I think it’s safe to say that the standard economist take on the Fed paying interest on reserves is that it was a tool to (try to) keep the federal funds rate from sinking. The Fed had flooded the market with tons of new reserves (see my new favorite chart below), and so naturally the interest rate on overnight loans of these reserves would sink. Thus, Bernanke may have thought that he could achieve both of his objectives–(1) buy up dubious assets and (2) peg the federal funds rate–if he started paying interest on reserves.

If that was in fact Bernanke’s plan, it obviously didn’t work. (Robert Wenzel points out that one problem is that the GSEs are still able to lend reserves in the federal funds market, but they’re not allowed to earn interest from the Fed. So they would lend them out.)

Tyler Cowen links to this interesting Interfluidity post that discusses a different aspect I hadn’t even considered:

Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge. So, let’s imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed’s balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed’s de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an “investment”: The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.

Now we can quibble about the calculation. What the guy (?) means is that the higher the interest rate the Fed pays, you’d think the greater the subsidy. But not if we take the interest rate to be “the” interest rate. A dollar the Fed pays to the banks next year isn’t the same as a dollar today, and so if you discount future payments at the same rate of interest at which the initial principal is rolling over, then the present value of that entire future stream of interest is exactly equal to the original principal.

For what it’s worth, it wouldn’t surprise me if the Fed discontinues interest payments once inflation gets out of control. But then again, if the banks are still on a morphine drip (which they will be–just look at housing projects), then maybe it will be too painful to contemplate.

Last point: Even more than the mysterious open market operations, in which the Fed buys an asset (such as a government bond) from a bank and then credits its account with more reserves, here the Fed quite openly is “creating money out of thin air.” Perhaps the actual mechanism is more subtle than this, but my understanding right now is that if you are a bank and have $1 million on deposit with the Fed, they pay you interest simply by changing the number in their records. No need to debit this payment from some other fund, no need to get Congressional approval, no need to float bonds to raise the money for it. You need to pay out a million dollars in reserves today? Go right ahead, just change the 1s and 0s in the computer.

I think it’s starting to sink in with people, even members of Congress, how powerful the Fed really is. I’m still pretty sure Bernanke is mostly an academic, and he’s trying to do what he can in an admittedly impossible situation. The only real deceit I think coming from Bernanke is his acting like he knows what the hell he’s doing.

But what happens when a real schemer runs the Fed? Do you realize that the Fed chairman effectively has a printing press at his command? Can you imagine the outcry if one sheik controlled the entire world’s supply of oil? Well the Fed chair controls the world’s supply of dollars.