NCPA - National Center for Policy Analysis


December 18, 2008

On October 6, 2008 the Federal Reserve announced it would begin to pay interest starting on October 9, 2008, on required and excess reserves that individual banks maintain at the Fed, stating that this would encourage banks to hold larger reserves.  But this is exactly the wrong policy objective in an environment where banks are reluctant to lend to businesses and others, says Jim Johnston, director of the Heartland Institute.

Banks faced with a choice between lending to risky business ventures and putting the money into excess reserves where interest (albeit short term) is guaranteed will choose the less risky.  This tendency is especially strong now that the financial community has undergone a substantial shock where financial institutions were caught holding toxic loans that endangered their very existence.  And with the current velocity of money so low, it might even be argued that paying interest on excess reserves is a small influence on bank behavior.

However, such an assertion ignores the lesson of the 1937-38 depression, says Johnston:

  • The recovery from the Great Depression was well on the way when the Fed observed that banks were holding more than twice the level of reserves than was required.
  • Under the Banking Act of 1935, the Board of Governors doubled the reserve requirement on member banks between 1936 and 1937 believing that doing so would generate an increase in public confidence and would not change the behavior of the banks.
  • However, the banks responded by sharply increasing their already-sufficient reserves, resulting in the sharpest downturn in U.S. economic activity in history.

Therefore, paying interest on excess reserves poses a substantial threat to the recovery.  The policy should be immediately reversed, suggests Johnston.  If it is not reversed, he continues, the Fed risks causing the current downturn to be even sharper than the depression of 1937-38.

Source: Jim Johnston, "Interest on Reserve," Memo to the Federal Reserve (Heartland Institute), November 14, 2008.


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