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Cochrane has proposed a 100% reserves system, not that we're headed there.

See here for the recent Hoover Institution conference on monetary policy: http://www.hoover.org/central-banking-agenda/178156

Cochrane's paper is here: (http://media.hoover.org/documents/2014CochraneMonetaryPolicywithInterestonReserves.pdf) (PDF)

Would love your thoughts on his paper. He argues for keeping the Fed's large balance sheet and using an interest on reserves monetary regime. If we did, he argues it would challenge fundamental assumptions about monetary policy, including where inflation would come from.

Tom: good find! Yes, I think that must be the paper I vaguely remember someone mentioning. Thanks! My second post, the one I'm planning now, will be related.

Now, do you happen to know where I put my memory?

"The first method makes it illegal for banks to borrow short and lend long. The second method flattens the term structure of interest rates so that banks choose to borrow short and lend short."

Cant banks issue term deposits of short maturities and lend long? Is there full reserve requirement on term deposits? Can banks not source funding from equity or securities market?

"The central bank would need to use Open Market Operations (aka "QE") to prevent aggregate demand from falling"

Why will AD fall? If money is neutral AD shouldn't fall. The money supply isnt contracting is it?

"In both cases, the balance sheet of the central bank would be bigger than the balance sheets of all the commercial banks combined."

Is this necessarily true? After all, banks' liabilities include not only deposits but also items for which no reserves are required even under a 100% percent plan.

My calculations indicate that bank reserves were around 2% of total bank deposits from 1973 until fairly late in 2008; they're now at about 28%. Total bank deposits are a little more than $10 trillion (nearly 75% of that is savings deposits) and total reserves are a little less than $2.8 trillion.

So if we were to move to a world in which interest on reserves is used as the tool to reach 100% reserve banking, and if doing so leads to a larger banking sector (and I think you're clearly right that it would), then the Fed's balance sheet would be something on the order of 4 times as large as it is now...and where those additional assets would come from is, indeed, a fairly important question.

Nick,

"Now consider two different ways Canada could move to a banking system with 100% reserves:
1. Regulation. Require banks to hold reserves against deposits, and slowly increase the legally required reserve ratio to 100%.

The first method makes it illegal for banks to borrow short and lend long."

Not exactly. It would make it illegal for banks to lend deposits. There is still the possibility of a commercial bank borrowing from the central bank's discount window and / or a commercial bank issuing short term commercial paper (see dannyb2b's post).

Then you still have to define what a bank is. If a bank is defined as any entity that either lends money or buys bonds, then that definition brings in insurance companies, pension funds, and even some large industrial companies.

Herbert: fair enough. "100% reserves" leaves open the question of what precise set of bank liabilities reserves are 100% of. I have ducked that question here, because I am more interesting in exploring the difference between two ways of achieving the same objective, rather than defining that objective precisely.

danny: you can think of a demand deposit as the limiting case of a term deposit, where the term gets very very short. Where precisely the 100% reserves people would want to draw the line is a question I have ducked here.


"Money is neutral" means that if the money supply falls, so (nominal) AD falls, the price level will fall too by the same percentage, so real variables will not be affected. In my examples here, implementing 100% required reserves, or paying higher interest on reserves, will increase the demand for central bank money, so (nominal) AD will fall. If money is neutral, the only effect would be a fall in the price level, with no real effects. But if prices are sticky, money will not be neutral, and the fall in AD will cause a recession.

Nick Rowe

What are your thoughts on the CB directly interacting with broad public for monetary policy instead of banks so that all expansions of base are permanent? Here is a brief rundown if your interested: cmamonetary.org

Donald: that's US data, right? And US banks are required to keep is it 10% reserves against demand deposits?? Are there required reserves for other deposits? It sounds like they have roughly 100% reserves against *demand* deposits right now though.

Nick,

Here is my proposal to you.

First, please write a post to discuss the role of banks as institutions in the functioning market economy.

And then, based on this role, discuss the functions needed to perform by banks to fulfill that role. What bank features have to be modernized or be abolished.

P.S. I was thinking recently about this. But I like to read other people's ideas as well.

Nick's post said: "Donald: that's US data, right? And US banks are required to keep is it 10% reserves against demand deposits?? Are there required reserves for other deposits? It sounds like they have roughly 100% reserves against *demand* deposits right now though."

Here in the USA, I believe the reserve requirement for demand deposits is 10%. However, I think "sweeps accounts" have lowered the effective reserve requirement since the mid 1990's.

I am pretty sure savings accounts and CD's (term deposits) have a 0% reserve requirement.

Are Reserve Requirements Still Binding?

http://www.ny.frb.org/research/epr/02v08n1/0205benn/0205benn.html

"Since the beginning of the last decade, required reserve balances have fallen dramatically. The decline stems in part from regulatory action: the Federal Reserve eliminated reserve requirements on large time deposits in 1990 and lowered the requirements on transaction accounts in 1992. But a far more important source of the decline in required reserves has been the growth of sweep accounts (chart). In the most common form of sweeping, funds in bank customers' retail checking accounts are shifted overnight into savings accounts exempt from reserve requirements and then returned to customers' checking accounts the next business day. Largely as a result of this practice, today only 30percent of banks are bound by a reserve balance requirement (chart)."

"The first method makes it illegal for banks to borrow short and lend long."

Let's use a 4-year car loan as an example.

Why can't the bank make a 4-year car loan and then issue a 2-year CD along with hoping to issue another 2-year CD later? The bank would be exposed to interest rate risk.

Reserves in the US right now exceed 100% of checkable deposits. (I was assuming a definition of 100% reserves that encompassed all deposits; I've seen both--just checking deposits and all deposits--sorts of proposals.

Donald and TMF: thanks for the data. What it suggests is that what we mean by "100% reserves" can be very fuzzy in practice, especially with loopholes.

You're welcome!

Always watch for loopholes!

Milton Friedman advocated full reserve banking. See 2nd half of Ch3 of his book “A Program for Monetary Stability” under heading “Bank reform”.

As to why full reserve has never been implemented, he gave the reason earlier in the book thus. “The vested political interests opposing it are too strong, and the citizens who would benefit both as taxpayers and as participants in economic activity are too unaware of its benefits and too disorganised to have any influence.”

"The first method makes it illegal for banks to borrow short and lend long. The second method flattens the term structure of interest rates so that banks choose to borrow short and lend short."

I remember my childhood when it was illegal for private restaurants to buy and sell - the first method. Then the Perestroika arrived and the Party wanted to use the second method - let's make the public restaurants so good and attractive so that private restaurants choose not to buy and sell.

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