Did Increased Required Reserves Prolong the Great Depression?

0:00The paper that I am presenting is actually co-authored with my colleague Jeff Herbner. The paper entitled, Did Increased Reserve, Required Reserves Prolong the Great Depression? The short answer is no. At least that's what we're going to argue. And the reason we're interested in this question is simply because of really monetary policy, more recent monetary policy during what we could call the Great Recession. Since the beginning of 2008, the monetary base has increased by 178% because the Chairman of the Fed wants it that way, to easily the highest level ever. And since the beginning of 2008, excess reserves in the banking system in commercial banks increased in the United States, increased from $1.65 billion to $1.037 trillion with If banks decide to expand credit in the form of demand deposits while maintaining, if they decide now we're finally actually going to start extending credit, seriously extending credit, while maintaining simply a 20% reserve ratio, that would allow M2 to increase by $5.185 trillion.

1:22If banks do the same while maintaining a more conventional 10% reserve ratio, M2 would increase by $10.37 trillion, and this would more than double M2. So, naturally, people have considered the question, what should we do besides run for our lives? And Ben Bernanke has told us and assured us we have a plan. We have a plan. Part of that plan included paying commercial banks interest on their reserve deposits to keep them in the system. Other people have pointed out that that doesn't really unwind the reserves, that just keeps them in the system.

2:07So what do we do? Well, we have a plan. One of the things that we could do to try to mitigate the potential serious inflationary impact of these increased excess reserves would be raise legal reserve requirements. This would constrain how much of the additional monetary base could actually be extended as credit and hence constrain the amount of new demand deposits and new money that is actually created by the banking system. And this is an idea that is out there. A number of people, a number of economists and policy makers, however, aren't too excited about this.

2:55David C. Wheelock, vice president of the St. Louis Fed in a little newsletter called Economic In 2009, he said that referring to the experience of the 1930s, he said experience demonstrates that raising reserve requirements is surely not the best way to eliminate excess reserves. It's not the best way. You could eliminate them this way, but it's not the best way because of negative economic consequences. Christina Romer, in an article in The Economist in June 18, 2009 entitled The Lessons of 1937, said this quote, In 1936, the Federal Reserve began to worry about its exit strategy.

3:41After several years of loose monetary policy, American banks were withholding large quantities of reserves in excess of their legislative requirements. Monetary policymakers feared the excess reserves would make it difficult to tighten if inflation developed. The Fed then doubled reserve requirements in a series of steps. It was a three-step process. And when the excess was legislated away, they scrambled to replace it by reducing lending. This contracted the money supply, and that ushered in then the recession and crash in 1938, which prolonged the Great Depression. and she explicitly cites the empirical work done by Friedman and Schwartz to demonstrate this case.

4:27And so people like Wheelock and Romer and Paul Casreal at Northern Trust follow Friedman and Schwartz in their warning us of the problems of raising excess reserve requirements to sop up excess reserves and make them non-excess. And so we wanted to investigate this hypothesis. Is this really the case? Is the Friedman-Schwarz hypothesis, is it a sound explanation for why the Great Depression lingered past 37? And Friedman and Schwarz's thesis is essentially that the three-step increase in legal reserve requirements during 1936 and 37 had deflationary effects.

5:16Because although commercial bank reserves were in excess in a legal sense, banks did not perceive them as excess in a prudential or economic sense. Increasing required reserves debased, or I'm sorry, decreased the current quantity of reserves banks could draw upon to meet depositors' demand for currency. Banks therefore, it is argued, took steps to increase their reserves even further. And this effort to further increase bank reserves resulted in a contraction of the money supply. And despite commercial banks holding excess legal reserves then, the increase in legal reserve requirements did have real economic effects at the time of the increase and not just in the future by restraining future excess credit expansion, which was really the desire of the Federal Reserve governors at the time.

6:16As Friedman and Schwartz tell their story of monetary history leading up to the recession in the Depression of 38, they argue that in 1936, banks began to accumulate excess reserves because they thought it was the prudential thing to do. Commercial banks, they argue, lost faith in the Federal Reserve as a lender of last resort and recognize that holding only legally reserved, legally required reserves was not enough to ward off insolvency in times of crisis. Consequently, banks accumulated cash assets because their demand for liquidity had arisen. And when the Federal Reserve raised Federal Reserve requirements in 1936 and 37, this immobilized that cash for use. So banks therefore built up even more reserves and increased their ratio of cash to total assets.

7:06The building up of reserves proved to be deflationary, they argue, causing the depression of 1938. Now a survey of the relevant economic literature reveals many who accept Friedman and Schwartz. Richard Timberlake, for example, argues in his work that was published primarily in the Friedman, as well as in his book on the history of monetary policy in the U.S. Timberlake argues that the Federal Reserve needlessly, as he puts it, and foolishly was concerned about inflation as excess reserves piled up in the mid-1930s. And I've heard similar language today. Inflation, where's the inflation? It's foolish to look around and worry about inflation now when prices are staying relatively Timberlake said that the policy of the Fed in the 30s is also foolish. He also agrees explicitly with Friedman and Schwartz that the U.S. Treasury reinforced the Federal Reserve's deflationary policies by sterilizing the influx of gold.

8:19We don't really deal with that element in much detail yet in this paper, which is still a paper in progress. But the heart of Timberlake's argument is to construct a measure of potential money supply and full employment money supply for the time period in question. And on the basis of what he perceives to be the full employment money supply, in other words the money supply that we should have had to maintain full employment in 36 and 37, He argues that the increases in the reserve requirements kept the money supply much below its full employment level. And so on the basis of this analysis, he repeats the conclusion of Friedman and Schwartz, almost word for word. Although commercial banks held large quantity of reserves that were excess legally, they were not economically in excess because the banks needed them because they couldn't trust the Federal Reserve to be a provider of adequate liquidity.

9:11Now, we note in our paper that Tiver Lake's definition of the full employment money supply level is not without its own problems. For instance, in identifying the supply that would yield full employment, he makes two adjustments to the existing money stock, and this is what he says, quote, one, the first adjustment is the additional amount that would have been necessary to accommodate the real output of goods of Goods and Services to a Fully-Employed Labor Force would, let me read that again. One, the additional amount that would have been necessary to accommodate the real output of goods and services a fully-employed labor force would produce. And two, this is the second adjustment, the additional amount of money that would have been necessary to get the price level back up to the value it had had in 1929 before the current cyclical decline began, end of quote.

10:06Now note that Timberlake here uses June 1929 prices as a benchmark as if conditions in June 1929 were normal, not the height of an inflationary boom, which I find personally somewhat problematic. Other economists besides Timberlake has agreed with Friedman and Schwartz, Meltzer in his This history of the Fed essentially adopts Friedman and Schwartz's story as one, the story that increases the reserves for deflationary is one contributing factor to prolonging the Great Depression. Christina Romer in a paper on what ended the Great Depression that she published in 1992 approvingly cites Friedman and Schwartz in her paper, just sort of accepts it as the case.

10:54However, there's not monolithic support for Friedman and Schwartz in the economics literature. Over ten years before Friedman and Schwartz wrote their work, Benjamin Anderson criticized in detail the hypothesis that raising reserve requirements lengthened the Great Depression. Anderson staunchly maintained that the crisis of late 37 and 1938 were in no way caused by the increase in reserve requirements. In supporting his argument, he noted that the increased reserve requirements coincided with very little changes in commercial interest rates. In fact, most interest rates fell during that period of time. Some rates increased slightly, some fell slightly during the relevant time period, most was in some level of decline during the relevant time period.

11:41and at the same time commercial loans increased from approximately 4.8 billion dollars in June 35 to almost 7 billion by the end of 1937. In summary Anderson concludes that no one who was credit worthy was denied credit due to the increased reserve requirements and consequently they did not interfere with commercial activity, commercial bank deposits, issuing of securities or any increase in the price of Securities. Timberlake's analysis of the Federal Reserve requirements, or Federal Reserve's required reserve policy was criticized explicitly by Joe Salerno. Using Timberlake's own statistics, Salerno points out that from June 36 to June 1937, the money supply continued to grow, didn't fall at all.

12:33And so what we then do is take a look at the data, monetary data and interest rate data and lending data, and look to see whether the sort of post-Hawk, ergo propter hawk plausibility of the Friedman-Schwarz hypothesis actually holds water. And looking at the data, we note that the first problem with Friedman-Schwarz's This explanation is that there was no great increase of bank reserves from August 36 to December 37, as Friedman and Schwartz themselves indicate. There was some increase in reserves, but not a great increase, not one that you would think would be large enough to cause a great monetary contraction.

13:32Additionally, if we look, for instance, from the start of the period of increasing reserve ratios in August 36 until January 1938, excess reserves continue to fall, reaching their lowest point by the end of December 1937. Total loans also fell from June 37 to December 37, But that cannot be due to a build-up of excess reserves, because they did not build up excess reserves during that time period. The decline, we argue, is most likely from reduced demand for loans. On the demand side, it was only in the first half of 1938 that total loans declined at the same time that excess reserves rose.

14:24The second problem that we find with Friedman's Theory is that Friedman's Theory requires a policy decline in the money stock, not just bank loans themselves. But the contraction in M1 in 1937 was caused entirely, we argue, from a decline in demand deposits. Since the banks were not building excess reserves, it's likely that this effect, too, was caused by reduced demand for these deposits. People were pulling out bank deposits and moving into other things like currency and non-bank assets. The contraction of M2, which is Friedman's preferred monetary aggregate in 1937, was even smaller than that of M1 because time deposits continued to increase during this period.

15:11As I also already mentioned, interest rates generally fell broadly throughout this period of time, which provides evidence that a reduced supply of credit was not the driving factor behind a reduction in loans, but a drop in the demand for loanable funds. If there was a drop in the quantity of loans due to a decrease in credit being made available by banks, we would expect a significant increase in interest rates, and this was not the case. So we argue, as is clear from the theoretical and empirical analysis, the preponderance of evidence indicates that the Federal Reserve's raising of the legal reserve requirements were not the cause of the recession of 1938.

16:09and one possible implication is that in the presence of the extremely large quantity of excess reserves in our contemporary banking system, raising legal requirements should be considered as an effective or relatively effective method of unwinding our excess reserves with relatively little monetary destabilization. Thank you.