08.29.2011 0

The Fed’s zero-interest bailout of Uncle Sam

The Federal Reserve HQBy Robert RomanoOn Aug. 26, Federal Reserve Chairman Ben Bernanke reaffirmed his decision to keep the Federal Funds Rate — the interest rate at which the Fed and banks lend to one another — at near-zero levels. He said, “[I]n what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.”

That would keep interest rates historically low for at least a period of the next two years. The Federal Open Market Committee says the purpose of the policy is to “promote the ongoing economic recovery”, even though the recovery to date has been anemic at best.

Since the Fed’s announcement, yields on 10-year treasuries have dipped to lows not seen for decades, dropping from a little more than 3 percent all the way down to slightly above 2 percent.

That move in itself has tremendous ramifications, most notably for the borrowing costs of the U.S. government. For every dropped percentage point of interest on treasuries, at $14.639 trillion of total debt, the government saves approximately $146 billion annually.

If rates on treasuries are held that low for the foreseeable future — as opposed to normalizing to the historic average of 5 percent — the biggest beneficiary of the policy will continue to be the government. In 2012, it would save $166 billion. In 2013, $177 billion. And so forth.

This puts Bernanke’s warning to Congress and the White House on fiscal policy into context. He said, “without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage.”

So, keeping interest rates low forestalls that outcome. If 10-year treasuries yield, say, 2.5 percent in 2021, instead of the 5.3 percent projected by the Office of Management and Budget, gross interest on the debt will only total $650 billion instead of $1.378 trillion as the debt soars to $26 trillion.

Ironically, if Bernanke was concerned about Congress continuing to kick the can down the road, his near-zero interest rate policy actually makes that the most likely outcome. That is because interest rates set by the bond market, left to their own devices, will tend to punish profligacy and reward fiscal prudence.

When borrowing costs spike upward, that is when governments will act to reduce spending and borrowing. And when rates go down, governments will almost always seize the opportunity to spend and borrow even more. That means his move to hold down rates makes it less likely Washington, D.C. will get its fiscal house into order in the near-term.

There are other effects of the continued easy money policy, which this piece will examine, but overall the biggest winner of the policy is the government. The other winner has been the primary dealers of U.S. treasuries — twenty international financial institutions that are required to participate in all treasuries auctions. How do they benefit?

Treasuries yields and the nominal prices of those securities have an inverse relationship. When rates go down, the price of purchasing the securities actually goes up. And for much of the past year, 10-year treasuries have traded above 3 percent. Now that they’re closer to 2 percent, bond dealers have seen an enormous appreciation of the values of those assets, which means big profits.

They also benefit because holding down rates forestalls the government’s fiscal day of reckoning, which extends the timeline that Washington will likely continue on its spending binge. So, they will reap more profits from the easy money scheme for a longer period of time before the casino closes.

Some of the side effects of Fed policy can be seen in more traditional lending institutions. Camden R. Fine, president and chief executive of the Independent Community Bankers of America, writing for the Washington Post, notes how the policy is hurting their profitability. He wrote, “With nearly zero percent rates and slack credit demand, how are community banks supposed to make a viable margin on their funds?”

With rates much lower, traditional banks have less incentive to lend — there is simply less money to be made doing so. This in turn dries up capital pools, in particular for small businesses. This leads to slower growth, less job creation and therefore relatively higher unemployment.

Another loser is savers and retirees, in particularly seniors, who earn next to nothing for having set aside their wealth.

Coupled with the inflationary consequences of the easy money policies, higher prices for consumer goods, energy, and food soaks up more of Main Street’s wealth. This in turn increases dependency on government welfare services. Higher costs also hit businesses, which then have smaller profits and less money to expand, leading to higher unemployment.

In short, Bernanke’s policies favor the government and Wall Street by incentivizing out-of-control government spending and borrowing, and punish the American people with higher costs, zero return on savings, increased government dependency, slower economic growth, and less jobs.

Hardly the outcomes that inspire confidence in the future prosperity of the nation, as they are precisely the things that have fostered a dizzying uncertainty in the markets since the financial crisis began. Can we get off now?

Robert Romano is the Senior Editor of Americans for Limited Government.

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