Jonas Salk once said that if all the earth's insects disappeared, all life on the planet would go extinct within 50 years.
I've always thought this is a perfect example of seemingly contained imbalances affecting the masses. You may not eat insects, but your food does, or your food's food does, or your food's food's food does.
In this sense, banks are the insects of our economy. If you don't borrow from a bank directly, your customers do, or your customers' customers do, or your suppliers do, or your customers' suppliers do. That deep interconnectedness can make even small imbalances in the banking sector spread to everyone else.
And to say banks are out of balance right now is the understatement of the year:
Source: Federal Reserve, author's calculations.
This is the anatomy of a failed financial system.
In a shift that began about a year go, banks are now lending more money to the government than they are to corporations, to the tune of roughly $400 billion. Just two years ago, it was exactly the opposite: Banks were lending $400 billion more to corporations than to Uncle Sam. That's an $800 billion shift in 24 months -- roughly the same amount, and during the same length of time, as our bedeviled stimulus package.
Why is this happening?
Many reasons, not the least of which is businesses' reluctance to borrow. But the Federal Reserve is playing a major role in pushing this shift.
For the past three years, the Fed has done everything in its power to lower the interest rate on government debt by buying the stuff up by the trillions. It doesn't do this in secret, but by explicitly stating its intent to buy a specific amount of bonds over a set period of time. Able to smell blood better than sharks, large investors -- including and especially banks -- can preemptively buy bonds before the Fed and enjoy the ride once the buying begins.
Bill Gross of PIMCO described this strategy early last year:
PIMCO's view is simple: shake hands with the government; make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond. Anticipate, then buy what they buy, only do it first.
The beauty in this is that we don't even need to anticipate anymore. A recent Fed press release explains:
On or around the eighth business day of each month, the [Fed] will publish a tentative schedule of purchase operations expected to take place through the middle of the following month, as well as the anticipated total amount of purchases to be conducted over that period.
When the Fed was buying $1 trillion worth of agency securities (Fannie and Freddie paper) last summer, bank analyst Meredith Whitney explained how banks like Citigroup
A lot of the banks got sort of back-door financing from the federal government by this massive agency trade, where they increased their holdings of government-backed securities ... and made billions of dollars off of writing those securities up [after the Fed drove up prices].
Can't blame them. But the irony is that this is exactly contrary of the Fed's intended goals. The idea of the Fed buying bonds is that banks will be chased out of low-yielding government debt and into riskier assets like corporate loans. Yet as the Fed continues to announce its intent to blindly buy bonds into the future, the opposite has happened. Banks' incentive today is not to make loans to business. It's to play a far more profitable game of arbitrage with the government. That's where the incentives are.
This hasn't been a problem for large corporations like Johnson & Johnson
But for the country's masses, the incentive for banks to play chicken with the Fed has rendered loose monetary policy not only ineffective, but counterproductive. The return on savings accounts has been whittled down to nearly nothing; pension liabilities have gone through the roof as discount rates plunge. An expansion of private bank credit, however, has been nonexistent.
To return to the Salk analogy, what has the Fed's monetary policy really done for the economy? Surely it's created many, many more insects. But rather than those insects working up from the bottom of the food chain and nourishing everyone else along the way, they've primarily fed bank shareholders -- who, you should know by now, are at the top of the food chain and refuse to share their meals.
Hard to call that anything other than a failed financial system.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.