On The Backs Of The Savers

Includes: KBE
by: Michael Chandler

Back in 1991 during the first Bush administration, I was teaching a group of local bankers an accredited course through the local community college on banking. Much of the course was about spreads and how banks make money.

I recall one of my students proclaiming that if George Bush continued to allow interest rates to fall, he would never be re-elected. With the country already deeply mired in recession, I found that a rather odd statement, especially from a bank executive.

A recession is a period when, for whatever reason, consumption slows and inventories increase, and production consequently slows. In a nutshell, the recession lasts until those inventories are worked off.

During a recession, prices tend to fall, causing inflation to slow or drop. With inflation low, the Federal Reserve can ease interest rates to stimulate consumption, thereby assisting us out of the recession.

So naturally, I found it surprising that this banker in my class apparently did not understand these basic concepts. I have since learned, however, that our fellow citizens in general, whether bankers or not, still do not grasp this concept.

Conversely, of course, most folks seem not to understand that when the economy is growing by leaps and bounds, and consumption is exploding, too few goods are chasing too many dollars, and inflation rears its ugly head. Then the Federal Reserve steps in to slow the economy by raising interest rates, in an effort to curb inflation. This is, more or less, how it accomplishes the first mandate of the Federal Reserve --- price stability.

The second mandate of the Federal Reserve, given to the Fed by an act of Congress back in 1977, is to achieve full employment. It has been an article of faith in the Federal Reserve for many years that if it can achieve price stability, the second mandate will fall into place automatically. Today that article of faith has fallen victim to doubting Thomases, however.

It is now widely accepted that price stability does not always lead to full employment. After all, productivity gains over the past 20 years have helped keep inflation down. Technology has facilitated inventory management, allowing companies to turn their inventories over many times a year by producing their goods closer to the time of actual sale. Inflation --- outside the food and energy sectors --- has been kept well in check and has occasionally even hinted at a deflationary trend. Basically, we've seen low inflation, but also slow growth and high unemployment.

The goal of full employment has eluded us, convincing most observers that full employment is an objective completely separate from price stability, and must be treated as such. Demographic shifts may play a role, of course, but nevertheless the Federal Reserve is now clearly focusing on its second mandate, taking steps completely independent of its first mandate.

With that said, how exactly is the Federal Reserve attacking the full employment mandate? And at whose expense?

Recall that, with the near collapse of the banking industry back in 2008-09 --- due partially to greed among bankers, and partially to decisions of elected officials anxious only to see their faces on the TV evening news --- liquidity froze up across the world, not just here in the United States. TARP, the so-called Troubled Asset Relief Program, was born. Very strict regulations were placed on bankers and lending practices.

As a direct consequence, lending came to a standstill, and the housing and automotive markets pretty much ground to a halt. As you can imagine, all this put a tremendous strain on employment throughout the country, bringing us to double-digit unemployment rates.

With Fed Fund rates already low, the Federal Reserve very quickly dropped them to near zero. Keep in mind that the Fed's "overnight funds rate" (?), coupled with the discount rate, is basically the cost of capital for all Federal Reserve Banks.

Well, with seemingly little impact, and for all practical purposes exhausting that tool (short of the Cypriot lunacy of charging depositors to deposit cash in their local banks!) the Federal Reserve resorted to what is known today as Quantitative Easing. QE1,QE2, and now the endless QE3 are the outright purchasing of bonds and mortgages by the Federal Reserve, which in this way artificially keeps rates down. This step, it is hoped, will instill bank lending, and will simultaneously prompt companies to borrow for expansion. All of which should --- should! --- increase employment.

As a result of all these endeavors, money is now in abundant supply. But before lending could resume, the Federal Reserve had to, for all practical purposes, "rebuild" the bank's balance sheets.

TARP, the bank bailout, was approved by Congress in a panic, but it was nowhere near enough to get the job done. It may have been effective as a public relations measure for certain political figures, and it may have been economically effective as a stopgap measure. But nonetheless, the heavy lifting was done by the Federal Reserve . . . or was it?

By keeping borrowing rates low, this policy truly rested on the backs of the individual saver, who deposited his or her savings at a measly .40% - 1.00%, while inflation rates were hovering around 2.00% and higher. The pain thus inflicted on the individual saver allowed banks to make their spreads and rebuild their balance sheets. On a real rate of return basis (after inflation), it was the saver who really lost money and paid the price --- the price for the Federal Reserve's intentional manipulation of rates to save the banking industry.

We were happy to have TARP, no doubt about it --- because it ultimately was profitable to our Treasury. But TARP in itself didn't save the banking industry. Ultimately, it was hard-working Americans, ones who socked away their earnings in savings, who paid the price and got the job done.

Now it seems the economy is finally turning around. It looks like 3.00% GDP numbers may be right around the corner. We could see unemployment rates drop down to the 6.00 to 6.50% area. Maybe then we could get back a sense of normalcy in our economy. But that hope doesn't take into account, of course, the Health Care Act's impact on employment, which will soon be felt, and which is difficult to predict with confidence.

Most Central Bankers don't have a dual mandate like our Federal Reserve has. Most are responsible for price stability alone. In a free and truly capitalist economy, this would have never happened. Banks would have failed, just as do other businesses.

What does this mean for individual investors? Essentially, it means that banks are a special breed. There is, after all, the "too big to fail" doctrine, a tenet that could prove profitable for canny investors. As long as I know the government will go to such an extreme to protect banks, well, when it looks like banks are about to implode . . . I'll be there to buy their shares, knowing very well the government will be there to bail them out again next time.

Life is good!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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