THE BLOG
10/20/2010 01:20 pm ET Updated May 25, 2011

Why the Federal Reserve's Contribution to Unemployment and Price Discrimination Continues

As I described earlier, the Fed began paying banks interest on their reserves one month after the September 2008 financial crisis struck the United States economy and spread throughout the world. The Fed (actually taxpayers) paid the banks more than $2 billion in 2009 at a small, but risk free, rate of one-quarter of 1 percent.

Economists inside and outside the Fed said these payments would be an incentive for banks to sit on their reserves rather than loan the money to businesses in a risky environment. This was the Bernanke Fed's contribution to unemployment.

I suggested that interest payments on reserves should be lowered and short term interest rates targeted by the Fed be allowed to rise to maintain a moderate rate of increase in the money supply.

However, Fed policy still persists as the banks sit on $1.047 trillion in reserves on September 1, 2010. This is 53.4 percent of the money (the monetary base) the Fed has issued. Compare this to 5.3 percent on August 1, 2008 before the financial collapse and the interest payments on bank reserves were paid.

So what does the Fed want to do now? Three Fed officials, Federal Reserve Bank Presidents, William C. Dudley (New York), Charles L. Evans (Chicago) and Eric S. Rosengren (Boston) have signaled their views making headlines: "Fed Officials Signal New Economic Push." (New York Times, 10/1/10) The officials reportedly suggest buying longer term Treasury bonds and thus issuing more money.

Once such transactions are made the sellers will deposit the money in a bank account. The banks may continue to hold more than half of the new money in reserves and collect more risk free interest. Instead of buying bonds why not follow the suggestion to lower interest payments on bank reserves and raise target interest rates to allow the money supply to increase at a modest rate?

Temporary attempts to change long term interest rates on U.S. Treasury bonds have many collateral effects, such as changing the current (spot) and future exchange rates, inducing outflows of capital from the U.S. and causing turbulence in the international money markets. I do not recall that the previous four Fed Chairmen (Arthur Burns, G. William Miller, Paul Volcker and Alan Greenspan) discussed these collateral effects of Fed policies in House Banking hearings where I assisted in preparing questions. Hello, the U.S. is affected by changes in the international money markets that respond to Fed policies.

The banks certainly favor the Fed's interest payments if they can continue to earn sufficient risk free interest on their reserves. Naturally, these Fed Bank presidents would be expected to have a strong incentive to please the banks that elected them to their office and may wish to be reelected at the end of their five-year terms. Two thirds of the nine board of directors that elect the presidents at each of the twelve Federal Reserve district banks are elected by Fed member banks in the district. (All national banks must be member banks. It is optional for banks chartered by state governments.) The election must be approved by the Board of Governors in Washington, but first the applicants must win over the votes of the bankers.

I had experience with this political process when a lawyer at the Kansas City Fed bank successfully ran to be its president. I was one of his staff tutors on monetary policy and general economics. It is an important political process that is also a major conflict of interest for the nation's most powerful bank regulators to be elected by the banks they will regulate.

When I testified against the payment of interest at a Congressional hearing, Congressman Pat Toomey (now running for the Senate in Pennsylvania) made a compelling and common argument for the payment of interest on bank reserves required by the Federal Reserve. (3/5/2005) If banks are required to hold reserves, it is a tax on their earnings, from money they cannot invest, that should be offset with interest payments to the banks. Surplus reserves (reserves that are not required) do not qualify under this rationale.

Economists have also said that the interest payments on reserves would be passed on to the depositors so that people could earn interest on money rather than wasting resources searching for secure investments that pay market rates of interest.

These arguments are not applicable in the current U.S. banking system. First, the interest payments on reserves are unlikely to be fully passed on to "ordinary" depositors by most banks. Rather, it would be a gift to bank stock holders estimated to have a present value of $16.7 billion. The reason interest payments are not fully passed on to depositors is another story about bank pricing practices.

An underlying fact is often ignored. Reserve requirements imposed by the Fed on banks are actually optional for many depositors. Vice President Richard G. Anderson of the St Louis Federal Reserve Bank calls them a "voluntary tax." ("Economic Synopses", 2008, No. 30) One reason is that many business depositors have "retail deposit sweep programs."

These are zero balance accounts because the money is taken off the banks' books before the banks close and interest is paid overnight. Then the money is put back into the accounts. That is all phony accounting to pretend there is no money in the account that would require the banks to hold reserves. The banks can pay a higher interest on these accounts because the Fed does not require reserves to be held against the accounts.

This a deplorable form of price discrimination that treats the "ordinary" depositors as fools who receive regular accounts that pay lower interest, currently often near zero. The Fed should stop this price discrimination, but why would they hurt the banks that elect the Fed Bank presidents?

Sweep accounts are not the only method banks have used to reduce reserve requirements. One example is an accounting scheme called "The Eurodollar Game" that large banks with offshore branches can use to reduce their reported deposits and thus their required reserves. (The game includes counting Friday as three days in calculating average deposits. The deposits can be transferred to offshore accounts so they don't appear on Friday and then brought back on Monday, another phony accounting trick.) Fed Chairman Paul Volcker replied to a request from Banking Committee Chairman/Ranking Member Henry B. Gonzalez to stop the Eurodollar game. Volcker replied that since there were other ways to bypass reserve requirements it would not be desirable to fix this one problem.