Are Banks Hoarding Cash? Debate Over “Free Money” Interest on Excess Reserves

In response to Free Money! Banks Paid $22 Billion to Not Lend? I received a comment from economist Professor George Selgin who said I do not know what I am talking about.

Selgin made similar comments about Chris Whalen, Chairman of Whalen Global Advisors LLC,  in two supporting links.

I also received a Tweet from economist Professor Steve Keen who said: “Mish Nails It“.

Both viewpoints cannot be right. Let’s explore competing viewpoints on lending excess reserves, banks hoarding cash, and free money banks receive from the Fed for interest on excess reserves.

Mish Statements

Excess reserves are a function of the Fed’s balance sheet and those reserves do not change whether a bank lends more or not.

There is no “demand” for excess reserves. Rather, the Fed has crammed excess reserves into the system and has decided to pay interest on them.

1. Mathematically speaking, excess reserves cannot spur lending.
2. Banks are not paid $22 billion to “not lend” $2.2 trillion as many contend.
3. Banks are paid $22 billion because the Fed decided to do so.

Whether or not banks lend has nothing to do with interest on excess loans. Rather, the decision to pay interest on excess reserves is simply $22 billion in free money to banks every year, at taxpayer expense.

Steve Keen

Selgin: Interest on Reserves

In Interest On Reserves, Part II, Selgin writes.

Of the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies’ apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves.

But let us set our befuddlement aside, in order to allow our authors to dispute the view that the vast post-IOR accumulation of excess reserves was evidence that the Fed’s emergency loans and asset purchases weren’t serving to “maintain” an adequate flow of credit:

To the contrary, the level of reserves in the banking system is almost entirely unaffected by bank lending. By virtue of simple accounting, transactions by one bank that reduce the amount of reserves it holds will necessarily be met with an equal increase in reserves held at other banks, and vice versa. As described in detail in a 2009 paper by New York Fed economists Todd Keister and James McAndrews, nearly all of the total quantity of reserves in the banking system is determined solely by the amount provided by Federal Reserve. Thus, the level of total reserves in the banking system is not an appropriate metric for the success of the Fed’s lending programs.

A gold star to all who spot the fallacy here. For those who can’t, it’s simple: “reserves” and “excess reserves” aren’t the same thing. Banks can’t collectively get rid of “reserves” by lending them — the reserves just get shifted around, exactly as Walter and Courtois suggest. But banks most certainly can get rid of excess reserves by lending them, because as banks acquire new assets, they also create new liabilities, including deposits. As the nominal quantity of deposits increases, so do banks’ required reserves. As required reserves increase, excess reserves decline correspondingly. It follows that an extraordinarily large quantity of excess reserves is proof, not only of a large supply of reserves, but of a heightened real demand for such, and of an equivalently reduced flow of credit.

IOER and Banks’ Demand for Reserves, Yet Again