What Bernanke's trying to do is really very, very interesting


I know, I know, central banking never scores all that highly on the excitement meter. However, what Ben Bernanke's trying to do over in the US is indeed fascinating. The discount rate (the rate at which the Fed will lend to banks) has risen but it's not expected to have much effect on market interest rates.

The increase widens the spread between the Federal funds and the discount rate to half a percentage point, the upshot of which will be to encourage banks to borrow from the short-term credit markets rather than using the Fed – until this decision the cheapest source of short-term funding.

A little explanation perhaps (I didn't say that all of this about central banking would be interesting). In normal times banks do a great deal of lending to each other on very short term bases. Overnight, 7 day, that sort of thing. Just juggling around the surplus or deficit cash balances they have: the differences between what people have dropped into the bank/taken out of it that day/week. This so called "interbank" market pretty much disappeared in the crisis. It was the disappearance of this that led to the worries about ATMs running out of money in 2 hours, the collapse of the entire banking system thing. If you didn't know whether the bank you were lending to would open its doors tomorrow then you wouldn't lend to it overnight, would you? Credit risk entirely overwhelmed the market in short.

The solution at the time was the same in both countries: banks lend their surpluses to the central bank and borrow to cover their operating deficits from it. The bank removes all of that credit risk. We have functioning short term credit markets again and a functional banking system. Excellent.

What Bernanke is trying to do is wean the banks off that credit guarantee that the Fed is offering and push them back into standard short term credit markets. The surpluses should once again be lent direct, the deficits covered direct.

So far so what? I can hear you saying. But this has a huge implication for that Robin Hood Tax thing. For their aim is to apply a 0.05% tax to all such interbank loans and borrowings. Such a tax is, when the interest to be earned from overnight lending something like 0.002%, obviously going to kill the market entirely. In fact, the tax alone makes overnight lending, when calculated on an annual basis, cost 15% or so. Indeed, for some supporters of the tax this is the very point: to stop banks using such short term markets.

There are two implications of this: if Ben Bernanke is deliberately trying to reopen the interbank and short term credit markets then he's not going to look kindly on a tax which entirely kills those markets. I think we can assume that the Federal Reserve will not support the Robin Hood Tax and thus, as an international idea, it's dead.

The second is that if we've got one of the world's most respected monetary economists (even if he is a central banker) saying that we need and want these markets, perhaps we might want to pay less attention to the likes of the nef, RSPB, The British Dietetic Association, the Chartered Association of Physiotherapy, the Musicans' Union (no, really, they're all signatories) who are not respected monetary economists who say we don't want and need these markets?