The “why” behind the why…

Our recent post asked a question that many of our clients have been asking us most of this year: Why aren’t the banks lending much money?

Despite the current $85B/month stimulus plan, the Fed is still looking for a way to create some inflation in the economy. The Fed knows they need  increase in the velocity of money in order to push the newly printed money into circulation and achieve this desired inflation (see previous blog post on the velocity of money).

One possible way to get an increase in the velocity of money is for the Fed to stop paying interest to banks on reserves (currently paying .25% on $2.4T of reserves).  The theory goes something like this: if the banks weren’t getting paid to leave this huge pile of cash on deposit at the Fed then they would use it to make loans and put it into circulation. Currently banks are leaving these reserves on deposit at the Fed because it is the easiest profit they’ve ever made and it requires absolutely no risk.

To some extent we don’t blame the banks… If we were allowed to borrow $2.4T for free, invest it at .25% and keep the $6B of annual profit, we would probably do it too.  Why actually engage in traditional banking activities (like taking in deposits and making loans) to make a profit when the Fed gives you free money so you don’t have to?

Let’s hope we see a strong shift away from this unintended consequence on 2014… and let’s get banks back to being banks again!

Categorized in: Blog

This post was written by Conscient Capital