A sick system

Talking of paradox, it may seem paradoxical that when I comment on economic issues here on the blog, I mostly comment macroeconomic issues; I am a resource and environmental economist, or more generally a microeconomist. Anyway, the Fed funds rate in the US has shown anomalous behaviour the last few weeks. Jim explains: The Fed funds rate is the interest rate at which institutions lend their deposits held in accounts with the Federal Reserve to one another overnight. Currently, the Fed is offering a 1% interest rate on such deposits, but the effective market rate is hoovering around 0.35%. This seems paradoxical (both ironic and illogical):

If you’re a bank and there’s a GSE out there willing to lend fed funds at 0.35%, how much do you want to borrow? Let’s look at the math. If you borrow $1 billion, you pay 0.35% interest and earn 1.0% from the Fed for just holding those funds overnight, from which you’d net $6.5 million over the course of a year. If you borrow $10 billion, you’ll earn $65 million. Totally risk-free, $65 million for your bank as pure profits. Here’s the question– How much would you like to borrow?

Me, I’d like to borrow a few gazillion.

The market does not work. A possible explanation is that carrying out the necessary transactions to take advantage of the situation, banks would see their leverage ratio decrease. Leverage has become (more) painful to banks after the financial breakdown in September. Jim comments:

I have to say that if this is the explanation, it is profoundly disturbing to me. If banks indeed are finding themselves hamstrung to the point that they are unwilling to pick up millions of dollars that are just lying around on the sidewalk, absolutely risk-free, then how can they possibly be expected to function in their traditional role of funneling capital to legitimate investments that all necessarily entail some risk? If this is indeed what is going on, we should be looking at the spread between the effective fed funds rate and the interest rate paid on excess reserves as another indicator of a profoundly sick financial system […]

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One Response to “A sick system”

  1. Jim argues for an inflation target « Kvams Says:

    […] made it clear that the standard measures the Fed usually use to govern the economy is failing; I reported on this earlier. Jim describes inflation targeting as ‘Plan C,’ and discusses why previous plans have […]

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