Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong’s terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it’s unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways. 

The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.   

Addendum: Lynne Kiesling draws the Olsonian conclusion.

A famous paper in economics showed how cigarettes became a medium of exchange in a POW camp (even leading to booms and slumps depending on Red Cross deliveries).  For a long time cigarettes were the money of choice in American prisons as well but today, according to a great piece in the WSJ, the preferred medium of exchange is mackerel.

There’s been a mackerel economy in federal prisons since about 2004,
former inmates and some prison consultants say. That’s when federal
prisons prohibited smoking and, by default, the cigarette pack, which
was the earlier gold standard.

Prisoners need a proxy for the dollar because they’re not allowed to
possess cash. Money they get from prison jobs (which pay a maximum of
40 cents an hour, according to the Federal Bureau of Prisons) or family
members goes into commissary accounts that let them buy things such as
food and toiletries. After the smokes disappeared, inmates turned to
other items on the commissary menu to use as currency…in much of the federal prison system mackerel has become the currency of choice.

I loved this point which raised the possibility of significant mack seignorage.

…Mr. Muntz says he sold more than $1 million of mackerel for federal
prison commissaries last year. It accounted for about half his
commissary sales, he says, outstripping the canned tuna, crab, chicken
and oysters he offers.

Unlike those more expensive delicacies, former prisoners say, the
mack is a good stand-in for the greenback because each can (or pouch)
costs about $1 and few — other than weight-lifters craving protein —
want to eat it.

Thanks to Brandon Fuller for the link.

R: "I’m quite pessimistic about the current financial system.  I’ve been buying gold."

A: "Gold?  That’s not pessimistic enough.  I’ve been buying rice."

Or so say Larry Summers and Mark Thoma who argue that we can have a bailout and a stimulus package and still have tax cuts and more spending on energy, health care, education and all the other goodies that we have been promised.  Salesman Summers explains:

Just as a family that goes on a $500,000 vacation is $500,000 poorer
but a family that buys a $500,000 home is only poorer if it overpays,
the impact of the $700bn programme on the fiscal position depends on
how it is deployed and how the economy performs. The American
experience with financial support programmes is somewhat encouraging.
The Chrysler bail-out, President Bill Clinton’s emergency loans to
Mexico, and the Depression-era support programmes for housing and
financial sectors all ultimately made profits for taxpayers…

Does this sound familiar?  I can hear it now.  A vacation sir is consumption but a home, ah a home, that’s investment.  Investments pay off.  Just look at the American experience.  Rising home prices!  Never a downturn.  Isn’t that encouraging?  Hell, at prices like these you can hardly afford not to buy.  Yes sir, a home that’s a wise investment.  And that makes you sir, a wise investor.  And a wise investor, well a wise investor can certainly afford a nice vacation.    

Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing.  At the time, Paul Krugman and others responded that this was just temporary as firms drew on previously existing lines of credit.  Well here we are in September and bank credit continues to look very robust.  As Robert Higgs points out consumer loans are up, commercial and industrial loans are up, even real estate loans are up.  Overall, total  bank credit is up with just a slight sign of leveling off in recent weeks.  So where is the credit crunch?

A credit crunch does exist in the sector of the market based on short-term, asset backed securities.  In addition, interbank lending is unusually risky.  But in light of what I have just said the "credit crunch" takes on a new meaning and potential new solutions are suggested.  The first question I have is this.  Investment banks were selling these securities and using the money to lend to whom?  I do not know the answer.  But let’s suppose that the money being raised in these markets was being lent to productive businesses.  If so, then any solution should focus on feeding those businesses that are starved for credit.

I look at the situation as follows.  Banks are bridges between savers and investors.  Some of these bridges have collapsed.  But altogether too much attention is being placed on fixing the collapsed bridges.  Instead we should be thinking about how to route more savings across the bridges that have not collapsed.  Government lending may be one way of doing this but why lend to prop up the broken bridges?  Instead, why not lend directly to the investors who are in need of funds?  After all, if these investors exist and have valuable projects that’s where the money is!  Let the broken bridges collapse, taking the shoddy builders with them.  Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.

Now here is a hypothesis.  It may be that there just aren’t that many firms in need of funds.  First, one reason that bank lending is up may be that firms with good projects have already turned to the substitute bridge of ordinary bank loans.  Second, I wonder how much real lending was actually being generated by asset backed securities.  Could it not be that most of the funds generated were used to buy more asset backed securities?  (The growth in these securities is certainly suggestive of that possibility).  If that is the case then it explains why the real economy has been remarkably resilient to the "credit crunch."

Now perhaps I am wrong about all this.  Bernanke has access to a lot more data than I do and he seems very worried.  I’d still like to know, however, which credit-worthy firms are credit starved.  And I’d suggest that we ought to think more about alternative bridges that will connect credit-starved firms with savers.