I had the opportunity yesterday to talk to a wonderful economics professor about the current economy. He explained that basically, what isn’t happening right now that needs to happen is banks need to feel more confident to lend to one another. Unfortunately, they’re all afraid that if they loan money, they may not get it back due to all of the unknown amounts of bad debt that’s floating around at all the banks. Which bank is going to go next, nobody knows, so nobody wants to take any chances. The banks hoarding the money and not loaning to other banks is causing the Federal Funds rate to rise, supply for loans low, demand, high. He said that at around 5%, it’s pretty high but ok. At 7%, it chokes the economy. A few days ago, before the Congress passed the Bailout bill, it went as high as 10%! Now you have an idea of the severity of what’s happening. When the financial sector gets this bad, and banks stop lending to one another, it also chokes out banks lending to companies; companies who rely on this money to grow, to pay employees, to operate. And it chokes out lending to us, for our credit cards, our student loans, and our mortgages. That’s what’s happening now. Not just a slowdown of the economy, but a virtual stop, via this ripple effect.

A little background on the Federal Funds rate: It is the rate banks charge to each other when they borrow overnight. Every day, banks borrow from one another. In the evening the net is calculated and an interest rate is charged to the borrowing banks for what’s owed to whichever banks are lending. This rate is only indirectly controlled by the Federal Reserve. Here all along I thought the Federal Reserve set the Federal Funds rate. Nope. The way this rate works is controlled by supply and demand of loans from banks to other banks. This in turn is controlled by the supply of money. And that is controlled by the Federal Reserve, which is why it’s only indirectly controlled.

The Federal Reserve controls the supply of money in circulation through the purchasing and selling of U.S. Bonds. They can’t issue bonds, but they can buy and sell them like anyone else. Bonds originate from the U.S. Treasury, when our government needs money to spend. Anybody can buy them; banks and countries buy them, essentially loaning the government money. Then the Treasury spends it. In that situation, when the Treasury sells bonds, the amount of money in circulation remains unchanged. Taking $2 from Jack and giving it to Jill means there’s still $2 in circulation. The Federal Reserve on the other hand buys and sells bonds to control how much money is in the economy. If they want to tighten the money supply they’ll sell bonds that they have. Take $2 from Jack and give him a bond. Then keep the $2 to take it out of circulation. The monies they collect on the sale of the bonds are hoarded, kept by the Federal Reserve. This also raises the value of the dollar and the Federal Funds rate goes up as banks increase their overnight rate to each other. When the Reserve wants to lower the Federal Funds rate, they buy bonds from banks, thereby handing cash over to banks, and putting it into circulation. We see the value of the dollar decrease, inflation, and a lower Federal Funds rate. In essence, when there are a lot of dollars around, they’re easier to come by as supply is high, so the interest rate (the cost of borrowing the dollar) is low. The lower the Federal Funds rate, the cheaper it is for banks to borrow, the more they’re encouraged to do so.

That is what Bernanke is trying to achieve now. He’s pushing money into circulation by buying bonds from banks to lower the Federal Funds rate so banks will start loaning to one another. Inflation, though a concern, is still secondary to the immediate troubles we’re facing.

The $700 billion dollar bill that Congress has recently passed allows the U.S. Treasury to purchase the bad debts and free the banks from the risk they’re carrying. The desired effect is to give banks more confidence to lend and borrow with one another as it clears up their bad investments and increases their liquidity. The Federal Reserve really has nothing to do with this except to bolster the argument to Congress that this money is necessary to get the economy going again. With Bernanke’s backing, the U.S. Treasury (H. Paulson) was better able to convince Congress that this was the right thing to do. The reason why the Federal Reserve keeps pumping cash into the system is to again, lower the Federal Funds rate and encourage banks to lend to one another.

Just to distinguish between the Treasury and the Reserve: the U.S. Treasury is a government entity. Their existence and what they do needs to be permitted or mandated by an act of law (Congress). They are the government’s pocketbook. Money that the government spends is held in the Treasury. The Federal Reserve on the other hand, is independent of the government. That’s why it’s often said, the Chairman (Bernanke) is the second, if not most, powerful person in the world. The Reserve basically has what’s called a “dual mandate.” Two things they pay attention to in the economy: 1. Inflation – controlling it so it’s relatively stable. Protecting the value of the currency. 2. Unemployment – keeping it low.

Right now, banks are still skittish and worried that the $700 billion is not going to be enough. The challenge is in assigning values to these foreclosed homes that the banks are holding. It was purchased at $500k. Is that what you put down as the value now? If it should be lowered, then by how much? That’s why it’s hard to gauge how bad these bad debts are.

And that is what is going on.