November 10, 2014 Reading Time: 2 minutes

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During the 2008 financial crisis, many banks became illiquid and did not have enough cash reserves to pay their debts. The Fed responded to the liquidity shortage by paying banks to hold more reserves.

The policy of paying interest on reserves (IOR) is intended to make banks safer, but can higher reserves actually increase risk? How should banks manage their reserves in case of an emergency or financial crisis?

Consider the analogy of a farmer saving food for the winter. In the summer months, the farmer has plenty of food. Rather than consume it immediately, he stores some away for the winter months. The farmer’s food production is much lower during winter months, so he saves nothing during the winter and instead consumes from the stores he accumulated during the summer. In other words, the farmer adds to his reserve when things are good and reduces his reserves when he is in need.

We would see a similar pattern for a worker who worries about potential unemployment. The worker saves some money so that if he happens to lose his job for some reason, he can live for a time off the funds he has saved.

Notice, however, the Fed’s IOR policy caused U.S. banks to do just the opposite. In the financial crisis, banks suddenly found themselves short on cash. Rather than using the cash their available cash to pay their debts, the Fed encouraged banks not to spend that money but instead to hold it as reserves. The Fed essentially made banks less liquid by turning bank reserves from liquid (usable) assets into illiquid (unusable) assets.

Think about how this would affect a farmer saving for winter or a worker saving for unemployment. Would it make any sense for a farmer to save very little during the summer months and then increase his savings in winter when he has little food available? Should a worker wait until he loses his job and then suddenly start putting money in his savings account? It seems quite the opposite of what they should do, and it’s the opposite of what banks should do too.

The Fed responded to the “credit crunch” of 2008 by starting to pay interest on banks’ reserves. At a time when banks were in need of liquid assets, this policy actually reduced liquidity in the banking system.

To make matters worse, the Fed’s IOR policy also inhibits it monetary policy since the base money created by the Fed’s quantitative easing programs is mostly being held as bank reserves rather than stimulating the economy. By preventing recovery, IOR at least partly caused the Great Recession.

The Fed’s IOR policy is all costs with no benefits, and these problems will only worsen as banks continue to add more reserves to their balance sheets. Rather than increase the interest paid on reserves as prescribed by Fed Chair Janet Yellen, the Fed should end its harmful IOR policy as soon as possible.

Thomas L. Hogan

Thomas L. Hogan, Ph.D., is an Associate Senior Research Fellow at AIER. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing and Urban Affairs. He has also worked at Rice University’s Baker Institute for Public Policy, Troy University, West Texas A&M University, the Cato Institute, the World Bank, Merrill Lynch’s commodity trading group and for investment firms in the U.S. and Europe. Dr. Hogan’s research has been published in academic journals such as the Journal of Macroeconomics and the Journal of Money, Credit and Banking. He has appeared on programs such as BBC World News, Stossel TV, and Bloomberg Radio and has been quoted by news outlets including CNN Business, American Banker, and the National Review.

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