Bruce Bartlett on Why the Fed Should Stop Paying Banks Not to Lend Money

The short answer is that they can make money by sitting on their reserves and earning interest from the Fed -- a risk-free option compared with loaning money at low market interest rates. He then goes on to speculate why interest rates are so low. One possible reason: Slow GDP growth means businesses aren't demanding loans. Another reason? Deflation.

"Another possibility is that the economy is experiencing de facto deflation; that is, a falling price level. While this is not evident in the consumer price index, economic theory nevertheless suggests that this may be the case.

That is because theory says that the real (inflation-adjusted) interest rate is relatively stable. A recent Federal Reserve Bank of St. Louis study says the "natural rate of interest" historically has been about 2 percent. So if banks are satisfied with a market interest rate of 0.25 percent or less, this suggests that the economy may be experiencing a deflation rate of about 2 percent. (The rate of deflation is added to the market interest rate to yield the real rate.)

If this is true, it explains why the economy appears to be suffering from tight money despite low nominal interest rates and a vast amount of excess reserves in the banking system. Deflation has a paralyzing effect on business activity because downward pressure on prices causes profits to be squeezed.

Indeed, the International Monetary Fund has lately warned of the danger of deflation, and The New York Times reports that China is now suffering from it. There is also evidence of deflation in the United States in daily price data collected by the Massachusetts Institute of Technology."

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