Is the Fed a Scam?

BY Paul Solman  January 12, 2011 at 8:22 PM EDT

Name: Charles, San Francisco

Question:The Fed Chairman and President Obama often complain that the banks are just not making enough private loans, while at the same time offering banks a strong incentive to buy risk-free T-Bonds with money borrowed from the Fed at virtually no cost.

Why does not the Fed simply limit the amount a bank can borrow from the Fed to an amount equal to the amount such a bank adds to its private loan portfolio? Is it really all just a scam against individual fixed income retiree investors to make federal deficit borrowing easier, boost bank profits and bonuses based on these “no-brainer” loans back to the government in the form of bond purchases, and to garner political campaign contributions by recycling some of these Fed funds back to incumbent politicians?

Paul Solman: I congratulate you for an exercise in extreme cynicism. And if you’d like even more fuel for your fire, how about the fact that the Fed PAYS banks to redeposit funds at the Fed? A mere 1/4 of a percentage point but still: no risk at all. Why lend out anything at all if your bank can earn free money with absolutely no risk at all; money that’s on deposit and can be used at any time?

So then why in the world would the Fed pump money into the banking system on the one hand, and induce the banks to redeposit it instead of lending it out?

The answer, presumably, is that the Fed worries about the banks. It wants them to have plenty of money on hand, thereby alleviating the risk that they’ll totter once again and imperil the economy. But it’s afraid of releasing all that money into the economy, lest inflation result.

Helping to teach a class at West Point recently in “Money and Banking,” I ran a mock meeting of the Federal Open Market Committee. The main topic was whether or not to go through with the real Fed’s promised QE2 — an infusion of $600 billion into the banking system to stimulate lending. There were various arguments, con and (mostly) pro. But playing the role of Fed vice-chair was the professor of the class, Major Jennifer Kasker. She boldly proposed reducing the 1/4% interest rate the Fed pays on “excess reserves” to zero in order to prod bank lending. Pretty interesting.