Interest Or No Interest On Excess Reserves, That Is The Question

For what it’s worth, there is an enormous amount of interference in the gold and silver share market.  I think that will end as soon as gold and silver break their highs.  When that happens, I think it’s going to unleash a rally in these stocks that is absolutely going to stun people.  People will be shocked that don’t understand the full extent of the manipulation and how cheap these stocks have become as a result of it.  - John Embry on King World News  LINK

Before I delve into "excess reserves" held at the Fed by banks, I wanted to post two more indicators that confirm my thesis that our economy is pretty much in "plunge" mode.  First, the Richmond Fed released its regional manufacturing index, considered a good proxy for the national economy.  It plunged from -3 last month to a reading of -17 for July.  The incompetent economists on Wall Street were expecting a reading of -1.  Every sub-component of the index was horrific.  You can read the details here:  LINK

Second, Cisco released its Q2 guidance yesterday.  It significantly lowered its expectations, said the outlook for the global economy looks grim and announced it will cut 1,300 jobs:  LINK  Cisco's stock price is down 6% as I write this.  With regions in Italy and Spain now in insolvency and 3 large California cities in bankruptcy, with more to follow there and across the U.S., if Bernanke does not open up the liquidity floodgate again, he is going to be tagged as making the same mistake the Fed made in the early 1930's - a decision of which he claims to be an expert - in causing the Depression.  Even more profound, he'll  hand the Presidency to Romney.  Note:  Bernanke is a Democrat and, given his background, he likely despises hardcore Christian sects.

Now for the debate on cutting the interest rate on the excess reserves held by banks at the Fed. I will try to be concise as possible.  First, bank excess reserves held at the Fed are bank funds - in excess of Fed capital ratio requirements - which banks keep on "reserve" at the Fed for lack of something better to do with them.  Currently the Fed is paying banks .25% in interest on these reserves (IOER - interest on excess reserves).  A big debate has erupted over this policy, as critics contend it's keeping banks from lending out that money into the financial/economic system.  Defenders of the IOER policy say that because the Fed/bank money system is "a closed system," whether or not the Fed pays IOER is irrelevant other than as a monetary tool to regulate the Fed funds rate.

This article, if you are interested, does a good job of explaining why it is said that the Fed/banking system is "a closed system:"  LINK, but you can ignore the part where Stella defends the current IOER policy.  And my friend and colleague wrote an excellent piece yesterday that explains why the argument being served up in the media both for and against IOER is disingenuous and flawed:  LINK  In fact, I didn't really care about the whole issue until Jesse and I started emailing back and forth in depth about the topic.

Let's strip away the Orwellian gobbledygook being served up by lousy economists and retarded financial TV show hosts and commentators.  As Jesse wrote in his piece linked above, the IOER is nothing but a direct means of pumping liquidity into the banks.  And where did the ER come from?  The excess reserves were created by the massive TARP and QE programs.  TARP is directly from the Government and the assets purchased by the Fed under QE are guaranteed in value by the Treasury.  In other words, the $1.46 trillion in bank excess reserves sitting at the Fed is YOUR money.  So the banks are being given a nice liquidity injection from IOER using YOUR capital.  Thank you Bernanke, Geithner and Obama (and Paulson and Bush).

Now to the issue of whether manipulating IOER will stimulate bank lending.  The answer is yes, but not to the private sector economy.  Think about it this way:  given what we know about the economic prospects of this country, would you lend money to a new Mercedes Benz dealership, a new shopping mall development or to build a new Cisco manufacturing plant?  No.  So why would we expect the banks to do that?  Taking the IOER to zero or negative will absolutely not stimulate lending to the private sector UNLESS there are loan opportunities that make sense from a risk/return standpoint.  On this basis, the .25% IOER is irrelevant because a bank can make several percentage points more in interest if it could find risk/return worthy lending projects.  Banks are still lending to homebuyers, but that's because ultimately that loan is being guaranteed by the Government/YOU.  It's also not relevant as a tool to manage the Fed funds rate - the argument against cutting the IOER.   As Jesse points out, IOER is irrelevant other than as a liquidity subsidy to the big banks.  To that I add: using YOUR capital.

Now, if the Fed were to cut the IOER to zero or take it negative, it will increase bank lending to the Government via Treasury auctions.  If the IOER goes to zero, the Fed will "force" a lot of that $1.46 trillion from the excess reserve account at the Fed and into the longer-maturity Treasury auctions.  The Government will be funded through the election and beyond without the Fed having to increase the size of its balance sheet - that is, print money.

They say the devil's greatest trick is to make you think it doesn't exist.   The second greatest trick - ironically by a surrogate devil, the Fed - is to finance the U.S. Government using your money and likely against your desires.  Welcome to this country's transition to totalitarianism.  Orwell smiles, Atlas shrugs.