More On The Fed (I)
Amid the chaos surrounding the financial panic and the recession, not many commentators paid much attention to two changes in Fed policy that enlarged on a massive scale its role in allocating resources. First, the Fed asked for and received from Congress the legal authority to pay interest on the reserves held by the banking system.
For many years before, economists had argued that the Fed should have the authority to pay interest on banks’ required reserves —that is, those reserves that banks are legally mandated to hold. But with the blessing of Congress, the Fed has gone further than this, by paying interest on excess reserves also—that is, on the reserves banks hold over and above the legally required minimum.
The problem with paying interest on excess reserves is that it discourages banks from making loans to individuals and businesses. Faced with a choice of making risky loans to the private sector or collecting guaranteed, risk-free interest from the Fed, many banks chose the risk-free option. The result is that excess reserves soared from their level of a few billion dollars to amounts well in excess of a trillion dollars— funds that were not available to private sector borrowers.
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