extra. And, with slack loan demand and people paying down debt and saving money (in the bank), banks are floating in money right now.

    ^^ I believe the Fed pays interest with the cash flow from its massive investment portfolio (i.e. all the bonds it has been buying).

  • Report this Comment On February 20, 2013, at 4:16 PM, TMFCrocoStimpy wrote:

    @slpmn

    I didn't mean in absolute amount, but as the fractional reserve percentage. So, if inflation is low, then the fractional reserve percentage to be held at the Fed is kept relatively small, and if inflation starts to kick in then the fractional reserve percentage rises. This would (theoretically) help regulate the amount of money that banks would have to lend, providing greater lending capability to the banks when inflation is low, and then reducing their capability to lend as inflation increases. Seems like that would mirror the desired action of allowing more cash into the economy during periods of low inflation, but then keeping the pent up cash from flooding the system as inflation starts to rise.

    This would be in lieu of the Fed paying interest, of course.

    -Xander

  • Report this Comment On February 20, 2013, at 4:16 PM, TMFCrocoStimpy wrote:

    "have to lend" == be able to lend

  • Report this Comment On February 20, 2013, at 6:41 PM, mtprx wrote:

    "Imagine what your taxes buy, we hardly ever try. But it's hard to tell the poison from the cure." I've heard this song before.

    Sting

  • Report this Comment On February 20, 2013, at 7:40 PM, ynotc wrote:

    When this kind of thing happens in the private sector (I consider the Fed an arm of the government) they call it money laundering.

    Wouldn't it just be easier to give the banks the money? Ahh. but thent he public wouldn't be fooled.

    When everyone realizes the emperor has no clothes it's gonna get scary.

  • Report this Comment On February 20, 2013, at 8:52 PM, bornboring wrote:

    I've been waiting for this article for months if not years. I suspect Morgan has been holding it back for fear of upsetting too many carts in the system.

    The funny thing thing is that QE is kept on, implying a number of banks and financial houses are still very very weak. They need those "interests" to prop up their tier 1 capital. This is one special QE for the industry only, decided before Obama became president, without using the term QE to set off more alarms.

    Regarding "leakage": some less precarious banks lent them to their best customers at a better rate of return. Anyone notice the hot money inflow towards the Orient in the past year? This helps the export of inflation to the Oriental markets. But this will come back to bite at a later date.

    Linking reserve to inflation has been the practice in China for decades. Over here as a non communist country I think it takes the Congress to agree on that. You can count on its death from the noise of objections.

  • Report this Comment On February 21, 2013, at 10:26 PM, NewAlchemist wrote:

    If inflation is up 2% and you get a 0% salary increase then you lost 2% purchasing power. It is a 2% stealth tax that people usually aren't aware of and don't fully understand.

    Now contrast that with a 2% salary reduction. If everybody got a FED mandated 2% pay cut then there would be riots in the streets.

  • Report this Comment On February 22, 2013, at 11:08 AM, devoish wrote:

    So in a coconutshell (cause this crime doesn't fit in a nutshell).

    2008 - The former and future employees of Goldman Sachs recommended to Congress that they should bail out the investment industry and leave main street hung out to dry because main street should pay for the mistake of borrowing from the investment industry.

    In return the investment industry promised they would continue to create the opportunity for main street to make the mistake of borrowing from the investment industry by lending to main street and thereby restore the main street economy.

    Instead the investment banks have parked the bailout money at the Fed to earn .25% interest because the investment industry knows they have milked main street dry and main street has nothing left but poverty in their future.

    With no other source of increasing income the future and former employees of Goldman Sachs are now advising us to cut back on services to the most vulnerable populations in order to funnel that money to investors.

    It would be smarter to give SSI retirement fund the money and raise the monthly payments retired folk get. They could put it into the economy by not living in poverty as their reward for building all these houses and roads and bridges and ski areas.

    SSI could in turn lend it to the Fed at interest and support SSI long into the future and really have to earn their money by making good loans and investments.

    Simultaneously we should probably stop the investment industry from stealing our money by using hedges to raise the price of consumer goods without adding value.

    Just a thought....

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 12:38 PM, thesalesman87 wrote:

    What happen to all the first time home buyers in today's market? I think all the reports that there is a recovery in the housing market are BS. only large investment companies are buyers not FIRST TIME HOME BUYERS. ;;;;;;;The SALESMAN;;;

  • Report this Comment On February 22, 2013, at 1:29 PM, smartmuffin wrote:

    "With no other source of increasing income the future and former employees of Goldman Sachs are now advising us to cut back on services to the most vulnerable populations in order to funnel that money to investors."

    Exactly what "services to the most vulnerable populatoins" are being cut? Please provide some specifics here.

  • Report this Comment On February 22, 2013, at 2:33 PM, morp79 wrote:

    Sorry guys, I'm not that technical, but let me see if I understand:

    The Fed makes money out of thin air (that I knew), therefore reducing the value of the money in my pocket. Then gives it to banks saying "here, give me back this money I just gave you and I'll pay you interest".

    So,

    -

  • Report this Comment On February 22, 2013, at 2:34 PM, morp79 wrote:

    - the banks are getting paid for NOT lending us money.

    - The banks are getting a large check for eternity, for having money in the Fed, that the Fed just made up?

  • Report this Comment On February 22, 2013, at 2:42 PM, TMFMorgan wrote:

    ^ Yes and yes.

  • Report this Comment On February 22, 2013, at 3:35 PM, dcrednek wrote:

    I think this article really misses the point of how disastrous it is (and will be) for the Fed to pay interest on bank reserves.

    The author argues that the Fed paying interest on reserves is somehow a good thing, because it induces banks to keep cash (i.e. the money supply) out of circulation and thus hold down inflation. Ridiculous.

    Just like real estate and credit, the government is attempting to use "new and progressive policies" to manipulate the basic laws of economics.

    The money supply will continue to increase so long as the federal government continues to run massive budget deficits and accumulate a larger national debt. The Fed will supply the money by becoming (or continuing to be) the largest purchaser of US government debt issues, which will for at least a while longer hold at an artificially low rate the interest rate on debts owed by the US government. What little interest income that flows into the Fed will go right back out the door in the form of interest payments to banks.

    Pretty soon not even the Fed's inept leadership nor Congress will be able to defer the economic reckoning that is headed our way.

  • Report this Comment On February 22, 2013, at 3:41 PM, TMFMorgan wrote:

    ^ Sorry, what's ridiculous about it?

  • Report this Comment On February 22, 2013, at 3:59 PM, GETRICHSLOW2 wrote:

    If the Fed does not want the banks to lend the money and therefore spur the economy then why print it in the first place?

  • Report this Comment On February 22, 2013, at 4:01 PM, sheldonross wrote:

    So how is this not just giving money to the banks.

    I wish I could get a loan from someone at (near enough) 0%, loan the same money back and get paid on it.

    But that doesn't work for the proletariat, only the bourgeoisie.

  • Report this Comment On February 22, 2013, at 4:04 PM, TMFMorgan wrote:

    <<If the Fed does not want the banks to lend the money and therefore spur the economy then why print it in the first place?>>

    Good question, with two answers.

    1) To push down interest rates.

    2) The Fed ostensibly wants banks to be lending more right now. It just doesn't want them lending so much in the future that it floods the economy with too much new cash.

  • Report this Comment On February 22, 2013, at 4:07 PM, ibuildthings wrote:

    Three things the "authorities" can control server as big levers on the economy: Tax rates, Interest rates at which business or consumers borrow, and government spending. Borrowed money must be repaid, so government spending has a cost. Interest rates become inflationary, so they have that risk. Tax rates hurt government inflows if the fall down to the "wrong" side of the Laffer curve, and help inflows if they stay on the "right" side. So they can help or hurt.

    This seems like the Fed is trying to control WHEN banks lend to consumers or business by inflating the money even more, when they pay low-risk interest to banks. It seems like an extra control point, but just like the others, it has its own risks too.

  • Report this Comment On February 22, 2013, at 4:20 PM, ibuildthings wrote:

    Oops, my proofreading bad: A repeat:

    Three things the "authorities" can control serve as control points on the economy: Tax rates, Interest rates at which business or consumers borrow, and government spending.

    Borrowed money must be repaid, so government spending has a deferred cost, but it can goose the economy temporarily. If they are smart, they spend on things that will make the economy run better, like new, shorter roads or bridges that cut transportation time.

    Cutting interest rates gooses the economy, by making it cheaper for business to expand, and cheaper for people to buy their products. Again, there is the repayment risks, but also the inflation risk with too much money chasing limited goods and services.

    Tax rate cuts make the rewards of a successful business more attractive, and they leave more money at the end of the month for consumers. Of course, they hurt government inflows if the fall down to the "wrong" side of the Laffer curve, and help inflows if they stay on the "right" side. So they can help or hurt. And the "sweet spot" on the Laffer Curve varies as the economy changes. And when the economy overheats, Congress can raise rates a little, which slow it down a little, but not so much that it causes a recession. That can also plant some cash in reserves for the days a recession hits, where they can cut the rates to goose the economy alive again.

    This move by the Fed seems like the Fed is trying to control WHEN banks lend to consumers or business, so that when the inflation rises, they can raise their own interest to the banks, so the banks will take the risk-free interest rather than lend to consumer or a business. Then when they want to goose the economy a bit, they cut the rate they pay to a bank, so the bank will take the money out of the Fed account and lend it to us at a better rate.

    But the Fed is inflating the money supply when they raise the rate they pay to the bank, even on paper. So it is still inflationary. At some point, the bank says, "Gimme my cash" and then that money is out there too. It seems like a fourth control point on the economy, but like the others, it carries its own risk.

  • Report this Comment On February 22, 2013, at 5:20 PM, devoish wrote:

    Exactly what "services to the most vulnerable populatoins" are being cut? Please provide some specifics here.

    Older people by cutting SSI or raising the retirement age to "save" it.

    Housing subsidies, for low income employees, State level jobs, teachers earned benefits, Policemens earned benefits, etc..

    Greeks in Greece through austerity cutting lower income workers and savings (same banks - different country)

    Spaniards in Spain (same banks - different country)

  • Report this Comment On February 22, 2013, at 5:26 PM, devoish wrote:

    Social Security, For Example

    Conservatives have been trying to cut or gut Social Security for decades. While this might mean government has to pay out less of what is owed to seniors, such cuts would have a negative effect on the larger economy.

    Medicare, For Example

    Republicans say we need to cut back on what the government spends on Medicare. But if you cut Medicare the health problems of elderly people and the larger problem of fast-rising health care costs in the larger economy don't disappear. In fact, both problems just get worse.

    What Does Government Do?

    Almost everything the government does is because it needs to be done. We need roads, bridges, schools & colleges, dams, courts, police & fire departments, water management, etc.

    Who Benefits From Cuts?

    The plutocrats now demanding government budget cuts obviously understand that this will result in slowing economies, but don't care -- they are already fabulously wealthy. What they want is reduced taxes and increased power. They say that cuts will bring growth, in order to persuade people to accept cuts. Blocking governments from providing things that don't directly benefit them and only them is a means to that end. And cutting government cuts government's ability to reign them in.

    What We, the People Want

    When We, the People are running government we insist that government increases overall prosperity. We demand laws and regulations that bring us good wages, benefits and safe working conditions. We demand good public schools & colleges, parks, safety and opportunities for our smaller businesses to fairly compete. We insist on a clean environment, consumer protections, regulations on business behavior, rules against monopolies and (after learning the hard way) rules that keep banks from taking risks that threaten the economy. And we want controls and limits on the use of wealth and power by the 1%ers.

    - http://www.huffingtonpost.com/dave-johnson/cuts-and-conseque...

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 5:33 PM, devoish wrote:

    Declaring their job is to “serve the public” and not be “puppets of the bank or its servants in the government,” Spanish firefighters joined protesters from Stop Desahucios to halt the eviction of Aurelia Rey, an 85-year-old woman who was one month's behind on her rent. In the wake of nationwide demonstrations against an estimated 350,000 austerity-linked eviction orders by banks - which have been repeatedly bailed out - the firefighters' union says it rejects any action that “contributes to inequalities and miseries suffered by the working class.”

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 5:38 PM, devoish wrote:

    Spain, like Greece, is indebted to the very foreign banksters who crashed their economy. And rather than telling those foreign banksters to take a hike like Iceland did, Spain's austerity-happy government is paying off the banksters by taking money from working people through cutting socials services like health care.

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 5:43 PM, devoish wrote:

    Children and mothers losing WIC nutrition aid: 600,000

    Low-income families losing rental housing vouchers: 125,000

    Formerly homeless people losing housing: 100,000

    Children denied Head Start: 70,000

    Funding cut from Head Start: $406m

    Children denied affordable child care: 30,000

    $ cuts deep enough to end services to these many low-income K-12 children: $1.2m

    Fewer people with disabilities served by Vocational Rehab: 75,700

    Fewer meals on wheels served to seniors: 4m

    Adults and children with serious mental illness losing treatment: 373,000

    Unemployment benefits cut for long-term unemployed: 9.4%

    Jobs lost because of sequestration: over 1m

    Media Matters has also assembled just a few things that will be cut:

    The sequester cuts would mean:

    70,000 children kicked off Head Start and 1.2 million kids seeing their schools lose education funds, which mean fewer teachers, crowded classrooms, and less learning time. What if it’s your child’s school?

    Emergency responders lose their jobs, which means slower response times and weaker disaster preparedness. What if your neighborhood is the next one hit by a weather disaster?

    Layoffs of airport traffic controllers and transportation security workers. Do you want longer lines and more hassles at the airport?

    Layoffs at the Social Security Administration, which mean delays and hassles for seniors enrolling in Medicare or calling about their Social Security benefits. What if it’s your parents?

    Up to 2,100 fewer food inspections. Do you want to worry about the safety of the food you put on your family’s dinner table?

    Fewer FBI agents and law enforcement to protect our families from violent criminals. What if it’s your family?

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 5:44 PM, devoish wrote:

    Smartmuffin,

    Ok.

    Best wishes,

    Steven

  • Report this Comment On February 22, 2013, at 6:14 PM, MikeMark wrote:

    Interesting.

    Banks don't increase lending. People increase borrowing. The only thing banks can do is lower rates and lower barriers to entry.

    Rates are already just about as low as they can get and the government has been mandating higher barriers to entry. That's why borrowing and credit creation are low.

    Credit is created at the banks, not at the Fed. The Fed just provides liquidity. Without credit creation, there is little actual inflation.

    The interesting part is to see how fast the Fed can mop up liquidity that's already in the system once people are willing to borrow. My guess is, not fast enough because by the time they know, it's already too late.

  • Report this Comment On February 22, 2013, at 8:57 PM, ChrisBern wrote:

    What is wrong with this picture:

    a) With its .25% payment on reserves, the Fed is currently handing banks several billion dollars per year.

    b) The Fed is supposed to conduct monetary policy, not fiscal policy.

    Anyone else tired of the handouts, subsidies, and bailouts?

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