The Most Massive "Welfare" Program in History?

The above chart shows a disturbing reality: a huge amount of societal wealth is sitting idle at the Fed, and has recently increased to record amounts. In my view, this fact is the result of the most massive welfare program in history--corporate welfare--for financial elites.

The Fed essentially purchased a wide variety of assets and paid for them by increasing bank reserves, leading to the above. CNNMoney.com refers to these efforts as the Fed's $2.2 trillion fire hose. Some in Congress want to know precisely the terms of the Fed's transactions and which banks benefited--for both balance sheet transactions and off-balance sheet transactions. Outside of the very general CNNMoney.com analysis it is impossible to know what exactly the Fed has been up to--and those in the mainstream media--like Maria Bartiromo--could not be less interested.

We do know that the Fed has made mass purchases of mortgage backed securities (including "troubled" assets) and Treasury obligations. Since banks hold these securities in huge amounts this not only keeps interest rates down but also pumps up bank capital by inflating asset prices on bank balance sheets. This subsidy is not costless: when the Fed sells the stuff they bought the US taxpayer will be on the hook for losses, as CNNMoney.com recognizes. If the Fed fails to sell the assets it purchased then banks can lend these reserves and through the operation of fractional reserve banking create a wave of inflation.

Another Fed action that helped create these idle reserves was the decision to pay interest on the reserve balances in October of 2008. In the middle of the greatest financial crisis in history, the Fed essentially decided to pay banks not to lend. One economist calls this one of the greatest errors in Fed history. Another calls it "utterly inexplicable."

But the answer lies in political economy not economics. The payment of interest on reserves allowed the Fed to give banks a safe harbor for parking capital at rates significantly higher than short term Treasury obligations. Again this subsidy is not costless. Aside from its contractionary effect, and its immediate cost of above market interest, either the Fed will have to raise the interest rates paid on these reserves at some point in the future or face the risk of inflation. If it raises the interest rate too high all of its operating income could be absorbed and the US taxpayer would have to bailout the Fed. As economist William Gavin states:

"It is relatively easy to imagine situations in which the interest cost paid on reserves would absorb most or all of the Fed’s income. Such conditions might include an inverted yield curve, reduced income from the GSEs, and/or a rising portfolio of nonperforming assets from bank rescue operations."

A bailout of the Fed is hardly unthinkable. Over the last year the Treasury has issued debt to pump $560 billion into the Fed pursuant to its "Supplementary Financing Program."

It will be years before all of this unwinds and we know the true costs of this stealth Fed bailout. But, it is a huge and unprecedented amount. We have pumped up asset values, limited loss exposures, and pumped up income, to keep the big banks afloat. Long term incentives have been destroyed. This is on top of the $700 billion TARP bailout that Congress (barely) passed.

All of this has been done with limited Congressional approval and limited public disclosure. It has also been broadly bi-partisan. The effort to audit these activities is the least Congress should do.

The central point is this: those concerned about federal spending need to recognize that the relatively trifling amount spent on "welfare" for real people has been dwarfed by welfare for the banks, which will ultimately amount to trillions not billions in expenditures. And, it may well be impossible for the Fed to avoid a torrent of inflation down the road, depending on the cost of keeping these reserves idle.

The bi-partisan decision to bailout the banks will be the key turning point in American economic history.