Where would you hide a trillion dollars?

A trillion dollars is a lot of money.  It is in fact more than actually exists in circulation.  And it is presently hiding from everyone in plain sight at the Federal Reserve.  

Regular Reserves of Depository Institutions have historically been the pots of money that banks have to show the Fed, to assure them they are still capable of staying open.  Think of a casino where you can't get in, until the guy sees that you have a few 20 spots in your pocket.  Little noticed, the Reserves numbers just sort of stayed there year in and year out and are very boring.

Excess Reserves are the money that banks put into the Fed when things get a little jumpy out there, above and beyond Regular.  Big moves in Excess Reserves are basically when the Fed turns into a panic room, and banks stuff it with their money.  When the all-clear is sounded they take it back again and go about their business.  Excess Reserves are Run-to-Daddy time.

For decades Excess Reserves have been rather steady, with the bumps generally coinciding with notable geo-political events or financial crises (click to enlarge):

Then of course in 2007 the real estate bubble began its overdue correction and all hell broke loose as it imploded.  Let's look at 2001-July 2009, to put the 9/11 'spike' into relative context with the advent of the financial crisis:

So what happened?  Well part of the bailout, er, stabilization, was the Federal Reserve announcing in October 2008 that they would start paying interest to banks on their excess reserves.  The concordant amount of money-equivalents that fled the system to the Fed safehouse jumped $200BN in that month, and by New Years stood at $767 billion.

That's a huge shift.  The amount of money that went into this category in just three months, exceeded the total amount of money we've spent on the war in Iraq since its beginning ($711 billion as of the time of this writing).  

Banks are now being paid by the Federal Reserve to park cash or junk assets counted the same-as-cash, whereas before they were not paid and would therefore lose money (since banks make money by lending it out).  

• "The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability."  - FRB Press Release, October 6, 2008. 

So, while banks were cutting the rates on your savings account to zero, they were getting paid by the Federal Reserve to open up their own savings accounts.  Pretty nifty, right?

Now perhaps the official story is true, and the fact that lending dropped off a cliff to credit-worthy businesses and others at the same time banks were getting paid was a sheer coincidence.  What does not appear to be in dispute is that the reduction in lending exacerbated the recession, likely further hurting employment and sending real estate another leg down.  Since reserves are needed by banks to actively make loans, I find the official story a little hard to believe.

But let's expand the view through present, to get a sense for how big this program has gotten since the stabilization rationale was presented.  

As of February 2010 there was $1.162 trillion dollars in Excess Reserves at the Federal Reserve, and its not slowing.

Interestingly the interest being paid to banks on these balances comes to just about $3 billion dollars annualized.  If the Fed was buying 5-year Treasuries at around 2.25% then the Fed is making the difference of about 2%, or $23 billion in profit.

What I think is most concerning though is that I believe the Fed is setting the stage for market distortion in the years to come in a way that could impact everyone from wage workers to retirees.  The Fed is taking these Excess Reserves and using them to buy other assets like US Treasuries.  This can create the appearance of  strong market support for the US dollar, since the mass purchases by the Fed of US Treasuries is helping keep those prices higher (and interest rates lower) than would be the case if free markets were to set the price.

Not unlike some of the recent Ticketmaster scandals... by those hackers who cracked the code and bought all the tickets for hot concerts before they went on sale to the public, who were then in turn forced to pay higher prices from re-sellers... if all this use of Excess Reserves is adding artifice to the US Dollar without fixing the underlying problems in US banking institutions (such as unregulated derivatives), then it could be the underpinnings of an even larger house of cards that market forces will eventually correct.  If the markets correct the imbalance in a sharp, uncontrollable way interest rates could skyrocket.

We also call this monetizing the debt, and it often leads to hyperinflation with rapidly rising prices (without necessarily any increase in pay for the people). 

So, monetization of sovereign debt is one of those really, really big no-no's.  It can lead to rather Weimer-esque replays that we should be re-studying now, because the use or abuse of Excess Reserves as a monetary tool could be affecting the Treasury prices in a way that looks pretty now, but is in fact masking structural defects in the trading schemes of Wall Street.

We ought not be afraid of creative destruction, capitalism needs a clear view to separate the winners from the losers.  We've spent a lot of time trying to prop up the losers in this business cycle.  I would have rather we conserved those resources for more important initiatives, such as renewable energy, investments in mass transportation, or public education.  It will telling to watch the ER figure to see what the Financial system and the Fed are doing with US capital flows, and to see how any distortions in the treasury market affects our ability to grow sustainably.

Peace out.