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Tuesday, June 04, 2013

The Fed's Credit Crunch (Or, Why Can't The Economy Grow?)

The Federal Reserve purports to make money cheap with zero interest rates. Yet, the economy is stuck in recessionary conditions while the stock markets grow to the sky. There's definitely something wrong with this picture.

Steve H. Hanke writes in The Federal Reserve vs. Small Business that the Fed is actually creating a credit crunch. He says:

As it turns out, the Fed's "stimulus" policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises ("SMEs").

To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market — a market operating with positive interest rates and without counterparty risks.

With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.

In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed's zero-interest-rate policies, the interbank market has dried up.

Indeed, he's right and the Fed is our number one economic problem. Getting rid of it makes more and more sense.