Reserve Requirement As Monetary Policy Tool
A central bank can manipulate the total money supplied in an economy by setting a short term interest rate target. To make market rates comply with the target rate, the central bank lends or borrows to/from banks in the open market.
In a fractional-reserve banking system a bank can use the central bank money to create a multiple amount of that as commercial money. The multiplier is defined by the reserve rate (or capital adequacy ratio) the bank is supposed to hold. The central bank has the authority to set the required reserve rate.
In principal a central bank has thereby two possible means to influence the money supply. It can change the interest rate target and/or it can change the reserve requirement of major banks and thereby the multiplier that transfers central bank money supply into total money supply.
The reserve requirement tool has been weakened in recent years with the Basel accords and in the U.S. other regulatory measures which allow banks to a certain extend to define their effective reserve rate themselves.
Therefore the current 'western' mainstream central banks tend to not change the required reserve rate but do rely on interest rate setting to induce changes the total money supply.
If the economy slumps, they lower interest rates to supply more money, make credit cheaper and allow for more economic expansion. If the economy runs too hot, creating the danger of inflation, the central banks increase the interest target rate and thereby lower the money it supplies through the banking system.
To solely rely on the interest rate target has some problematic consequences. While a low interest rate may be intended to increase industrial production, it also lessens the saving rates as saving at low interest rates becomes unprofitable. Low interest rates encourage to take on debt. While that can be healthy if a loan is used for productive activity, buying overvalued unproductive assets or consuming from debt has negative economic effects.
The Chinese central bank takes a different approach. The Shanghai stock index was around 1,000 in early 2006. It increased to 6,000 in late 2007. This was obviously a overheating market bubble. The Chinese central bank pricked the bubble not by changing its interest rate target as the u.S. Fed would have done, but by increasing the reserve requirement for the major banks step by step from 7.5% in June 2006 to over 11.5% in June 2007. The ability of Chinese banks to make loans to people to buy more overvalued stocks was thereby lowered. With the usual time delay such measures take, the policy was effective and at the end of 2007 the overheated Shanghai index started to decline.
I have long thought that the Chinese way may be better in setting money supply targets because, in my view, it has less negative side effects. But I have to admit that I am no expert in that field and should be careful to argue for a dual central bank policy approach of active use of interest rate targets AND reserve requirement settings.
But the recent market turbulence seems to give the reserve requirement approach some new life.
If central banks decide to again use reserve requirements for monetary policy such requirements must be binding for all financial entities including hedge funds and other parts of the shadow banking system. Via Eurointelligence we learn that some knowledgeable folks start to argue in that direction:
The report was written by group headed by Otmar Issing, and includes Bill White, formerly of BIS, Jan Pieter Krahnen of Frankfurt University, as well Jorg Asmussen, deputy finance minister, and Jens Weidmann, Merkel’s economic adviser.
...
The most important is that all financial companies, whether banks, hedge funds, or banking departments in companies, have to come under a supervisory umbrella, as do all financial products, including CDS, CDO etc. The Issing group also proposes that each bank should hold capital of at least 5% of all its lending (bringing back the spirit of Basle I into Basle II.
Via Yves Smith the proposal of a Japanese expert:
First, adjust capital adequacy ratios to restrain the lending cycle. For example, the 4 per cent target for the tier one capital ratio for banks might be raised to 8 per cent in booms but lowered to 3 per cent in recessions. Cycle-dependent capital ratios would reduce the tendency of banks to lend too generously in booms and too timidly in recessions.
...
Fourth, impose leverage limits to counter the funding cycle. In recent years, some financial institutions became overleveraged as a result of competitive pressures on regulators to lift leverage limits. Such limits should be reinstated on an internationally consistent basis. When times are good, the leverage limits should be lowered in order to prevent overshooting. When times are bad, the limits should be raised in order to spur recovery.
Bush continues his "free market" sham while using $5 trillions to prop up the private banking system. It is unlikely that he will allow the G20 meeting this weekend from to be successful and to introduce better regulation and monetary instruments.
But as the problems induced by adverse effects from interest rate target setting continue to haunt people, the reintroduction of reserve requirements as a monetary tool is likely to gain favor.
Could Obama find a Secretary of Treasury who supports such a policy?
Posted by b on November 14, 2008 at 14:50 UTC | Permalink
In case you all had missed this, Paulson actually had a genius plan for bank reserves that failed along with his original two and a half page long bailout proposal: Failed Bailout Bill Would Have Authorized 0% Bank Reserves
I've no idea how this piece of the scheme developed since then.
Posted by: Alamet | Nov 14 2008 17:36 utc | 2
My thinking on all this is rock-bottom primitive. Super dumb.
Lowering interest rates creates more debt, so more 'future' money, including for the insurers who rake a slice off the top.
When the real economy cannot expand any longer, the debts go unpaid, are defaulted on. Future earnings will not be forthcoming, and all the paper (lending, insuring, hedging, betting, leveraging more, etc.) becomes pretty well worthless. Simultaneously, the sacrosanct ‘market’ (stocks and bonds) thus stumbles and falls, as Cos. are dependent on bank services, and nobody grasps what is going on with them any longer.
The God or Monster of endless growth is shown up to be the King without clothes, naked in the ‘free’ market place. But let us all pretend...
Gvmts buying up the toxic paper, or bad debt, will not help, though it provides a reprieve and time to think.
Posted by: Tangerine | Nov 14 2008 17:43 utc | 3
A commenter brought up in a previous thread the matter of the sharp contraction in global trade as seen in Baltic Dry Index. Here is London Banker on the subject:
Systemic Risk, Contagion and Trade Finance - Back to the Bad Old Days
Sane and sensible... therefore, scary.
Posted by: Alamet | Nov 14 2008 17:57 utc | 4
b,
I doubt this would be possible in the US until the banking system completely crashed. I started working at the Fed in 1980 when the Monetary Control Act took effect, bringing 'all' depository institutions under Fed reserve requirements and money supply reporting. What happened? The banks just invented new deposits like money market accounts and other, for that time, exotic vehicles. interest on savings accounts dropped from 4 or 5% to 1% and the stable money disappeared. Private companies are always a few steps ahead of the regulators in an environment where everything is permitted unless it is very specifically regulated.
While the regulators did a fair job in regulating banks, the main causes of the current crisis came from the non-bank entities. (Were they around long enough to be rightly called institutions?)
Look at the inability of the US and US states to raise gasoline taxes. Now that fuel prices have dropped taxes should be raised, but they won't because it would hurt the poor consumer. The private sector would easily make a similar campaign against imposing more reserve requirements, despite it being in their own best interest in the long run.
Despite his past mistakes, Volcker would probably agree with your objectives. Whether he could implement them means to do them is another story.
Posted by: biklett | Nov 14 2008 18:01 utc | 5
@biklett - Private companies are always a few steps ahead of the regulators in an environment where everything is permitted unless it is very specifically regulated.
Which is why I am for stringent inverse regulation which includes severe penalties.
Everyone is in principle forbidden to do money-money business (borrow-to-lend).
Only regulated companies are allowed to do money-money business.
Only registered and regulated products are allowed to be dealt by these companies and all have to be dealt on full disclosed official exchanges.
Ten years jail for anyone breaking the above rules.
---
@Tangerine - My thinking on all this is rock-bottom primitive. Super dumb. ... When the real economy cannot expand any longer ...
Maybe not so super dumb. Some serious guy had similar ideas:
In general, Marx rejected any idea that the working class (or the unions) ‘cause’ the crisis by ‘excessive wage demands’. He would recognise that under conditions of overheating and ‘full employment’, real wages generally increase, but the rate of surplus-value can simultaneously increase too. It can, however, not increase in the same proportion as the organic composition of capital. Hence the decline of the average rate of profit. Hence the crisis.But if real wages do not increase in times of boom, and as they unavoidably decrease in times of depression, the average level of wages during the cycle in its totality would be such as to cause even larger overproduction of wage goods, which would induce an even stronger collapse of investment at the height of the cycle, and in no way help to avoid the crisis.
why is _everybody_ busy trying to sustain the ruling economic system? outside the new "G20" (G7>G8>G20>G...) do we only have subjects/markets?
Posted by: constant | Nov 15 2008 0:35 utc | 7
Naomi Klein -
Wall Street's Bailout is a Trillion-Dollar Crime Scene
Why Aren't the Dems Doing Something About It?
Posted by: Alamet | Nov 15 2008 0:47 utc | 8
There are 6.7 billion people on earth, and the global economy is now measured in the tens of trillions of dollars each year. Worldwide, what is the average income per person?
A. $1,700 B. $7,000 C. $18,500 D. $35,000B. $7,000 is correct. The world's average income - total world income divided by total number of people - is about $7,000. Still, only about 19 percent of the world's population lives in countries with per capita incomes at least this high.
Countries with an average income near $7,000 include Mexico, Chile, and Latvia. They rank about 40th in the global income table.
As of 2005, people living in rich countries had an average income of about $35,000. The high incomes in these countries make the world average income four times larger than the world median income, which was $1,700 that year.
The Globalist Quiz is produced by The Globalist, a Washington- based research organization that promotes awareness of world affairs. © 2007 The Globalist, theglobalist.com.
Posted by: constant | Nov 15 2008 0:52 utc | 9
Shoppers around the country say they are planning to spend an average of $431 for gifts this holiday season, down from $859 last year according to the twenty-third annual survey on holiday spending from the American Research Group, Inc. The overall average planned spending is down almost 50% from 2007 and it is the lowest level of planned spending recorded by the American Research Group since 1991.
party at the expense of others is over?
Posted by: constant | Nov 15 2008 1:26 utc | 10
Well its Saturday night here so I'll keep it simple:
'America's just one big credit card.'
Posted by: Rick | Nov 16 2008 6:43 utc | 11
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i'd suggest to call this chaos and mayhem effect "the bush effect"..i can almost see it writen on history books..flucking sociopatic frik
Posted by: rudolf | Nov 14 2008 15:44 utc | 1