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Massive Misconceptions About Where the Bernanke Fed's Money Explosion Went

06/25/2013 12:48 pm ET | Updated Aug 25, 2013
  • Robert Auerbach Professor of Public Affairs, The University of Texas at Austin

Market mayhem broke out in the stock markets when Federal Reserve Chairman Ben Bernanke told the world on Wednesday June 19, 2013 that the Fed's $85 billion per month printing press stimulus may be reduced. This stimulus is called "QE [Quantitative Easing] 3- infinity" because it has no specified termination date. Fears of reducing or ending QE3 drove the Dow Jones Industrial Average down 560 points in two days. Before stock traders rushed to sell, algorithms at companies using high frequency stock trading computers immediately acted on Bernanke's message and amplified the stock price changes.

There is a massive misconception about where the Bernanke Fed's stimulus landed. Although the Bernanke Fed has disbursed $2.284 trillion in new money (the monetary base) since August 1, 2008, one month before the 2008 financial crisis, 81.5 percent now sits idle as excess reserves in private banks. The banks are not required to hold excess reserves. The excess reserves exploded from $831 billion in August 2008 to $1.863 trillion on June 14, 2013. The excess reserves of the nation's private banks had previously stayed at nearly zero since 1959 as seen on the St. Louis Fed's chart. The banks did not leave money idle in excess reserves at zero interest because they were investing in income earning assets, including loans to consumers and businesses.

This 81.5 percent explosion in idle excess reserves means that the Bernanke Fed's new money issues of $85 billion each month have never been a big stimulus. Approximately 81.5 percent (or $69.27 billion) is either bought by banks or deposited into banks where it sits idle as excess reserves. The rest of the $85 billion, approximately 18.5 percent (or $15.72 billion) continues to circulate or is held as required reserves on banks' deposit accounts (unlike unrequired excess reserves).

One reason that the excess reserves grew to an extraordinary level is that in October 2008, one month after the financial crisis when Lehman Brothers went bankrupt, the Bernanke Fed began paying interest on bank reserves. Although it has been 1/4 of 1 percent interest, this risk free rate was not low compared to the Fed's policy of keeping short-term market rates near zero. The interest banks received was and is an incentive to hold the excess reserves rather than lend to consumers and businesses in the risky environment of the major recession and the slow recovery.

The Bernanke Fed is now facing a $1.863 trillion time bomb, they helped to create, of excess reserves in the private banking system. If rates of interest on income earning assets (including bank loans to consumers and businesses) rise, the Fed will have to pay the banks more interest to hold their excess reserves.

At the current level of the time bomb, raising interest paid to banks on excess reserves would give the banks $18.6 billion a year at 1 percent interest, $55.9 billion a year at 3 percent interest and $93.2 billion a year at 5 percent interest. Because of concentration in banking, it is unlikely that much of the interest would be passed on to depositors. Bank stockholders would receive much of these large bonuses from the government.

I criticized the Fed's policy of paying interest on excess reserves at the National Press Club on January 9, 2009. On January 30, 2009, I made similar comments as a panelist at a Chapman University School of Law symposium. Jim McTague, Washington editor of Barrons, wrote in his February 2, 2009 column: "The banks prefer the sure rate of return they get by sitting in cash, not making loans. Fed, stop paying, he [Robert Auerbach] says."

On February 18, 2009, Chairman Bernanke spoke at the National Press Club: "Because banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed, the interest rate the Fed pays on bank reserves should help to set a floor on the overnight interest rate." That peculiar rationale was an admission that the Fed's payment of interest on reserves did impair bank lending.

Eighty five billion a month will seem tiny compared to the avalanche of the $1.863 trillion excess reserves exploding rapidly into the economy. That would devalue the currency, cause more rapid inflation and worry investors about a coming collapse.

Chairman Bernanke should explain the massive misconceptions about where 81.5 percent of the Fed's $2.284 trillion in new money landed. It is also time to admit that paying banks interest to hold idle excess reserves makes the problem worse. The Bernanke Fed should slowly lower interest paid on excess reserves to zero to give the banks incentive to make more loans to consumers and businesses. That policy could increase employment. The Bernanke Fed's printing press explosion is a major problem I discussed April 20, 2013 on Huffington Post.