Editor's note: This editorial, "A Program For Economic Recovery" was co-authored by Chris Marchese and colleague Edward Fuller.
The financial markets were primarily concerned with the possibility of price deflation when the financial crisis began in 2008. The Federal Reserve System (the Fed) responded to the possibility of price deflation by taking unprecedented actions. These actions have created the potential for a dangerous increase in the money supply. Now the Fed is caught between a rock and hard place. The Fed’s conventional methods of alleviating the problem will severely hamper economic recovery. To grasp the severity of this problem, we must first examine money, fractional reserve banking, and the Federal Reserve System. Then we can move on to outline a remedy.[i]
The Money Supply
Money is the general medium of exchange. It is the most marketable good. People accept money because they believe it can be easily sold in exchange for other goods. Therefore, the money supply should include everything that can be used as a general medium of exchange. The Fed publishes several measures of the money supply. Unfortunately, the Fed does not publish a perfect measure of the money supply. With this in mind, we will use MZM (Money Zero Maturity) as our measure of the money supply. This measure conforms most closely to our rule above, where the money supply includes anything that can be used as a general medium of exchange.[ii] We shall refer to MZM minus the currency component as just demand deposits for simplicity.
Fractional Reserve Banking
Bank reserves are the amount of money a bank keeps on hand for instant redemption. Suppose a bank has $50,000 of demand deposits (checking accounts). These demand deposits can be redeemed by the customer at any time. If the bank keeps all $50,000 in its vault, then the reserve ratio is 100%. However, if the bank lends out the $50,000 to another customer, then the bank now has $100,000 of demand deposits backed by only $50,000 of reserves. The reserve ratio in this case has fallen to 50%. This is called fractional reserve banking because the bank only has a fraction of their deposits covered by reserves. In the United States, the legal reserve ratio at commercial banks is 10%.[iii] In the example above, the bank can legally have $500,000 of demand deposits with just $50,000 of reserves. The bank can achieve $500,000 of demand deposits by making loans. When a bank makes a loan, they do so by simply creating a demand deposit for the amount of the loan. Since demand deposits are money, banks create money when they make loans. Fractional reserve banking is inherently unstable. Firms should arrange their affairs so the time structure of their assets is shorter than the time structure of their liabilities. For example, suppose Mr. A owes Mr. B $1,000. In addition, Mr. C owes Mr. A $1,000. Mr. A should arrange his affairs so Mr. C pays him before he must pay Mr. B.
However, the time structure of a fractional reserve bank’s assets (its loans) is always longer than the time structure of its liabilities (its demand deposits). Demand deposits are due instantly, so it is impossible for a fractional reserve bank to arrange its affairs accordingly. This is equivalent to Mr. A owing Mr. B $1,000 on demand, while Mr. C owes Mr. A $1,000 five years from now. Consequently, fractional reserve banks are always in a state of inherent bankruptcy. A fractional reserve bank can never satisfy all their customers’ redemption demands simultaneously.
In short, fractional reserve banking systems are highly unstable and susceptible to collapse.[iv]
The Federal Reserve System
It is possible for governments to control the money supply through a central bank. The Federal Reserve System is the central bank of the United States. The Fed is the banker’s bank, where commercial banks deposit their reserves at the Fed. The Fed also acts as a cartelizing device to combat the instability inherent in our fractional reserve banking system. The Fed coordinates the fractional reserve banking process and acts as a lender of last resort.The Fed can influence the financial markets and economic activity by manipulating the money supply. The Fed exercises considerable influence over the money supply by controlling the level of reserves.
The following equation simplifies the process by which the Fed increases the money supply through changes in the levels of reserves. D is the level of demand deposits, r is the reserve ratio, and R is the level of reserves.[v]
Change in D = 1/r x Change in R
The Fed can directly control the level of reserves, and hence indirectly control the money supply, by engaging in open market operations. Open market operations entail the purchase or sale of government securities in the open market. The Fed purchases securities when they wish to increase the money supply. This operation increases the level of reserves. The new reserves are then multiplied through the banking system and the level of demand deposits increases.On the other hand, the Fed sells securities when they wish to contract the money supply. This pulls reserves out of the system and thereby reduces the level of demand deposits. To demonstrate this process, suppose the Fed wishes to increase the money supply by $1,000,000. The Fed will go into the open market and purchase $100,000 of securities. The Fed pays by writing out a check to the seller.[vi] Now the person or institution deposits this check at their bank. This bank now has excess reserves of $100,000. This bank does not expand its loans by 10:1. Instead, the bank expands by 1 minus the legal reserve requirement of 10%. In this case, the bank will create $90,000 worth of new loans, thereby increasing the money supply by an additional $90,000.
Eventually, a second bank will receive this $90,000. This second bank will have $90,000 of excess reserves and expand their loans by 90%, or $81,000. This process will continue until the Fed’s initial purchase of $100,000 results in the Fed’s desired increase in the money supply of $1,000,000.
Again, this process is condensed in the equation below:
Change of 1m = 1/.10 x Change of 100k
The Crisis
The Fed was concerned with deflation when the crisis began in 2008. Ben Bernanke is convinced that the Great Depression could have been prevented if the Fed had combated deflation by increasing the money supply:[vii] By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy. Consequently, the Fed responded to the current crisis by pumping an unprecedented amount of reserves into the banking system.[viii] In August of 2008, bank reserves were $44.99 billion. This level of reserves supported $7,937 billion of demand deposits. [ix] The money stock, which is comprised of demand deposits and currency in circulation[x], was $8,712.3 billion. The reserve ratio at commercial banks was .567%.[xi]
Reserve Requirement = 44.9/7,937 = .567%
In contrast, bank reserves were $1,140.5 billion in December of 2009. In short, bank reserves increased by a stunning 2,400% between August of 2008 and December of 2009. Furthermore, a large proportion of the new reserves are excess reserves. Excess reserves in December of 2009 were $1,075.44 billion compared to $1.97 billion in August of 2008.[xii] The Fed’s attempt to prevent deflation has resulted in a dangerous increase in the banking system’s level of reserves. There is the potential for a massive increase in the nation’s money supply. Ben Bernanke recently acknowledged this danger: “the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures.”[xiii] If the banks return to their previous reserve ratio of .567%, then the money stock would increase to $202,029 billion![xiv]
201,164 = 1/.00567 X 1,140.5
Such a massive increase in the money supply poses a serious threat to the global economy and U.S. dollar. Hyperinflation would be the inevitable result.[xv] Hyperinflation would destroy the U.S. dollar and severely hamper economic activity by making commerce nearly impossible to conduct. This potential increase in the nation’s money supply constitutes the single greatest threat to global economic recovery.[xvi]
Alternative Solutions
Some observers offer a simple solution. Some say the Fed should deal with the massive level of reserves by conducting open market operations. Selling securities in the open market would indeed remove reserves from the banking system. However, such a large sale of securities would drive up interest rates to intolerable levels.[xvii] This would cause widespread defaults and severely hamper economic activity.
The Fed’s current solution to the problem is paying interest on reserves.[xviii] This provides the banks with some incentive to refrain from lending. However, this cannot be a long term solution to the problem. The interest rate the Fed pays on the reserves is an extremely low .25%. Eventually banks will be tempted to forego the low, risk free interest they receive on their reserves and make loans that offer higher rates of return. More importantly, the Fed pays interest on bank reserves by simply creating more reserves. Paying interest on reserves results in more reserves, thereby compounding the problem. The Fed’s current policy of paying interest on reserves is simply delaying the inevitable and ensuring that the problem is much worse when we finally decide to address it.
The Plan
The Fed can prevent a massive increase in the money supply by instituting a 100% legal reserve requirement. This change in the legal reserve requirement would be accompanied by an increase in the level of bank reserves, so that the level of reserves is equal to level of demand deposits. This plan can be carried out in three steps. First, the government should reinstitute Regulation Q. Regulation Q prohibited “member banks from paying interest on demand deposits”.[xix] Any account that was checkable was defined as a demand deposit, and any account that earned interest was not a demand deposit. This regulation gave us a simple definition of demand deposits, and hence a simple definition of the money supply.[xx] It will be difficult for the Fed to determine the amount of reserves to create without a simple measure of demand deposits. Reinstituting Regulation Q will ensure that the Fed creates the appropriate amount of reserves. Second, the Fed should create an amount of new reserves so the amount of total reserves is equal to the amount of demand deposits. Demand deposits were $8,716.7 billion in December of 2009. Reserves were $1,140.5 billion. Under these circumstances, the Fed should create new reserves of $7,576.2 billion. Third, the Fed should simultaneously institute a 100% legal reserve requirement. This means that there could be no further increase in the money supply. Furthermore, there would be no scope for a decrease in the money supply. It is very important that the 100% reserve requirement be strictly enforced. If banks used their new reserves to expand their loans, there could be a dangerous increase in the money supply.[xxi] Instituting a 100% reserve requirement with a corresponding increase in reserves will ensure that we don’t experience a dangerous increase in the money supply.
Bank Capital
This plan has one especially important additional benefit. The increase in the amount of reserves will constitute a huge infusion of capital into the banks. Even the most troubled banks will be saved. This operation will save troubled banks and end the financial crisis. Suppose that a bank before the crisis had $100 of IOU’s and $10 of reserves. Total assets are $110. On the right hand side of the balance sheet, the bank has $100 of demand deposits and $10 of equity. Total liabilities and shareholders’ equity is $110. The reserve ratio is 10%. Now suppose the crisis strikes and the value of the bank’s IOU’s falls to $50. This dramatic fall in the value of the bank’s assets results in equity of -$40. The bank is now in serious trouble. If the proposed plan were implemented, the Fed would give the bank $90 of reserves so that the bank’s reserves were equal to their demand deposits. Notice that the bank’s equity account is now positive again. The bank has been saved by the injection of new reserves despite the losses on their loans. Even a bank that took a 100% loss on its loans would be able to satisfy all of their customers’ redemption demands.[xxii] The 100% legal reserve requirement will end the financial crisis by savings banks and preventing an insufferable increase in the money supply.
Conclusion
The single greatest threat to global economic recovery is the massive level of bank reserves. The Fed cannot remove these reserves without causing interest rates to rise to intolerable levels. Astronomical interest rates would severely hamper economic activity by causing defaults on a colossal scale. Paying interest on reserves only compounds the problem. The only viable solution is to institute a 100% reserve requirement. This operation would keep the money supply from expanding or contracting. It would also save the banks.[xxiii]
Resources
[i]The solution offered in this paper is a variation of a plan developed by George Reisman. See: Reisman, George. "A Pro-Free-Market Program for Economic Recovery" (here). The primary difference and advantage of this plan is the reinstitution of Regulation Q.
[ii] “Assets included in MZM are essentially redeemable at par on demand, comprising both instruments that are directly transferable to third parties and those that are not. This concept excludes all securities, which are subject to risk of capital loss, and time deposits, which carry penalties for early withdrawal.” Carlson, John B. "MZM: A Monetary Aggregate for the 1990s?". Cleveland Fed (here).
[iii] Federal Reserve Board, "Reserve Requirements". The Federal Reserve (here).
[iv] Fractional reserve banks can collapse during a bank run. Depositors will make a run on a bank if they suspect the bank can’t satisfy all redemption demands.
[v] Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th Edition: Pearson Addison Wesley, June 2003. Pg. 370
[vi] It’s important to understand where the Fed gets the money to conduct this open market purchase: the Fed creates this money out of thin air. They simply write out a check on themselves.
[vii] Bernanke, Ben. "Money, Gold, and the Great Depression". The Federal Reserve.
[viii] “The Federal Reserve's purchases have had the effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.” Bernanke, Ben. "The Fed's Exit Strategy". The Federal Reserve.
[ix] MZM is “M2 less small-denomination time deposits plus institutional money funds.” "MZM Money Stock". Federal Reserve Bank of St. Louis
[x] The currency component of M1, sometimes called "money stock currency," is defined as currency in circulation outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions. "Currency Component of M1". Federal Reserve Bank of St. Louis
[xi] Some of the computations in this paper are affected by rounding.
[xii] "Excess Reserves of Depository Institutions". Federal Reserve Bank of St. Louis
[xiii] Bernanke, Ben. "Semiannual Monetary Policy Report to the Congress". The Federal Reserve
[xiv]The average reserve ratio from August of 1998 to August of 2008 was .74%. If the reserve ratio returned to .74% with reserves of $1,140.5, then demand deposits would increase to $153,923. This means the money stock could increase to $154,788. This would be an increase of more than 1,500%.
[xv]The purchasing power of money is determined by the supply and demand for money. A large increase in the supply of money causes the supply curve to shift right. The result is a decrease in the purchasing power of money. This relationship between the overall price level and money supply is also captured by the famous Equation of Exchange: MV=PQ.
[xvi] Famous economist Art Laffer recently recognized the danger posed by the Fed’s massive increase in reserves: “the Fed's behavior over the past 15 months has put America on a very dangerous path. The Fed has increased the monetary base (high-powered or wholesale money) by the largest amount ever, from colonial times to the present, times 10. Without an exit strategy, inflation is a virtual certainty over the coming decade, while an effective exit strategy virtually assures a further weakening of the U.S. economy. Chairman Bernanke has put the U.S. economy in a lose/lose situation.” Laffer, Arthur B. "We Can, and Should, Do Better Than Ben Bernanke". The Wall Street Journal (here)
[xvii] The Fed also influences interest rates when they engage in open market operations. Open market purchases drive up bond prices, thereby driving down interest rates. Alternatively, open market sales drive bond prices down. The result is higher interest rates. The operation required to remove the massive level of reserves would drive interest rates up to intolerable levels.
[xviii] "Interest on Required Balances and Excess Balances". The Federal Reserve (here)
[xix] "Regulations". The Federal Reserve
[xx] The law currently fails to properly distinguish between the bailment contract and the loan contract. This failure is by no means trivial. One essential difference between a bailment contract and a loan contract is interest. In a bailment contract there is no interest. In the 100% reserve system, depositors must specify whether they intend the contract to be a bailment contract or a loan contract. Regulation Q partially accomplishes this objective by stating that any account that pays interest is not a demand deposit.
[xxi] It’s very important the 100% reserve is strictly enforced. Suppose the 100% reserve was not enforced and commercial banks continued to engage in fractional reserve banking. The potential increase in the money supply would be ruinous. Assuming banks returned to a reserve ratio of .567% and level of reserves was $8,716.7 billion, the potential money stock would be approximately $1,538,000 billion. The 100% reserve must be strictly enforced.
[xxii] Some observers may object that this plan constitutes a huge gift to the banks. This is certainly true. However, this gift would come with the condition that the banks can no longer engage in fractional reserve banking.
[xxiii]Sadly, our policy makers are unlikely to implement the plan proposed in this paper. First, our policy makers believe there is a trade-off between price inflation and unemployment, and they will always error on the side of price inflation. Second, a 100% reserve requirement would make it impossible for the banking system to help finance large budget deficits and thereby impose strict limits on government expenditures. Therefore, it is the author’s opinion that the United States will experience substantial price inflation in the coming years.
