Tags: Auerbach | Fed | excess | reserves

UT's Auerbach: Fed Has Created a $2.7 Trillion Time Bomb

By    |   Wednesday, 24 September 2014 01:07 PM

The Federal Reserve has built a $2.7 trillion time bomb that will cause economic mayhem if not carefully diffused, says Robert Auerbach, a professor of public affairs at the University of Texas at Austin.

Although the Fed has pumped trillions of dollars into the economy since 2008, most of it has remained idle in the form of private bank's excess reserves it continues to hold, he writes in an article for The Huffington Post.

Excess reserves exploded under the former Fed Chairman Ben Bernanke and have continued soaring under current Chair Janet Yellen, from $1.6 billion in August 2008 — almost nothing in central bank terms — to $2.7 trillion as of Sept. 4, notes Auerbach, a former economist with the House Financial Services Committee, the U.S. Treasury's Office of Domestic Monetary Affairs and the Fed.

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Why don't banks put their excess reserves to good use by increasing their lending and boosting the economy? Because the Fed pays them interest on those reserves, he argues.

"The Federal Reserve policy of paying banks to hold $2.7 trillion of excess reserves they are not required to hold is an incentive for banks to reduce loans to business, consumers and other income earning assets," Auerbach writes. "This Fed's policy that began in October 2008 reduces employment and the production of goods and services for the people of the United States."

Auerbach recommends that the Fed sell its longer-term Treasury bonds to the public while reducing interest it pays on excess reserves.

"The monetary time bomb would be dissipated slowly and the money supply would not rapidly increase. Allowing the monetary time bomb to explode would flood the economy with money leading to rapid inflation and economic chaos."

University of Chicago finance professor John Cochrane takes a different view, arguing in an article for The Wall Street Journal that paying banks interest on reserves "is highly desirable for a number of reasons." It increases financial stability. Banks with lots of reserves don't go under.

When it wants to raise interest rates, the Fed can simply raise the interest it pays on reserves, he says. "It does not need to soak up those trillions of dollars of reserves by selling trillions of dollars of assets.

"Reserves that pay market interest rates are not inflationary," Cochrane writes. "Banks don't care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin."

Auerbach takes issue with Cochrane's argument, saying Treasury's can decline in value.

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The Federal Reserve has built a $2.7 trillion time bomb that will cause economic mayhem if not carefully diffused, says Robert Auerbach, a professor of public affairs at the University of Texas at Austin.
Auerbach, Fed, excess, reserves
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2014-07-24
Wednesday, 24 September 2014 01:07 PM
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