Whiteboard

Why the Fed is buying back Treasuries and how that helps

Paddy Hirsch Sep 1, 2010

Here’s an email I got earllier this week:

Hi Paddy,

Love your website and Whiteboard videos!

Can you explain the role of the current Fed buying back Treasuries and why that stimulates the economy? Maybe this has already been discussed in a video I missed.

Thanks, Tai-Li

Hi Tai Li,

When the Fed buys bonds of any kind from the banks, it pays the the banks cash – or at least puts a cash credit in their accounts.

So buying Treasuries back from the banks is really just a way of injecting more money into the banking system.

The idea is that the banks will then “put this cash to work” – by lending it to people and businesses. People will hopefully use those loans to buy homes and cars and Barbie dolls for their kids. Companies will hopefully use the money they borrow to buy other companies and stock up on more inventory and open more stores.

Ideally, all that spending by people, and that expansion by companies will put more people to work, and get the economy moving again.

Sounds great in theory, right?

Unfortunately the banks aren’t co-operating right now. They’re sitting on a lot of that cash, rather than lending it out.

Now, I don’t want to sound too sorry for the banks, but they are in a bit of a tough spot. They’ve been slammed for having lax lending standards in the past. They’re now trying to tighten up now, lending only to people who are a good credit risk. And the government is insisting that the banks hold more cash on their balance sheets, in case things go wrong(we don’t want the taxpayer to be on the hook if the banks collapse again).

So on the one hand, they’re being told to be more conservative. But on the other hand, the government is trying to get them to lend MORE, even though the economic outlook is very uncertain.

Kind of a mixed message, right?

To make things worse, the banks are saying that people aren’t even asking for loans right now. Companies are too nervous about the state of the economy, and people are nervous because the unemployment rate is still very high. After all, who wants to borrow wads of cash when there’s a big risk of losing your job?

A recent article from the Financial Times says “evidence does exist to support the claims of weak demand. The latest report from the Bank of England’s team of regional agents who gather on-the-ground intelligence on the state of the economy shows that uncertainty about demand, not lack of credit, is the biggest factor in deterring businesses from expansion plans. But as [Simon Maughan, a banking analyst at stockbroker MF Global] points out, banks do not need to reject loan applications in order to ration credit; they can simply raise the price, something they have all done in the past year.”

Clearly there’s a debate going on here, but the message is that the Fed’s methods for getting cash into the bank, and getting the economy flowing again, simply aren’t working.

Hope this helps!

Paddy

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