I have argued in the past that the Federal Reserve’s policies may be helping in some ways, but hurting in others. Way too much borrowing and lending is running through the Fed which is drying up lending between banks. It also reduces the need for banks to find reasons to communicate and trust each other, keeping the atmosphere of mistrust alive.
On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:
One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.
The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.
Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.
When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages – from where it’s most needed to where it’s most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.
