Uneasy Money

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.