Why is Ben Bernanke paying banks to push money under mattresses (i.e. keep it on reserve at the Federal Reserve)? That is the question that Hall and Woodward ask. By paying interest on the reserves on deposit at the Federal Reserve at the same time that the economy enters what appears to be a deflationary cycle, Bernanke is encouraging banks to essentially remove money from the working money supply and place it under a (virtual) mattress where it is absolutely of no use insofar as fostering economic activity.
Let us not forget that the only purpose of money is to foster economic transactions. Money in and of itself has no intrinsic value -- it's just funny-shaped pieces of toilet paper with pictures of dead people on it. It's what you can buy with money that has value, not the money itself. Money on reserve in a bank vault effectively does not exist as far as the economy is concerned. So why is Bernanke encouraging banks to essentially remove money from the money supply?
My theory: Bernanke is a follower of Milton Friedman monetarism. Friedman focused upon money volume, not money velocity, and believed that simply increasing the base money supply was sufficient to prevent deflation (his famous "helicopter drop" speech). Bernanke believes that he is increasing the money supply by printing money to pay this interest on the Fed deposits, and thus performing his duty as a central banker. The problem is that it simply is not working. Instead it is encouraging banks to take money out of the money supply and stuff it under a (virtual) mattress at the Federal Reserve -- exactly the opposite of what should be done during a deflationary cycle.
What's the first thing to be done? First of all, the Fed needs to quit paying interest on reserves. Paying interest on reserves creates a perverse incentive to put money on deposit at the Fed rather than put it into the economy. This would at least unlock lending for consumers and businesses who are solvent, though the core solvency issue underlying our economy -- the sheer numbers of consumers and businesses that are effectively insolvent -- still remains, meaning that it's unlikely that this would reduce bank reserves more than a few percent.
So how to encourage more movement of bank reserves out of the Fed vaults? Hall and Woodward suggest negative interest rates to actually discourage banks from holding money on reserve at the Federal Reserve and encourage them to instead put their money either into loans or into something a little less risky than loans such as Treasuries, where at least it makes it into the economy rather than sitting under a mattress. Greg Manikiw, on the other hand, is skeptical. Manikiw believes that banks, lacking any safe alternative to keeping their excess reserves on deposit at the Federal Reserve, will simply start offering negative interest rates on deposits (i.e., charge you to keep money in their vaults), at which point all that happens is that instead of the money being under a (virtual) mattress at the Federal Reserve, it instead gets withdrawn from banks and shoved under real mattresses. And frankly, given the core solvency problem, I'm not so sure Manikiw is wrong about the effects of charging negative interest rates on bank deposits at the Federal Reserve.
So to reiterate: Bernanke needs to at least quit with this nonsense of paying banks to withdraw money from the money supply. That's the last thing you want in a deflationary cycle. Return the Fed interest rate on reserves back to zero, and get as much of that money as is possible back into the economy (which, as I've previously pointed out, needs roughly a 2% rate of inflation to encourage money to circulate rather than sit under mattresses). Beyond that there is no magic bullet, but at least Bernanke can quit throwing gasoline on the deflationary fire...
-- Badtux the Monetary Penguin