The European Central Bank (ECB) recently cut to zero the interest it will pay to banks on what amounts to excess reserves held overnight by the ECB. European banks have been holding “excess liquidity” at the ECB. U.S. banks are doing the same at the Federal Reserve. Excess reserves amounts to the cash banks have above and beyond what they are legally required to “hold” with the Central Bank/Federal Reserve. Paying interest to the member banks on this excess liquidity gives them an incentive to not lend money. This is precisely why the ECB dropped the rate to zero -- to remove the incentive tilting banks toward non-lending.
It is too soon to know how effective the program will be in Europe given the confidence issues that permeate the continent. However, the ECB move does bring to mind what we have advocated in the past vis-a-vis the Federal Reserve. Stop making it profitable for U.S. banks to not lend money. Stop paying interest on excess reserves. Confidence in the short to intermediate term should not be as big an issue in the U.S. as it is in Europe given the Fed’s stress tests on banks, federal system of oversight, growing economy, and our contention that your typical bank wants to do what is profitable (responsibly lend money). Putting excess cash into play would most likely improve the current business cycle rate of rise.
