In his recently released book - "Back to Work: Why We Need Smart Government for a Strong Economy" - President Bill Clinton has evidently proposed a slew of ideas to boost job growth and the US economy. Although I've not read the book yet, he has been discussing many interesting ideas through this year, including at the 2011 Clinton Global Initiative (my discussions on the Q&A with President Bill Clinton at CGI 2011 are available here: Part 1, Part 2, Part 2A, Part 2B, Part 3). One of his ideas apparently ties to the reserve policy set by the US Federal Reserve according to Dave Johnson's review of the book in Alternet [the use of bold text is my emphasis throughout this post]:
...Clinton offers a three-part economic and jobs growth strategy:
(1) put as much of the $4 trillion now held in banks and corporate treasuries back into the economy as fast as we can; (2) concentrate on the areas most likely to produce good jobs that have a positive ripple effect, jobs in modern infrastructure building, high-end manufacturing, green technologies, and exported goods and services; and (3) do literally dozens of other things that, when combined, can make a real impact now and also increase our long-term economic growth.
The list is full of smaller policy ideas, like #3, the Federal Reserve has to give banks an incentive to lend. The Fed should charge banks for parking money, maybe .25% and/or require banks to pay their customers a minimum 1% interest on deposits...
Dave's fairly detailed review is worth reading in full but I'm inclined to disagree with his characterization of the latter idea as a "smaller policy idea". I'll use this post to explain why an idea like this could have a substantial impact on increasing lending and thereby boosting nominal GDP (NGDP). In fact, arguably pioneered by economist Scott Sumner who blogs at The Money Illusion, numerous economists across the political spectrum are advocating the need for NGDP targeting by the Fed (rather than prices or inflation), as a response to the large and persistent nominal and real output gap in the US economy. This becomes even more important given recent indications from historically reliable leading indicators that the U.S. could be headed into another recession.
Excess v. Required Reserves
To explore this topic more broadly, it's worth starting with the post "Cash Is Not The Problem" by Paul Krugman back in July 2011. Krugman discussed the massive cash balances that corporations have accumulated and briefly discussed the large amount of excess reserves held by depository institutions (banks), well above the level of required reserves:
Second, banks are also sitting on large amounts of cash that they aren’t lending...
At face value, Krugman has a point - banks are holding well over $1 Trillion in excess reserves. Given that we have a serious NGDP gap with anemic employment growth, it would seem appropriate for the Fed to drive banks to reduce their excess reserves via increased lending in order to stimulate faster economic growth, especially in a political environment where stimulative fiscal policy seems out of reach. However, the fact that banks have large and growing excess reserves does not automatically mean that loan growth is not occurring. To understand this better, we need to look at both excess reserves and required reserves.
I've included below a reserves chart from the St. Louis Federal Reserve Economic Database (FRED). Note that the scales for required reserves (left) and excess reserves (right) are completely different - by over an order of magnitude - meaning that excess reserves have been growing more than order of magnitude faster than required reserves since the start of the Great Recession. Excess reserves have grown from zero prior to the Great Recession to almost $1.5 T now, with the most rapid growth beginning in Fall 2008 when the Fed started aggressively intervening to prevent another Great Depression - via liquidity facilities, loans, asset purchases, etc. (QE1 and QE2 are good examples). The Fed also modified its policy on reserves starting in October 2008 and started paying 0.25% interest on reserve balances - the first time in its history.
Back in July 2009, Todd Keister and James McAndrews of the NY Fed published a report titled "Why Are Banks Holding So Many Excess Reserves?" - their paper is worth reading in its entirety because it addresses possible misconceptions or misinterpretations tied to the growth of excess reserves held by banks. Here is the abstract:
The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve’s liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending. We also argue that a large increase in bank reserves need not be inflationary, because the payment of interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.
One of the many simple examples they cite in the paper is this one:
Now suppose that the financial system enters a period of turmoil that disrupts the normal pattern of interbank lending. Such a market “freeze” might reflect uncertainty about the creditworthiness of Bank B or uncertainty on Bank A’s part about its own future funding needs. Regardless of the reason, suppose Bank A is unwilling to continue lending to Bank B. This disruption places a severe strain on Bank B when it must repay Bank A: if it is unable to obtain a similar loan elsewhere, or quickly raise new deposits, it will be forced to decrease its loans by $40. This decrease in lending would be accompanied by a decline in total deposits, as borrowers scramble for funds to repay the loans, and by a sharp contraction in economic activity. 
Given the nature of the problem in our example, however, the central bank might be able to intervene more effectively in another way. Suppose that instead of lowering its target interest rate, the central bank lends $40 to Bank B. In making this loan, the central bank credits $40 to Bank B’s reserve account. Bank B can then use these funds to repay Bank A without decreasing its lending. The banks’ balance sheets after these actions take place are depicted in Figure 3, where the changes from the earlier figure are in red. For Bank B, the loan from the central bank has replaced the interbank loan. Bank A holds the funds that it previously lent to Bank B as reserves. Notice the change in reserve holdings: total reserves have increased to $60, and excess reserves are now equal to $40.
The goal of the central bank’s lending policy here is to mitigate the effects of the disruption in the interbank market by maintaining the flow of credit from the banking sector to firms and households. The policy is highly effective in this regard: it prevents Bank B from having to reduce its lending by $40. This simple example illustrates how such a policy creates, as a byproduct, a large quantity of excess reserves. Looking at aggregate data on bank reserves, one might be tempted to conclude that the central bank’s policy did nothing to promote bank lending, since all of the $40 lent by the central bank ended up being held as excess reserves. The point of the example is that such a conclusion would be completely unwarranted.
I recommend reading their whole report and all of their other examples - including one in which net lending increases, while still increasing the amount of excess reserves in the system. So, what are the key takeaways? As far as I can tell:
- Growth in total and excess reserves is dominated by Federal Reserve policy initiatives. For example, in the FRED chart above, excess reserves started to skyrocket around the time the Fed intervened in the markets starting in September 2008 and peaked roughly around the time the Fed ended QE1 (March 2010). After declining, excess reserves started to rise again in the Nov 2010 timeframe (start of QE2) and peaked around mid 2011 (coinciding roughly with the termination of QE2 in June 2011).
- Growth in excess reserves cannot be viewed in isolation and does not automatically allow us to infer that lending is either decreasing or not occurring. In fact, after their initial rise in Fall 2008 based on the Fed's actions, required reserves have also been increasing - albeit on a much smaller scale - since the nominal end of the Great Recession, signaling overall lending growth.
It's also worth noting that excess reserves have been decreasing since mid-2011 and required reserves have increased slightly in this period. This is also a normal mechanism when lending is occurring, as explained in the Mar/Apr 2009 paper "More Money: Understanding Recent Changes in the Monetary Base" by William Gavin of the St. Louis Fed:
Second, the banking system as a whole cannot create or destroy bank deposits at the Fed. Only the Fed (and technically, the Treasury) can create or destroy bank reserves. If one bank makes a loan and the funds are deposited in another bank, then the ownership of the deposits at the Fed would change, but the total bank deposits at the Fed would remain the same. In theory, the banking system reduces excess reserves—but only by expanding loans and the money supply in a way that increases required reserves by an equivalent amount. The key is that the Fed will have to drain reserves when the economy begins to recover if it is to prevent a rapid acceleration of inflation.
I infer from these papers that under conditions of economic growth and financial stress, both excess and required reserves could rise during periods when Fed policy measures are in progress (such as QE), and in the absence of Fed actions, the more normal trend of declining excess reserves and increasing required reserves is likely during a business cycle expansion.
Increasing Lending - The Role of Interest Payments on Reserves
If you followed the train of thought above, the key question that emerges is not so much whether lending is occurring, but rather whether enough lending is occurring to seriously shrink the output gap. Regardless of whether the conditions for lending are conducive, it is hard to argue that there is enough stimulative spending in the US economy now given the large and persistent outgap gaps that are yet to be closed and the large amount of excess reserves at banks. This in turn prompts the question as to whether the reserve policy of the Fed is imposing constraints on further lending growth.
The answer seems clear. Perhaps out of a somewhat misguided fear of unchecked inflation, the Fed has effectively and indirectly capped and constrained lending and growth by paying 25 bps of interest on reserve balances of banks (both required and excess reserves) since Oct 2008. The result is that for over the last 3 years, banks could earn more by merely adding to their reserves rather than lending to each other at the effective Fed Funds rate (close to 0 bps), as can be seen from this FRED chart:
The implications of this are significant and have been discussed by Keister and McAndrews of the NY Fed:
The idea that banks will hold a large quantity of excess reserves conflicts with the traditional view of the money multiplier. According to this view, an increase in bank reserves should be “multiplied” into a much larger increase in the broad money supply as banks expand their deposits and lending activities. The expansion of deposits, in turn, should raise reserve requirements until there are little or no excess reserves in the banking system. This process has clearly not occurred following the increase in reserves depicted in Figure 1. Why has the money multiplier “failed” here?
The textbook presentation of the money multiplier assumes that banks do not earn interest on their reserves. As described above, a bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will decrease the short-term interest rate. This lending also creates additional deposits in the banking system and thus leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further.
This multiplier process continues until one of two things happens. It could continue until there are no more excess reserves, that is, until the increase in lending and deposits has raised required reserves all the way up to the level of total reserves. In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts.
As discussed above, however, most central banks now pay interest on reserves. When reserves earn interest, the multiplier process described above stops sooner. Instead of continuing to the point where the market interest rate is zero, the process will now stop when the market interest rate reaches the rate paid by the central bank on reserves. If the central bank pays interest on reserves at its target interest rate, as we assumed in our example above, the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start.
Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.
In summary, making banks actually pay interest on excess reserves (not required reserves!), as President Clinton appears to be suggesting, would make it more profitable for them to lend their money out to other institutions at the Fed Funds rate rather than continue to accumulate excess reserves. It would be a disincentive for banks to maintain excess reserves in this scenario and it could start forcing a much larger portion of excess reserves into the economy. The stimulative effect of this on NGDP could be significant, as long as this happens in controlled fashion and in concert with other policy initiatives that lower the risk of defaults and undesirable levels of inflation (not necessarily limited to the Fed's current inflation target but a higher level commensurate with a period of output gap shrinkage). In my opinion, if the US does sink into another recession, this might increase the pressure on the Fed to adopt NGDP targeting - which, among other things, might force the Fed to revisit its interest rate policy on bank reserves.
P.S. Via Mike Konczal (also), I see that SoberLook has a post attributing an increase in excess reserves at the ECB in the aftermath of the Great Recession with a drop in interbank lending. As I've explained in this post, increase in excess reserves don't always mean that loan operations are paralyzed.