Raising Reserve Requirements

In Monday’s Wall Street Journal, Charles Calomiris advocated raising reserve requirements on banks as a pre-emptive strike against gathering inflationary forces inherent in the huge growth in bank reserves since 2008, forces expected by Calomiris to become increasingly powerful in coming months.

The end of credit crunches like the one we’ve just gone through can see dramatic and sudden increases in bank lending. After six years of zero loan growth in the banking system from 1933 to 1939, for example, a sudden shift in the economic climate produced a surge in lending by U.S. banks, and from December 1939 to December 1941 lending grew by roughly 20%.

That is precisely the risk the U.S. faces over the next several years. Given the huge amount of reserves held by banks in excess of their legal requirements—excess reserves today stand at roughly $1.5 trillion—there is the potential for an even more sudden increase in credit and money growth today, accelerating the inflation rate.

By increasing reserve requirements, in effect quarantining a big chunk of those reserves, the Fed, Calomiris believes, could help keep a lid on inflation while it drained reserves from the banking system over a longer time horizon than it might otherwise have.

However, this recommendation flies in the face of a half-century old consensus, dating at least to the Monetary History of the United States by Friedman and Schwartz, that a key factor in causing the 1937-38 downturn, a downturn shorter but almost as sharp as the 1929-33 downturn, was the doubling of reserve requirements in 1936-37. It was thought at the time that since the banking system was then holding very large amounts of excess reserves, raising reserve requirements would entail no tightening of monetary policy, instead just eliminating slack in the system, thereby making it easier to implement monetary policy. Calomiris acknowledges that his proposal resembles the proposal to increase reserve requirements in 1936-37, now viewed as a disastrous mistake, but maintains that the consensus that raising reserve requirements in 1936-37 led to the downturn of 1937-38 is itself mistaken.

In 1936-37 the Fed doubled reserve requirements as an insurance policy against inflation, and some monetary economists have argued that this contributed to the recession of 1937-38. But recent microeconomic analysis of bank reserve holdings by Joseph Mason, David Wheelock and me in a 2011 working paper available from the National Bureau of Economic Research showed that the higher reserve requirements were small relative to the banks’ pre-existing excess reserves and had no effect on interest rates or the availability of credit.

In their recent paper, Calomiris, Mason and Wheelock attribute the 1937-38 downturn mainly to a policy of sterilization of gold inflows undertaken by the Treasury starting in early 1937. Scott Sumner has similarly emphasized the sterilization policy as a key factor in causing the downturn by increasing the real value of gold, a deflationary shock in the quasi-gold standard monetary regime of the time, with gold convertibility suspended but with gold still playing a very important role in the international monetary system. Doug Irwin has also attributed the 1937-38 downturn to the gold sterilization policy in his recent paper on the subject, and even Friedman and Schwartz in the Monetary History ascribed about as much importance to gold sterilization as they did to the increase in reserve requirements. So Calomiris’s argument that doubling reserve requirements in 1936-37 was not the cause of the 1937-38 downturn is not quite as far out of the mainstream as it seems at first. Nevertheless, Scott Sumner is very critical of Calomiris’s historical argument about the 1937-38 downturn and about his current policy proposal for launching a pre-emptive strike against the gathering inflationary threat.

Now I must admit that I am not that well-informed about the 1937-38 downturn, more or less accepting at face value what I learned as an undergraduate, second-hand from Friedman and Schwartz, that it was the doubling of reserve requirements that caused the problems. While I have come to reject much of what Friedman and Schwartz had to say about 1929-33, until I read what Scott Sumner wrote in his unpublished work on the Great Depression about the role of gold in the 1937-38 downturn, it never occurred to me that there might be more to the 1937-38 episode than the doubling of reserve requirements.  I’m also now aware if Hawtrey wrote anything about the 1937-38 downturn, though it would actually be pretty surprising if he did not.  So, I now have something new to think about. How nice.

So here’s the first thing to cross my mind. Doubling reserve requirements increased the demand for reserves by the banking system. Calomiris et al. deny that increasing reserve requirements raised the demand for reserves, relying on regression estimates of the demand for reserves over 1934-35, which they use to simulate the demand for reserves in 1936-37, finding that there is little unexplained residual left to be attributed to the effect of increased reserve requirements. I still don’t understand the argument, so I can’t say that they are wrong. But it seems to me that if doubling reserve requirements did increase the demand for reserves, as I would expect to have happened, the consequence of the excess demand for reserves would be an influx of gold imports, which is just what happened. However, the policy of gold sterilization prevented the banks from increasing their holdings of reserves. The ongoing excess demand for reserves was translated into an ongoing increase in the demand for gold, causing an increase in its value and a drop in prices as long as the dollar price of gold remained stable. Thus, there was an underlying connection between the doubling of reserve requirements and the sterilization policy, a possibility that Calomiris seems to have overlooked.

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13 Responses to “Raising Reserve Requirements”

  1. 1 Julian Janssen March 12, 2012 at 10:48 pm

    I have added a somewhat relevant, somewhat irrelevant post on my blog which barely touches on this, but is more centered on some stupendously bad economics from none other than the worst economist of which I am aware, Arthur Laffer:


    I would appreciate any thoughts anyone has on my presentation or any errors that I may have made.

  2. 2 Tas von Gleichen March 13, 2012 at 3:08 am

    The dollar is going to lose it’s status as the reserve currency of the world. Which currency will be next in line? I would guess the renminbi has a good chance.

  3. 3 foosion March 13, 2012 at 4:07 am

    We have two issues for economic policy (1) existing slow growth and very high levels of unemployment and (2) the possibility of inflation at some point in the future. The first problem is inflicting massive human suffering today. The second issue is a theoretical concern.

    Why would we want to embark on a policy course to deal with the second issue when the first is immediate and pressing and dealing with the second today will make the first worse?

  4. 4 Julian Janssen March 13, 2012 at 5:22 am

    What I really do not understand is why there is so much paranoia about inflation when it only momentarily reared its head, then went to sleep after a brief commodities boom (that was probably more about international demand, than about demand in the U.S.). I suppose the idea of raising the reserve requirement is about “soaking up” the extra liquidity in the U.S. economy, except that there really isn’t that much right now. Okay, the monetary base is considerably higher than it has been, but much of the new money is just being used as reserves anyway. If it’s not being used for expanding credit or in the form of hard currency on the street, how is it going to be direly inflationary?

  5. 5 Frank Restly March 13, 2012 at 10:34 am

    Here is a plot comparing three items – Consumer Price Index, Inflation adjusted fed funds rate, and total credit market debt outstanding:


    Notice that even as credit growth exploded throughout Reagan’s presidency, the inflation rate kept falling. Part of the reason was the elimination of housing prices from the CPI in 1983 and part of the reason is Paul Volcker keeping the fed funds rate above the rate of inflation.

    Reserve requirement’s can limit credit creation, but ultimately they cannot determine how credit is used (productively or non-productively).

    From the equation of exchange:

    MV = PQ

    Replacing M with debt, and PQ with Real GDP * (1 + Inflation Rate) we get:

    Debt * Velocity = Real GDP * (1 + Inflation Rate)

    Productivity is simply:

    Productivity = Real GDP / Debt = Velocity / (1 + Inflation Rate)

    It should be obvious that positive real interest rates correspond with a higher velocity of money and higher real GDP growth – except maybe to the current FOMC and certain Wall Street Journal reporters.

  6. 6 on your MArx March 13, 2012 at 2:08 pm

    The major problem of the 1937 explanation of reserve requirements slowing the economy is that the Fed did exactly this in 1941 to little effect!

    Both Friedman and Schwartz gloss over this.

  7. 7 Julian Janssen March 13, 2012 at 7:42 pm

    Um… I think there was a mitigating factor… World War II?

  8. 8 flow5 March 14, 2012 at 8:30 am

    Nothing today is like that in 37-38. The only method in a free capitalistic soceity by which the volume of money can be controlled is via reserve requirements. Contrary to Milton Friedman, reserve requirements are not a tax.

  9. 9 on your MArx March 14, 2012 at 2:21 pm

    Yes fiscal policy was not tightened in 1941. quite amazing that

  10. 10 David Glasner March 17, 2012 at 9:15 pm

    Julian, I had a quick look at your post about Laffer. I am not a fan of his, but he occasionally does have some worthwhile things to say, so I would not grade him as harshly as you. On what caused the crisis in 2008, I actually think that he is right (if I understood what he was saying) that tight money in 2008 caused the recession to get much worse in quarters 1-3, before the financial crisis in the fourth quarter. So although the housing bubble and other bad stuff helped cause the recession, the Fed made it worse by focusing on commodity prices and not easing between March and October of 2008, even though conditions were deteriorating rapidly.

    Tas, I don’t think that the dollar’s position is in an immediate or even medium term danger. Beyond that, anything might happen, but it won’t be because of any decisions being made now.

    foosion, Very well said.

    Julian, I agree.

    Frank, Thanks for sharing.

    on your Marx, There generally is more than one factor affecting the economy, so it’s always tricky to predict what will happen by focusing on just one variable. But it would be valid criticism of Friedman and Schwartz if they did not mention an increase in reserve requirements in 1941. I have not checked to see whether they do or not.

    flow5, There must be a positive demand for currency or reserves for the value of fiat money to be positive. Legal reserve requirements are one way of creating such a demand, but not the only one. If I can force you to hold my IOUs without paying interest on them, I am extracting wealth from you. That seems to me to be a very much like a tax.

  1. 1 Links for 2012-03-13 | FavStocks Trackback on March 13, 2012 at 12:27 am
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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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