The Fed Gave Wall Street A Bomb, And The Taxpayers Are Paying Ransom

When Janet Yellen testified before the House Financial Services Committee last month, she faced grilling on a topic that hasn’t received enough mainstream attention: the interest being paid on excess reserves at the Fed. While the topic has come up occasionally since the program began in 2008, it is worth noting that Yellen was pushed by both Jeb Hensarling, the committee chairman, and Andy Barr, the chairman of the Monetary Policy Subcommittee.

While ending this taxpayer subsidy to Wall Street is important, it’s also important to understand the dangers posed by allowing these excess reserves to be lent out of major financial institutions.

To understand what is at stake, recall back to 2008 when many Fed observers were concerned about the inflation dangers posed by the policies of the Bernanke Fed.

In a six year period, the base money supply increased over four-fold.

Understandably, this sparked grave fears about the devaluation of the dollar – fears that, to date, have yet to really present themselves in the CPI. While stock prices, real estate prices, and other types of asset-price inflation are likely being fueled by this monetary policy, the Fed isn’t facing political pressure from inflation concerns – but rather being grilled by misinformed legislators for not reaching their (unfortunate) 2% inflation target.

This is, in part, due to the fact that a lot of this new money has been kept sterile by being parked within the Fed itself as excess reserves.

Today, more than $2 trillion worth of these reserves are parked at the Fed, which means that only two thirds of the newly created money has actually been pumped into the “real economy.”

Now this policy should rightfully puncture the narrative that the Fed was at all concerned with providing liquidity to businesses on Main Street (i.e., not big banks). After all, if the aim of the various rounds of QE was to get banks to loan, then paying them not to is irrational. Instead, the Fed was using taxpayer dollars to subsidize the very same banks that they just bailed out. We are continuing, to this day, to pay banks to not make loans. 

While Bernanke repeatedly dismissed the problem of incentives posed by paying 25 basis points on these reserves, the reality is that this was a risk-free investment at a time of great market volatility. Considering that several important banks had issues passing the Fed’s stress tests – tests are designed to exaggerate the stability of the financial sector – it doesn’t require a great logical leap to suggest that the Fed misrepresented this program to public in the name of “stabilizing” the financial sector.

In 2016, this policy paid $16 billion to big banks, a number that will likely rise as the interest rate payments go up with every increase in the federal funds rate (we are now paying 1.25% interest, higher than the public can receive from their own banks.)

While both the public and Fed critics on Capitol Hill should be outraged at this clear example of cronyism, simply ending it is not enough. After all, the danger of refusing to pay ransom money is that the ransomer will follow through on their threat. If the Fed was to simply stop payment on these funds, and banks decided to lend it out — then $2 trillion would be injected into credit markets. Given the amplifying effects of a fractional reserve banking system, it’s easy to see how quickly this could unleash severe inflationary pressures.

So this is the true policy issue going forward, how do you stop the taxpayer subsidy to Wall Street while avoiding lighting the fuse to Bernanke’s inflation bomb? One way would be to increase reserve requirements. Currently banks with over $115.1 million in liabilities have to keep 10% at the Fed, by raising that number up you will not only serve to keep this expansion of the monetary base “sterile,” but will make the banking sector as a whole more stable.