Fed Reserve Chairman Ben BernankeThe heart of the Federal Reserve's policy to extricate the nation from the lasting grip of a deep recession is in essence a variation of what's known as "trickle down economics." The government aims to boost the net income of the wealthiest Americans, so that as these top earners spend, their wealth will "trickle down" to average Americans via service and production jobs.

The Fed's current policy has two intentions:

1. By lowering interest rates to near-zero (called "zero-interest-rate policy," or ZIRP) and flooding the banks with liquidity (the banks can borrow from the Federal Reserve for almost no cost), then the banks will be able to loan more money to households and enterprises. This also helps the banks to slowly rebuild their capital by reaping easy profits because they can borrow from the Fed at 0% and loan it out at much higher rates. This fat profit margin is in effect a gift from the Federal Reserve.

2. All this "easy to borrow" money resulting from the Fed's "quantitative easing" is supposed to flow into the real economy (as opposed to flowing into speculation) as households borrow and spend, and as enterprises borrow to expand their production.

The net result of ZIRP is that savings and short-term Treasury bonds -- safe investments -- earn next to nothing. The policy is designed to push investors and money managers into putting their money into the stock market, an inherently risky investment.

The goal is to create a so-called wealth effect: If people see their 401(k) and IRA accounts rising in value as the stock market rises, then they'll feel wealthier, even if they aren't directly spending any of their increasing wealth. In theory, consumers who feel richer will open their wallets and start spending again, boosting economic activity.

A "Feel-Good" Payoff

Brian Sack, the markets chief of the New York Federal Reserve, has explicitly stated that the Fed's ZIRP and QE policies are designed to "add to household wealth by keeping asset prices higher than they otherwise would be."

A recent report from the Federal Reserve Bank of Dallas made it clear that stabilizing housing prices is also part of the Fed's plan to create a wealth effect. After all, during the recession U.S. households saw their housing worth plummet by more than 50% and their total net worth fall by $14 trillion.

There's also a broader "feel good" payoff to rising equity and housing markets. Even consumers who aren't directly benefiting are supposed to feel increasingly confident that the economy is on the mend as they read about fatter corporate profits and rebounding housing prices.

Directly Penalizing Average Americans

Unfortunately for the Fed, its policies have been grand failures, either backfiring or even perniciously impoverishing the very Americans it claims to be helping. Here's why.

One of the key tenets of classic capitalism is that capital -- cash -- must be accumulated and then put to work in the most productive and profitable manner available. ZIRP actually works against capital formation by discouraging savings, and it directly penalizes average Americans and the elderly who depend on earnings from their no-risk savings accounts and Treasury bonds to augment their incomes.

Unfortunately, "cash is trash" now, thanks to the Fed's ZIRP. And rather than encourage capital formation -- the basis of capitalism -- it encourages borrowing and speculation in risky assets, arguably the two very things that put the U.S. economy in the dumps.

A generation ago, banks were required to pay 5% interest on all savings accounts (savings and loans paid 5.25%). Now, Americans earn a meager 1/10th of 1% interest on much of their cash. In effect, ZIRP has taken money out of the pockets of average savers and transferred that income to the banks, which can borrow at zero interest and loan the money out at 5% to 18% (or more on many credit card accounts).

Encouraging Dangerous Speculation

Has ZIRP restored the health of the nation's economy as the Fed intended? Sadly, the net effect has been to further impoverish Americans by making their cash trash.

There's one more equally destructive result of zero interest rates: They encourages lending not to businesses in the real economy but to speculators seeking a higher yield than 1/10th of 1%. Think about it. If you're an investment bank that can borrow vast sums for next to nothing from the Fed, then why not use that money to place some big bets on, say, overseas emerging markets or skyrocketing commodities?

According to financial commentators such as Caroline Baum, this is precisely what's happening: "Zero-percent interest rates are causing a misallocation of capital, a nice way of saying, 'asset bubbles.'"

So the Fed is actually encouraging the very unproductive leveraging, borrowing and speculation that sank the housing market and pushed the nation into a deep recession.

No Need to Borrow, No Matter How Low Rates Are

The primary goal of the Fed's quantitative easing policy is to stimulate borrowing and spending by households and borrowing and expansion by businesses. But once again, the Fed's policy is a complete failure. U.S. households are burdened by too much debt as it is, and the last thing most families want or need is additional debt burdens.

Businesses don't borrow because interest rates are near zero. They borrow when they have unmet demand from customers.

This is why many commentators characterize the Fed's policy as "pushing on a string": You can't force banks to loan money to over-indebted consumers, or force strapped households and sagging businesses to borrow money they don't need.

No matter how low interest rates are, loans must be paid back. And any effort that gets over-indebted Americans to borrow more is just another policy that further impoverishes households by diverting their income to service more debt.

Thus, it's no surprise that household consumer credit is contracting, not expanding.

Is More Debt the Solution?

The recent push to funnel $30 billion into community banks to lend to small business hit a snag: The banks reported their small-business customers didn't want loans, even at low interest rates, because expansion plans made no sense in the current economy.

Meanwhile, total debt in the U.S. (private and government) has skyrocketed from 221% of GDP in 2000 to 291% in 2008, reaching $42 trillion.

Is increasing debt really the solution, as the Fed keeps pushing, or is it the problem?

A Simple See-Saw

The Fed's quantitative easing (QE) policy has failed on two other fronts as well. By crushing the purchasing power of the U.S. dollar since June, it has indeed boosted the stock market, but it has also raised prices on commodities that average Americans need.

It's a simple see-saw. As the dollar drops, the cost of imports rise. As a result, the net effect of QE has been to further impoverish average Americans by raising the cost of essentials such as grains and oil. But a lower dollar boosts the profits of U.S. corporations' overseas earnings, and that's one reason why profits at U.S. companies that get 50% or more of their revenues overseas have been so strong.

The Fed seems to have forgotten that average Americans have little stake in the stock market. The top 20% of Americans own 93% of all financial wealth (stocks, bonds, preferred shares, business ownership, cash, etc.), and the bottom 80% own a mere 7%.



So, while the recent run-up in stocks has created additional wealth for stockholders, very little of that translates into more wealth for the bottom 80%. Statistically, incomes for most Americans are stagnant because only the top slice of earners have seen their incomes rise. From 2002 to 2006, the top 1% of Americans received two-thirds of the gain in national income.

"A Very Distorted Economy"

Former Federal Reserve Chairman Alan Greenspan recently commented on this division between those benefiting from rising equities and those left out of that increase in wealth.

"Our problem, basically, is that we have a very distorted economy in the sense that there has been a significant recovery in a limited area of the economy amongst high-income individuals who have just had $800 billion added to their 401(k)s and are spending it and are carrying what consumption there is."

Added Greenspan: "The rest of the economy, small business, small banks, and a very significant amount of the labor force, which is in tragic unemployment, long-term unemployment, that is pulling the economy apart. The average of those two is what we are looking at, but they are fundamentally two separate types of economy."

In sum, the U.S. has lost its ability to distinguish finance from investment. The Fed's policies are directly encouraging finance and speculation while further impoverishing average Americans with higher commodity prices and low yields on savings. The Fed's basic plan has been to boost financial assets, which are mostly owned by the top 10% of households, at the expense of the bottom 90%. But this wealth is not "trickling down." It's flowing into new asset bubbles.

Any way you measure the results, the Fed's policies have been grand failures. They have actively encouraged the very leveraging, debt and speculation that made the American economy dependent on risky, credit-bubble speculative financial excesses for its growth. That's hardly the healthy, sustainable economy the U.S. needs now.

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