How Bernanke Can Get Banks Lending Again ...

If the Fed reduces the reward for holding excess reserves, banks will have to find something else to do with their money, like making loans or putting it in the capital markets. The U.S. economy could use another boost, and it won’t come from fiscal policy. Can the Federal Reserve provide it? Chairman Ben Bernanke keeps insisting that the central bank is not out of ammunition, and in a literal sense he is right. After all, the Fed has not yet exhausted its bag of tricks. It is still twisting the yield curve. It can purchase more assets. It can tell us that its federal funds target interest rate will remain 0-25 basis points beyond late 2014. – Wall Street Journal

Dominant Social Theme: These banks have got to lend!

Free-Market Analysis: Well known Princeton University academic and Keynesian economist Alan Blinder has written an article posted by the Wall Street Journal that urges Federal Reserve Chairman Ben Bernanke to stop paying banks so much money in interest on funds that the banks hold in reserve.

These funds have been printed by the Federal Reserve and shipped to commercial banks so that the banks can circulate the money as they choose.

Say, don’t you wish you were a distribution channel for the Federal Reserve, dear reader? The Fed would send you millions and billions, too. Sound a bit strange? It’s the system that has “evolved.”

In fact, the Fed doesn’t actually print money anymore. It merely sends electronic digits to commercial banks in the hopes these banks will lend the money. If they don’t, it pays them anyway.

But as we and others have pointed out, the Fed would be better off simply distributing this money to the end users − individual savers and consumers. Of course, if the Fed merely dropped money from helicopters, as Bernanke himself has facetiously suggested, people would begin to realize that their hard-earned money was actually printed at will by a handful of men running an electronic printing press.

The Fed has enormous powers, far beyond what is apparently stated in various statutes. Bernanke has been fairly imaginative in the ways he has tried to stimulate the economy, but Blinder believes he can do still more …

There is more the Fed can do. I have two out-of-the-box suggestions to make, one in today’s column and another in a companion piece soon.

The simpler option is one I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.

The Fed sees this as a radical change. But remember that it paid no interest on reserves before the 2008 crisis and, not surprisingly, banks held practically no excess reserves then. In early October of that year, Congress gave the Fed authority to pay interest on reserves, which it promptly started doing. When the Fed trimmed the federal funds rate to its current 0-25 basis-point range in December 2008, it also lowered the interest rate on reserves to 25 basis points, where it has been ever since …

The Fed’s hostility toward lowering the interest on excess reserves is almost self- contradictory. When Mr. Bernanke lists the weapons the Fed plans to use when the time comes to tighten monetary policy, he always gives raising the IOER a prominent role. His reasoning is straightforward and sound: If the Fed makes holding reserves more attractive, banks will hold more of them. Why doesn’t the same reasoning apply in the other direction?

This is a big question indeed that Blinder asks. And it is one that we have wondered about for some time. Free-market economics tells us that banks would lend if there was demand. In other words, you cannot raise the velocity of money artificially.

If the economy were not so distorted and propped up by bailouts and government handouts, the distortions would already have unwound. People would know what enterprise was solvent and what was not. But it’s hard to tell in an environment where so many institutions have been propped up.

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