Why the FED has turned the banking system into the Living Dead

Treasury Secretary Tim Geithner and Federal Reserve Chairman Ben Bernanke have denoted that the recession is over. Now that the DJIA has broken the 10,000 mark, we can expect to  have full confidence that economic growth is here to stay.

But the credit markets are in a lot worse condition than some indexes  suggest.

Buried within the October 3, 2008 bailout bill, which set up the Troubled Asset Relief Program (TARP), was a provision permitting the Fed to pay interest on bank reserves. Within a week, the Fed implemented this new power and  essentially converted bank reserves into more government debt.

As the fed funds rate hovers around zero and existing loans in technical default continue to sit in bank portfolios, why should banks make new loans when they can make money for free with the government?

They can now borrow from the Fed and  earn a huge spread by borrowing virtually unlimited amounts of money for nothing and simply lend that same money back to the Treasury.

In sum, the banks now have no incentive to lend. Most of them still have a significant amount of bad loans sitting on their books that they don't want to recognize as nonperforming. If  banks were to recognize these bad loans, all the write-downs could force them into bankruptcy.

So what Bernanke and friends have created is a banking system consisting of the living dead – Banks that suck money out of the system, and which have not made significant new loans to the small to mid-size business sector since the Bailout was enacted. It’s just like in one of those “Zombie” movies. The only problem is – it’s for real.

A few multinational banks like Citigroup are “too big to fail”.
Credit spreads in the markets reflect the relatively risk-free nature of these large companies, which now have de facto government guarantees.

But this protection doesn't apply to smaller banks, some of which are being shut down by the FDIC (over 100 so far in 2009). These smaller banks have done most of the lending to the many small and medium-sized businesses that do most of the hiring in our economy. 

According to ADP’s August employment report, large businesses lost 60,000 jobs, and employment at medium-sized and small businesses declined by 116,000 and 122,000 jobs in August alone. According to Ann Lee, writing in the Wall Street Journal, small businesses,  (employing  from one to 49 people) account for 48 million jobs in the U.S., and medium-sized businesses ( 50 to 499 employees)  account for 42 million jobs. Large businesses account for just 17 million – only about 20 percent of jobs.

Without access to capital, these small and medium-sized businesses will continue to lay off  employees, creating a cycle of shrinking consumer credit and demand similar to the Japanese “lost decade” of the 1990’s.

Bernanke and friends have architected this upside-down, zombie-like banking system with their ill-conceived Keynesian solutions. Is it any wonder that elected representatives like Ron Paul (one of the few in Congress that actually understand voodoo economics) want legislation to abolish the Fed?

We should be questioning whether our current banking system actually makes any sense. Rather than giving capital to businesses with real products and services, Wall Street now plays a government-backed Ponzi scheme, enriching bankers' pockets at everyone else's expense.