08/29/2011 02:39 pm ET Updated Oct 29, 2011

The Bernanke Fed Is in a Deep Hole With a $1.6 Trillion Time Bomb

The Bernanke Fed's policy has created a $1.6 trillion time bomb that has contributed to high unemployment and may explode under the Fed's new policy adopted August 9, 2011. The growth of the time bomb began one month after the Lehman Brothers collapse (September 16, 2008) ignited worldwide financial market mayhem followed by massive unemployment in the United States. The following month (October 6, 2008) the Bernanke Fed decided to begin paying the country's banks interest (1/4 of one percent) on their idle excess reserves.

From August 1, 2008 until July 1, 2011 the Bernanke Fed has pumped $1.85 trillion into the monetary base of the country's money supply. Eighty-eight percent of that increase sits as idle excess reserves at the nation's banks. Why should the banks make loans to small and medium size businesses in the present slow growth -- high unemployment economy spooked by wild stock market gyrations instead of collecting a risk free 1/4 of one percent interest on $1,600,000,000,000.00?

I spoke against this Bernanke Fed policy in January 2009 at the National Press Club and at Chapman University Law School. Jim McTague, Washington editor of Barron's, wrote in his February 2, 2009 column, "University of Texas Professor Robert Auerbach thinks he has the makings of a malpractice suit against Federal Reserve Chairman Ben Bernanke, as the Fed is holding a record number of reserves: The banks prefer the sure rate of return they get by sitting in cash, not making loans. Fed, stop paying, he says."

Shortly thereafter, Fed Chairman Bernanke explained: "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." (National Press Club, February 18, 2009). That was an admission that the Fed's payment of interest on reserves would impair bank lending if they wanted to make loans at lower rates.

The next month, William T. Gavin, an excellent Federal Reserve economist, wrote in a March\April 2009 St. Louis Fed publication: "first, for the individual bank, the risk-free rate of ¼ percent must be the bank's perception of its best investment opportunity."

If the Fed lowers the interest they pay banks on their excess reserves to zero, today's $1.6 trillion time bomb could explode with a huge increase in the money supple. The explosion would continue to debase the country's currency, lowering its international value, and raising the price of imports such as oil and gas. Then the country will face more inflation than currently exists. "Over the last 12 months, the all items index increased 3.6 percent before seasonal adjustment." (Consumer Price Index - July 2011, Bureau of Labor Statistics) That is a painful implicit tax on lower fixed income people.

The Fed should stop paying interest on the banks' excess reserves. This policy change will provide an incentive for commercial banks to shift to buying private sector income earning assets including loans to smaller existing and planned businesses. These loans will substantially increase employment.

The money supply will then expand rapidly if the Fed tries to maintain a near zero interest rate target. The Fed must then raise its target interest rate to keep the money supply from exploding as the banks reduce their $1,600,000,000,000.00 investment in excess reserves which no longer receive a money award from the Bernanke Fed.

Chairman Ben Bernanke and six of his colleagues on the Fed's Federal Open Market Committee (William C. Dudley, Elizabeth A. Duke, Charles L. Evans, Sarah Bloom Raskin, Daniel K. Tarullo, and Janet L. Yellen) voted for the August 9, 2011 policy statement to keep the target range for the federal funds rate for "at least" two years:

(...) the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Although these powerful Fed officials announced their hands are tied to a near zero interest rate target for two years, three Fed officials voted against the policy statement by changing the two year policy to "an extended period."

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

A policy to reduce the $1.6 trillion time bomb to help spur commercial loans and increase employment awaits the attention of the officials at the Bernanke Fed.