Right now, the most powerful man in the world regarding the US economy is not the President.  It is the Chairman of the Federal Reserve, Ben Bernanke.  It is his board, which he leads and is rarely overridden, that sets monetary policy.  What this means is that the Federal Reserve (the Fed) determines things like how much new money is printed and how much it charges banks for that money when it lends it to them.

When the Fed lends money to banks it’s called “adding liquidity to the system”.  Right now, it is charging almost zero percent interest to banks who borrow money from the Fed.  This means that banks can go to the Fed, borrow money with no cost to speak of, turn around and lend it out to borrowers for almost any rate they choose and still make money for themselves.  The hope is that this will spark a new wave of lending to businesses and help pull us out of the recession.
 It might.  Then again, it might not. This is because if you put yourself in the shoes of a Bank President, you are faced with both conflicting information and one big conflicting choice.

First, as bank President, you still have so-called “toxic assets” on your books.  Now technically the Fed is allowing you to account for these loans differently than you did last year, which means you can pretend they are worth something when in fact, they probably aren’t, but that is just the nature of the game.

Second, you know that the money you borrowed from the Fed  may in the long term, still sink your bank so your number one duty as its President is to try and strengthen your bank’s balance sheet (by loaning to consumers) in order to make it as strong as you can, as fast as you can.
Third, you take a look around at lending and you quickly discover that collateral for lending is starting to become a real problem.  You ask yourself how you can lend money against a piece of commercial real estate when the value is dropping every day?  How much money can you lend when you can’t really determine what the collateral is actually worth? 

To illustrate this point, let’s say a borrower owns a commercial building free and clear and wants to borrow $150,000 against it and today it appraises for $200,000.  A few years ago your bank would have jumped up and snagged that loan but today you ask yourself, what if the property drops in value to less than the amount the bank is intending to lend?  The reality is it very well could, and then you would just have added another toxic asset to the bank’s books.

Instead you might decide, as many bankers do, to only lend money to the very best customers and put the rest of the money you borrowed at zero percent into, ironically enough, Treasury Bonds at 3% interest, therefore bringing in pure profit to your bank, with no risk of default.  To many smart bankers, this is a prudent, if not full-proof choice. Strangely enough, as a result of this kind of wise thinking on the part of bankers, the Fed is in reality just printing money to finance its own debt.  Does your head hurt from all of this?  Oh, and did I leave out that the Fed is also buying Treasury Bonds directly, in order to finance about 15% of the current year’s deficit of $1.8 trillion? 

The issue with banks doing what I have just explained, and they are, there is no accurate way to know how much of our debt we are just financing by printing paper money and pretending it is working for us.  It doesn’t take a lot of imagination to see us getting into more trouble, and fast! Here’s what you need to know: This is a dangerous time.  You need to keep a close eye on what they are doing at the Fed.  And continue to invest wisely.  We all need to have a back- up plan.