Are Tighter Reserve Requirements the Answer to Mr. Bernanke’s Dilemma?

In the February 3rd edition of the Wall Street Journal, Andy Kessler lays out his preferred approach for Ben Bernanke and the Fed to unwind the monetary stimulus they have injected into the banking system in the past two years. This stimulus has been staggering. The monetary base, the part of the money supply the Fed actually controls, has ballooned from $850 billion to $2 trillion. Not exactly chump change. Mr. Kessler believes that the Fed should increase the required reserve ratio, the percentage of deposits that a bank must keep on hand: that is, the percent they can’t lend out; by 1% per year until it hits 20%. This would dampen the effect of the fractional reserve system we have. Since the ratio is about 3% now, this will take 17 years or two business cycles to complete.

This isn’t a new idea. Usually, though, people follow it to its logical conclusion: 100% reserve money, or something akin to a gold standard. With 100% reserves, a bank could only lend out their own funds, debt or the deposits, but not a multiple of the deposits. Without going through the math, a fractional reserve regime allows the banking system to lend out 1/reserve ratio it has as initial deposits. If the reserve ratio is 8% then $1 of deposits could support a total of $12.50 in loans, $1/.08. This is, in effect, increasing the money supply by $11.50.

A one hundred percent reserve policy would eliminate the fractional reserve banking system. It would cause an increase in the velocity of money and/or cause prices to decline (including wages) and cause trade credit to expand, as would any decrease in the money supply. Now, if there would be a jolt to the system (not all jolts are monetary) trade creditors would bear the brunt. Since they tend to have narrow focus’s – lack of diversity in assets – they could be clobbered. Banks tend to diversify their assets because their expertise is in risk evaluation. Trade creditors are just trying to move product out of the factories.

The author understands how fractional reserve banking got started but doesn’t seem to understand that Goldman Sachs, Lehmann Bros., etc. couldn’t engage in it because they don’t have demand deposits, only commercial banks do. Investment banks can’t create money! While people may grouse about Goldman’s knack for “printing” money, that isn’t the same thing. The fact that investment banks were very highly leveraged doesn’t derive from any reliance on fractional reserve banking.

Mr. Kessler’s approach is completely wrong to implementing a higher reserve ratio. It is a classic case of the law of unintended consequences. If banks knew that the reserve ratio was going to climb in the future they would lend like mad today, allowing the natural runoff of the loans to bring them into compliance with the higher ratios in the future. This would balloon the money supply causing prices to rise rather substantially, igniting the inflation that he wants to avoid. It would be followed by a recession as the money supply decreased but individuals didn’t believe that the cycle wasn’t going to repeat itself. For those of us old enough to remember, this is just the Carter years revisited.

It would make more sense (but see below) to immediately raise the ratios to effectively sop up a portion of those excess reserves sitting on banks’ balance sheets. However, this doesn’t address the real problem: the creation of the excess reserves. As long as the Fed pumps reserves into the banking system the multiplier effect exists with any fractional reserve system. It may be lower with a 20% reserve ratio than with a 10% reserve ratio (and, of course, it is higher than larger one) but it is still there.

Since it would be unfair to jump to a 20% reserve ratio immediately because most of the banks in the US weren’t part of the debacle and adjusting that quickly would wreak havoc on them and their customers. The easiest way would be for the Fed to start selling those securities they purchased back into the banking system. This would be reversing the expansion process. Those banks with the excess reserves would see them decline. Other banks that do not have excess reserves wouldn’t be impacted.

Once the excess liquidity is sopped up then it would be time to seriously consider an 100% reserve requirement. Also, and probably more importantly, at that point the Fed should cease and desist discretionary open-market operations. Real per capita GDP growth in the US is about 2.25%. The Fed should add reserves to the system at an annualized rate of 2.0% each week. This wouldn’t be perfect but it would reduce the volatility in the economy emanating from the monetary sector to white noise. The Fed’s intervention would be limited to providing liquidity to sound banks that experienced a run. Any serious volatility would then be attributable to events in the real sector of the economy.

There is one final aspect which isn’t the Fed’s concern, directly,  since their mandate is to maintain price stability, along with full employment.  Banks are not eleemosynary  institutions.  They are there to make money.  Reducing the extent to which they can expand the money supply will make them less profitable.  As such, they will raise fees and interest rates and lower deposit rates.  The marginal banks will fail.  Thus, the banking industry will undergo accelerated consolidation.  This may or may not be a good thing.  However, those who are impacted will cry to their elected officials to “do something.”  This will, without a doubt, be a bad thing.  Politicians who by their nature do not understand economics or finance will concoct a solution that makes things worse.

Therefore, be careful of what you wish for.  As Thomas Sowell has pointed out we need to think past stage one.

Posted by Jim