Tuesday, October 28, 2008

100 Percent Reserves?

Irving Fisher, 1927    Irving Fisher

Today in class I told my students that one way to restore consumer confidence in the banking system was to have the Fed stop injecting liquidity into the system. This is because ultimately it was counterproductive because such actions would lead to inflation. I then pointed to the steepness in the yield curve as an example of growing inflationary expectations. Rather, I suggested that the Fed do the opposite and raise the reserve requirement to 100 percent. This would assure depositors that their money was safe, stop inflation in its tracks, restore confidence in the financial system and raise the value of the dollar worldwide. What is there not to like?

This is not a new idea. Irving Fisher in his 1936 book "100 Percent Money" makes these same points. The Canadian blogger Paul McKeever has an excellent blog on the matter as well (go to blog.paulmckeever.ca). 100 percent reserves would mean that banks could not create money as they do now through fractional reserving. Since as Milton Friedman often noted, inflation is always a monetary phenomena, without increases in the rate of growth of money there is no inflation. The question arises as to how banks would make money under 100 percent reserving. First, the Fed could pay interest on reserves. This is something that the Fed has tried to do for years but the Congress has not allowed it. Second, the banks could borrow money and lend it out. This is exactly what nondepositories such as finance companies and mortgages bankers do. Third, the banks could lend out deposits dollar for dollar at attractive interest rates to those who agree not to withdraw their money for a certain period of time, say one year (see McKeever on this point). Early withdrawals would be subject to severe penalties that would eat into the principal and return depositors less than their original deposit. 

When I was in graduate school Milton Friedman was touting the idea of 100 percent reserves. However, he realized that it had absolutely no chance of being enacted. It probably still has no chance of enactment. But Friedman once said that it took about 50 years for such radical ideas to find traction. It has been only 40 years since I heard him make it the suggestion so there are 10 years to go. So maybe if enough of us support it, who knows what could happen.

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