I recently came across a post on the “Dr. Econ” web page of the San Francisco Fed that discussed one of the most intriguing changes in the US since the Great Recession started. The phenomenon in question is a change that was brought on by the Financial Services Regulatory Relief Act of 2006.
That law authorized the US Federal Reserve, for the first time in its history, to pay interest on “Excess Reserves” (the “optional” reserves banks keep at the Fed over and above what they must keep as a “safety cushion” against certain types of balances they hold).
The logic behind this change was that by paying interest on excess reserves the Fed could better allow it to control the floor of the Federal Funds rate. As the Fed explained in a FAQ from 2008:
Without authority to pay interest on reserves, from time to time the Desk has been unable to prevent the federal funds rate from falling to very low levels. With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk’s ability to keep the federal funds rate around the target for the federal funds rate. (http://www.newyorkfed.org/markets/ior_faq.html)
The other main driver for the change was that by paying, and adjusting, the interest on excess reserves the Fed could control the rate at which those funds would re-enter the economy post-recession, thereby avoiding inflationary pressures cause by a sudden increase in the general money supply.
Well, an interesting thing has happened since that law went into effect, as illustrated below:
As the chart nicely shows, required reserves have grown modestly, but excess reserves have skyrocketed (and here that clichéd term is justified) to over $2 trillion as of July 10, 2013 (http://www.federalreserve.gov/releases/h3/current/). What that means is that an amount equal to about 115% of what the Fed admits it lent to the banks during the crisis ($1.7 trillion) has gone not into an ailing economy but right back into the Fed’s own vaults, for which privilege the Fed is paying interest to its depositors.
Now, even an Econ 101 student would ask a basic question right about now: if the US economy needed a $1.7 trillion liquidity injection because of bad bank investments back in 2008, and the Fed gave the banks the $1.7 trillion to save the US from going broke, how did US banks, businesses and consumers (the source of the bank funds, of course) manage to put an excess $2 trillion into their own accounts five years later? Either the US economy (and the banks’ balance sheets) were not that bad back in 2008, in which case all the Fed money should have been repaid (which has not happened), or the US economy has roared back (also has not happened), or the Fed bailout had to have been much more than $1.7 trillion.
To answer that question we can turn to a recent study by two researchers at the Levy Institute (part of Bard College) who estimate that the real bailout amount was much, much higher. As their research director, L. Randall Wray of the Univ. of Missouri notes:
I have argued that if we want to get a measure of the size of the Fed’s bail-out, we ought to add up the lending and asset purchases undertaken over the past three years through its alphabet soup of special emergency facilities. This is what my students Nicola Matthews and James Felkerson have done, and you can read the first working paper reporting those results over at http://www.levy.org. The total is $29 trillion, much bigger than estimates by Bloomberg, but actually in line with the GAO’s estimate of $16 trillion that excluded the “liquidity swaps” with foreign central banks. As that was about $10 trillion, our number is in the same ball-park.
So, whether it’s $30 trillion or $16 trillion, the fact is that the real cost of saving Wall Street was much higher than the Fed has ever admitted and, if Matthews and Felkerson are right, close to 2X US GDP. Put aside for one second the fact that with unemployment in the US still close to 8%, that money is sitting idle and not being put to job-creating, capitalist purpose, that $2 trillion (and growing) sitting in the Fed’s vaults has to come out some time and in some way. Sure, the Fed thinks it can manage a controlled exit of those funds by engineering a slow decrease of the excess Fed Funds rate, but whether it comes out slowly or quickly, the effect will still be the same: $2 trillion will enter the broad money supply and then perhaps inflationary impact that so many predicted, but has yet to fully materialize, will finally be at hand.
Stay tuned for more on this topic, of course. After all, $2 trillion is still real money, even in the US in 2013.
The $29 trillion number:
The excess reserves interest policy: http://www.newyorkfed.org/research/staff_reports/sr380.pdf