The Fed is getting really desperate

The Fed tells banks to lend or else. I wonder, "Or else what?"

The agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers. Moreover, as a result of problems in financial markets, the economy will likely become increasingly reliant on banking organizations to provide credit formerly provided or facilitated by purchasers of securities. Lending to creditworthy borrowers provides sustainable returns for the lending organization and is constructive for the economy as a whole.

...

The agencies will continue to take steps to promote programs that foster financial stability and mitigate procyclical effects of the current market conditions. However, regardless of their participation in particular programs, all banking organizations are expected to adhere to the principles in this statement. We will work with banking organizations to facilitate their active participation in those programs, consistent with safe and sound banking practices, and thus to support their central role in providing credit to support the health of the U.S. economy.

This is so interesting on multiple levels. On one level, the banks got into this mess by making bad loans to people who couldn't afford to pay them back. The Fed never complained while that was happening. In fact, it outright encouraged it. It set interest rates far below market rates and below the rate of inflation which punished savers and subsidized debtors. This resulted in investors taking excessive risks in order to keep up with inflation. Greenspan even encouraged exotic mortgages like pay-option ARMs. So now that the Fed helped create this mess by encouraging the banking system to lend to people who couldn't afford these loans, it now is coming down hard on banks for being conservative and trying to rebuild their reserves.

On another level, it is so clear that the Fed is just terrified -- absolutely terrified -- of deflation. And they can't reinflate the money supply without more lending and borrowing. But the Fed is not able to make that happen because attitudes toward debt are changing. There is a psychological shift going on where people are starting to reject debt. The Fed will do everything in its power to prevent this, but so far, it has been pushing on a string. The more vehicles the Fed creates to lend money to the private sector, the more it makes the private sector dependent on the Fed. Why should a company borrow from a bank at the risk-adjusted interest rate when the Fed will lend it money at below-market rates?

Finally, what we're headed towards is nothing less than full nationalization of the banking system. The banking system and the housing sectors are already the most regulated and manipulated parts of the US economy -- it's no surprise that this is where disaster stuck. Now that the banks have taken money from the Treasury, the next step will just be the Treasury and Fed ordering banks to do exactly what they say. The Fed and the Treasury can ultimately make the banks do what they want, but the results won't be good for the economy. They are trying to fight the market which is begging for liquidation, structural change, and ultimately the shift of capital from malinvestment to where it's actually needed. The more the government tries to prevent this, the more they are going to turn the US into Japan and create the deflation they so want to avoid.

I don't know why anybody at this point would want to own equity in a bank. This letter from the Fed makes it clear that the banks serve the US government, not their shareholders. And if that means destroying their balance sheets even further, that is what the banks must do.