Saturday, December 4, 2010

Validation of my rant in class about the Fed-to-Banks-to-US Treasury circular flow of money/circular flow of logic that reminds me of a hamster on a treadmill...

Last class period I explained one of the pieces of the puzzle as to why the banking system is not lending as much money as they could be. even though the Federal Reserve is/has been on a bond buying spree.  The short version---(1) Federal Reserve BUYS a $1,000 bond  from a bank--(2) Bank withholds more than is required (or another way of saying this, is they lend out less than they are able to) because they believe  it is too risky to lend to people/businesses right now--(3) Bank buys US Treasury Bonds/Notes as a way to earn interest on the money...Repeat steps 1 through 3...Some lending is occurring, but not on the level required to get the economy going.  Just so you can see that I am not making this up because it sounds so preposterous, here is a comment from today's NYTIMES:
""Here’s the way things are supposed to work and normally do: Banks take in deposits and then lend that money out.

And here’s what’s happening more frequently now: People are doing a better job of spending less than they earn, but any leftover money is going toward paying down debt, not taking on new debt.

So to the extent that banks have deposits, they can’t lend them out in the quantity they used to (or aren’t because of tightened credit policies). Instead, they buy Treasury bills, according to Bill Hampel, the chief economist for the Credit Union National Association. And those don’t pay as they once did because of the interest rate environment. Nor do they deliver the kind of returns the banks would get if they were lending the money under normal conditions. ""
Low returns from US Treasurys are, at best, better than taking chances with credit risks and, at worst, better than a sharp stick in the eye.  I suppose it falls somewhere inbetween...
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