A Response to Arnold Kling

Arnold Kling:

An Assignment for Mark Thoma: I would like for Mark or for Paul Krugman to write an essay on the topic of what would happen if tomorrow the Fed stopped paying interest on reserves. ... I would like for Mark or for Paul Krugman to write an essay on the topic of what would happen if tomorrow the Fed stopped paying interest on reserves.

I don't know if I can get a whole essay out of this. This is something the Fed is considering, but I don't think it would have a very large impact on economic activity. The reason is that I don't think the lack of investment activity, or loan activity more generally (a new report says consumer credit fell again), is due to a problem on the supply side. Banks have tightened up a bit as the economic outlook has deteriorated, but I believe the main problem is lack of loan demand. Here's one reason I hold this view:

How "discouraged" are small businesses? Insights from an Atlanta Fed small business lending survey, macroblog: ..[T]here is congressional debate going on about how to best aid small businesses and promote job growth. Many people have noted the decline in small business lending during the recession, and some have suggested proposals to give incentives to banks to increase their small business portfolios. But is a lack of willingness to lend to small businesses really what's behind the decline in small business lending? ...

We at the Federal Reserve Bank of Atlanta have ... noted the paucity of data in this area and have begun a series of small business credit surveys. ... [T]he results of our April 2010 survey suggest that demand-side factors may be the driving force behind lower levels of small business credit. ...

Based upon this and other indications that this is primarily a demand side problem, I am not convinced that lowering the interest rate on reserves from one quarter of a percent to zero will have much of an effect on investment activity. What we need is a reason for firms to want to invest, and that will require a much improved outlook for the economy, something that could be aided by the government providing additional stimulus to aggregate demand.