Playing Economics: The Lender and the Borrower of Last Resort

If you have ever gone to Versailles and seen Marie Antoinette's "village", you can begin to appreciate what extreme delusions those in power entertain when engaging in "unlimited play" to justify their increasingly maladjusted and distorted view of the real world. So it is with the Fed ... which seems to have recently declared "let the games continue". The next phrase we will hear from them will almost certainly be something akin to "let them eat cake" ... so listen ... it is surely coming

Meanwhile, the financial establishment and its nearsighted media minions are warning that the Federal Reserve’s vital “independence” as the sole and omnipotent manipulator of our national currency [sorry for the political insensitivity] is being dangerously eroded by Congress robbing the Fed’s "earnings" [Peter] to pay the national Highway Fund [Paul] … and by Congress even thinking about passing Senator Rand Paul’s bill to “Audit the Fed” so that everyone can see in ugly detail just what the Fed is doing behind its opaque cloak of monetary secrecy. However, it is doubtful that Congress or the American people will EVER understand what the Fed has done and what a proper response to its actions would be for two reasons.

First and foremost, drug addicts NEVER take time to consider the sensibility or sustainability of their actions … they live in a “do whatever it takes” world that lurches from the agony of the next threatened withdrawal to the ecstasy of the next promised fix … and so it is with Americans in Washington and on Wallstreet as well as Mainstreet … they are all addicted to free [albeit completely counterfeit] money and credit. That some Americans still retain a vestigial financial conscience that is involuntarily offended by the lack of financial honesty and self-responsibility is an historical anachronism. And of those rare exceptions, only a very few can understand HOW they are being victimized by a monetary authority bent on eradicating every trace of individual responsibility in the name of social security.

But the second reason people will never understand the Fed is because the Fed has no method in its madness. The Fed has not merely broken but absolutely shattered the law contained in the Federal Reserve Act. Without civil law to inform and guide its actions, the Fed has resorted to serving large and powerful special interests … governments, banks and corporations … with the implicit understanding that if it supplies them with infinite and indefinite amounts of free credit, they will “somehow” take care of the details. But the entire process is breaking apart in absurdity and the Fed is being progressively revealed for what it is … a tale told by an idiot, full of sound and fury, signifying nothing.

 

Swamp the Banking System!

You may recall that in 2008 the Fed bailed out the banks by “buying” trillions of dollars of defaulting loans from them at 100 cents on the dollar … which filled the banks with newly counterfeited cash … which the banks promptly “loaned” back to the Fed which agreed to pay them a nice rate of interest on their new “deposits” … a rate that was much higher than any private saver could earn on his savings at the time or since.

In essence, the Fed added to its historical role of being the “overnight lender of last resort” to the banks by becoming the “perpetual borrower of last resort” from the banks. It no longer supplied “marginal credit” to the banks permitting them to act as the lenders to the real economy. Instead the Fed flooded the banks with counterfeit cash [accepting their worthless loans in return] and agreed to borrow back its own stash of counterfeit cash from the banks … without limits in amount or duration. The banks loved this deal which replaced their massive portfolios of defaulting sub-prime home loans with mountains of interest-bearing deposits at the Fed … by selling the Fed their worthless assets and then lending the Fed its own counterfeit money.

As the storm clouds slowly dispersed, the banks began lending more and more of their new hoard of counterfeit cash to others and slightly reducing their massive “deposits” at the Fed … because they could now earn more from others than the Fed was willing to pay. But with their remaining deposits at the Fed, the banks no longer  “needed” private savers. In effect, the Fed financially banned private savers from the economy while simultaneously competing with borrowers for the banks’ idle funds. The Fed became a one-man-band … usurping both the lending and the borrowing functions of the real economy.

Fast forward to today. The real economy is supposedly strengthening and the Fed is faced with whether or not to permit the interest rates it savagely suppressed to rise. So how is the Fed going to do this? John Hussman explains:

“Holding the Fed’s balance sheet constant, the only way to raise rates is to pay banks interest on idle excess reserves, and the main effect of that will simply be to draw currency into the banking system and make excess reserves even larger than they already are.” http://www.hussmanfunds.com/wmc/wmc151109.htm

In other words, the Fed is already holding [and paying interest on] massive amounts of the 2008 “deposits” from the banks which remain at the Fed because the banks cannot/will not lend them into the real economy. So the banks clearly do not need any more money from the Fed much less from real savers.  Now to “raise rates” the Fed is going to raise the rate it already pays to the banks on their idle deposits. The banks are ecstatic … even more income and no risk. The hope is that the banks will then offer private savers a “little more” to encourage them to increase their real savings [aka reduce their real consumption] which the banks will then turn around and deposit with the Fed under the new program earning income on the difference between what it pays the private saver and what it can earn from the Fed as the “borrower of last resort”. The end result, as Hussmann explains, will be even more idle deposits sitting at the Fed … and by implication … even greater profits at the banks … even less credit available to borrowers in the real economy … and throwing a phantom bone to real savers [who have been emaciated by interest starvation] by permitting them to lend to the Fed via the banks’ idle deposits. Is something wrong with this picture?

 

Drain the Swamp? No!

If this sounds absurd … it is. First the Fed releases a flood of fake money which swamps the banks. Now, in order to protect the real economy from flooding, the Fed proposes to pay the banks even more to drain private savings from the real economy in order to increase idle Fed deposits which still remain at flood levels from the 2008 swamping of the banking system. Of course, what needs to be done is to drain the swamp which the Fed created in the banking system and which is now threatening economic flooding [real inflation and speculative asset bubbles]. Hussmann explains what should be done.

“Without hiking the amount that the Fed pays banks to hold [their existing] idle bank reserves, the Fed [could] … contract its balance sheet by about $1.4 trillion before market forces would raise rates even to a fraction of 1%. In other words, fully $1.4 trillion of needless excess zero-interest liquidity could be removed from the financial system without pressuring rates higher.” ibid.

But this would mean the Fed relinquishing some of its control over the financial economy … and the Fed is not going to do that … what tyrant has ever voluntarily acted to reduce his power? But even if it wanted to do so, who would “buy” the worthless loans [acquired in 2008] that publicly adorn and silently damn the asset side of the Fed’s balance sheet? The Fed would literally have to give them away … and take huge losses ... at whose expense? At the expense of every person who holds cash in any form.

 

Just Dig It Deeper!

To the list of pejoratives describing it, the Fed must now add “bipolar”.  Hussmann describes the reason for this sad diagnosis somewhat more clinically:

“In essence, the economic value of time has [already] been driven to zero [by the Fed since 2008]. The incentive to save has been trampled. The Fed seems to want this in order to discourage investors from saving and encourage them to spend. Investors who refused to take the speculative bait may have been the first casualties of the Fed’s policies. But now, it is investors who [obeyed the Fed and] remain fully invested in obscenely overvalued equities and junk credit that have become the unwitting dupes in this game. If the Fed cannot force people to abandon saving behavior with zero interest rates, some members of the FOMC have openly talked about driving interest rates to negative rates to “stimulate” spending. This is not economics, it is megalomaniacal sociopathy. Centuries of economic history warn that this speculative episode, too, will end in a collapse.” ibid.

And so the Fed is put in the absurd position of forcing interest rates below ZERO [by acting as “lender of last resort”] … while simultaneously raising them higher [by acting as “borrower of last resort”]. The Fed has been reduced to lending its flood of fake money to itself … “playing economics”. While this may be cute with children, it reveals serious mental illness for adults. But, then, these are crazy times.