Paying back TARP is a cost to taxpayers!

Many detractors of bailouts usually invoke the “Theory of Loanable Funds” when arguing against such measures. This theory suggests that when the government deficit spends (for anything), it takes funds away from the private sector, which could have been used for other, more productive uses. Therefore, deficit spending—whether for national defense, transfer payments or bailouts—only constitutes a “redistribution” of wealth and nothing more.

What they miss is the fact that when the Treasury spends (for anything) it results in an increase in reserves in the banking system and those are the funds used to buy the securities that “fund” deficit spending. In other words, the money is provided by the government itself and therefore, does not take anything away from the private sector. On the contrary, it adds to private sector wealth in the form of a greater holding of one asset—Treasuries.

On the other hand, when private firms pay back TARP money (which was just created simply by a keystroke on the government’s spreadsheet), the result is a net reserve drain: The funds go from the private sector to the Treasury and literally, disappear. The banking system is left with fewer reserves and, all else being equal, the public loses.

I say all else being equal because, in reality, the Fed will replace those funds if the reserve drain results in an unwanted increase in its overnight lending rate. However, given the current level of reserve balances the Fed may decide to leave system reserves lower by the amount of TARP money that has been paid back, so the public loses.