Banks can borrow from the Fed at rates near zero. Then, they can purchase Treasuries for about three percent. Voila, banks have a three percent risk-free return, and no incentive to lend to business.

The conclusion is that the Fed has rates too low.

I disagree.

First, we need to acknowledge that many banks are in no condition to be taking risks, and many of their customers are in no condition to be assuming additional debt. Also, the Fed is paying interest on excess deposits, which is silly, and it complicates the analysis. However, even if banks could lend, borrowers could borrow, and the Fed didn’t pay interest on excess reserves, I don’t think the above analysis is correct.

The easiest way to think about the situation is to ask: what would the banks be doing if there were no Treasuries to buy? They would be investing in something else, something like loaning to businesses and consumers. This is pretty much the definition of crowding out.

The fact is that downside risk still dominates the forecast, and the Fed needs to keep interest rates low, at least for a while longer. If our banks were healthy, this would be a clear-cut example of crowding out. The banks aren’t healthy, but I’m thinking some crowding out is definitely happening.

I’m as concerned as anyone about total government spending and the deficit. I’m probably more concerned than most about bank lending to business. But, conspiracy isn’t the problem.

Part one of Melloan’s theory is that the Fed is causing banks to be excessively risk averse. He says “The Federal Reserve, which supervises some 7,000 banks, has been telling bankers that they must cut risk.”

The FDIC reported today that there are 552 banks on their problem list. Banks have been charging off $40 to $50 billion per quarter in loans for a year now. Capital has been eroded, and banks are way overleveraged, in part because of excessive risk taking. You think that maybe banks should be more risk averse today? You think that maybe there is a rational reason for banks to lend less to business and purchase more government securities?

The real problem is not some government conspiracy. The real problem is the government’s quiescence.

Too many of our banks are zombies, and we face something like Japan’s lost decade if we don’t fix them. This is the single most serious United States problem today. It drives me crazy that we are wasting huge amounts of resources and political capital on second-order problems while ignoring the bank problem.

Robust recovery requires banks lending to businesses. Banks can’t lend to businesses until they are adequately capitalized, and the bad assets are off the books. We will not have a robust recovery and put people back to work until our banks are fixed.

Bankruptcy is one way to clean up our banks. Since the FDIC fund is currently upside down, -8.2 billion, this would require external funds to the FDIC. The other option is the one successfully used by Sweden. They nationalized the banks, cleaned them up, and resold them. This would also require an investment.

Either way, fixing the banks is a far better use of money than some Stimulus 2 program or even the unspent portion of the current stimulus program.

“Establishing financial stability—in addition to price stability and growth—is the essential role of the central bank. Achieving this goal in a way that avoids moral-hazard distortions, as with the too-big-to-fail finance institutions, and prevents another bubble in the next years will surely be one of the greatest challenges ever faced by the Fed.”

The piece is a quick and worthwhile read. It’s here.