Tuesday, December 29, 2009

The Revival of the Bank of the United States

The U.S. government is, for all practical purposes, becoming the most important bank in America. Two recent measures demonstrate the point. First, the Treasury Department announced yesterday that it was lifting the $200 billion limit it had previously placed on the funding it would provide to each of Fannie Mae and Freddie Mac. It will now back those two firms without limit. Admittedly, $200 billion is pocket change these days, with our multi-trillion dollar federal debt and all that. But the absence of any limit now means that for all practical purposes, the federal government, through its cheery sales staff (Fannie, Freddie, Ginnie Mae and the FHA) is responsible for virtually all the mortgage loans in America. Okay, the government is technically guaranteeing the loans, not funding them. But without the government (and taxpayers) being on the hook for defaults, there would be hardly any mortgages. The government makes today's real estate market (however weak it may be) possible.

Second, the Federal Reserve announced yesterday a new measure to "withdraw" some of the accommodative flood of liquidity it spewed into the financial system over the past year. It will offer interest bearing term deposits (equivalent to certificates of deposit) to member banks. These deposits will take cash out of the financial system for the length of the term, so there is a temporary reduction of liquidity. But what happens when the term ends? The deposit goes back to the member bank, where as part of the money supply it could have inflationary impact.

Why doesn't the Fed simply take back some of the cash it printed and sent out into the financial system? It hasn't said. Remember that much of that money was used to buy asset-backed securities and U.S. Treasury securities. One suspects that the reason is that it can't find buyers for those assets, not without pushing interest rates higher than it wants them to go. Thus, the Fed won't reduce its balance sheet (just as it wouldn't with its previously announced reverse repo idea; see http://blogger.uncleleosden.com/2009/12/will-feds-reverse-repos-reverse.html). The Fed will continue as a major financier of asset-backed securities and U.S. Treasury securities (the latter being really weird because it means the government is printing the money it "borrows" and spends; that would be a pure money print in any place except a rabbit hole).

One also suspects that another reason for the member bank term deposit idea is that these accounts would be treated as part of the bank's capital for regulatory purposes. The banks all know that higher capital requirements are in the picture. If they had to buy, say, U.S. Treasury securities in the bond markets to meet those requirements, they might push interest rates up. By offering special CDs to member banks only, the Fed allows them to meet capital requirements without having to roil the Treasury securities markets. In other words, the federal government would appear to be providing special funding to capitalize banks while keeping interest rates lower.

We've already proposed that Fannie and Freddie be reconstituted as nonprofit organizations whose public purpose would not be entwined with private, profit-seeking shareholder interests that distort incentives. See http://blogger.uncleleosden.com/2009/12/fannie-and-freddie-dont-privatize-them.html. Yesterday's announcement by the Treasury Department that it was lifting its ceiling on federal assistance boosted Fannie's and Freddie's stock prices by about 20% over the last two days. This was a nice belated Christmas present to the speculators who probably comprise most of Fannie's and Freddie's shareholders. But what about the taxpayers, who so generously now guarantee assistance without limit to Fannie and Freddie? They get lumps of coal, as far as we can tell.

There are good reasons for government intervention in times of crisis and panic. But growing mission creep is turning the government into another Bank of the United States. There were two Banks of the United States in the late 18th and early 19th centuries. The federal government twice created a national bank in order to provide financial services on a larger scale than it thought private banks of the day could handle. But the charter of the Second Bank of the United States was allowed to expire by President Andrew Jackson, out of concern that the Bank favored commercial interests of the East Coast, to the detriment of rural interests and the Western states (those now called the Midwest). This may ring bells in light of present day concerns that the federal government is too attentive to Wall Street while ignoring Main Street.

When the government supersedes private industry, market principles become diluted by politics. This isn't wrong by itself. Taxes, police and fire protection, national defense, social safety nets like unemployment compensation, workers compensation, Social Security, Medicare, Medicaid and so on all represent political solutions to problems that market principles were thought to handle poorly. But if the federal government is going to become the most important bank in the country, then we should have a serious, explicit discussion about how it will allocate credit--instead of today's quiet, step-by-step mission creep--and why so much federal support should be given to humongous private banks that compensate their executives munificently but lend so little the government needs to step in and lend in their place at the expense of the soon-to-be-more-heavily-taxed citizenry.

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