By Warren Coats
To save financial institutions from the collapse that threatened them after the bankruptcy of Lehman Brothers in September 2008, the Federal Reserve purchased government securities and Mortgage Backed Securities (MBS) sufficient to increase the size of its asset holdings from $0.9 trillion to $4.5 trillion by the end of 2014. These large open market purchases were not meant to increase the money supply, the traditional purpose of such operations, which after a sharp drop followed by a sharp increase in the growth rate of broad money (M2) has grown at its historical average rate of around 6% per year. Rather they were to support the market prices of government debt and hard to price MBS in the face of market panic (at least initially).
The Fed accomplished this trick (large increase in the Fed’s asset holding with only modest increases in the money supply) by paying banks to keep the proceeds of their sales of securities to the Fed in deposits with the Fed, so called “reserves,” in excess of what is required, so called “excess reserves.” Beginning in October 2008, the Fed began to pay interest on bank required and excess reserves deposited with Federal Reserve banks. This kept broad money from growing in response to the huge increases in base money (the counterpart of the securities purchased by the Fed) and became the primary tool of monetary policy.
The Fed is now pondering what to do about its abnormally large balance sheet. A year ago it announced its intention to gradually reduce the size of its asset portfolio in order to return to its traditional policy tools—regulating the growth in bank money and credit by targeting the overnight interbank lending rate (the Fed funds rate) via open market operations. After having suspended the open market purchases that had inflated its balance sheet in recent years (QEs 1, 2, and 3), in October 2017 the Fed stopped replacing the maturing securities it held to the extend of about $20 billion per month. As a result its asset holdings dropped about $150 billion in the nine months since then and by the end of June 2018 stood at $4,315 billion. Its current intention is to reduce its asset holdings to $3 trillion by the end of 2022.
The reduction in the Fed’s holdings of these securities (Treasuries and MBSs) is an increase in the market’s holdings of them, other things equal. But other things are not expected to be equal. Our profligate government is expected to run a one trillion dollar deficit in 2019, adding that amount of government debt to the market on top of the Fed’s additions. The Congressional Budget Office projects a worsening federal deficit every year over the next ten of its official forecast, worsening even as a percent of GDP. This will put pressure on the Fed to rain in or suspend its program to return its asset holdings to more traditional levels.
There is a better way to handle this difficult situation. Bank reserves with the Fed are currently about $2 trillion (the rest of the Fed’s monetary liabilities is Currency in Circulation of $1.7 trillion) and banks’ checkable deposits are about the same amount (of which demand deposits are $1.5 trillion). Requiring 100% reserve backing of checkable deposits was recommended in the 1930s by a group of University of Chicago economists as a way to protect our payment system from the loan default problems being experienced by many banks at the time. This so called Chicago Plan would remove any risks to checkable deposits, a key part of our payment system, and thus eliminate the need for deposit insurance for such deposits. Required reserves would continue to earn interest as they do now, but excess reserves would not. But in addition to strengthening our payment system, adopting the Chicago Plan today would convert existing excess reserves into required reserves and end the debate over whether to further shrink the Fed’s balance sheet.
Adopting the Chicago Plan would prevent banks from on lending our checkable deposits. At the moment they are not doing that anyway. This raises the question of where banks would get the funds (our savings) to on lend in their financial intermediary role? In an extreme version of the Chicago Plan (100% required reserves against all deposits and deposit like bank liabilities) all bank lending would be finance by equity rather than debt. Savers would hold claims on the value of a portfolio of loans as they now do with mutual fund investments and as in some Islamic banking instruments. Equity rather than debt financed bank intermediation is a more stable structure as a result of shifting the risk of loses (loan defaults) from banks to the ultimate public investors. The Federal Deposit Insurance Company would stop insuring 100% reserved deposits and its bank resolution functions would be moved to the Office of the Comptroller of the Currency (OCC) in the U.S. Department of the Treasury.
For purposes of requiring a 100% reserve and dropping deposit insurance, a more pragmatic boundary between all deposit liabilities and checkable deposits might include savings deposits (which can generally be shifted into checkable deposits almost automatically) and time deposits with a maturity of less than six months (or maybe three months). This would add almost $10 trillion dollars to required reserves and would need to be phased in gradually. The Fed would need to buy an equivalent amount of government securities in order to finance the increase in required reserves without contracting the money supply or bank credit.
It is very desirable to separate our payment system (checkable deposits of one definition or another) from the necessarily risky lending by banks and other financial institutions and make our money (currency and deposits) risk free. Doing so would allow banks to take whatever risks with investor funds those investors are willing to finance. This would enable a significant reduction in the government’s regulations of these activities. “Changing Direction on Bank Regulation” Cayman Financial Review April 2015
Dr. Coats retired from the International Monetary Fund in 2003 and is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.