It would be very easy to repeat the Fed's mistake in 1936 and 1937.

TO BE NOTED: From Bob McTeer:

"The Fed’s Balance Sheet and Excess Bank Reserves

People keep talking and writing about the explosion of the money supply and the coming inflationary tsunami. Let me point out once again that the M1 and M2 measures of the money supply spiked but have since come back down. There is no explosion of the money supply.

I

The monetary base (currency outstanding plus bank reserves) has exploded, and it's graph is indeed startling-startling that is until you realize that excess bank reserves on deposit at the Fed is the reason. We learned to pay attention to the monetary base because it provided the raw material (reserves) from which the banking system can create new money by lending and investing. Because of the money expansion multiplier, the monetary base has been referred to historically as "high powered money."

In today's ongoing financial crisis, however, the base is not being used as the basis for monetary expansion. The accumulation of excess reserves behind the explosion of the monetary base is the result of the weak state of many banks and the fear of bankers that they won't have enough liquidity to meet deposit withdrawals. In other words, the reserves that are excess in a regulatory or legal sense, aren't excess at all in the minds of the bankers. They represent the prudent hoarding of bank cash in uncertain times. Measures to reduce "excess" reserves could, therefore, have disastrous results as banks liquidate assets to restore their liquidity.

This movie has been shown before. It played a significant role in the 1930s when the Fed acted to "mop up" excess reserves in the banking system by raising reserve requirements in 1936 and again in early 1937. Then, as now, the reserves were excess only in a regulatory or legal sense. Under the circumstances bankers did not regard them as excess, and their reaction to the increase in reserve requirements helped prolong and deepen the Great Depression. We should not make the same mistake now.

I find it amazing that I have not heard a single talking head on financial television or read a single article in the financial press about this instructive experience in the 1930s that has such important lessons for today. I suppose it's largely a result of the youth of the pundits these days and their reliance on memory.

What follows is my review of the 1930s episode along with a refresher on money and banking.

II

One might think of the Fed influencing the economy by influencing the reserve base of the banking system to generate more or less lending and money creation. If bank reserves become more plentiful, through Fed loans to banks or open market security purchases, the banks will make more loans or purchase more investments and, in doing so, cause the money supply to expand.

Largely because of gold inflows resulting from the devaluation of the dollar in 1934, banks accumulated large amounts of reserve deposits at the Fed. By 1936 banks had accumulated much more reserve deposits at the Fed than were "required." In other words, they had excess reserves, or substantially more than were required. The Fed came to think of those excess reserves as a buffer or cushion that loosened its rein on the banks. Its policy actions might not elicit the response intended for the banking system. If the Fed added or removed reserves from the banking system, the banks could let losses be absorbed by their excess reserves and might just let additions add to the excess already there.

In an effort to tighten the link between its actions and the banks' reactions, the Fed in 1936 and again in early 1937 raised reserve requirements to mop up the excess reserves. Its intent was to tighten the reins, not to tighten monetary policy. It wasn't tightening policy, it thought, because the reserves absorbed were already in excess. It wouldn't force banks to cut back on lending.

But cut back they did. On Monday morning, it was revealed that those bank reserves were excess only in a legal or regulatory sense. The banks didn't regard them as excess given the uncertain and turbulent times. In effect, the banks own reserve requirement were higher than the Fed's reserve requirement. The banks thought of all their reserves as precautionary balances needed for emergencies; so the increase in reserve requirements had the unintended consequence of a substantial tightening of monetary policy which either made the depression worse or helped cause a double dip recession, whichever you prefer.*

We hear many references today to the "excess liquidity" represented by the large amount of excess reserves on the Fed's balance sheet. Before we recommend doing something about that in the interest of preventing future inflation, we should consider the lesson of the 1930s. Those excess reserves may not be considered excess by their owners, even less so since they do now earn a nominal interest rate. It would be very easy to repeat the Fed's mistake in 1936 and 1937.

*An excellent account of the excess reserve experiment during the depression may be found in Richard H. Timberlake, Money, Banking, and Central Banking. In the first edition, it begins on page 201. Professor Timberlake was my teacher in these matters back in the olden days."