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"William F. Hummel" wrote:
> Henry Liu wrote in part:
>
> >To gain support for the Monetary Control Act of 1980, the Fed offered
> >member and non-member banks that, under universal membership, the existing
> >levels of reserves would be lowered for every bank. Reserves required for
> >demand deposits, the checking accounts that represented the core of bank
> >funds, were reduced from 16.25 to 12%. This would mean a substantial loss
> >of revenue for the Fed. The Fed had been paying handsome dividend to the
> >Treasury from surplus income from reserves holding invested in government
> >securities over operating expenses ($9.3 billion in 1979).
>
> (1) The Fed creates reserves by monetizing the debt, i.e. by
> purchasing Treasury securities from the private sector. The
> accumulated portfolio of Treasury securities provides interest to
> the Fed which is its primary source of "income."
>
Fact.
>
> (2) In principle the Fed can monetize as much debt as it chooses
> to. In practice it only monetizes that amount needed to create
> the reserves required to support its target Fed funds rate. An
> excess would cause it to lose control of that rate.
Not according to monetarist principles which state that the Fed should limit
the annual growth of money supply to less than 3% long term. The FFR is
targeted to produce that effect. The money supply generally is not manipulated
to support the FFR, except when Volcker introduced his new operating method
briefly.
>
> (3) The cumulative total of Treasury securities in the Fed's
> portfolio is a function of the monetary base, most of which is in
> the form of currency. It is mainly the leakage of bank reserves
> into currency that forces the Fed to monetize the debt.
> Increased bank lending also forces it to do so.
As I pointed out in my previous post, the number that the bond market and the
Fed watch is the M-1. The actual amount of the M-1 is less significant than
the change which foretells inflation or deflation rates in the near future.
>
> (4) When the Fed (actually the Congress) lowered the reserve
> ratio requirement in 1980, the Fed had to sell a substantial
> portion of its Treasury portfolio to the private sector in order
> to soak up the excess reserves that were created by the Act.
> Otherwise the Fed funds rate would have collapsed.
This observation is tautologous. In my previous post, I tried to show that it
is not that simple. I will go into some detail here. I already mentioned that
the Monetary Control Act of 1980 was Congress' reaction to the Fed's push for
universal membership that it needed for political protection rather than
monetary policy control. The lowering of reserves was a concession made to the
banks, both members and non-members, to win their support for the new act.
Volcker and other Fed officials had fundamental concerns about financial
deregulation, both by institutional reflex and with real apprehension that the
elimination of government interest rate ceilings would weaken the Fed's own
control over the expansion of credit. But the political objective of universal
reserves outweighted the concerns of mechanical control. Volcker warned
Congress, rather disingenuously, that shrinking membership was atrophying the
Fed's "fulcrum for the conduct of monetary policy". As attrition causes the
total amount of reserves held at the Fed to decline, Volcker warned ominously,
the "multiplier" relationship between reserves and money increases tend to
become less stable. Consequently, fluctuations in the amount of reserves
supplied can cause magnified and unintended changes in the money supply. But
the same arguement applies to the lowering of reserves requirements which the
Fed had proposed. In both cases, the total amount f reserves fell. Yet Volcker
was silent on its mutiplying effect on reduced reserve requirements.
>
> (5) That lowered the interest income to the Fed. However the
> Fed typically rebates about 90% of its income. Thus the Fed has
> no need to increase its "revenue" by lowering the reserve ratio
> requirement. That is not a concern to the Fed.
>
You may have misspoken. The Fed decreases "revenue" when it lowers reserves
requirements. It is not accurate that this issue is of no concern to the Fed,
even though no question of Fed operating deficit was involved. But as the
bankers repeatedly complained, the Fed's merry-go-round cash flow with the
Treasury is actually using the banks funds to earn interest for the nation or
the people. Thus cutting down on reserve requirement is an anti-popuplist move
and the Fed was concerned politically with possible criticism. It introduces
fees to check clearing to cushion potential protest. The reserves reduction
amounted to a $5 billion tax rebate to the banks, and this was done at a time
when banks were charging 20% prime rates. The big banks got most of the
rebates while the small banks paid the freight. In 1980, 37% of US families had
no savings accounts. Another 29% had saving balances below $2,000. High
interest resulting from the 1980 Act cost them more in higer prices than they
received in added interest income. The elderly was in similar situation. One
truth about deregulation is that it tends to benefit large customers and
penalize small ones by shifting hidden subsidies to direct cost to customers.
>
> (6) Since bank reserves earn no interest in the US, they are a
> drag on profits. The reason for lowering the required reserve
> ratio was to help US banks compete better with foreign banks,
> most of which have little or no reserve requirement.
>
In 1980, globalization of finance was not in full swing. Foreign banks were not
competing with US banks in any sustantial way. US banks were lending overseas,
but no too many foreign banks lent in the US, except in real-eatate. Besides,
those foreign banks that operated in the US are subject to the same reserve
requirements, and US bank subsidaiaries are not subject to Fed regulations.
Global competitiveness was seldem, if ever, mentioned in any of the
Congressional testimonies related to The Monetary Control Act of 1980.
Certainly, there was no race to the bottom argument in favor of lowering
reserves for US banks to compete with foreign banks. Governor Henry Wallich
was vocal about the Fed's ability to run the economy without any reserve
requirments, as some other central banks did. The discount window makes the
need for reserves redundant.
Henry C.K. Liu
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