Should the Fed should start paying interest on bank reserves, or at least on the noncash portion of them?

This old issue, which seems to come up every few years, has been revived again.

The substance of the arguments never changes. A principal one in favor of the proposition goes like this:

Banks get no interest on their required reserves, which the Fed invests, turning most of what it earns back to the U.S. Treasury. In effect, banks are paying a tax in the form of lost earnings.

Whatever the merits or deficiencies of such arguments, we should be clear about the central issue.

It seems to be widely assumed that the Federal Reserve System acquires the reserves from financial institutions and then uses those reserves to purchase government securities, upon which the Fed draws interest.

There are two basic misconceptions in that view of what happens.

Creating Money

The first is that the Federal Reserve buys government securities simply because it has the "cash" deposited by banks in their reserve accounts.

Commercial bankers can be forgiven for thinking that way. After all, that is how things work at a depository institution.

However, the Federal Reserve has a motivation other than to employ deposits in an earning asset. Rather than using reserves to buy government securities, the Fed buys securities in order to create bank reserves, which in turn enable banks to create money (deposit liabilities) through lending and investments.

The extent to which banks can create money depends upon their reserve position, and it is that reserve position which the Federal Reserve affects by its purchase of government securities.

So, the Fed acquires securities as a result of its attempts to influence the economy by affecting the growth of the money supply.

The Fed's Magic Check

The second misconception is that the Fed needs bank reserves to acquire the securities on which it draws interest.

In no way does the central bank use a financial institution's reserves as a means of payment for government securities.

The Fed does not need any reserves or any cash to buy securities. In fact, the reserves and money supply are created precisely because the Fed writes a check and uses it to purchase government securities.

If the Fed did not buy securities, there would be no bank reserves other than the relatively small amount created by the Fed's lending to banks through the discount window.

The very act of buying those securities creates reserves in the financial system. Therefore, it is wrong to suggest that the Fed uses those reserves to purchase securities.

Fundamental Paradox

It may be a bit difficult to grasp the idea that the Federal Reserve can buy government securities without having any money in a checking account - but that is one of the main characteristics that make the Fed different from any other entity.

Quite simply, the Fed has a checkbook but no checking account. When my students learn how the Fed works, they want to become a Federal Reserve System, if only 30 minutes!

Let us hope that bankers and politicians, as they debate whether the Fed should pay interest on reserves, understand understand what they will be debating.

A More Basic Question

Also, perhaps the debate should be expanded to consider whether we need reserve requirements today.

Money market mutual funds, insurance company annuities, and other substitutes for bank deposits are not subject to such requirements. In terms of competitive equity as well as regulatory burden, it may be a good time to consider eliminating the requirements entirely.

Mr. Staats is Louisiana Bankers Association professor of banking at Louisiana State University, Baton Rouge.

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