09/23/2014 05:29 pm ET Updated Nov 23, 2014

A Few Things the Fed Has Done Wrong

For very good reasons I have changed one word in the title of an editorial in the Wall Street Journal (August 21, 2014) by John Cochrane, a professor of finance at the University of Chicago Booth School of Business and a senior fellow at the Hoover Institution. The Janet Yellen Federal Reserve, the central bank of the United States, has continued to build a $2.7 trillion monetary time bomb and Cochrane admires that policy.

One month after the Wall Street's September 2008 financial collapse, which spread worldwide, the Ben Bernanke Fed began to pay private banks interest on their reserves, including their excess reserves the banks are not required to hold.

The private banks held near zero ($1.6 billion) excess reserves in August 2008 compared to $2.7 trillion they hold now (September 4, 2014). Those excess reserves are now 83.2% of all the $3.2 trillion of currency plus bank reserves that the Bernanke and Yellen Feds have pumped into the economy since August 2008.

The Fed policy gives the private banks an incentive to hold excess reserves instead of making loans to businesses and consumers. An excellent economist at the St. Louis Federal Reserve wrote in its March\April 2009 publication:

"...first, for the individual bank, the risk-free rate of ¼ percent [from the Fed] must be the bank's perception of its best investment opportunity."

Cochrane describes a policy that Yellen, Bernanke and some other Fed officials may also favor:

"When it is time to raise interest rates, the Fed will simply raise the interest it pays on reserves. It does not need to soak up those trillions of dollars of reserves by selling trillions of dollars of assets."

With $2.7 trillion in excess reserves at private banks, a rise to 1 percent would require $37 billion to be paid to private banks each year on their excess reserves. A rise to 3 percent would increase the payment to $81 billion.

Where will the billions of dollars of interest go? My teacher at the University of Chicago, Milton Friedman, who died in 2006, wanted interest to be paid on private bank reserves so that competition between banks would result in the interest being passed through to depositors. That result is unlikely to happen today since the concentration of most assets and deposits are now in a few large banks that do not need to pass most of the interest payments to domestic deposit accounts. These banks are so large they attract deposits because they are too big for the government to allow them to fail.

Cochrane also writes that:

"...banks don't care if they hold another dollar of interest-paying reserves or another dollar of Treasury securities. They are perfect substitutes at the margin."

Does that mean the bankers do not know the difference between obtaining $1 interest from U.S. Treasury securities that could decline in value instead of obtaining $1 interest from the Federal Reserve, without gambling on the value of Treasury securities? If so, they would fail in banking classes, especially since Bernanke said as early as July 21, 2009 that the Fed my increase interest payments on reserves.

Making the banks safer by paying them to hold $2.7 trillion excess reserves reduces their ability to act as an essential intermediary between the money from their depositors, excluding required reserves, and the banks' purchase of income earning assets, such as loans to businesses and consumers. This financial intermediation in more advanced economies is one basis for increasing the production of goods and services and stimulating new innovative businesses.

Holding 83.2% of all the money the Fed pumped into the economy since 2008 as idle excess reserves is similar to the Fed's destructive policy of raising reserve requirements in 1937 as the country began to pull out of a terrible depression. The Fed policy sent the country back into the depression with massive unemployment.

The Bernanke and Yellen Feds have built a $2.7 monetary time bomb that should not be allowed to explode rapidly. The Fed should sell longer-term Treasury bonds to the public as the Fed reduces the interest they pay on the $2.7 monetary trillion time bomb. The monetary time bomb would be dissipated slowly and the money supply would not rapidly increase. Allowing the monetary time bomb to explode would flood the economy with money leading to rapid inflation and economic chaos.

The Federal Reserve policy of paying banks to hold $2.7 trillion of excess reserves, they are not required to hold, is an incentive for banks to reduce loans to business, consumers and other income earning assets. This Fed's policy that began in October 2008 reduces employment and the production of goods and services for the people of the United States.