John Edward, a resident of Chelmsford who earned his master’s degree at UMass Lowell and who teaches economics at Bentley University and UMass Lowell, contributes the following column
There is something terribly wrong here. Banks are being paid more for not lending money than they are paying seniors on fixed incomes for use of their life savings.
When the financial crisis hit in 2008, the Federal Reserve Bank started taking extraordinary steps. One of the less-well-known steps was to start paying banks for doing nothing.
The story begins with the money you have in the bank. The bank is only required to keep a small percentage of your money on hand. At most, they must keep 10 percent of checking deposits “in reserve.” The bank can use the rest of your money to make money by lending it out.
If a bank has $1 billion on deposit in checking accounts, it is required to keep about $95 million in reserve. The bank does not keep all that money in their vaults. They keep much of it in an account with the Federal Reserve.
A bank has “excess reserves” when there is more money in their reserve account than required. Normally banks detest having excess reserves. Normally banks do not let cash sit idle when it could be earning them a profit. Neither Fed policy nor bank behavior is normal right now.
The Federal Reserve tracks excess reserves for the U.S. banking system. The total usually ranges between 1 and 2 billion dollars. There was an exception after the attack on 9-11. Banks panicked and excess reserves briefly jumped to $19 billion.
Then in September of 2008, a financial panic took over the banking system. Excess reserves soared from $2 billion to over a trillion dollars! As of April 2012, excess reserves were roughly $1.5 trillion.
Banks are being very cautious about lending money. The Fed is making things worse by paying them to sit on cash.
In October 2008, the Fed started paying interest on excess reserves. The Fed had never done this before. The intention was to provide flexibility in controlling inflation.
The interest rate the Fed pays on excess reserves is currently only 0.25 percent. That may seem very low. However, that rate is higher than rates at which banks can borrow. That rate is higher than most of us currently get on savings accounts.
With $1.5 trillion in excess reserves, the Fed will pay out $3.75 billion in interest to banks in one year. In one quarter of 2011, Bank of America made a $63 million profit on excess reserves.
Banks are making easy money on excess reserves rather than risk money by lending it out to entrepreneurs. To make our economy grow, we need to improve worker productivity. To improve productivity, we need more capital investment. More capital investment requires borrowing.
Ultimately, the money for investment comes from people who save. We need more savings.
The personal savings rate in the United States is very low compared to historical norms, and compared to other countries. Interest rates near zero do not offer an incentive to save.
The Fed is conducting an extremely aggressive monetary policy. The Fed’s current interest rate target is the lowest ever. They want low interest rates in order to encourage investment. Low rates have the unintended consequence of discouraging savings.
Unless you have a lot of money in a tiered account, most savings accounts pay less than 0.25 percent. Money market funds and 1-year Treasury Securities also pay less than that. With inflation, the return on these investments in 2011 was negative 3 percent!
Low interest rates also cause a serious problem for people depending on savings for income. Many retirees who thought they could live off interest payments have had to change their plans.
Even with a 1 percent return, a half-million dollar retirement account will only generate a little over four hundred dollars a month. That is before taxes. Many retirees are understandably reluctant to accept the risk necessary to get a higher return.
The Fed has been very aggressive in keeping rates low and making sure there is plenty of money to go around. In the short run, this is a sound policy. However, the Fed knows easy money is not the strategy to promote long-term economic growth.
The Bush and Obama administrations have been very aggressive with their fiscal policies. Independent analyses show government spending and lower taxes have created economic growth and millions of jobs. However, building up a very large national debt is not the strategy to promote long-term economic growth.
Consumption is over 70 percent of the U.S. economy. In the short run more consumption is necessary to keep the economy growing. However, consumption to the almost total exclusion of savings is not the strategy to promote long-term economic growth.
To promote sustainable economic growth we need to encourage savings and investment. The Fed’s policy on excess reserves is not helping.
Bentley University economist Scott Sumner is a closely followed commentator on Fed policy. Professor Sumner called for the Fed to stop paying interest on excess reserves. Further, he suggested they apply a penalty for holding excess reserves.
The Fed is paying interest on excess reserves to help keep a lid on inflation. Some economists are faulting the Fed for keeping the lid too tight. Professor Sumner has offered a very detailed case for changing the Fed’s target. Not the target for inflation, but rather aiming at a target other than inflation. I will target that topic in my next column.
Perhaps I was expecting too much when I suggested we Bend the Fed to target inequality. At least, they should do something for savers in dire straits and do less for banks getting money for nothing.