Saturday, 1 September 2012

Martin Feldstein thinks banks lend out reserves.

I always had a low opinion of Martin Feldstein, but this article of his is rock bottom. (hat tip to Frances Coppola)

Both he (and apparently the Fed) think that private banks can be dissuaded from lending their excess reserves by having the Fed raise the interest paid on reserves. Feldstein and the Fed need to Google the phrase “banks do not lend reserves”. They’ll find plenty of articles to put them straight on that one.

When the private bank system sees a series of profitable lending opportunities, it creates money out of thin air and lends it out. The Fed can pay 8%, 18% or 28% on reserves: it won’t have the slightest effect given the large excess stock of reserves that private banks currently have.

If the Fed wants to pay 28% on reserves, it can. Private banks will just – laugh all the way to be bank. Or put it another way, they’ll just be helping themselves to even more billions of taxpayers’ money than hitherto.

As to when reserves drop to their minimum level relative to deposits at private banks (10% for large banks in the U.S. as I understand it), that’s a slightly different scenario. That is a QUANTITATIVE control. But assuming private banks continue to see profitable lending opportunities, the result will just be a rise in interest rates.

The Fed at that point could of course say “this has gone far enough – it’s time to raise interest rates”. But given the 10% reserve requirement and continued profitable lending opportunities, interest rates would (to repeat) rise anyway. Which makes the Fed’s interest rate adjustments look somewhat irrelevant.

And indeed they are. As suggested above, the fundamental point is aggregate demand which in turn determines the amount of profitable lending opportunities.

Of course lending itself influences demand. But the basic cause effect runs from demand to profitable lending opportunities. So how about abandoning interest rate adjustments as a means of regulating the economy – or at least demoting interest rate adjustments to a regulatory tool to be used only occasionally and in emergencies? That’s the policy advocated on p.10 here.


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