There has been a fair amount of chatter lately saying that the Feds are keeping banks from lending. The story goes something like this:
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.
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.