I said yesterday that if Ben Bernanke wanted to stimulate the economy and reduce unemployment he could reduce interest payments on excess reserves to zero or even to some negative level. Kevin Drum is skeptical:
Fiddling with interest rates on excess reserves is indeed a new and powerful weapon in the Fed’s arsenal. At the moment, though, it’s not clear that lowering rates would do any good, because it’s not clear what it is that’s keeping bank lending low. The most likely reason, though, is that the private sector growth projections are weak, excess capacity still abounds, the housing market continues to suck, and there’s just not a lot of demand for new loans. Lowering the interest rate on excess reserves won’t change this, it will just eat into bank earnings, and right now the Fed is eager for banks to recapitalize as quickly as possible.
I don’t think that’s right. In hip-hop terms, this is Drum taking the side of Hayek against Keynes, Friedman, Greenspan, and Ben Bernanke. The idea of a profitable investment is a purely relative one. Lending money for a risky endeavor with an expected return of 0.3 percent doesn’t look so good when the Fed is offering a guaranteed return of 0.25 percent. But reduce that to a guaranteed return of zero percent or to a guaranteed loss of 0.5 percent and suddenly things look different. This is exactly why increasing the interest payments on excess returns can (and most likely will) be an effective tool in fighting inflation when the time for that comes—fiddling with an easy-to-access alternative can swiftly and systematically alter perceptions of what kinds of loans make sense.
And look at this another way. It’s true that private sector growth projections are weak. But we’re talking about one trillion dollars in excess reserves (compare that to $600 billion in ARRA money). If Bernanke not only cut the interest payments on excess reserves but also publicly and credibly committed himself to continued cuts until either the reserves or drained or else we’ve caught up with the price-level trend then that itself would alter projections of future growth. $1 trillion is 0.7 percent of GDP—that’s a lot.
People keep making up reasons why they think Bernanke can’t adopt one suggestion or other to boost growth and reduce unemployment. Remarkably, though, he’s only been asked to address this point once and he delivered a very clear answer: He believes he could boost growth and reduce unemployment but he doesn’t want to because he thinks that it “could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.” I really think we should take Bernanke at his word. My view is that this weighting of the relative risks reflects bad values and bad priorities, but I don’t see any reason to think that Bernanke is lying.